Course 109: Finding Economic Moats
Economies of Scale
In this course
1 Introduction
2 About Economic Moats
3 High Customer Switching Costs
4 Economies of Scale
5 Intangible Assets
6 The Network Effect

In commodity industries such as oil, steel, and personal computers, economic moats are very difficult to create. Take the airline industry (please). Most travelers are looking for the lowest fare, regardless of the airline. That forces airlines to compete aggressively on price to generate business, which translates into small profits when the economy is hot and large losses when it's not. In fact, according to Warren Buffett, in the entire 100-year history of the airline industry, not one net dollar of profit has been made.

An economic moat is a barrier against competition. When price is the only thing to compete on, there is only one form of barrier--the ability to offer lower prices than your competitors for the same product or service. However, for those rare companies that thrive on being the low-cost provider in a commodity industry, profits are plentiful.

In the airline industry, that low-cost provider is Southwest Airlines LUV. Southwest's entire mission is centered on offering cheaper flights than competitors, without shirking on service. By keeping costs down, it has been able to thrive in an environment that forces many other airlines to take large losses or declare bankruptcy. Southwest has been able to dramatically increase its profits and, subsequently, its stock price.

As the "economies of scale" name implies, many times this lower cost structure comes from being the largest in an industry. This is because the behemoths can typically negotiate better deals from suppliers while spreading their fixed administrative costs over a larger sales base. The bottom line is that if a company can provide a product or service for less than its competitors, it has a major advantage.

Next: Intangible Assets >>

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