Right-Sizing The Domestic PPE Industry Is Too Important To Get Wrong

The U.S. government is the main purchaser of domestically made masks and gowns that help protect against Covid. Most individuals and businesses are content to buy less expensive, foreign made PPE, but the federal government wants to ensure that there remains a robust domestic industry that can produce them in case another emergency ensues and foreign countries prohibit exports of PPE, as they did in 2020.

Federal government purchasing rules provide a distinct advantage to small businesses, to the extent that companies that meet the definition of a small business—which for this industry requires less than 750 employees— constitute nearly the entire domestic PPE industry.

The Small Business Administration is in the midst of assessing the thresholds for a small business across the economy to determine whether any of them need to be changed. The trade off is that most industries benefit from economies of scale, and costs fall as a company’s size increases. That means that the lower the threshold for being a small business, the costlier it will be for the government to acquire the goods it requires in a particular industry.

For industries that greatly benefit from economies of scale—that is, where manufacturing requires a significant capital investment—the threshold is generally set higher: The firm needs to sell more products to recoup its investment, and its per-product cost falls as it produces more as well.

However, there really isn’t a good formula for determining the extent to which economies of scale exist in a particular industry. Instead, the SBA came up with another metric to determine the appropriate threshold for a small business: It compares the small business share of the domestic market to its share of total federal contract dollars, and increases the existing size standards when the small business share of total industry receipts exceeds the small business share of total federal contract dollars by at least ten percentage points.

For example, if the small businesses in the ball bearing industry—as defined by the SBA—had 30 percent of the domestic market but only 15 percent of federal contract dollars, then the size threshold would increase so that more firms could bid on federal contracts as small businesses. Ideally, that would result in small businesses having a share of federal contracts proportionate to the size of the market they control.

While this may seem intuitive, it doesn’t work when the government is effectively a monopsonist, which is essentially the case in the Cut and Sew Apparel industry, the one that covers the production of most PPE.

Since it’s practically impossible for a domestic PPE manufacturer to compete with companies that make their products abroad, at a larger scale and with cheaper labor, that leaves the federal government as their only customer. And since the federal government gives a preference to small businesses—defined for this industry as businesses with less than 750 workers—it effectively constrains U.S. firms to be under those limits.

But staying that small imposes a cost on these businesses—who cannot expand too much to take on new contracts, lest they go over the size threshold—as well as the federal government, which must pay more for its PPE because of the size limitations it imposes.

Because small businesses in the Cut and Sew Apparel constitute the entire industry—which solely exists because of the government’s small business contracting preference for them—the SBA is not considering an adjustment to the size threshold for this industry. Small businesses constitute nearly 100 percent of government contracts and the entire market.

But the 750 worker limit does not reflect the optimal threshold for a size cutoff or anything else other than the government-imposed limit that dictates the entire market. If the government is the only buyer, and it gives a preference to small businesses, then that threshold will utterly and completely determine the size of the market.

In effect, the metric for determining the threshold for being considered a small business set forth in the notice of proposed rulemaking is completely meaningless in a market where the government monopsonist’s dictates alone determine the firm size.

This superfluous constraint means that businesses competing to sell the government masks and gowns must bid on many contracts and hope that they get some of them—but not so many that they need to expand beyond the 750 limit.

It also constrains their investment in new plant and equipment; the nature of the industry is such that it behooves companies to have so many workers to fully take advantage of the most up-to-date equipment, but that too would risk putting a company over the size standards, because they would need to increase production—and employees—to make it work.

By hewing to a metric that makes no sense for a market the government dominates, it not only ends up paying more for PPE but it also limits the capacity and flexibility of the industry to supply its needs.

The solution is simple: the government should recognize that where it’s effectively a monopsonist it should ignore its size threshold formula and do the necessary job of considering the entire market—its capital intensity, necessary employment levels, and the strategic importance of the industry—in setting size standards.

Creating small business thresholds for literally thousands of different industries is a difficult task, and it makes sense for the SBA to devise an objective metric for doing so. But at the same time, it needs to be cognizant of the fact that some priorities must come above standardization.

Jim Allen, a principal at Delahaye Advisers, co-authored this essay.