Friday, December 2, 2011

Economies of Scale or Economies of Knowledge?

This Post is of an unpublished paper I wrote in 2008 and 2009.  Dr. Chris Marai helped me by commenting and proposing edits.  The concepts it presents and some sections of the writing I subsequently used in my book, Organizational Economics: The Formation of Wealth.  I think it may be of interest.  If there are things with which you don't agree, please comment in the box below this post.  Bob

The Fiction of Economies of Scale and Barriers to Entry[1]
Robert S. Ellinger Ph.D.


The global economy is on the threshold of a change in the structure of industrialization, from mass production to mass customization, whose root cause is the exponential growth of knowledge and the unprecedented ability to store, and communicate this knowledge.  While, a number of leading business and economic thinkers have predicted this change, and while the precursors of this change are already self-evident to many.  The present fluctuations and perturbations of all of the commodity, stock, and financial markets may well be an example.  Firms and other organizations that ignore or miss this new reality will not thrive over the next ten years and may not survive.
There are two ways that growth of knowledge is causing this structural change; by removing economies of scale and barriers to entry, and by creating a collaborative and technology savvy generations, that expect repetitive and non-thinking jobs will be performed by automation.  However, currently, proponents of many mergers and acquisitions and consolidation of industries base their mergers on the twin concepts of economies of scale and barriers to entry.  In today’s global and knowledge-based economies, these concepts are fictional.  While both economies of scale and barriers to entry are real with a constant a given level of knowledge, economies of scale only exist for a given level of knowledge and that as the knowledge increases the economies become diseconomies; barriers to entry function in the same manner.  Further, for the Generation X and Y with their use of technology including the Internet’s collaborative environment, these economic and business cultural concepts will appear as fiction.
The implications of the change in status of economies of scale and barriers to entry from near religious economic axioms to fiction are major.  For example, many more generation X and Y will own small firms, rather than working for large firms.  These small firms will sell innovative products and services.  While the current economic strategy of major corporations is buying entrepreneurial firms to survive, this strategy will become a difficult strategy to execute because the small firms will not be for sale.  Instead, consortiums of small firms will execute large programs and because of automating most of the house keeping (or cost of doing business) functions and because of inter-organizational international standards, they will out-compete the major corporations on quality, cost, and schedule.  For firms embracing this new paradigm there are eight recommended change strategies to enable them to survive and thrive in this new culture and environment.

“Current Shock”

In 1970, A. Toffler in his book “Future Shock” argued that society was, and is, undergoing a revolutionary transformation from the “industrial society” to what he termed a “super-industrial society.”[2]  Further, he argued that this change would overwhelm people, with the accelerating rate of technological and social change leaving them disconnected and suffering from “shattering stress and disorientation,” which he terms “future shocked.”
The paper will discuss two effects of this revolutionary transformation, a fundamental change in economic theory and a shift in culture.  It will then describe how these effects will cause change in the structure of firms and industries.  Finally, it will recommend strategies that will enable firms and other organizations to cope with this transformation.
The fundamental change in economic theory is that two tenets of microeconomics, economies of scale and barriers to entry increasingly are becoming fictional.  The paper will argue that while both concepts are valid as long as the knowledge-based remains constant, once the knowledge-base starts expanding at a rapid rate, the barriers to entry become knowledge barriers to entry and economies of scale become economies of knowledge.
The fundamental change in culture is from regional cultures to global generational cultures caused by the growth of knowledge and the resulting growth in technology.  Until the end of WWII, cultures were solely regional; that is, there was the Far Eastern, the Islamic, the Western European, and so on, cultures.  Each could be mapped with core and peripheral areas, and each was easily sub-divided.  However, since 1945 culture is becoming much less regional and much more generational; that is, the Boomer, the YUPPIE generations, and Gen X and Gen Y.  These cultures occur globally, rather than regionally and are stratified along their acceptance of and acculturation to technology.  Now, 7 and 8 year olds have avatars meet in a virtual club house on the Internet.  North Americans, may have “friends” from Europe, Asia, and South America for their play time; a virtual global village.  They learn to collaborate and team virtually using the technology.  Consequently, technology and knowledge are creating a generation with a completely new set of skills and expectations.
Firms and other organizations that do not prepare, plan, and strategize to take advantage of both workers and customers with these skills, talents, and culture, likely will not survive and thrive in the next 10 to 15 years.  This is the “Current Shock” – “Future Shock Now.”

Are There Really Economies of Scale?

The change in knowledge growing exponentially and technology is defusing this knowledge globally nearly instantaneously.  Further, the increasing knowledge is producing new technology and the technology is enabling the production of new knowledge in an accelerating double helix of cumulative causation. 
Economies of scale occur only when technology and process knowledge is constant.  As the knowledge base grows, economies of scale shrink.  Therefore, in today’s environment, in which information, conservatively, is doubling every two years, economies of scale are fictional, and should be replaced by economies of knowledge.  Further, the paper will posit that the economic concept of the barrier to entry is really the knowledge barrier to entry.

Economies of Scale: The Example of Steel

It is a tenant of economics that there are economies of scale; that large lots of a product can always be made more cheaply than small lots; services can be provided more easily at a large scale than small.  The concept of economies of scale has been “the reason” for many mergers and acquisitions, which may have been true fifty years ago, but are not true now.  This concept permeates business thinking; didn’t Henry Ford reduce the cost of automobile assembly using this concept; didn’t Andrew Carnegie, Paul Mellon, and J.P. Morgan reduce the cost of producing a unit of steel by using the concept of economies of scale?
From the 1970s to the 1990s, the United States steel industry went into a severe decline.  At the time, this decline was blamed on “steel dumping” (i.e., that is selling below cost) from steel plants in emerging economies and the high price of labor in the US due to trade unions. While there may have been some truth in both of these charges, there was a false underlying assumption, that large-scale steel plants can make steel more cheaply than small plants.
The steel industry people based their assumption of the economies of scale on the history of the steel industry.   In 1855, Henry Bessemer took out a patent on a process to turn pig iron into steel economically.   The Bessemer converter could transform batches of 8 to 30 tons of pig iron into steel.  This process produced much larger quantities of steel than the previous processes and at a much lower cost per unit; but the equipment and installation costs were much higher.  This eliminated the weak competitors; meaning those that either culturally are unwilling to adopt the new technology or financially unable to acquire the new converters.  Eliminating many small mills led to concentrating steel making.  “Sharp practices” in the parlance of the day, further concentrated steel making in the hands of Carnegie, Morgan, and a few other “robber barons”, aided an abetted by the railroad barons.  These monopolists sold the concept of this concentration solely on the bases of economies of scale; that is, they needed to concentrate enough demand so that they could use the new tools and processes, which, in turn, would greatly reduce the cost per unit of product.
While President Theodore Roosevelt remediated many of the monopolist practices that caused the “economies of scale”, the concept of economies of scale remains axiomatically fixed in the discipline of economics.  And why not?  After all imperial data demonstrated that there are economies of scale and barriers to entry (that is the economic analog to the sound barrier in physics.)
After WWII, the steel making in the United States underwent a sever decline, in part due to foreign competition.  Other reasons included the price of labor and the costs of meeting new environmental standards, but it was easiest to blame “foreign dumping” that is, selling the steel below the cost of making the steel, in part because there was some foreign dumping.  Killing off the competition by selling below cost had been a favorite tactic of the “robber barons” that built the US steel industry.  Nonetheless, part of the reason that the foreign competition could “sell below cost” (in addition to foreign government subsidies), was that their large integrated steel plants were constructed using modern technology and processes, acquired from the increased metallurgical knowledge base.  That refinement increased the plant’s throughput.
Then in 1968, Nucor Inc. started producing steel in small batches using an electric arc furnace.  This was a complete change in technology based on new knowledge of technology and processes.  These micro-mills could produce specific grades and qualities of steel at prices competitive with the major manufactures.  Further, the cost of building micro-mills is much less, than the integrated steel works.  That is, the economies of scale are less, and the barrier to entry is lower.  So, are there really economies of scale and barriers to entry, or rather, like the sound barrier, economies of knowledge and barriers caused by lack of knowledge?

The Concept of Economies of Scale

The Forbe’s Investopedia has a good and understandable definition of economies of scale,
“The increase in efficiency of production as the number of goods being produced increases. Typically, a company that achieves economies of scale lowers the average cost per unit through increased production since fixed costs are shared over an increased number of goods.”[3]  It goes on to say, “There are two types of economies of scale:
·         External economies – the cost per unit depends on the size of the industry, not the firm.
·         Internal economies – the cost per unit depends on size of the individual firm. 
Economies of scale give big companies access to a larger market by allowing them to operate with greater geographical reach. For the more traditional (small to medium) companies, however, size does have its limits. After a point, an increase in size (output) actually causes an increase in production costs. This is called "diseconomies of scale.”[4]
Internal economies of scale are the most fundamental.  For example, having giant earthmoving equipment (tools) has revolutionized the way many miners mine, especially for low-grade ores.  The cost of moving earth to extract the minerals has been dependent the quantity of earth moved per unit of time; which means that large equipment is more cost efficient than small.  Therefore, the largest trucks ever built are found working in mines.
Yet, if a new chemical or physical process is invented that allows for on sight separation  of minerals from the rest of the material, then, all of the investment in mega-earth moving equipment may become “diseconomies of scale” such as is found in the integrated steel works.  For example, if a low cost chemical method could be found for separating traces of gold from seawater, then gold mines might be outdated.  This example makes the point; there are not economies of scale in a knowledge-increasing environment.  Rather, for a given level of knowledge, there are economies of scale and of barriers to entry, which like the sound barrier are overcome or destroyed by new knowledge.

Adam Smith and Pins

The underpinning example in Adam Smith’s book “Wealth of Nations” is the production of pins.[5]  Using the example of a “trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of pin-making”, he demonstrates that by breaking the manufacturing process into discrete tasks and adding specialized tools, the output per unit of labor is much greater.[6]  By bringing 8 to 10 “pin makers” together, and having each perform one pin-making task with special tools, they could produce 10 times the number of pins as the pin makers could individually.  This produces the effects known as economies of scale and barriers to entry.  That is, individual pin makers could not compete with the pin making organization.  Each individual did not need all of the skills to make a pin, only those for the one task he was doing; so the organization could pay these individuals less (having less skill.) 
Further, individuals invented tools to help themselves make pins of more uniform high quality; in effect, they were embedding some of the skill one function of pin making in the tool, which meant that yet less skilled individuals could make large numbers of uniform quality pins.  For an organization, embedding skill and knowledge in tools (that is, technology) reduced the cost of labor, while increasing the capital necessary to buy the tools—creating a barrier to entry.

The Fiction of Economies of Scale

Frequently, internal economies of scale is cited as the reason for many of the best known mergers and acquisitions, especially in the financial industry.  Firms like Citigroup, J.P Morgan Chase, and so on, which are a product of mergers, are so large that they have difficulty accounting for all of their assets (and their value), let alone demonstrating that they achieved the economies of scale they predicted going into the merger.  In today’s technology and knowledge-based business context, this reasoning may be fallacious.

The Growth of Information Handling

Intel co-founder Gordon E. Moore empirically described the growth of the complexity of integrated circuits in a 1965 paper[7].  Based on the increase in complexity at that time, the paper describes a long-term trend in the history of computing hardware.  In brief, Moore’s Law, as it became known, described that from the invention of the integrated circuit in 1958, the number of transistors that can be placed efficiently on an integrated circuit doubles approximately every two years.  Numerous papers have corroborated this “law” for 50 years and is not expected to stop for another decade at least and perhaps much longer.  Since this empirical law applies equally to all digitally-based devices, in terms of processing speed, storage capacity, and so on, nearly all devices from PCs, to cell phones, to digital cameras, to network switches are improving exponentially as well.
The exponential increase in computing power and the use of that power in handling information has dramatically transformed in nearly every segment of the global economy.[8]  For example, until the 1970s, there were many small financial institutions, like banks, stock brokerages, and insurance firms.  The reason for the number was that after a certain point, the paper-based technologies supporting those organizations’ processes were incapable of supporting more than a relatively small number of customers.  For example, the cost of storing the data in a paper format becomes expensive; in the 1970s the floor space for one file cabinet could total $150 per year, including environmental factors for the storage of paper.  More importantly, the friction caused by simply retrieving the information, the time it would take a file cleric to find one document, even if it was not misfiled, could be a half hour.  At some point, this tool-based friction (paper being the information repository tool in this case) caused diseconomies of scale.
Enter the mainframe computer.  In the 1960s and 70s, with the advent of large-scale computers (those with at least 1MB of memory and 100 MB of storage) house in environmentally controlled rooms (the “glass house”), the cost per retrieval transaction dropped drastically.  However, the sunk costs for the mainframe and glass house, soured; creating new economies of scale and a major barrier to entry.  Consequently, a few of the larger firms in these industries gradually acquired many of the smaller firms because of economies of scale and barriers to entry.
Now, the United States faces mega, and oligopolistic financial institutions, which it cannot to let founder, and which are managed for short-term benefit of its management and shareholders.  At the same time, the cost of computing power has followed Moore’s law so that people carry most of the computer power of an old-technology mainframe in their MP3 player, which is only part of their cell phone.  This means that the technology-based economies of scale and the barriers to entry no longer exist in these industries.  Instead, the mergers and acquisition teams claim that the economies of scale come from the need for relatively fewer employees in large financial institutions as compared with small firms and that large firms are more resilient to risk than small.
As recent events have shown the latter is false, large financial firms can fail, and when they fail, it can damage the entire global economy.  Actually, small financial firms can hurt the global economy much less than large firms and both are only as strong as their management and its decision-making abilities.
A further consequence of Moore’s Law is that it militates against economies of scale.  For example, take large systems purchases. Since these take a large investment, the idea is that the organization will use this investment for an extended period.  However, computing systems become obsolete within 6 months of the time an organization acquires them.  According to Generally Accepted Accounting Practices (GAAP) things that last only 6 months are an expense item; not a capital items.  Therefore, a large investment in computing power is difficult to justify creating further diseconomies of scale.

Organizational Friction

With respect to merging financial firms to reduce labor costs per transaction, that axiom is false too.  The larger firm will always have more people than the two prior firms.  Any organization of more than one person generates organizational friction; simply because consistently clear succinct communications is impossible.  All expend time and energy used to correct a misunderstanding is organizational friction.  Simply put, it reduces an organization’s process throughput, while increasing the costs in time and resources.  As more people are added, the organizational friction increases.  While using standard terms, phrases, help, there is still much violent agreement.  Organizations over twenty people use standardized processes, procedures, and templates to reduce this friction, as well as dividing the organization into functional sub-units, all to reduce organizational friction.[9]
Regardless of how an organization manages its processes and functions, and how formally it is organizes; the organizational friction will increase with size.  One reason is that people miscommunicate; the larger the size, the higher the probability of miscommunication.  Even with standardize processes, procedures, methods, and templates, if these functions and processes are non-repetitive, as in research, design, development and customizing solutions, then standardization will create some process friction; the more inventive, the more friction that formal processes and procedures will create.  When a merger occurs, generally, the management of the new organization is less willing to take risks on inventive ideas, chasing the inventive personnel of both legacy organizations out of the merged organization, so that the general level of inventiveness decreases.  Consequently, large organizations have lower ratio of inventiveness than small organizations.
A second reason is that people can achieve the same result through different processes and procedures.  Just look at Microsoft word; there are several methods, built into the tool, for copying and pasting.  Why; because people work differently, but achieve the same result.  Standardizing a process or procedure helps some people, but hinders others.
A third reason is “span of control” versus “increasing overhead.”  Span of control refers to the number of subordinates that each superior has, be it individuals or departments.  The situation is:
“that with larger spans, the costs of supervision would tend to be reduced, because a smaller percentage of the members of the organization are supervisors [which reduces the organization’s overheads]. On the other hand, if the span of control is too large, the supervisor may not have the capacity to supervise effectively such large numbers of immediate subordinates. Thus, there is a possible trade-off to be made in an attempt to balance these possibly opposing tendencies.”[10]
Much research has found that the span of control should be in the range of 3 to 7 (US Homeland Security specifies 5).[11]  Other experts claim that for very routine jobs (those that are transaction or assembly line-based), one manager can supervise up to 30 subordinates. Davis (1951) divided managerial work into two categories, one requiring the attention to physical work, the other one requiring mental activity. Depending on the type of supervision, a span of 3-8 subordinates for managers at higher levels was considered adequate, while first level supervisors, i.e. those supervising shop floor personnel could have up to 30 subordinates.  While, 30 subordinates per first line manager may be applicable to a shop floor, finance departments have generalized it to include all first line management. The result has been the growth of quality control and quality auditing organizations.  This means that for large financial firms, each account, now, has higher costs of coordination for the “management labor” than smaller firms or has less ability to control the quality of services provided. This is not good where large sums of money are involved.  Either way, the result is diseconomies of scale.
Without technology-based barriers to entry, and with diseconomies of scale due to inherent management risk from either span of control problems or increasing overhead costs, large firms, are doomed, particularly large financial firms.

Economies of Knowledge: The New Reality

The new reality is that with the continuous acceleration of the quantity of data, information, and knowledge collected, any economies of scale are ephemeral.  An investor should treat any economies of scale based merger or acquisition with skepticism.  If it is economies of scale based on technology, it is probably that both the barriers to entry and the reduced costs will disappear shortly and if it is based on reduced labor, that if the organization is large enough, the organizational friction will eat up any cost savings.
However, there is a second culturally based force militating against large organizations and mergers and acquisitions, the up and coming technology generations.  Until the 1950s, researchers did not name generations.  Yet, since WWII, they have been named. These include “The Greatest Generation” (born in approximately 1920 to 1940), the Boomer Generation (born mostly from 1945 to 1965), Generation X or the “Me Generation”, (born in the 1970s and 1980s), and Generation Y or the “Techno” or “Millennium Generation” (born in the late 1980s to the current time, though we may be into Generation “Z?”.) 
The simple fact that researchers and marketers are naming these generations is important.  In the 2000 thousand years or more prior to WWII, there was no such naming and no such importance attached to generations.  Instead, researcher named epochs or ages; the Stone Age, the Copper Age, the Bronze Age, the Iron Age, and so on.  Additionally, these included the Dark Ages, the Middle Ages, the Renaissance, the Industrial Revolution, the Age of Mass Production, the Atomic Age, the Space Age, and the Information Age.  Researchers are describing these human generational epochs in terms of technology, the knowledge gained, or the political environment of the time.[12]

Generation X and Y

Since WWII, knowledge and the consequent technology have grown so exponentially fast and so globally that researchers are treating each generation as separate populations that have grown up with separate characteristics, attributes, values, and cultures, as far different from their parents as the cultures of the Renaissance and the Industrial Revolution.  Consequently, the researchers have named them as such.  The characteristics of generation’s X and Y differ greatly the previous generations and from each other.  The cultural differences are so great that it is the equivalent of a US or EU firm attempting to set up a plant in China, India, or an African country.

Attributes of Generation X

Individuals in Generation X were born early in the period of the transformation from paper information storage and retrieval to automated; from early mainframes to notebook computers, PDAs and cell phones, and the Internet.  Information storage has included, 8 track tapes, cassettes, floppy disks, CDs, and “thumb drives.”  Researchers have not entirely agreed on the cultural characteristic Generation X has derived from this experience, but most maintain that the culture of Generation X includes the following:
·         Are not loyal to an organization, but to themselves.  They have seen how firms treat their parents, laying them off without warning because of management ineptitude in the face of the continuously changing business environment (e.g., technology changes, or globalization), where extremely important skills become obsolete overnight.  So they are always looking for training and certification so they can change organization and survive and get promoted that way.
·         Want challenging work.  Generation X has grown with the exponential growth computing power, per Moore’s Law.  They expect computing and automation to reduce the repetitive work to a minimum.
·         Want the freedom to manage time and work.  Generation X has grown up being self-directed.  Further, since they are not loyal to an organization, they will take a new job that promises more freedom to manage their time and work.
·         Want to work for organizations that understand the value of the individual and nurturing relationship with the individual.
·         Finally, they expect feedback and recognition from the organization.  If not, they will find a new job.
Only employers that can meet these requirements will attract and keep the best personnel.  If the organization is not responsive, it will keep only those that are mediocre, at best.  This is far different from the way many organizations currently treat their personnel.  Large organization, especially, attract transactional managers; managers that manage only to cost, schedule, and company policies, and have no ability to create a sense of vision or mission within their organizations.  This is opposed to transformational managers; managers that lead with vision and a sense of mission.  On the other hand, entrepreneurial organizations are entrepreneurial because of their sense of mission and vision.  These are likely to attract the best and brightest. 

Attributes of Generation Y

Generation Y was born into a computing and networking technology environment.  They expect to be connected with “everyone, everywhere, everywhen.”  They don’t pass notes in class, they “text” one another.  Generation Y expect to be able to call, e-mail, IM, or “Tex” anyone, anywhere, at any time of the day, and they are comfortable with all of these technological forms of communication. This has shaped their culture.[13] 
Again, while researchers have not entirely agreed on the cultural characteristics or attributes of Generation Y, they generally agree that they include:
·         They expect technology.  Generation Y has never been without technology.  They do not “go to the phone”, or login to the computer”; they expect to have computing power, storage, and communications wherever they are.  They have inculcated technology into the daily life, that is, they use it without thinking about using it, like their senses.  Technology enables them to stay connected with their friends and associates.  They use UTube, and Facebook to communicate the way the Boomer Generation used the car and the drive through restaurant to associate.
·         They expect to be connected 24 hours a day, 7 seven days a week.  They work with their friends who are located globally and communicate with their associates whenever they feel like it.
·         They are collaborative.  They use their technology and the global interpersonal networking to work on their personal and professional challenges and opportunities. 
·         They are impatient for answers, whether personal or professional.  Their experience with the technology, including the data and information mining applications on the World Wide Web, and the instantaneous wireless communications in several modes, has taught them to expect it, now.  Additionally, they have grown up in a period of abundance and instant gratification.
·         They work well on teams because they have always had instant collaboration due to the digital and communication support throughout their lives.  These teams do not need to be co-located, but can be virtual in space and time.
·         They are comfortable with change; and in some cases, they expect and embrace it.  After all, they have never lived without constant change in technology and a constant enlargement of their community to include the entire globe.
Generation Y expects change and expects to collaborate and team in unorthodox ways to transform their environment.  Any organization that is too hierarchically driven will find their best minds leaving and making large sums of money off new ideas on which they have collaborated with others.  Immediately, these organizations will be on the going out of business curve.

The Home Office as an Enabler

Another trend is enabling Generation X and Y’s expectations, that is, the home office.  With the increasing ubiquity of high speed Internet and associated software systems, knowledge workers could start to telecommute.  This has advantages for the worker, for the employer, and for the transportation infrastructure.  For the worker, there can be significant time and cost saved in driving forth to and back from work each workday.  Additionally, it allows the worker significant flexibility when they work, allowing for a more balanced work/life experience.  For the transportation infrastructure, fewer vehicles commuting each day, reduces the wear and tear on the system, which in turn, reduces the maintenance costs.  For the employer, the benefits are enormous. Researchers estimate that employers save approximately $15, 000 per telecommuter per year.[14]  Consequently, many large employers have embraced the concept.
However, if a valuable Generation X or Y employee works from a home office there are two negative externalities.  First, they are used to working on their own, with little informal interactions of the “water cooler” variety.  This further decreases the team spirit of the knowledge worker; making him or her feel more like a consultant and less like a team member.  Second, if a telecommuting worker changes jobs, but continues to work from the home office, many of the psychological barriers to change are removed, since all that changes are the voices of the rest of the participants are on the teleconference, the website, and servers on which employee works.  If the websites are poorly designed, the organization’s policies are overbearing, the organization has transactional management (management that is only interested ensuring the policies are followed, e.g., CYA managers), or the salary, benefits, and training are poor, then the employee can easily change employment.

An Assembly Line of Suppliers: Examples of Economies of Knowledge

Given that knowledge is growing exponentially and consequently, the barriers to entry will continue to fall and current economies of scale will disappear (reducing the ability of large firms to compete).  Further, the future leadership is pro transformational management, rather than transactional management (that occurs in large organizations), organizational economics dictates that, over time, large firms disappear, unless propped up by laws and regulations.  The question is what organizational models will replace them?
Currently, several industries have business models based on economies of knowledge.  Researchers and others call these models by terms such as “Mass Customization” (as opposed to mass production), the “Virtual Enterprise”, the “Virtual Extended Enterprise”, and “Next Generation Manufacturing.”  All of these models have one thing in common; they assemble organizations from small component organizations, based on knowledge (in the form of needed core competencies).  These assemblies are of two types, alliances or associations of geographically dispersed firms, all providing the same products or services, and supply chains that design, assemble, and manufacture complex products.
Two examples of the associative model are IGA and Best Western.  The Best Western hotel chain (alliance), founded in 1946, is the world’s largest hotel chain.  The hotels are independently owned and operated.  They are more an alliance than a franchise, since, unlike a franchise, they differ great from hotel to hotel.  The chain formed by formalizing an informal alliance of independent hotels, whose owners would recommend one another’s hotels.  This improved everyone’s business; which is still the reason for the chain.  Today, “the chain” provides two key functions; first, it sets and enforces quality standards for the rooms at each hotel, and second, it provides marketing services, like a reservation system to the hotels.
The Independent Grocery’s Alliance (or IGA), founded in 1926, includes nearly 4,000 independently owned supermarkets worldwide, supported by 36 distribution companies and more than 55 major suppliers.  This is a supply chain, (vertically federated) as well as a marketing (horizontally federated) organization.
Other industries, like the beer brewing industry and the movie industry have started migrating to these economies of knowledge models.  Until the late 1980s, a few major brewers dominated the US market.  The reason was mass marketing and the economies of scale in the brewing process.   However, beginning in the late 1980s, a micro-brewing movement started.  These breweries produce small batches beer with varying characteristics of taste.  Today, these microbreweries produce 20 percent of the industry’s total and continue to increase their percentage of the market.
The Movie Industry, too, continues to migrate to economies of knowledge.  Early in its history, the movie industry consolidated into a few major studios, (e.g., MGM, RKO, Universal, and Disney).  Virtually everyone involved in the industry was an employee of one of the studios, since these controlled the distribution network, that is, the movie theaters.  However, the 1960s, for a number of reasons independent films have become important.  The major studios are still an important marketing and distribution organization, but now a film company forms around a script.  The producers find the resources, hire a director, and the others necessary to produce the film from the various gilds and unions.  This relatively complex organization is relatively ephemeral, since once the film has been completed the organization dissolves.
The Automotive Industry is divesting itself of its internal supply chain.  The best example is General Motors “spinning off” Delphi.  The major auto manufacturers are abandoning their vertically integrated model, which they have used since the industry grew into a mass production industry.  When Henry Ford set about creating the Ford Motor Company he felt that it was necessary to control the complete supply chain, in order to get the materials he required in order to achieve the economies of scale he desired.  Therefore, he bought iron mines, and iron ore transport ships, rubber plantations, glass manufacturing plants, and so on.  Other pioneers followed suite, which created a tremendous barrier to entry.
However, when the Japanese entered the automotive market, they used an entirely different model of a supply chain of many suppliers.  Using the supply chain model for manufacturing was one of the reasons that the Japanese were able to gain global market share.  The US automotive industry took more than 15 years to react, which allowed the Japanese to maintain their competitive advantage and turn the “Big Three” into the “Detroit Three” automakers.
With today’s technology and supplier-base, a visionary model of the automotive industry of the future might be much more akin to the current movie industry.  A consortium of suppliers led by a “general contractor” could design a new vehicle, and set up an assembly line to manufacture it, dependently of any “major” manufacturer; each supplier might set up its own workstation on the assembly line, greatly reducing the barrier to entry.  Examples of these suppliers could include: The Eaton Corporation, Stewart-Warner, TRW, and Magna International.  The general contractor could contract with an association of auto dealers to sell the vehicle.  A prototype of this automotive manufacturing model is found already in racecar and custom car construction.
Generation X and particularly Generation Y take this trend to a further extreme.  For example, in the fashion industry, today’s automated/robotic technology would enable an individual to stand in a booth to get his or her measurements.  The person could then choose a style of garment and see it on a virtual model of him or herself.  They then could choose a material and color, push a pay button and within a day or two have the garment delivered.  This technology has been available for the past 10 years.
There are two reasons that this technology has not established itself in the fashion industry.  The first is a set of cultural behaviors including, shopping behavior as a recreational activity and the need for privacy with respect to body dimensions.  The second is economic including the current investment in the entire apparel supply chain from the fabric makers, to the garment manufacturing, to the apparel marketing industry, to the retailer, and to the mall owners.  Additionally, there is the cost of retooling the industry, given the cost of the new equipment and the current sunk costs by the supply chain.  Sure sounds like barriers to entry.
However, given Generation Y’s propensity to embrace new technology and use it with facility, and given the continued decrease in the cost of automation and robotics, there will be a significant market shift to this type of an apparel industry within the next 5 to 15 years; and it is likely that these manufacturing facilities will be small sized, but serving a global market across the Internet.

Facing Large Challenges with Small Organizations: Swarming

One reason for large organizations is to meet the resource requirements for large challenges or opportunities.  It is difficult to see how many small organizations can construct a mega-cruise ship, or mega-tanker ship.  Yet, other major construction projects create 100+ story buildings, 15-mile tunnels, and 17-mile bridges using just this process.  A general contractor coordinates the other subcontractors and an architectural firm creates the overall design.  This general contractor has two roles.  First, the contractor has the mission to complete the job and produce a product that meets all of the customer’s requirements, both programmatic (cost and schedule) and system (what the system is supposed to do and how well it is supposed to do it.)  Second, the contractor must either enact and enforce or use others’ policies and standards to minimize the process friction among the sub-contractors.
With today’s technology and the emerging technical and business service standards, there is no reason that small firms cannot transform nature’s tactic of swarming to attack these large challenges and opportunities.  For example, in nature, a swarm of bees attacks any animal they feel is threatening their hive.  Again, white blood cells swarm to any wound to fight any invading bacteria and viruses.
The US military is looking at resurrecting a concept used in WWII; that of having many small units (approximately 40 troops) that can swarm to carry out a mission.[15]  Using many small units, each with specialized functions (e.g., infantry, artillery, and so on), coordinated by a mission commander (the analog of the general contractor) is a much more flexible than throwing large units into the mission.  For very large missions, the mission commander could form a command hierarchy for its duration.  When the swarm completes the mission, the hierarchy dissolves.
In WWII the swarming concept was applied to armored units, since prior to the war the US Army produced two doctrines for its use.  The first was as mobile artillery and machine gun support for infantry in breaking through enemy main lines of resistance.  This was the doctrine pioneered in WWI.  The second was the concept of mechanized cavalry.  This doctrine was pioneered at Camp Knox, (later For Knox) in the late 1920s and early 1930s.[16]  The Germans, who visited Fort Knox in 1933, built on this doctrine and implemented it as the “Blitzkrieg” that Hitler’s armies used so successfully in 1939 and 1940. 
By 1944, the US Army had implemented both doctrines.  Armor had separate battalions that the army commanders could assign either to infantry divisions in support of a breakthrough of the enemy’s lines or to armored units to support a breakout behind the enemy.  This demonstrates swarming as an agile strategy.   With today’s technology-based precision strike weapons and command and control systems, swarming is again becoming preferred.  It allows the commander to much more easily mass the correct balance of forces, yet economizes the total use of forces.  Additionally, it enables flexible (or agile) use of the forces available.
If swarming is a favored model of nature, is becoming a favored model of the military, is already in use in some industries, and is sociologically a good fit with the Generation X and Y cultures, then CEOs and investors should expect the expansion of economic swarming of knowledge-based services model in the near future.  This model is the virtual extended enterprise.  Small firms provide these services and vie with one another for a place on a team to build some unprecedented complex system.
One of the first of these swarming “organizations” in the IT industry is “Linux Unincorporated.”  In the 1990s, many computer geeks took umbrage with Microsoft’s dominance of the PC operating system and office products market.  These individuals formed a loose software development confederation.  Each of the approximately 750,000 members of Linux Unincorporated worked on what they were interested in, had the skills for, or had a problem with, with respect to the product, the Linux operating system.  While much of the output this team has been scrapped or superseded, several companies, notably, Red Hat, have marketed some of the best code at very competitive prices.  The net result is that Linux has a small, but significant share of the PC server operating system market.  Their competition is based on their knowledge.  Again, the economies of knowledge and knowledge barriers to entry rule, not economies of scale and financial barriers to entry.

Implications and Recommendations for U. S. Business

The twin concepts of the economies of knowledge and the technology generational cultural gaps will have an enormous impact on US business.   In fact, economic chaos in the financial markets may be part deconstruction caused by the change implied by these concepts.  Large firms will have a difficult time attracting and keeping talent.  As more customers of large firms become accustomed to working with consortia, there will be less emphasis on doing business with known firms and more on getting the right combination of performance, dependability, cost, and schedule.  This change has at least eight implications for US firms.
First, successful organizations must have agile processes and agile systems.  About 1991, the Virtual Extended Enterprise Workgroup of the Agility Forum defined agility as “the ability to respond successfully to unexpected challenges and opportunities.” The reason that firms must have agile processes and systems is that knowledge is increasing so rapidly that in the three to six months it takes to implement a new system, it becomes obsolete.  Consequently, firms will require modular implementation of all products and services.  For example, large mining shovels, some of the largest earth moving equipment, is already being automated to enable increased productivity.  However, it is unclear how modular the control systems are.  However, in the future, all of the onboard electronics will need to be modular, to keep the technology up to date and to enable it to work with the rest of the mine’s automated systems.  These may include measuring the quantity of ore in each bucket, to optimize the loads on the trucks, and sensing impending maintenance problems before they become an expensive repair.
On assembly lines, robotic systems have become the standard because of their agility.  No longer are many large single purpose machines built.  For example, as early as 1985, one furniture manufacturing plant spent an additional significant amount of money to allow their 40 ton metal fabrication presses to have their dies changed in under one hour, instead of the 12 hours normally taken at the time.  With the continued increase in automation and increased modularity of functions, this time has probably dropped to minutes.  This would allow the manufacturer to fabricate of a part on demand, rather than needing to warehouse a large number of parts until needed; greatly reducing costs.
Recommendation: When defining or refining the firm’s processes and supporting systems, especially core competencies, structure them to enable change. 
Second, successful organizations will produce customized products.  This mass customization is a natural result agile processes and systems, as just described.  However, the reason for customization is to increase customer satisfaction.  Since customers like products and services customized to meet their requirements, any firms that can meet or exceed the customer’s requirements will take business from those that produce a product that meets the narrowest common set of customer requirements, as mass production does.
Recommendation: When building or refining the firm’s processes and supporting systems, enable the employees to reconfigure quickly both functions and process flow to enable product customization.
Third, successful organizations will emphasize consistent policies and standards and a consistent and agile governance process for enacting policies and adopting standards.  Modular processes and tools will not work without known and well-described interfaces to connect the modules or hardware and/or software.  Without these policies and standards, there will be an enormous amount of friction at the interfaces among the processes, functions, procedures, and systems.
Without consistent policies, the process or system creates an enormous amount of process friction, as exemplified in the novel Catch 22.[17] If the policies or standards become too numerous or convoluted, the processes and systems will operate as if there was sand in their gears; again, process and system friction.  Only by having a simple governance process for instituting and transforming policies and standards, while maintaining consistency among the organization’s policies and standards, will the organization have the ability to be successful.
Contract policies for standard terms and conditions (T’s & C’s) and business process service level agreement (B-SLA’s) will permeate the supply chain; otherwise, the friction of the supply chain will make virtual extended enterprise (VEE) impossible.  The VEE will spend too much time and budget negotiating and not enough time doing.
Recommendation: When building or refining the firm’s processes and supporting systems a disciplined and flexible governance and policy management  processes are  vital to the organization’s success.
Fourth, consortiums of small organizations will supplement or replace large organizations on programs of significant size.  An organization’s core competencies will become the organization’s services that it can market within the VEE.[18] There are five types of core competencies that will be needed; these are the analog of infantry, armor, and artillery in an army.
·         General Contractor – the organization or service that coordinates development, manufacturing, and operational tasks.  The general contractor is accountable to the customer for defects in the product or service.
·         Teaming partner – an organization or service that provides an overall core competence for the design, manufacture, or operation of some significant portion of the product or service.  The teaming partner shares the overall accountability with the general contractor.  For example, an architect will share in the overall accountability with the general contractor of a new resort complex.
·         Sub-contractor – an organization or service that provides a significant core competence for the design, manufacture, or operation of some significant portion of the product or service.  However, the sub-contractor is accountable only for the portion of the product or service it provides to the general contracting team, and not the customer.  For example, the electrical sub-contractor will be accountable for the installation and/or operations of the electrical subsystems of the resort.
·         Supplier – an organization or service that provides components or materials that meet a standard set of specifications to one of the above.  The supplier is accountable for meeting the stated specifications only.  For example, the supplier of cinder blocks for the walls of the resort is only accountable to ensure that they meet the cinder blocks specifications as given to it by one of the above.
·         Concierge – the service or organization that discovers, evaluates, and maintains a library of core competencies.  The concierge is accountable for its evaluation of other organizations core competencies.
Recommendation: When a medium or large sized firm prepares to meet the challenges and opportunities of the economies of knowledge environment, its executives must evaluate the services of each of the firm’s division and departments to determine what service (core competence) it provides and if the service has value in the firm’s vision and future direction.
Fifth, there will be fewer large development programs and more outsourcing programs with both development and operation components.  Large development efforts require an implementation period of years.  In this period, significant advances in technology may reduce the knowledge barrier to entry to the point that the system is obsolete when the general contractor delivers it.  Therefore, for anything other than projects like constructing a skyscraper or cruise ship, the customer will modularize the project into small efforts.  That is, instead of a single $1B effort over 5 years, it could be 100 $10M efforts, each less than a year, done concurrently as well as sequentially.  This allows the customer and contractor to introduce new technology in the process reducing the risks of obsolescence and total project failure.  Additionally, it allows the customer to both add and update requirements during the construction period and to use the Initial Operating Capability (IOC) while additional portions are constructed.
Recommendation: All firms developing products or transforming systems under contract will need strategies for creating processes that enable short cycle iterative development and implementation.
Sixth, there will be a reduction of the size of successful firms.  The economies of knowledge and the decreasing knowledge barriers to entry, plus the increasing standardization of both technology and business practices are the reasons.  Large firms will have diseconomies of scale due to their overhead of hierarchy of high priced management, when compared with consortia.  Further, with fewer large development and operational programs and many more small programs, there will be less need for large sized firms.
Recommendation: When a medium or large sized firm prepares to meet the challenges and opportunities of the economies of knowledge environment, its executives must flatten the management hierarchy and treat the firm’s core competencies as independent services provided to the global market.
Seventh, there will be an emphasis on transformational leadership rather than transactional management throughout the organization.  Management researchers have defined a transactional manager as a supervisor that ensures that all employees of the organization follow its policies, procedures, and standards.[19] A transformational manager focuses on achieving the organizations mission using its strategies.  When an organization’s policies cause organizational friction sufficient to put its mission at risk, the transformational manager will work to change the policy so that the firm can better meet its challenges and take advantage of its opportunities.  In this new knowledge-based context, changing an organization’s policies, procedures, and standards to enable the organization to take advantage of business and technology challenges and opportunities may be the difference between success and failure; therefore, transformational management behavior will be high priority.
Recommendation: When a firm prepares to meet the challenges and opportunities of the economies of knowledge environment, its executives must not only ensure good governance and enactment policy management processes, but also ensure that both the policies and the personnel enforcing the policies have disciplined flexibility so that policies that run counter to the firm’s business strategies are culled or replaced and that the firm has only those policies necessary to insure a minimum of organizational friction both internally and with suppliers and customers.
Eighth, in this emerging business context, attracting and keeping knowledge workers, not management, will be critical to business (mission) success.  Excellent management without talented and knowledgeable workers will not produce results, but excellent Generation X and particularly Y workers will; and they will need less (transactional) management because of the collaborative culture. This will mean that, in the future, the knowledge workers will get bonuses and extended benefits, either in addition (or instead of) mere management.  Firms, like Google and Microsoft have taken a few initial steps to embrace this culture.
Recommendation: When a firm prepares to meet the challenges and opportunities of the economies of knowledge environment, its executives must ensure that the dysfunctional genius[20] has a significant place in the organization as well as all transformational thinkers.  A firm will need to continue to “court” these people, to the same level they continue to “court” executive talent, in terms of training, tools, and bonuses to keep them, that is, show loyalty to the knowledge worker.   
Like economies of knowledge replacing economies of scale, these eight recommendations run counter to the prevailing quarterly financial business culture.  Yet, executives that dismiss these recommendations are little better than the battleship admirals before Pearl Harbor ignoring the aircraft carrier as only an auxiliary to the fleet. 
The current accelerating knowledge growth rate is invalidating the economic concepts of economies of scale and barriers to entry.  Additionally, the understanding and use of technology by the coming generations are changing the organizational cultures and the economic context of organizations.  Together, these will have a major impact on all firms in all industries globally.  The trend to economies of knowledge will directly effect all stakeholders of large firms, including investors, management, suppliers, workers, and retirees, as well as governmental organizations and the firms’ customer-base.  While there still will be some relatively large firms, these will be far fewer and will have far fewer workers.  Understanding the coming changes and planning for them will ease the transition, which will otherwise be more traumatic than it need be.

[1]The Concepts for this paper were derived from R. Ellinger, Organizational Economics, (unpublished manuscript, 2008)
[2] A. Toffler, Future Shock, (New York: Random House, 1970).
[5] Adam Smith, An Inquiry into the Nature and Causes of The wealth of Nations, (Dublin: Whitestone, 1776)
[6] Adam Smith, An Inquiry into the Nature and Causes of The wealth of Nations, (Dublin: Whitestone, 1776), p.1.
[7] Moore, Gordon E., Cramming more components onto integrated circuits, Electronics, (Volume 38, Number 8, April 19, 1965).
[8] Rauch, Jonathan, The New Old Economy: Oil, Computers, and the Reinvention of the Earth, The Atlantic Monthly,  (January 1, 2001), see 
[9] However, as the number of sub-units increase, the organizational friction will increase because of conflicts and hidden agendas of the management of those sub-units.
[10] Mackenzie, Kenneth D., Organizational Structures, (AHM Publishing Corporation, 1978)
[11] “Span of Control: A supervisory range of three to seven individuals, with the ratio of one-to-five being established as optimum.” Found on :!ut/p/_s.7_0_A/7_0_1OB?navid= HOMELANDICSGL&parentnav=HOMELANDICSC&navtype=RT#glossary_S

[12] While some may quibble that these are very European centric terms, and that is true, nonetheless the growth of human knowledge across the globe is embodied in these terms.
[13] An example of this is a television ad where the Generation X’er admits that her 3 year old (Generation Y) knows more about her computer than she does.
[14] See “Inteleworks Cost-Benefit Analysis Worksheet for a Part-time and Full-time Home-based Teleworker” found at (2001).  This worksheet is based on J. Niles, Managing Telework: Strategies for Managing the Virtual Workforce ().
[15] B. Alexander, How Wars Are Won: the 13 Rules of War from Ancient Greece to the War on Terror, (New York, Three Rivers Press, 2002), pp. 11-20.
[16] M.H. Gille, Forging the Thunderbolt: History of the U.S. Army’s Amored Forces, 1917-45, (The Military Service Publishing Company, 1947).
[17] J. Heller, Catch 22, (New York: Simon and Schuster, 1961).
[18] See G. Hamel and C. Prahalad, Competing for the Future: Breakthrough Strategies for Seizing Control of Your Industry and Creating the Markets of Tomorrow, (Boston: Harvard Business School Press, 1994) for a discussion of core competency and core business.
[19] P. Northouse, Leadership: Theory and Practice, 4th ed (Thousand Oaks CA: Sage Publications, 2007), pp. 175-207.
[20] Dr. House of the television program “House” is an example of this type of individual.

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