Economic Moats: Low-Cost Producers or Economies of Scale

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Economic Moats: Low-Cost Producers or Economies of Scale

Companies that can deliver their goods or services at a low cost, typically from economies of scale, have a distinct competitive advantage because they can undercut their rivals on price. Likewise, companies with low costs can price their products at the same level as competitors, but make a higher profit while doing so.

This type of moat creates a significant barrier to entry, since a prohibitively large amount of capital is often required to achieve a size needed to be competitive in a market.

Wal-Mart

Wal-Mart (WMT) is perhaps the most salient example of a company benefiting from economies of scale, and for good reason. As a dominant player in retailing, the company’s size provides it with enormous efficiencies that it uses to keep costs low. For example, its size allows Wal-Mart to do its own purchasing more efficiently since it has roughly 5,000 large stores worldwide. This gives the company tremendous bargaining power with its suppliers.

Not only does it get its products cheaper, but its size allows it more inexpensive distribution. In addition, it has an enormous amount of information concerning consumer likes and dislikes, and it can spread its best practices across its entire store base.

To see economies of scale in action, let’s assume that Wal-Mart can acquire a DVD from a supplier for $5, while it costs one of Wal-Mart’s smaller competitors $6. It also costs Wal-Mart $4 to distribute the DVD and pay for the overhead costs of the stores, while it costs the smaller competitor $5 to do the same. Wal-Mart can then sell the DVD for $9.50, and still make a $0.50 profit. The smaller competitor can’t charge that little, because at a cost of $11 per DVD, it would be losing money.