Mental Model 5 | Scale Economics Shared
Sharing Success By Sacrificing Profit, Typically Leads To Greater Success
Our series on mental models continues with Part #4. If you haven’t read the first three, here are the links:
Mental Models #1 - The need for a lattice of mental models, Charlie Munger
Mental Models #2 - Commercial democratization as a mental model
Mental Models #3 - Incrementally better isn’t enough, be fundamentally different
Mental Models #4 - Ideas have no value
Mental Models #5 - this article
Mental Models #6 - coming soon
There are more to follow in the weeks ahead. Don’t miss them, sign up and we’ll send them directly into your inbox:
Spotting Winners
Nick Sleep, the former fund manager behind the famous Nomad Investment Partnership, had a knack for breaking down investment ideas. One of his favorite concepts was something he called "scale economics shared." The idea is simple: when a business grows and becomes more efficient, it shares those benefits with its customers by lowering prices. This creates a kind of positive loop: lower prices bring in more customers, which increases scale and market share, leads to more efficiency, and results in even lower prices. Pretty clever, right?
Now, compare that to how some businesses used to operate back in the late 1800s. As the U.S. was booming, industries like steel, railroads, and oil needed huge investments to get off the ground. This led to the rise of the so-called "robber barons" like John D. Rockefeller (Standard Oil), Andrew Carnegie (Carnegie Steel), and railroad giants like Cornelius Vanderbilt, Jay Gould, and Leland Stanford. These guys built monopolies by buying out their competition and creating massive trusts, giving them the power to control prices however they wanted.
The problem? They weren’t exactly playing fair. Workers were exploited, competitors were crushed, and prices for the average consumer were sky-high. Eventually, people got fed up, and this led to big changes. In 1890, the government introduced the Sherman Antitrust Act to fight back against these monopolies. It was a game-changer, and President Teddy Roosevelt, known as the "trust-buster," made it his mission to restore competition. By 1911, Standard Oil was split into 34 different companies, putting an end to its stranglehold on the industry.
Nowadays, the Department of Justice keeps an eye on companies to make sure no one’s abusing their market power and hurting consumers. But here’s the good news: a business doesn’t have to resort to shady tactics to succeed - scale economics shared is a much better way to win. It starts with putting customers first and many of today’s winners deploy this strategy, so it is a great mental model for investors to have in their toolbox.
It should be noted that scale economics shared is not a new concept and can be traced back in history where it worked equally well.
Ben Franklin is best known as one of the Founding Fathers, but he was also a shrewd businessman with interests across a range of industries.
One of his big ventures was his printing business, which produced an early version of a newspaper and a publication which he called ‘Poor Richard’s Almanac’. Over time, Franklin refined his printing technology and processes, making his operations way more efficient than his competitors’. Instead of keeping the extra cash for himself, Franklin did something unusual for his time - he passed the savings on to his customers by lowering prices. Franklin’s lower prices brought in more customers, which in turn boosted his sales. That’s how he turned his printing operation into a powerhouse that ruled colonial America.
Franklin didn’t stop there. He used the same playbook for his retail venture, the "Pennsylvania Stores." Always one to keep costs low, Franklin ran a lean operation, bought inventory in bulk to secure the lowest wholesale prices, and avoided unnecessary expenses. His famous line, "a penny saved is a penny earned," wasn’t just advice - it was his business mantra.
Franklin could’ve boosted margins by charging the same prices as his competitors and pocketing the elevated profits, but that wasn’t his style. Instead he lowered prices, making his store super attractive to customers.
The result? More sales, more scale, and a business that was tough for competitors to challenge. An unintended consequence of this strategy was that it created a "moat" around his business. Running efficiently and thriving on slim profit margins made it hard for competitors to step in and compete.
Franklin was arguably way ahead of his time - he basically invented the idea behind modern discount retailers including dollar stores.
Franklin’s customer-first philosophy inspired some of the biggest names in business today. Companies like Walmart, Costco, Dell, McDonald’s, Southwest Airlines, and Amazon have all embraced the idea of sacrificing short-term profits for long-term dominance. And it’s a win-win: customers love the lower prices, and these companies lock in both loyalty and growth.
Nick Sleep spotted this golden thread running through all of these uber successful businesses and actively looked for others deploying a similar strategy as a precursor to investing. The idea is that as the company grows, it creates a massive competitive advantage, or what Sleep referred to as a "deep and widening moat," making it nearly impossible for competitors to catch up. It’s also a hallmark of businesses that can compound in value over decades.
So, what should you look for? Find businesses with a history of lowering prices as they scale. That’s a sign they’re passing their savings on to customers and building loyalty in the process. While it’s tempting to seek out ever increasing margins, sometimes top line growth and increasing market share is more important for a long-term investment. Big margins attract competition and make it easier for others to disrupt an industry.
“Your margin is my opportunity”
Jeff Bezos
Costco lives and breathes this principle. Their gross margins are capped at 14%, even though most of their competitors enjoy margins of 25% or more. Costco’s "everyday low pricing" (EDLP) is a non-negotiable policy. There’s a great story that demonstrates this perfectly. Costco secured two million pairs of designer jeans at a super low cost - just over $20 a pair. The Costco merchandiser suggested keeping the retail price unchanged as customers had previously shown a willingness to pay and it would still be half the price other stores charged for the same jeans, thereby earning Costco a bigger profit. But founder Jim Sinegal shot this idea down. His reasoning? If they bent the rules once, they’d want to do it again and this behaviour would spread like cancer, destroying the ethos of the business. Instead, they passed all the savings directly to customers. That commitment to the model is a big reason why Costco is arguably the best brick-and-mortar retailer in the world today, despite having the lowest margins.
TSMC, the semiconductor giant, operates similarly. Founder Morris Chang built his business by leveraging massive scale and advanced manufacturing tech to drive costs down, which he used to be more competitive on pricing. He had deployed a similar model at Texas Instruments where he had been formerly employed.
And then there’s Herb Kelleher at Southwest Airlines, who applied the same principle to air travel, making Southwest the most successful domestic airline in U.S. history.
Amazon plays the same game, especially with Amazon Web Services (AWS), its cloud computing arm. Jeff Bezos explained it perfectly in a shareholder letter: “Amazon constantly lowers prices for customers as it grows more efficient, even though the "math" might suggest raising prices is smarter in the short-term.” Bezos argued that continually passing savings on to customers creates a virtuous cycle - lower prices drive more customers, which drives more growth and thereby creating long-term value in the business. It isn’t about optimizing the profit that can be squeezed out of customers today, it is instead about optimizing the lifetime value of each customer.
If a successful business is one that creates value for its customers and is able to capture a fraction of that value for itself, it becomes evident that extracting too much value for itself is counter productive. While building the castle is one thing, protecting it from attack is where many fail. A great CEO will protect his castle by maintaining its moat at all costs. That is exactly what Bezos did by deploying protective pricing. By 2012, six years after launching AWS and with very little competition, he had introduced 23 price reductions across the board for all AWS services. By 2013 this had increased to 40, and by 2015 the tally stood at 51 price reductions.1
These companies might operate in wildly different industries, but their success isn’t random. They’re all leaders because they mastered the "scale economies shared" model.
Funny enough, a lot of investors still think the best businesses are the ones with the highest profit margins. As these examples show, that’s not always the case. Instead, using this mental model might lead you to a completely different, and often better conclusion.
Here’s how to spot a business that nails the "scale economies shared" model:
Gaining market share: Evidence of gaining market share over time as their value proposition improves relative to competitors.
Customer-first mentality: An emphasis on customer value over short-term profits in corporate communications and in its actions.
Relentless efficiency: They’re obsessed with finding ways to do things better, faster, and cheaper.
Thin margins, strong cash flow: Their profit margins might look slim, but their scale and efficiency generate impressive cash flow.
Loyal customer base: High customer loyalty and low churn.
This model requires serious long-term thinking: leaders willing to play the long game. Unfortunately, most U.S. public companies don’t operate this way. The average CEO tenure is just 4.2 years, which isn’t exactly a recipe for long-term vision. Many leaders are more focused on hitting short-term profitability targets to score bonuses than making decisions that will benefit the business decades down the line. It’s a leadership culture that often puts personal gain over sustainable progress.
Surprised to see Berkshire Hathaway appear in this narrative? You shouldn’t be. Known primarily as a conglomerate, Berkshire Hathaway holds full or partial ownership in a vast array of companies across many industries. Companies become part of the Berkshire family by embodying specific traits, one of which is the "scale economies shared" model.
We’ve already talked about Costco, in which Berkshire was a long-term shareholder, but there are plenty of other examples in its portfolio. Geico in auto insurance, Borsheims in jewelry, Nebraska Furniture Mart and RC Willey in homeware business, Shaw Industries in carpeting, Fruit of the Loom in apparel, and ISCAR/IMC in tools all operate on this principle. Even its industrial giants like Burlington Northern Railway and Berkshire Hathaway Energy focus on being low-cost providers that deliver exceptional customer value.
Take Geico, for instance. It limits its underwriting profit to just 4%. If the combined ratio (an insurance profit metric) starts to swell, Geico lowers premiums instead of pocketing the excess. This isn’t about being generous - it’s a tried and tested strategy. By offering better value, Geico attracts and keeps more customers, which drives volumes and boosts overall profits.
“Be the low-cost seller and thereby generate enough volume to drive top-line sales for superior bottom-line results.”
Warren Buffett
This approach isn’t just smart, it’s scalable and sustainable. And it’s a big reason why businesses like those in the Berkshire portfolio continue to dominate their industries.
While most of the companies mentioned in this article are well known established names, if you are able to identify newer businesses that have exceptional management which recognizes the power of scale economics shared, it may be worth short-listing them as investment targets.
A few spring to mind, all coincidentally in the financial sector.
NuBank, David Vélez, CEO of Nubank, has frequently emphasized that reducing costs for customers is a foundational principle of Nubank’s strategy. Vélez has noted that by keeping customer costs low, Nubank not only attracts more users but also grows trust and customer loyalty. This strategy helped Nubank amass over 80 million users in the region, all while sustaining a competitive edge in a challenging banking market.
Wise Plc (formerly TransferWise) has built its reputation on offering low-cost international money transfers by passing on cost savings to customers.
“Greater speed and efficiency, coupled with greater scale reduces our unit costs. This allows us to sustainably reduce prices over time while still achieving our targeted margins.”
Kristo Käärmann, Co-founder and Chief Executive Officer, Wise Plc
“We managed to reduce our cross-currency take rate by 7bps to 0.63% in FY22 as compared to 0.70% in the prior year. Reduced unit costs were passed on to our customers. With price reductions being funded in this way we are able to grow the business and strengthen our market position while generating a healthy level of gross profit to reinvest into our future.”
Matt Briers, CFO, Wise Plc
It should also be noted that NuBank and Wise have a significant partnership. This partnership is part of a larger trend where banks and financial institutions are pushing to provide their customers with best-in-class international payments services. The connection between these two corporations, located on entirely different continents, is more than a coincidence. They both share common DNA in relation to the way in which they operate.
Alpha Group Plc is exceptionally well-managed, prioritizing long-term value over short-term profits. Their strategy echoes Jeff Bezos’ approach at Amazon, focusing on maximizing customer lifetime value. By prioritizing the customer experience, even at the expense of short-term profitability, Alpha secures repeat business, ensuring strong future cash flows and increasing the overall value of the company.
Alpha emphasizes integrity over all else by offering simple products that are well suited to the customer’s needs, even if that means sacrificing short-term profit gains for itself. For instance, rather than chasing high margin business by touting complex options, as many of its competitors do, it has adjusted its commission structure to incentivize its sales team to favour simple lower margin solutions which are better for its customers. This resulted in the proportion of revenues flowing from complex options falling from 13% in FY22 to 4% in FY23, thereby aligning with its customer-centric objectives. Alpha’s core customer charter is both “knowing what’s right” and “doing what’s right”.
Conclusion
To wrap up, the scale economics shared strategy offers a powerful way for companies to gain a competitive edge by becoming the lowest-cost producer in their industry. By focusing on economies of scale, operational efficiency, cost control, and technology, businesses can achieve significant cost reductions that enable them to capture more market share and so increase aggregate profits.
This strategy needs to be done properly for it to work. It’s important for management to ensure that cost-cutting flows entirely from increases in efficiency making it difficult for others to compete. In contrast, cost cutting from compromising on quality is likely to damage the brand and reputation of the business, while triggering an industrial price war may jeopardize the economics of the business entirely.
This and much more like it is contained in the book, Fabric of Success available at Amazon.