View profile

Economies of scale

Economies of scale
By Conor Svensson • Issue #26 • View online
Software continues to eat the world in Web3 too

One of the greatest ways in which we’ve seen technology disrupt industries time and time again is by removing the advantages incumbent businesses have with economies of scale.
Due to their size, incumbents are usually in the fortunate position where their size enables them to produce a good or service at a price that a smaller organisation simply could not.
This size advantage results in firms like Apple being able to manufacture and sell iPhones for $1000, and Samsung their televisions for $300. These are price points that a small business could never dream of achieving due to the high costs of R&D, manufacturing and distribution they face.
The venture capital industry exists to give companies a leg up to help them compete against incumbents, offering capital in return for an upside in the business. However, outside of venture funding, it’s close to impossible to compete against these firms.
It’s not just in electronics and hardware that this occurs, the costs of doing business at scale in many industries such as pharma, finance and travel are huge due not just due to material costs, but also to regulatory and compliance overheads required to operate.
These barriers to entry result in highly profitable markets for those who manage to establish themselves as the leaders, who for many years can be untouched by any significant competition. However, when the competition does appear, it can capture these firms significantly off guard as the ways in which business is done can change significantly.
Marc Andresson’s 2011 essay on software eating the world is one place where we’ve seen the effect of mass disruption from software destroy the advantages held by many an incumbent.
During the past decade or so it manifested itself via the combination of Web2, cloud computing and smartphones. Prior to the emergence of Amazon Web Services (AWS), any firms wishing to host their own web infrastructure had to lease space in a data centre or host their own servers. Both approaches came with cost overheads and tradeoffs such as cost versus redundancy or availability.
Economies of scale greatly benefitted larger firms with their technology infrastructure. They could afford to host their own data centres, which due to their scale were significantly cheaper — computer hardware could be purchased in bulk, with dedicated staff who could service large parts of the infrastructure and reduced relative power costs due to the scale of consumption. All of these factors ensured healthy margins on business activities once operational costs were accounted for.
When AWS was launched, it eroded the advantage that incumbents had with their own dedicated technology infrastructures. Any business regardless of size was able to purchase virtualised servers without the cost or management overheads that were historically associated with such infrastructure. These could be scaled up or down at the touch of a button (or automatically).
This innovation obliterated the economies of scale advantage for technology infrastructure almost overnight, allowing pure-software businesses to scale to a degree never previously thought possible. With companies like Netflix, Airbnb and Uber decimating more traditional industries.
Whilst we’re still early in the evolution of Web3, we’re already seeing ways in which Web3 can impact economies of scale in industry and even where it’s playing out in the world of cryptocurrencies.
The Bitcoin and Ethereum networks have historically relied on the proof of work (PoW) consensus mechanism. Whereby large amounts of electricity are used by the networks’ miners to find solutions to computationally hard mathematical problems, which when solved produce a reward in the form of the native cryptocurrency of the network.
Given access to electricity and computing power are the key resources required by these miners, those organisations running cryptocurrency mining operations have benefitted from economies of scale, enabling them to mine new cryptocurrencies at a lower cost than everyone else. This significant power consumption has also been an ongoing criticism by many of these blockchain networks.
In Ethereum’s case, this is being addressed with the imminent migration to the proof of stake (PoS) based consensus mechanism, where network participants put up a stake in the Ether cryptocurrency to secure the network (generating a yield in the process) . This will reduce the power consumption of the network by ~99.95%.
In addition, the economies of scale benefiting miners will evaporate, as regardless of the size of your stake in the network, the way you stake your Ether is the same, and the return is the same. This equitable access to yield on cryptocurrencies via mechanisms such as staking and DeFi protocols is one of the many benefits offered by decentralised Web3 protocols and applications.
Outside of cryptocurrencies and DeFi, Web3 will likely over time erode some of the benefits large corporations and listed companies enjoy. One such example is in the valuation of companies. It’s not uncommon for public companies to be valued at price/earnings ratios of 20, whereas their equivalent, but smaller private counterparts achieve four to five times earnings at best.
Smaller companies do have a higher risk profile that plays into their valuation, but their lack of liquidity is also a significant factor for them, as shares in them cannot be easily traded by investors. Historically, it was only when companies went public on an exchange that significant liquidity was achieved for investors in them.
We’ve already seen how various types of tokens such as utility or security tokens have the potential to add liquidity to Web3 companies and entities such as DAOs, with early investors able to realise gains far earlier in the life of companies than was historically possible. This isn’t without issues, but this type of company liquidity is likely to become increasingly common in the evolution of Web3.
As support for widespread tokenisation and DAOs become more widely embraced in different jurisdictions, it’s feasible we’ll see structural advantages larger companies have historically enjoyed being replicated in the smaller ends of the scale. We already have greater governance transparency, but coupled with liquidity and reporting obligations it could get interesting. And this is another potential area for the widespread disruption that Web3 is only just getting started with.
If you’d like to learn more about some of the concepts I’ve covered here, I encourage you to read my book “The Blockchain Innovator’s Handbook” for additional background.
Did you enjoy this issue?
Conor Svensson

Subscribe here to get my weekly insights on Web3.

In order to unsubscribe, click here.
If you were forwarded this newsletter and you like it, you can subscribe here.
Powered by Revue