Tesla’s market value broke the $1tn mark on 25th October, turning the car-maker into the sixth company to join that exclusive club together with Alphabet, Amazon, Apple, Microsoft and briefly Facebook. But it is so easy to get caught up in the hype that we sometimes forget basic economics. Many commentaries have been outlining “Tesla’s plan for world domination” and share-owners around the world have bought into these stories. The problem is that they fly in the face of everything I have learned about business.
The other members of the trillion-dollar club are platform companies selling information-based services – Apple is the partial exception, with its iPhone. Tesla has impressive technology, but it’s a product company, selling a physical commodity. This matters for three reasons.
Firstly, Tesla doesn’t benefit from network effects. Platform companies become more valuable the more people use their networks: Google’s search engine attracts more advertisers when more people use it. The value of your Tesla, however, doesn’t increase because your friends also own Teslas.
Tesla’s marginal cost of production is significant. According to economic theory, the fixed costs of creating an operating system like iOS are billions, but the variable costs per user tend towards zero. Physical products are different: there are huge fixed costs in developing a new car, but the variable costs are also large. Building larger car factories provides economies of scale up to a point, but if you make the factory too large there are diseconomies of scale, because of the complex coordination required.
Finally, Tesla doesn’t benefit from customer lock-in. We may not like using Windows, but it would be so tiresome to switch to iOS that we stick with Microsoft. What are the switching costs for car owners? Pretty negligible – you can switch from a Tesla to a Volkswagen with a few minutes of familiarisation.
Put these three points together, and it should be clear that Tesla is operating with a very different economic model to the digital giants. Firms selling information-based products and services live in a world of increasing returns to scale. The only thing stopping them is government regulation. Firms like Tesla live in a world of decreasing returns to scale. Diseconomies of scale kick in eventually, and the lack of switching costs creates more scope for new entrants. Competition, not regulation, is what keeps companies in check.
Just take a look at the market for battery-powered cars today. Tesla came up with a breakthrough design, giving cars enough range to make them viable. But over the last decade every large car manufacturer has poured money into the sector, and they may have already caught up. In the UK, for instance, Mercedes claims the longest range (the EQA can cover 485 miles without a charge, the Tesla S 405 miles). Tesla’s electric vehicles may still offer the best all-round option, but this is a super-competitive market. It doesn’t end up with one or two dominant firms – it ends up as an oligopoly with maybe four or five major players in each region.
Tesla has transformed the car industry – and in a good way. It has forced the big established players to raise their game. But it is operating in a very different part of the business world – the world of decreasing returns – and this means the economics of industrial production will eventually catch up with it. In sum, we shouldn’t buy any sort of comparison of Tesla to the big digital giants.