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Intellect Economics – Increasing Returns

Our understanding of how markets and businesses is an understanding based squarely upon the assumption of diminishing returns: products or companies that get ahead in a market eventually run into limitations so that a predictable equilibrium of prices and market shares is reached. The theory was in rough measure valid for the bulk-processing, smokestack economy of Marshall’s day. And it still thrives in today’s economics textbooks. But steadily and continuously in this century, Western economies have undergone a transformation from bulk-material manufacturing to design and use of technology—from the processing of resources to processing of information, from the application of raw energy to application of ideas. As this shift has taken place, the underlying mechanisms that determine economic behavior have shifted from ones of diminishing to ones of increasing returns.

Increasing returns are the tendency for that which is ahead to get farther ahead, for that which loses advantage to lose further advantage. They are mechanisms of positive feedback that operate—within markets, businesses, and industries—to reinforce that which gains success or aggravates that which suffers a loss. Increasing returns generate not equilibrium but instability: If a product or a company or a technology—one of many competing in a market—gets ahead by chance or clever strategy, increasing returns can magnify this advantage, and the product or company or technology can go on to lock in the market. More than causing products to become standards, increasing returns cause businesses to work differently, and they stand many of our notions of how the business operates on their head. Mechanisms of increasing returns exist alongside those of diminishing returns in all industries.

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But roughly peaking, diminishing returns hold sway in the traditional part of the economy—the processing industries. Increasing returns reign in the newer part—the knowledge-based industries. Modern economies have therefore become divided into two interrelated, intertwined parts—two worlds of business—corresponding to the two types of returns. The two worlds have different economics. They differ in behavior, style, and culture. They call for different management techniques, different strategies, different codes of government regulation. They call for different understandings. Alfred Marshall and Classic Economics (Diminishing Returns) In order to understand the term “Increasing Returns”, first we must define “Diminishing Returns”. In Marshall’s world of the 1880s and 1890s, there was bulk production which consisted of iron cores, mining, coffee planting, lumber, and coal production, mostly depended on resources rather than know-how. Still, in some cases where bulk production is the case, much of human economic activity suffers from diminishing returns.

For example, in farming, the farmer will first farm the most fertile land with the most valuable crops. To expand the farm’s business, the farmer will have to cultivate progressively less fertile land and will have to grow less valuable crops (once the demand for the most valuable crop has been met). If a coffee plantation expanded production it would ultimately be driven to use land less suitable for coffee—it would run into diminishing returns. So if coffee plantations competed, each would expand until it ran into limitations in the form of rising costs or diminishing profits. The market would be shared by many plantations, and a market price would be established at a predictable level—depending on tastes for coffee and the availability of suitable farmland. Planters would produce coffee so long as doing so was profitable, but because the price would be squeezed down to the average cost of production, no one would make a killing. Marshall said such a market was in perfect competition.

In general, the bigger a business gets, the less optimal its last venture. Today, we can still see the diminishing returns in economy-related with bulk production. Product names and brands tell us that there are few companies rather than many but if these companies wanted to expand their business, they would face some limitations in a number of consumers preferring their brand, in regional demand, or in access to resources or raw materials. And because these products have close substitutes, there would occur an equilibrium or a standard price. There is always a margin and no one can dominate the whole industry. There is another approach in economics which was brought to attention by W. Brian Arthur, called “ Increasing Returns”. Let’s see what happens if a product becomes popular and gets ahead and therefore becomes more popular and dominates the market…

The software industry and the operating systems show increasing returns. If one system gets ahead, it attracts further software developers and hardware manufacturers to adopt it, which helps it get further ahead. In the 1980s, when Dos, Apple’s Macintosh systems, and CP/M were competing, increasing returns started to play their role. CP/M was first in the market and by 1979 was well established. The Mac arrived later but was wonderfully easy to use. DOS was born when Microsoft locked up a deal in 1980 to supply an operating system for the IBM PC. For a year or two, it was by no means clear which system would win. The new IBM PC—DOS’s platform—was a kludge. But the growing base of DOS/IBM users encouraged software developers such as Lotus to write for DOS. DOS’s prevalence—and the IBM PC’s—bred further prevalence, and eventually, the DOS/IBM combination came to dominate a large portion of the market.

That history is well known. But there are several things to be noticed: It was not predictable in advance (before the IBM deal) which system would come to dominate. Once DOS/IBM got ahead it locked in the market because it did not pay users to switch. The dominant system was not the best: DOS was derided by computer professionals. And once DOS locked in the market, its sponsor Microsoft was able to spread its costs over a large base of users and gained enormous revenue. Furthermore, customers find extra value from buying software from a bigger vendor: because more other people use the software, it is easier to exchange files in its data format, it is easier to hire staff that is trained in the use of the software, and it is even easier to find books that explain how to use the software. In other words, the more other people buy a software product, the more likely you are to buy it yourself.

A major part of the economy in fact was subject to increasing returns—high technology. There are several reasons for that: Up-front Costs: High-tech products—pharmaceuticals, computer hardware and software, aircraft and missiles, telecommunications equipment, bioengineered drugs, and suchlike—are by definition complicated to design and to deliver to the market place. They are heavy on know-how and light on resources. Hence they typically have R&D costs that are large relative to their unit production costs. The first disk of Windows to go out the door cost Microsoft $50M, the second and subsequent disks cost $3. Unit costs fall as sales increase. Network Effects: Many high-tech products need to be compatible with a network of users. So if much downloadable software on the Internet will soon appear as programs written in Sun Microsystems’ Java language, users will need Java on their computers to run them. Java has competitors. But the more it gains prevalence, the more likely it will emerge as a standard.

Customer Groove-In: High-tech products are typically difficult to use. They require training. Once users invest in this training—say the maintenance and piloting of Airbus passenger aircraft—they merely need to update these skills for subsequent versions of the product. As more market is captured, it becomes easier to capture future markets. In high-tech markets, such mechanisms ensure that products that gain market advantage stand to gain further advantage, making these markets unstable and subject to lock-in. Of course, this domination of the market is not forever. Technology comes in waves, and being dominant and most popular in a market, such as DOS’s, can only last as long as a particular wave lasts. So, we can usefully think of two economic regimes or worlds: a bulk-production world yielding products that essentially are based on resources with a little knowledge and operating according to Marshall’s principles of diminishing returns, and a knowledge-based part of the economy yielding products that essentially are based on knowledge with little resources and operating under increasing returns.

The two worlds are not neatly split. Hewlett-Packard, for example, designs knowledge-based devices in Palo Alto, California, and manufactures them in bulk in places like Corvallis, Oregon, or Greeley, Colorado. How to manage Increasing Returns. What is needed is the active management of increasing returns: One active strategy is to discount heavily initially to build up an installed base. Netscape handed out its Internet browser for free and won 70% of its market. Now it can profit from spin-off software and applications. Although such discounting is effective—and widely understood—it is not always implemented. Companies often err by pricing high initially to recoup expensive R&D costs. Yet even smart discounting to seed the market is ineffective unless the resulting installed base is exploited later. America Online built up a lead of more than 4.5 million subscribers by giving away free services. But because of the Internet’s dominance, it is not yet clear it can transform this huge base into later profits.

Technological products do not stand alone. They depend on the existence of other products and other technologies. Unlike products of the processing world, technological products exist within local groupings of products that support and enhance them. They exist in mini-ecologies. So, we mustn’t forget that there is another world as a part of the ecology outside the company’s control. Another strategy that uses ecologies is linking and leveraging. This means transferring a user base built up upon one node of the ecology (one product) to neighboring nodes or products. Increasing Returns in Service Industries.  Where do service industries such as insurance, restaurants, and banking fit in? Which world do they belong to? It would appear that such industries belong to the diminishing-returns, processing part of the economy because often there are regional limits to the demand for a given service, most services do consist of “processing” clients, and services are low-tech.

The truth is that network or user-base effects often operate in services. Certainly, retail franchises exist because of increasing returns. The more McDonald’s restaurants or Motel 6 franchises are out there geographically, the better they are known. Such businesses are patronized not just for their quality but because people want to know exactly what to expect. So the more prevalent they are, the more prevalent they can become. Similarly, the larger a bank’s or insurance company’s customer base, the more it can spread its fixed costs of headquarters staff, real estate, and computer operations. These industries, too, are subject to mild increasing returns. Popularity and Clustering Increasing Returns. What do we consider or think about when we are buying a product or a service? It’s certain that we think about a lot of factors such as price, quality, etc. But sometimes and maybe usually, there is a very big effect that perhaps we don’t recognize easily, which is POPULARITY.

Nature tends to promote quantity. Rather than being one, it is better to be 2. People usually act as united. There is an external factor called N, influencing us when making decisions about buying a product. We look at other people, what they are doing? We try to be like the rest. We choose certain products because they are popular and other people are using them? Why %90 of operating systems in the world is Microsoft software? Can you choose something else if your environment is using a different product than yours? This is basically called networking effect and I think that the major cause of Increasing Returns is this. When talking about the intellectual economy, we don’t need a solid product to promote. We can promote ideas or just images. By promoting a certain idea product or image, we can enjoy the benefits of increasing returns in time.

Microsoft Case in Increasing Returns. What should be legal in this powerful and as yet unregulated world of increasing returns? What constitutes fair play? Should technology markets be regulated, and if so in what way? These questions have come to a head with the huge publicity generated by the US Justice Department’s current antitrust case against Microsoft. In Marshall’s world, antitrust regulation is well understood. Allowing a single player to control, say, more than 35% of the silver market is tantamount to allowing monopoly pricing, and the government rightly steps in. In the world of increasing returns, things are more complicated. There are arguments in favor of allowing a product or company in the web of technology to dominate a market, as well as arguments against.

Convenience. A locked-in product may provide a single standard of convenience. If a software company such as Microsoft allows us to double-click all the way from our computer screen straight to our bank account (by controlling all the technologies in between), this avoids a tedious balkanizing of standards, where we have to spend useless time getting into a succession of on-line connection products. Fairness. If a product locks-in a market because it is superior, this is fair, and it would be foolish to penalize such success. If it locks-in merely because the user-base was levered over from a neighboring lock-in, this is unfair. Technology development: A locked-in product may obstruct technological advancement. If a clunker such as DOS locks up the PC market for 10 years, there is little incentive for other companies to develop alternatives. The result is impeded technological progress. Pricing: To lock-in, a product usually has been discounted, and this established low price is often hard to raise later. So monopoly pricing—of great concern in bulk processing markets—is therefore rarely a major worry.

Conclusion. At the beginning of this century, industrial economies were based largely on the bulk processing of resources. At the close of the century, they are based on the processing of resources and on the processing of knowledge. Economies have bifurcated into two worlds—intertwined, overlapping, and different. These two worlds operate under different economic principles. Marshall’s world is characterized by planning, control, and hierarchy. It is a world of materials, processing, of optimization. The increasing returns world is characterized by observation, positioning, flattened organizations, missions, teams, and cunning. It is a world of psychology, cognition, of adaptation.

Technology comes in successive waves. Those who have lost out on this wave can position for the next. The ability to profit under increasing returns is only as good as the ability to see what’s coming in the next cycle, and to position oneself for it—technologically, psychologically, and cooperatively. If you double the size of a business, does it become more or less than twice as valuable? In traditional industries, diminishing returns set in, so getting 100% bigger may only generate, say, 90% more value. In software and other industries governed by increasing returns, getting 100% bigger may generate, say, 150% more value. Thus, the question is not whether bigger is better (it almost always is), but how much better it is to be big.

References:

  • “Increasing Returns and the New World of Business.” Harvard Bus. Rev. July/August (1996)
  • “Competing Technologies, Increasing Returns and Lock-in by Historical Events,” Economic Journal, 99, 106-131,1989
  • Jakob Nielsen’s Alertbox for April 15, 1997
  • “Increasing Returns and Economic Progress”, Economic Journal, 38
  • Class Notes, 2000[/i:7fb70befe2]

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