I'll give you this.
I do agree that most small local shops could do a better job overall if they could raise the money (problem), double or triple their inventories and support your initial premise. When people return from the LBS wondering why they would go back there especially if the shop never has the few items they really want, or in the size they need, the local store's value is greatly diminished. Stores need to have some critical size regardless of local sales volume. Therefore they need to be large enough to play in the online space as well so either way they can compete on an equal footing with the bigger online retailers - who aren't all that great an often out of stock themselves. Too many issues prevent this, esp. as psimet notes - the distribution conundrum. Or the Trek exclusivity for example which is why I don't bother going to certain stores. But I will agree with the OP on this, you can carry larger inventories with smarter inventory management and sourcing, and still find ways to profit. Too many shops don't do this and you can see the writing on the wall for may of them - poor service, no community or club rides, practically no inventory or dated overpriced junk that you know is going to be marked down in a fire sale next month. The inventory management they could learn from certain manufacturers and distributors that turned to smarter distribution & warehousing, supply chain management to compete.