Amazon: The economics of scale: The Amazon, Airtel, and Apple of tomorrow is a small business today – The Economic Times

Clipped from: https://economictimes.indiatimes.com/small-biz/sme-sector/the-economics-of-scale-the-amazon-airtel-and-apple-of-tomorrow-is-a-small-business-today/articleshow/79691276.cms

Synopsis–China’s success as a manufacturing exporter is partially attributable to scale, but historically, India’s policy environment has been allergic to large businesses.

Across the developed and emerging world, a common policy aspiration is support of small businesses. Small businesses are critical to job creation and make significant contributions to economic activity. Small business owners, from the local shopkeeper to the small factory operator, are pillars of their communities. However, the primary objective of economic policy is to create good jobs and provide affordable goods and services for consumers. Large businesses are better equipped to deliver on these objectives, and this is because of economies of scale.

Economies of scale can help lower production costs, distribution costs, and procurement costs.

Scale is an essential aspect of many businesses, especially those that are technology intensive, require large capital expenditure or have network effects. An automobile plant or a microchip factory will not survive if it only serves its local neighborhood, since the significant R&D costs required by these operations have to be spread across a large customer base in national and global markets. Facebook or LinkedIn will be useless without their large user bases. Scale is the reason that most countries have three or four mobile phone providers, not 15 or 20. For each provider, we need millions of customers to support the cost of the license and network infrastructure investments.

China’s success as a manufacturing exporter is partially attributable to scale. Global buyers of manufactured goods such as textiles and electronic components prefer to work with large vendors so that they can fulfill large orders at a low cost. Large established businesses help lower cost and increase choice for consumers, become global market leaders and create high quality formal jobs.

Historically, India’s policy environment has been allergic to large businesses. Before 1991, if a small business faced increased demand for its goods, it could not expand capacity without a ‘capacity license’ from the government. It was difficult to be successful without connections in Delhi. While the capacity licensing restrictions were thankfully lifted in 1991, the aversion to size persisted. Labor laws are more restrictive for large and organized businesses, acquiring large parcels of land is challenging and compliance burden is higher.

Policymakers in India have woken up to the benefits of scale. GST helps level the playing field since it improves tax compliance by both small and large businesses. There has been some progress on labor laws in India. The recent reforms in the agriculture sector will allow organized businesses to bring in technology and scale to the agri sector, increasing India’s export potential in agri products and improving farmer incomes.

Of course, not every economic impact of big businesses is positive. Large businesses that dominate markets due to favorable regulations, regulatory capture, access to natural resources, or monopolistic behavior are bad for consumers and economic growth. As Clayton Christensen famously described in his book, The Innovator’s Dilemma, innovation is often driven by new entrants since large organizations cannot justify the risks and investments needed for breakthrough products. The key to sustainable innovation is sustainable competition.

Large businesses should be challenged by small ones and by foreign competitors. US consumers used to drive clunky gas guzzlers before Toyota started selling highly reliable and fuel-efficient cars in that market. Walmart, the largest brick and mortar retailer in the US, is challenging Amazon’s dominance in e-commerce and now generates $38 billion in online sales a year.

In India most small businesses stay small and fail to scale.These giants, of course, were small once. In 1995, Jeff Bezos was selling books from his garage. Infosys was a small consulting company in Narayan Murthy’s house. While we need to nurture large businesses in India that will become global leaders and create high quality jobs, we also need more startups and small businesses in India that will become market leaders in the future.

Policy makers do not need to favor large businesses over small ones, or vice versa, but rather remove hurdles for businesses of all sizes. On the regulatory side, the tax code needs to be simplified and tax refunds should be processed faster. Access to capital also needs to improve. Much of India’s financial system is organized around collateral based lending. An entrepreneur who is fortunate or resourceful enough to offer collateral such as land or building can get a loan. A growing services-based business struggles to raise financing–lenders in India prefer asset based lending to cash flow based lending. Non bank finance companies are emerging to fill the void but the unmet need is significant. The cost of financing in India remains high. Promising business ideas become unviable in the face of annual interest rates of 15% and short payment cycles.

Equity capital can help fill some of the financing gap. Tech entrepreneurs in Bangalore or Gurgaon can raise venture capital. But unfortunately, venture capitalists do not go visit the food processing company in Indore or the auto parts manufacturer in Aurangabad. Venture capital and private equity investors and non-bank lenders need to increase their focus outside the large metros.

Young businesses do not need a subsidy or any special favors, they need access to financing and fair competition. The Amazon, Airtel, and Apple of tomorrow is a small business today.

(The writer is Managing Director, Zephyr Peacock India)

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