Economy of scale, high tech and corporatocracy

Fiat‘s CEO, Sergio Marchionne, predicted a few months ago that six large car companies would survive by the end of 2010. In this article that prediction is analyzed, and while an expert thinks it might be a little bit exaggerated, it is also mentioned that it is a fact that the car industry is increasingly collaborating on technological development.

There also is another example in a different market. Almost all of the microprocessors used in desktops and laptops are manufactured by either Intel Corporation or Advanced Micro Devices. In this market it’s nothing new, because both companies have formed a duopoly in this market for years already. Nevertheless, AMD has always a small market share compared to Intel. According to the most recent data of 2008, Intel had a 80,3% market share and AMD had 19,2%. In recent years AMD didn’t manage to turn a profit and encountered difficulty in competing with Intel. Last October AMD decided to transfer it’s production facilities (also called fabs) to a joint venture called The Foundry Company as part of their reorganization plan. With the joint venture, AMD can share production facilities with other companies and cut production costs. As the press release mentions “the cost and complexity increases and capital and research and development costs have become too high”. Soon Intel will be the only company left which can afford it’s own manufacturing facilities, and can spend a lot more money on research and development than AMD. This article from the beginning of 2007 predicted this development, stating that the production and design costs of integrated circuits keep increasing because of technological innovation, and that only the big players can afford their own fabs. AMD apparently isn’t the only one affected by this problem.

The relationship between these examples is the role of economy of scale. There seem to be too much players in both the car market and on the integrated circuits market some companies are too small. To keep earning profits, they have to join forces. In AMD’s case the reason is clear, production and design costs are too high, and as a high tech company they need to spend a lot of money on research and development because they have to keep innovating to be able to compete. This is supported by the fact that their R&D intensity is high, according to data of the top 100 companies with largest R&D spending in 2006. AMD’s R&D intensity was 21,3% and Intel’s was 16,6%. However, in absolute spending that is $1.205 million for AMD and $5.873 million for Intel. This establishes that R&D is quite costly, and that Intel has a serious advantage over AMD because they can spend five times as much money on R&D.

When it comes to the car market however, the reasons are not clear to me. According to the Wikipedia article on high tech, the car industry is medium tech and not high tech, because R&D intensity isn’t so high there. Toyota is on the first spot in the R&D top 100 of 2006, with $7.648 million on R&D spending, but only 3,7% R&D intensity. Many car manufacturers follow closely, with similar relatively low R&D intensity numbers. I theorize that their R&D intensity is low because they can’t afford to spend more money on R&D for some reason. Yet R&D is becoming more important in the car industry, so that’s why they have to increase their efforts to collaborate on R&D, because joining forces for R&D reduces R&D cost. But do they really collaborate on R&D because it is too expensive, or because of other advantages? As the expert in the article on the car market already said, I tend to believe that such a huge decrease in the amount of car manufacturers seems indeed rather exaggerated.

I think there is a rule of thumb for high tech and car manufacturing: because of the knowledge required to operate in the market, economies of scale and large companies are key requirements. I wonder, what would be the consequences in the hypothetical situation only six car manufacturers survive, or AMD wouldn’t survive? In the case of the car market, those six manufacturers would become more powerful, and there would be less diversity. In the case of the microprocessor market Intel would have a monopoly, quite possibly a natural monopoly because it would be difficult for a new competitor to enter the market and compete with Intel. Intel wouldn’t be motivated to keep innovating at it’s current pace if they would have a monopoly. Such a monopoly would certainly be very dangerous, because it would make one company far too powerful. It reminds me of the megacorporation often seen in science fiction literature. In our time megacorporations do not exist, but maybe they could become a reality in the future, when technology will be even more advanced and more important to the society? Possibly we would need a different economic system in the future, different from capitalism, to solve the problem?

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