Increasing returns and the New World of Business

This article by theoretical economist W. Brian Arthur challenges one of the basic economic theories on returns of margin. Up until then, much had been written about the diminishing margins of return by Alfred Marshall and his contemporaries. In Arthur’s words, the old way of thinking was “Well, we have a pretty good product, and if we look after our costs and we manage to execute pretty well, we’ll get our 15% of the market”. This may be true for industrial-age factories or barbershops. However, the principle doesn’t hold for modern industries, especially in the Internet age, as we slowly move further away from a purely industrial economy.

Although published in 1996, the theory of increasing return is at the heart of success for companies such as Google, Facebook, and Uber.

Concept of Decreasing Returns

In the 1880s, Alfred Marshall’s world consisted of bulk production industries like metal ores, coal, and lumber. Industries that produced goods that were heavy on resources, light on know-how. For example, if a coffee plantation continued expanding, it would ultimately run into a shortage of land unsuitable for coffee production. So, in the Coffee market, each company would run into some form of limitations in the form of rising costs or diminishing profits. This concept is the concept of diminishing returns. Over time, the price of coffee would reach the average cost of production ie the market price. Such a market was in perfect competition.

His model still holds true to this day but only within that part of the market economy where bulk processing still prevails: the retail sector. A few brand names exist and compete with each other. But typically, if they try to expand, they run into some limitations (in customers who prefer tier brand, in regional demand, or in access to raw materials). So no single company can corner the market and a standard price slowly emerges for the products.

Concept of Increasing Returns

Increasing returns are the tendency for that which is ahead to get further ahead, for that which loses advantage to lose further advantage. If a product or a company or a technology 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.

Back then, Microsoft’s successful effort to turn Windows into the standard operating system was the primary example of increasing returns in the tech industry. Microsoft worked along with Intel and used increasing returns to wrest control of the entire PC architecture from its inventor, IBM. Microsoft was on track to be the default OS for over 90% of the world’s personal computers.

The more people used Windows (and DOS, its predecessor), the more it benefitted users, manufacturers, and even other software vendors. Users gained from compatibility with other users. PC manufacturers did not have to create unique software for each of their new products. A similar model was successfully implemented by Google with Android in the smartphone market. Apple also started with this same model with their range of Macintosh computers around the same time as Microsoft.

Limitations

The scale of increasing returns is not infinite though. In the case of Uber, the more drivers who sign up for Uber, the faster Uber can reach a customer. The faster Uber gets to a customer, the more customers want to use Uber. The more customers use Uber, the more attractive Uber becomes to drivers. But this cycle cannot go on forever. It plateaus out. Once Uber gets a certain number of drivers in a particular area, doubling the number of drivers will not make much difference.

Why Increasing Returns work

By the mid-1980s, it was clear that more and more companies were leveraging increasing returns and more of the economy was subject to it. The reasons were -

Upfront Costs

Software has high costs upfront but minimal ones later. Developing software requires much time and money; printing and mailing diskettes with code were inexpensive, and delivering code over the internet is even cheaper. This made it a business with great potential for increasing returns.

Network Effects

Companies create products such that the product valuation increases with its user base. As more users sign up for the product, more value can be delivered by the product. Facebook, Uber and Airbnb have done this brilliantly. They produce and keep updating products that rapidly gain customers, and this makes the product even more valuable with more customers. These products also offer linked services such as ads and cross-sell data to other companies, further enhancing the profit.

Customer Groove-in

When Sun Microsystems launched Java in 1995, it was free for all users. Using this advantage over the period of the last 25 years, it gained prevalence and locked in the user base from moving to competitors. Now that it has become a standard, it charges a fee to use the same software. A similar model was followed by Reliance Jio.

Co-Existence

Although the increasing returns model is lucrative and managers want to incorporate this style, it is not a one size fits all solution. There are two cultures of competition.

In bulk processing, production tends to be repetitive and a standard price emerges. Managers need to keep products flowing, improve quality and keep costs down. It allows for constant improvement and constant optimization. Hence, this favours a hierarchy of bosses and workers.

The competition is different in the knowledge-based industries such as high-tech because the economics are different. Here, the competition is to spot the next cash cow or The Next Ground-breaking Idea. The manager needs to be mission-oriented not production oriented. The hierarchy of such companies tends to be flatter because the teams need free rein to deliver the next big thing and hence report directly to the CEO.

Parting thoughts for Managers

Economies have bifurcated into two worlds and these two worlds operate under different economic principles. To be successful in either of them, managers need to plan for -

Understanding the market

In a bulk-processing economy, understanding the market means understanding customer needs, distribution channels and rival’s products. In the knowledge economy, understanding means working on the feedback received from the market at different levels and different time frames.

Understanding the ecology

Success depends on understanding the ecology to which the product belongs to. Not just the product itself, companies need to create and actively support an interwoven community of vendors around that product, who will create and publish technologies based on the original product.

Resource and strategy planning

Leveraging the increasing returns requires excellent technology, the ability to be the first-mover and deep pockets to sacrifice current profits for long-term advantage. All these also requires courage and resolution and also, the foresight to leave a market when increasing returns are not working in the company’s favour.

Envisioning the future

On top of staying relevant in the current wave of technology, companies should also envision the next cycle and adapt accordingly. Those who lost out on the current wave should plan and position themselves for the next. The ability to profit under increasing returns is directly related to the ability to see what’s coming in the next cycle and to position oneself for it — technologically, psychologically, and cooperatively.

As the economy shifts steadily away from the brute force of things into the powers of mind, from resource-based bulk processing into knowledge-based design and reproduction, so it is shifting from a base of diminishing returns to one of increasing returns. Success goes to those who have the vision to foresee, to imagine, what shapes these next games will take. And nowhere is this more true than in high technology.

Every company is a software company; even if it’s not in the software business