So if coffee plantations competed, each one would expand until it ran into limitations in the form of rising costs or diminishing profits. Using sophisticated techniques from qualitative dynamics and probability theory, I and others have developed methods to analyze increasing-returns markets. The new IBM PCâDOSâs platformâwas a kludge. Initially, as we employ more and more units of variable factors with fixed factors, productivity of both the factors increases. CEOs need to understand which positive and negative feedback mechanisms are at play in the market ecologies in which they compete. Because bulk processing is repetitive, it allows constant improvement, constant optimization. Increasing Returns and Path Dependence in the Economy. But steadily and continuously in this century, Western economies have undergone a transformation from bulk-material manufacturing to design and use of technologyâfrom processing of resources to processing of information, from application of raw energy to application of ideas. There is little need to watch the market every day, and when things are going smoothly the tempo can be leisurely. A new economicsâone very different from that in the textbooksânow applies, and nowhere is this more true than in high technology. It is not possible for the employer to have more complex division of labour and advantageous combination of factors of production, when production is carried on small scale basis and labour intensive technique is adopted, i.e., emphasis is laid on the employment of more labour rather than capital. For this, the CEO employs a financial manager to perform all financial activities. It was at equilibrium and therefore orderly, predictable and therefore amenable to scientific analysis, stable and therefore safe, slow to change and therefore continuous. But over the long term, airlines in fact experience a positive feedback: under the hub-and-spoke system, once an airline gets into trouble, it cannot work the feeder system for its routes properly, its fleet ages, it starts a downward spiral, and it loses further routes. Once DOS/IBM got ahead, it locked in the market because it did not pay for users to switch. And, a fall in cost of production means the operation of law of the diminishing cost or the law of increasing returns. As more and more units of the commodity are produced, the cost per unit goes on steadily falling. Success or failure is often decided not just by the company but also by the success or failure of the web it belongs to. Above all, the rewards go to the players who are first to make sense of the new games looming out of the technological fog, to see their shape, to cognize them. Some productsâlike the IBM PCâstart in the increasing-returns world but later in their life cycle become virtual commodities that belong to Marshallâs processing world. So far, Iâve talked mainly about high tech. Of course, lock-in is not forever. Hence we see psychological jockeying in the form of preannouncements, feints, threatened alliances, technological preening, touted future partnerships, parades of vaporware (announced products that donât yet exist). Now the manager has to identify the sources of funds needed for producing the new product. 3. The two worlds are not neatly split. We can now begin to see that the new style of management is not a fad. It favors an environment free of surprises or glitchesâan environment characterized by control and planning. Bill Gates is not so much a wizard of technology as a wizard of precognition, of discerning the shape of the next game. Novell recognized that NetWareâs success depended on attracting software applications to run on NetWareâwhich was a part of the ecology outside the companyâs control. The Law of Increasing Returns was propounded in the seventeenth century by Antonia Seera. The law of returns to scale analysis the effects of scale on the level of output. But roughly speaking, diminishing returns hold sway in the traditional part of the economyâthe processing industries. Economist Adam Smith identified the division of labor and specialization as the two key means to achieving a larger return on production. Prodigy was first into the on-line services market but was passive in building its subscriber base to take advantage of increasing returns. Similarly, the larger a bankâs or insurance companyâs customer base, the more it can spread its fixed costs of headquarters staff, real estate, and computer operations. With a few changes, Marshallâs world lives on a century later within that part of the modern economy still devoted to bulk processing: of grains, livestock, heavy chemicals, metals and ores, foodstuffs, retail goodsâthe part where operations are largely repetitive day to day or week to week. They surprised me when I first perceived them in the late 1970s. Consider these pros and cons: Convenience. The ability to profit under increasing returns is only as good as the ability to see whatâs coming in the next cycle and to position oneself for itâtechnologically, psychologically, and cooperatively. Economies of scale external to a firm are the result of spatial proximity and are referred to as agglomeration economies of scale. It is a world of psychology, of cognition, of adaptation. In 1939, English economist John Hicks warned that admitting increasing returns would lead to âthe wreckage of the greater part of economic theory.â But Hicks had it wrong. Increasing returns in financial services. Apple indeed dominates its Mac-based ecology. The cabin crew can usefully be âempoweredâ and treated as human beings. So if much downloadable software on the Internet will soon appear as programs written in Sun Microsystemsâ Java language, users will need Java on their computers to run them. So theyâand the commando teams that report to them in turnâwill be treated not as employees but as equals in the business of the companyâs success. According to Dr. Marshall, the law of increasing returns is generally applicable to manufacturing industries as these units are dominated by man. What are the rules? He plays a vital role for using the factors of production in a more proper way. Arrangement of fixed as well as variable factors can be made more effective. In Marshallâs world, antitrust regulation is well understood. Java has competitors. Contrary to recent management evangelizing, a style that is called for in Silicon Valley will not necessarily be appropriate in the processing world. According to the law of diminishing costs as the output increases, average cost per unit goes on diminishing. Barring regulation, consumer banking will then become a contest among a few large banking networks. Certainly, retail franchises exist because of increasing returns. Mechanisms of increasing returns exist alongside those of diminishing returns in all industries. Hence, economies that are available in large scale production, i.e., internal and external economies are helpful for operation of the law of increasing returns. You sit at one. But typically, if these companies try to expand, they run into some limitation: in numbers of consumers who prefer their brand, in regional demand, in access to raw materials. Are these new insights or are they fads? Whoâll be playing? What would happen if Marshallâs diminishing returns were reversed so that there were increasing returns? Welcome to EconomicsDiscussion.net! But the growing base of DOS/IBM users encouraged software developers such as Lotus to write for DOS. A locked-in product may provide a single standard of convenience. They require training. It would be difficult to separate out each thread and to regulate it. In short, it needs to adapt. The law can also be explained in term of diminishing costs. But the more it gains prevalence, the more likely it will emerge as a standard. Letâs look at the market for operating systems for personal computers in the early 1980s when CP/M, DOS, and Appleâs Macintosh systems were competing. Technology Development. 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. Conversely, those who have made a killing on this cycle should not become complacent. Exit may not mean quitting the business entirely. The marginal and average production of the fourth unit will be 10 and 7 respectively. 5.71 and Rs. Increasing returns are the tendency for that which is ahead to get further ahead, for that which loses advantage to lose further advantage. The law of diminishing returns, or the law of variable proportions, acknowledges that a firm can combine its resources in different proportions and still produce the same product. 6.66, Rs. Once users invest in this trainingâsay, the maintenance and piloting of Airbus passenger aircraftâthey merely need to update these skills for subsequent versions of the product. What has to happen if we want to convert this success into an opportunity? Not five-year plans. Because the two worlds of businessâprocessing bulk goods and crafting knowledge into productsâdiffer in their underlying economics, it follows that they differ in their character of competition and their culture of management. In fact, a major part of the economy was subject to increasing returnsâhigh technology. It means demand of each factor can be increased whenever required. This law is also known as the Law of Diminishing Costs. High technology, pursued at this level, is not for the timid. Above all, strategy in the knowledge world requires CEOs to recognize that a different kind of economics is at work. Let’s expand on the idea that the Marginal Cost of Capital repre… But the company itself wound up with a small share of the spoils. Neither world of business is for the fainthearted. 14. In a word, genteel. In manufacturing sector, the nature is not as strong as it is in agriculture sector. It is only on account of several external as well as internal economies in the form of innovations; marketing, publicity, management etc. In the long run, companies and production processes can exhibit various forms of returns to scale- increasing returns to scale, decreasing returns to scale, or constant returns to scale. This fact is clear from table 5 and Figure 5. These two worlds operate under different economic principles. The law of increasing returns is based on the following assumptions: 1. you ask. The profit for a business owner is the difference between the return on capital and the cost of capital. Returns to scale, in economics, the quantitative change in output of a firm or industry resulting from a proportionate increase in all inputs.If the quantity of output rises by a greater proportion—e.g., if output increases by 2.5 times in response to a doubling of all inputs—the production process is said to exhibit increasing returns to scale. These feedbacks are interwoven and operate at different levels in the market and over different time frames. Precisely because processing is low-margin, operations must struggle to stay afloat. What you can do is adapt. But these tactics were not enough. Indivisibility of Factors of Production: One of the Main Reasons which Give Rise to the Law of Increasing Returns is the Indivisibility of Lumpiness of Factors of Production. Many managers have some intuitive grasp of this new increasing-returns world. The question is tricky. The … As this shift has occurred, the underlying mechanisms that determine economic behavior have shifted from ones of diminishing to ones of increasing returns. What strategic issues do you need to think about? But it was launched into a market already dominated by Sun Microsystems and Hewlett-Packard. It is purely a matter of psychology. And part of that resolution, that courage, is also the decisiveness to leave the market when increasing returns are moving against one. They have lost the main game. Systematic risk includes market risk,Market Risk PremiumThe market risk premium is the additional return an investor will receive (or expects to receive) from holding a risky market portfolio instead of risk-free assets. Playing one of the increasing-returns games in the Casino of Technology requires several things: excellent technology, the ability to hit the market at the right time, deep pockets, strategic pricing, and a willingness to sacrifice current profits for future advantage. It tries to pinpoint increased production in relation to factors that contribute to production over a period of time. They flatten because, to be effective, the deliverers of the next-thing-for-the-company need to be organized like commando units in small teams that report directly to the CEO or to the board. In case of 2, 3, 4, 5 units, average cost declines to 8, 6.6, 5.7 and 5 respectively. For example, a profit of 5% or $5,000 wouldn't have existed without the debt capital borrowed by the business if it borrowed $100,000 and paid 10% interest yet earned 15% after taxes. In the early days of my work on increasing returns, I was told they were an anomaly. Where do service industries such as insurance, restaurants, and banking fit in? The knowledge-based part of the economy demands flat hierarchies, mission orientation, above all a sense of direction. What if you hold a losing hand? Success goes to those who have the vision to foresee, to imagine, what shapes these next games will take. Hierarchy dissipates and dissolves. There are many such tables. As more market is captured, it becomes easier to capture future markets. Similarities and Dissimilarities between the Law of Diminishing and Increasing Returns. But by the mid-1980s, I realized increasing returns were neither rare nor ephemeral. Two maxims are widely accepted in knowledge-based markets: it pays to hit the market first, and it pays to have superb technology. If it locks in merely because user base was levered over from a neighboring lock-in, this is unfair. Suppose you are a player in the knowledge-industry casino, in this increasing-returns world. Product differentiation and brand names now mean that a few companies rather than many compete in a given market. Modern economies have therefore bifurcated into two interrelated worlds of business corresponding to the two types of returns. As this reengineering of services plays out, centralized software facilities come to the fore. An aircraftâs safe arrival depends on the captain, not on the flight attendants. Three billion, the croupier replies. Letâs go back to beginningsâto the diminishing-returns view of Alfred Marshall and his contemporaries. 9. Novell managed these cross-product positive feedbacks actively to lock in its market. Pharmaceuticals exist within a network of physicians, testing labs, hospitals, and HMOs. The market risk premium is part of the Capital Asset Pricing Model (CAPM) which analysts and investors use to calculate the acceptable rate interest rate risk, purchasing power risk, and exchange rate risk. And if they did exist, they would last for only a few seconds before being arbitraged away. But their center of gravity is crossing over to the latter. It believed that with its superior technology, it could hold its increasing-returns market to itself. All rights reserved. You can position. They are mechanisms of positive feedback that operateâwithin markets, businesses, and industriesâto reinforce that which gains success or aggravate that which suffers loss. Increasing returns cause products that are ahead to get further ahead. The answer to this question helps … In the increasing-returns world, things are more complicated. 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. Does this mean that hierarchy should disappear in meatpacking, steel production, or the navy? As for technology, Steve Jobsâs NeXT workstation was superb. Over at that one, a game called Web services. Thoseâll emerge as the game unfolds. TOS4. Technologies exist not alone but in an interlinked web, or ecology. Law of increasing returns applies due to following reasons: For instance, it is not possible to break machinery into two parts, nor it is possible to pass it on to another man, nor it is possible to make an organizer to look after two firms just because there is not much work in the firm which has employed the organizer. In the manufacturing industry, new inventions also play a positive role for the operation of the Law of Increasing Returns. With the application of third, fourth and fifth units, it has further fallen to Rs. They exist in mini-ecologies. By contrast, the style of competition in the increasing-returns arena is more like gambling. 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. But it should have been predictedâgiven increasing returns. So in knowledge-based markets, entering first with a fine product can yield advantage. Margins are thin and nobody makes a killing. They begin to operate as the efforts are made by the organizer to expand the production. In the corner is electronic banking. The Internetâs World Wide Web operates within a grouping of businesses that include browsers, online news, E-mail, network retailing, and financial services. On balance, I would favor a high degree of regulatory restraint, with the addition of two key principles: In practice, these principles would mean allowing the possibility of winner-take-all jackpots in each new subindustry, in each new wave of technology. These are important also in the knowledge-based world, but so, too, are other strategies that make use of the special economics of positive feedbacks. In his book Microcosm, technology thinker George Gilder remarked, âThe central event of the twentieth century is the overthrow of matter. Success will strongly favor those who understand this new way of thinking. The key in web building is active management of the cross-company mutual feedbacks. In that world it was reasonable to suppose, for example, that if a coffee plantation expanded production it would ultimately be driven to use land less suitable for coffee. A. These internal and external economies are helpful in reducing the cost of production and increasing the amount of production. It shows that marginal production will increase as the units of capital and labour increase. Exs: diff types of profit margins, return on assets, return on equity Market value or market based Ratios ratios that examine the market value of a company's share price, its profits and cash dividends, and the book value of the firm's assets and relate them to other data items to determine how the firm is perceived in the stock market It is important to understand the ecologies a companyâs products belong to. Often there are several such mechanismsâinterbraided, operating over different time frames, each needing to be understood, observed, and actively managed. We canât say. Unlike products of the processing world, such as soybeans or rolled steel, technological products exist within local groupings of products that support and enhance them. Why should this be so? In other firms, because of the nature of the industry or the firms financial condition, there may be tight liquidity conditions. Copyright © 2020 Harvard Business School Publishing. Each virtual bank will gain in advantage as its network increases. Marshall’s world of the 1880s and 1890s was one of bulk production: of metal ores, aniline dyes, pig iron, coal, lumber, heavy chemicals, soybeans, coffee—commodities heavy on resources, light on know-how. In fact, the art of playing the tables in the Casino of Technology is primarily a psychological one. These questions have come to a head with the enormous amount of publicity generated by the U.S. Justice Departmentâs current antitrust case against Microsoft. Or physicians tied in to an HMO. But over the long term, increasing returns will dominateâeven though their destabilizing effects are not as pronounced as in high tech. This means transferring a user base built up upon one node of the ecology (one product) to neighboring nodes, or products. A locked-in product may obstruct technological advancement. It is on account of this that an organizer or machinery or building or even labourer is lumpy or indivisible. And once DOS locked in the market, its sponsor, Microsoft, was able to spread its costs over a large base of users. One source of this power is increasing returns to scale. It is evident from table 5, that with the application of the first unit of labour and capital, average cost is Rs. C. economics of scale. The law of increasing returns operate in the initial stage due to its idle capacity in the fixed factors of production while the law of diminishing returns operate in subsequent stage because that idle capacity is fully utilized. Active management of such a web can be an important magnifier of increasing returns. The increasing return is the better analysis of price effect as the cost per unit falls when production increases. Therefore, cost per unit goes on decreasing. With the application of the next unit, average cost comes down to Rs. It is important to note that these … One of the marks of our time is that in services everything is going softwareâeverything that is information based. In fact, if technological ecologies are now the basic units for strategy in the knowledge-based world, players compete not by locking in a product on their own but by building websâloose alliances of companies organized around a mini-ecologyâthat amplify positive feedbacks to the base technology. A new product often has to be two or three times better in some dimensionâprice, speed, convenienceâto dislodge a locked-in rival. The theory of increasing returns is new, but it already is well established. At least one factor of production is divisible. Technological products do not stand alone. The producer increases factors of production by 20 per cent and as a result the production of shoes increases by 35 per cent. You can observe. You can be cunning. Let us look at the two cultures of competition. Marshallâs world of the 1880s and 1890s was one of bulk production: of metal ores, aniline dyes, pig iron, coal, lumber, heavy chemicals, soybeans, coffeeâcommodities heavy on resources, light on know-how. Needs to reinvent its purpose, its way of thinking derided by computer professionals find out what! Against Microsoft returns reign in the processing of resources by 1979 was well established may... The same from day to day or even labourer is lumpy or indivisible by the mid-1980s I! ; the second and subsequent disks cost $ 3 should not become complacent practice... Employed the average cost is Rs one world is characterized by planning, and nowhere is this more than. Upgrades, spin-offs, and hierarchy the theory was roughly valid for the other.! 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