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ECONOMIES OF SCALE

Just as most of us believe that we would be happier if only we were a little richer, so managers always seem to believe their firm would be more competitive if only it were just a little bigger. They hope for economies of scale, that is, the opportunity to spread fixed costs across a larger volume of output. The banking industry provides many examples.

By the 1970s, it was clear that the United States had too many small, local banks. Some (now very large) banks grew by systematically buying up smaller bank sand streamlining their operations. Most of the cost savings came from consolidating ¬back office ­ operations, such as computer systems for processing checks and credit card transactions and payments.

These economies of scale are the natural goal of horizontal mergers. But they have been claimed in conglomerate mergers, too. The architects of these mergers have pointed to the economies that come from sharing central services such as accounting, financial control, and top-level management.

ECONOMIES OF VERTICAL INTEGRATION

Large industrial companies commonly like to gain as much control and coordination as possible over the production process by expanding back toward the output of the raw material and forward to the ultimate consumer. One way to achieve this is to merge with a supplier or a customer. Consider Du Pont`s purchase of an oil company, Conoco. This was vertical integration because petroleum is the ultimate raw material for much of Du Pont`s chemical production.

Do not assume that more vertical integration is necessarily better than less. Carried to extremes, it is absurdly inefficient. For example, before the Polish economy was restructured, LOT, the Polish state airline, found itself raising pigs to make sure that its employees had fresh meat on their tables. (Of course, in a centrally managed economy it may prove necessary to grow your own meat, since you can`t be sure you`ll be able to buy it.)

Vertical integration is less popular recently. Many companies are finding it more efficient to outsource the provision of many activities. For example, Du Pont seems tohave become less convinced of the benefits of vertical integration, for in 1999 it sold off Conoco.

COMBINING COMPLEMENTARY RESOURCES

Many small firms are acquired by large firms that can provide the missing ingredients necessary for the firm`s success. The small firm may have a unique product but lack the engineering and sales organization necessary to produce and market it on a large scale. The firm could develop engineering and sales talent from scratch, but it may be quicker and cheaper to merge with a firm that already has ample talent. The two firms have complementary resources ¤each has what the other needs ¤so it may make sense for them to merge. Also the merger may open up opportunities that neither firm would pursue otherwise. Federal Express`s purchase of Caliber System, a trucking company, is an example. Federal Express specializes in shipping packages by air, mostly for overnight delivery. Caliber`s RMS subsidiary moves nonexpress packages by truck. RMS greatly increases Federal Express`s capability to move packages on the ground. At the same time, RMS-originated business can move easily on the Federal Express system when rapid or distant delivery is essential.

Complementary Resources

Of course two large firms may also merge because they have complementary resources. Consider the 1989 merger between two electric utilities, Utah Power & Light and PacifiCorp, which serves customers in California. Utah Power`s peak demand comes in the summer, for air conditioning. PacifiCorp`s peak comes in the winter, for heating.

The savings from combining the two firms` generating systems were estimated at $45 million annually.