The Impact of Vertical and Horizontal Differentiation on Minimum Efficient Scale in Investment Banking

We define Business-to-Business service firms as: advertising agencies, audit firms, investment banks, corporate law firms, and management consulting firms. These firms all share certain common characteristics: (i) their primary "asset" consists of the talent and reputation of their professional employees, (ii) compensation for their professional staff is a major cost of doing business, (iii) the services provided by the firms (unlike products) cannot be inventoried, and (iv) their services are marketed not to consumers, but to other institutions. A theoretical model is presented in this paper which explores vertical and horizontal differentiation in service industries. It is predicted that: B2B service firms will vertically differentiate in product quality; lesser (low) quality firms will horizontally differentiate in location (serving a local market), while superior (high) quality firms will horizontally agglomerate (serving clients nationally from a central location). In traditional consumer markets, we often find that larger purchasers are less quality conscious. For example, warehouse stores are oriented to provide relatively low quality service to retail clients who purchase in bulk. In B2B service markets, however, we predict that large purchasers will purchase from high quality firms, and small purchasers will purchase from low quality firms. Lastly, as a corollary to this analysis, we predict that high quality firms will have different cost curves compared to low quality firms. This model is tested using approximately 100,000 transactions from the Public Finance investment banking industry from 1986-1999. We find evidence of the predicted vertical differentiation, as well as clear evidence of horizontal agglomeration among the high quality firms, and horizontal differentiation among the low quality firms. Further, we find support for the proposition that high quality and low quality firms have different cost curves and different Minimum Efficient Scales (“MES”) of operation. This leads to the paradoxical outcome that the low quality firms can be operating at MES (for their quality level), while the high quality firms are still striving to achieve MES (although they are generally much larger than the low quality firms) even as both types of firms compete in the same general market. We test our predictions regarding MES by examining the size of the firms. For the low quality firms, we find that, by revenues, only 12% of the firms are operating below MES. For the high quality firms, we find initially that more than 50% of such firms are operating below MES. However, we find that over time approximately 80% of the high quality firms operating below MES exit the industry. These findings have important implications for firms' marketing strategies. We suggest that, in many B2B service markets, we are likely to see the continued existence of many small low quality regional competitors, while an ever reduced number of large firms strive to reach sufficient size on a global and national basis. Indeed, we suggest that for firms aspiring to be high quality B2B service firms, size may well be the key strategic marketing variable.