What if you hold a losing hand? 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. We can also fathom the mystery of what I’ve alluded to as re-everything. Contrary to recent management evangelizing, a style that is called for in Silicon Valley will not necessarily be appropriate in the processing world. This law is also known as the Law of Diminishing Costs. Likewise the employment to third unit of capital and labour will raise the production to 5. The firm … Privacy Policy3. Repositioning an investment strategically also offers an important source of value creation for private-equity managers. Those’ll emerge as the game unfolds. It went on to profit hugely from upgrades, spin-offs, and applications of its own. Now the manager has to identify the sources of funds needed for producing the new product. The question is tricky. The profit for a business owner is the difference between the return on capital and the cost of capital. Processing, in the service or manufacturing industries, has its own risks. 10. In the manufacturing industry, there is a wider scope for the division of labour. Technologies exist not alone but in an interlinked web, or ecology. Two maxims are widely accepted in knowledge-based markets: it pays to hit the market first, and it pays to have superb technology. Hence, it can be concluded that the law of increasing returns operates as a result of division of labour and specialisation. There are plenty of independent sources of credit available to buyers – your role as a seller is to identify those sources and facilitate the introduction between your buyer and the lender. Glimpsing some of these properties in 1939, English economist John Hicks warned that admitting increasing returns would lead to “the wreckage of the greater part of economic theory.” But Hicks had it wrong: the theory of increasing returns does not destroy the standard theory—it complements it. The law of returns to scale analysis the effects of scale on the level of output. 14. Further Reading You can be smart. Let’s go back to beginnings—to the diminishing-returns view of Alfred Marshall and his contemporaries. But these tactics were not enough. We can’t say. In a word, mannerly. Once DOS/IBM got ahead, it locked in the market because it did not pay for users to switch. Conversely, those who have made a killing on this cycle should not become complacent. Companies often err by pricing high initially to recoup expensive R&D costs. If two different fuel sources (e.g., coal and natural gas) are perfect substitutes in the long-run production of energy. It means there is always some idle capacity in factors of production which is deliberately kept by the organizers to expand its production. Not five-year plans. Technological products do not stand alone. Hence they typically have R&D costs that are large relative to their unit production costs. 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. What can you do to capitalize on the increasing returns at your disposal? The various sources of liquidity for a firm can be classified as primary and secondary sources. Active management of such a web can be an important magnifier of increasing returns. The term " returns to scale " refers to how well a business or company is producing its products. So it seemed in 1981 that deregulation should enhance competition, as it normally does under diminishing returns. As for technology, Steve Jobs’s NeXT workstation was superb. Increasing returns reign in the newer part—the knowledge-based industries. But because of the Internet’s dominance, it is not yet clear whether it can transform this huge base into later profits. The answer to this question helps … These internal and external economies are helpful in reducing the cost of production and increasing the amount of production. What you can do is adapt. Here are some questions managers need to ask themselves when they operate in knowledge-based markets: In the processing world, understanding markets means understanding consumers’ needs, distribution channels, and rivals’ products. What should be legal in this powerful and as yet unregulated world of increasing returns? The knowledge-based part of the economy demands flat hierarchies, mission orientation, above all a sense of direction. And of course it may be impracticable to regulate a market before it forms—before it is even fully defined. Why are we seeing this new management style? However, when production is carried on large scale basis, it is possible for a firm to have more complex and better machinery, i.e., it is possible to have complex division of labour and advantageous combination of factors of production ; which brings down the cost of production. Let’s expand on the idea that the Marginal Cost of Capital repre… He plays a vital role for using the factors of production in a more proper way. Initially, as we employ more and more units of variable factors with fixed factors, productivity of both the factors increases. So it favors a hierarchy of bosses and workers. Let us look at the two cultures of competition. Each virtual bank will gain in advantage as its network increases. This means making a careful choice of partners to build upon. If knowledge-based companies are competing in winner-take-most markets, then managing becomes redefined as a series of quests for the next technological winner—the next cash cow. But steadily and continuously in this century, Western economies have undergone a transformation from bulk-material manufacturing to design and use of technology—from processing of resources to processing of information, from application of raw energy to application of ideas. We can imagine the top figures in high tech—the Gateses and Gerstners and Groves of their industries—as milling in a large casino. D. All of the above. Certainly, retail franchises exist because of increasing returns. Rain, winter and summer have no effect on industries. As a result, it has fallen from its leading position and currently lags the other services. 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. The producer increases factors of production by 20 per cent and as a result the production of shoes increases by 35 per cent. C. economics of scale. Bill Gates is not so much a wizard of technology as a wizard of precognition, of discerning the shape of the next game. Not too rushed, not too profitable. The Marginal Cost of Capital (MCC), which is sometimes called the Opportunity Cost of Capital (OCC) or Weighted Average Cost of Capital (WACC), tells us how much we are paying for our financing. Where do service industries such as insurance, restaurants, and banking fit in? The new IBM PC—DOS’s platform—was a kludge. Three billion, the croupier replies. Most production functions include both … Therefore, both laws are said to be the two phases of a single tendency. Let’s look at the market for operating systems for personal computers in the early 1980s when CP/M, DOS, and Apple’s Macintosh systems were competing. accrue to the producer. Market research indicates the possibility of a large volume of demand and a significant amount of additional capital will be needed to finance production. 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. 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. And they are exciting. According to Dr. Marshall, the law of increasing returns is generally applicable to manufacturing industries as these units are dominated by man. 10. If it locks in merely because user base was levered over from a neighboring lock-in, this is unfair. But it recognizes that positive feedbacks apply across markets as well as within markets. Novell recognized that NetWare’s success depended on attracting software applications to run on NetWare—which was a part of the ecology outside the company’s control. At the close of the century, they are based on the processing of resources and on the processing of knowledge. Above all, it is a world of optimization. You can be cunning. With the application of the next unit, average cost comes down to Rs. The alternatives are then slow death or graceful exit—relinquishing the field to concentrate on positioning for the next technology wave. 9. Why? The concept has revolutionized economics. Using sophisticated techniques from qualitative dynamics and probability theory, I and others have developed methods to analyze increasing-returns markets. Updated July 29, 2019. One active strategy is to discount heavily initially to build up an installed base. Mechanisms of increasing returns exist alongside those of diminishing returns in all industries. CEOs need to understand which positive and negative feedback mechanisms are at play in the market ecologies in which they compete. We can now begin to see that the new style of management is not a fad. 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. Where does all this leave us? They require training. This isn’t exactly Marshall’s perfect competition, but it approximates it. Above all, strategy in the knowledge world requires CEOs to recognize that a different kind of economics is at work. So in knowledge-based markets, entering first with a fine product can yield advantage. America Online built up a lead of more than 4.5 million subscribers by giving away free services. “An increase of labour and capital leads generally to improved organization, which increases the efficiency of the work of labour and capital. It shows that marginal production will increase as the units of capital and labour increase. What are my odds of winning? When first unit of labour is employed the average cost is Rs. This phenomenon can have two consequences. But the more it gains prevalence, the more likely it will emerge as a standard. Exercise 7.1 Sources of finance Outdoor Living Ltd., an owner-managed company, has developed a new type of heating using solar power, and has financed the development stages from its own resources. 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. Content Guidelines 2. This approach is wise and proper. It is on account of this that an organizer or machinery or building or even labourer is lumpy or indivisible. Copyright © 2020 Harvard Business School Publishing. 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. This fact is clear from table 5 and Figure 5. In the early days of my work on increasing returns, I was told they were an anomaly. Those who have lost out on this wave can position for the next. Who’ll be playing? So operations that were once handled by people—designing fancy financial instruments or automobiles or fashion goods, processing insurance claims, supplying and inventorying in retail, conducting paralegal searches for case precedents—are increasingly being handled by software. This interdependence has deep implications for strategy. Because the two worlds of business—processing bulk goods and crafting knowledge into products—differ in their underlying economics, it follows that they differ in their character of competition and their culture of management. Technology comes in successive waves. Therefore, an increase of labour and capital generally gives returns which increases more than in proportion.” Marshall, “As the production of one factor in a combination of factors is increased up to a point, the marginal productivity of the factors will increase.” Benham. Microsoft levered its 60-million-person user base in DOS onto Windows, then onto Windows 95, and then onto Microsoft Network by offering inexpensive upgrades and by bundling applications. 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. 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. What is needed is active management of increasing returns. DOS’s prevalence—and the IBM PC’s—bred further prevalence, and eventually the DOS/IBM combination came to dominate a considerable portion of the market. Many high-tech products need to be compatible with a network of users. Technology Development. CiteSeerX - Document Details (Isaac Councill, Lee Giles, Pradeep Teregowda): This paper reviews various types of increasing returns from a critical perspective. In case of 2, 3, 4, 5 units, average cost declines to 8, 6.6, 5.7 and 5 respectively. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. B. increasing marginal returns. But as strategy, this is still too passive. In this milieu, management becomes not production oriented but mission oriented. Competing therefore means keeping product flowing, trying to improve quality, getting costs down. Share Your Word File There is an art to this sort of management, one widely discussed in the literature. First, where the local character of service remains important, it can preserve a large number of service companies but clustered round a dominant software provider—like the large numbers of small, independent law firms tied in to the dominant computer-search network, Lexis-Nexis. 8. It takes place when economies of scale no longer function. The software writers did just that. But because the rules of the game differ for each, companies often separate them—as Hewlett-Packard does. Dominance may consist not so much in cornering a single product as in successively taking over more and more threads of the web of technology, thereby preventing other players from getting access to new, breaking markets. Another strategy that uses ecologies is linking and leveraging. Thus, increase in price which is the result of the law of diminishing returns has adverse effect on economic welfare. 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. So no company can corner the market. 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. The increase in labor productivity can bee attributed to technological progress, increase in the quantity of capital per worker, improvements in the education and training of workers, the exploitation of economies of scale, and improvements in the allocation of labor across different industries. It is important to note that these … Law of Increasing Returns: Definitions, Assumptions, Explanation, Causes and Similarities and Dissimilarities! Thus man is supreme. Example: Company X is willing to introduce a new product. More than causing products to become standards, increasing returns cause businesses to work differently, and they stand many of our notions of how business operates on their head. It is a mistake to think that what works in one world is appropriate for the other. Such businesses are patronized not just for their quality but also because people want to know exactly what to expect. The Law of diminishing returns and increasing returns have similar as well dissimilar characteristics with each other. 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. Adaptation means watching for the next wave and positioning the company to take advantage of it. 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. When the output is undertaken, it is unthinkable that a good organizer will purchase that machinery which can meet the present needs of the market, but he will always establish or purchase that size of plant which has sufficient potential to increase the amount of the product. Due to these economies total cost per unit falls while the total product increases at an increasing rate. No moves need be made in this strategy of premarket facedown. There are several reasons: 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 marketplace. Man by his technical knowledge and far sightedness has succeeded in deferring the operation of the law of diminishing returns for a long period. Increasing Returns to Scale. This means transferring a user base built up upon one node of the ecology (one product) to neighboring nodes, or products. The market place is the number one area to look for opportunities. But roughly speaking, diminishing returns hold sway in the traditional part of the economy—the processing industries. Often there are several such mechanisms—interbraided, operating over different time frames, each needing to be understood, observed, and actively managed. Consider these pros and cons: Convenience. But the growing base of DOS/IBM users encouraged software developers such as Lotus to write for DOS. 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. Adaptation is what drives increasing-returns businesses, not optimization. But by the mid-1980s, I realized increasing returns were neither rare nor ephemeral. In such firms, it’s important to effectively manage liquidity to avoid problems. It is important to understand the ecologies a company’s products belong to. To lock in, a product usually has been discounted, and this established low price is often hard to raise. These questions have come to a head with the enormous amount of publicity generated by the U.S. Justice Department’s current antitrust case against Microsoft. In other words, it would run into diminishing returns. In order to define the sustainable growth rate for a particular business, shareholders must first identify the maximum growth rate their business can achieve without having to increase financial leverage or debt financing. The more McDonald’s restaurants or Motel 6 franchises are out there geographically, the better they are known. With a few changes, Marshall’s 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 goods—the part where operations are largely repetitive day to day or week to week. But the company itself wound up with a small share of the spoils. They differ in behavior, style, and culture. Product differentiation and brand names now mean that a few companies rather than many compete in a given market. Suppose you are a player in the knowledge-industry casino, in this increasing-returns world. Likewise the employment of third unit of capital and labour will raise the marginal production to 8 and average production to six. In the increasing-returns world, things are more complicated. Thus, it shows that both marginal and average production increase as a result of the increase in the factors of production. You sit at one. A locked-in product may provide a single standard of convenience. The goal becomes the search for the Next Big Thing. A locked-in product may obstruct technological advancement. If a clunker such as DOS locks up the PC market for ten years, there is little incentive for other companies to develop alternatives. So we can say more accurately that service industries are a hybrid. If products that got ahead thereby got further ahead, how would markets work? Netscape handed out its Internet browser for free and won 70% of its market. Much of this “re-everything” predilection—in the bulk-processing world—is a fancy label for streamlining, computerizing, downsizing. The U.S. airline business, for example, processes passengers day to day. Economist Adam Smith identified the division of labor and specialization as the two key means to achieving a larger return on production. 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. But each contender should have access to whatever degree possible to the same technologies, the same open standards, so that all are lined up behind the same starting line. It favors an environment free of surprises or glitches—an environment characterized by control and planning. The Law of Increasing Returns was propounded in the seventeenth century by Antonia Seera. In other firms, because of the nature of the industry or the firms financial condition, there may be tight liquidity conditions. The Internet’s World Wide Web operates within a grouping of businesses that include browsers, online news, E-mail, network retailing, and financial services. These properties, then, have become the hallmarks of increasing returns: market instability (the market tilts to favor a product that gets ahead), multiple potential outcomes (under different events in history, different operating systems could have won), unpredictability, the ability to lock in a market, the possible predominance of an inferior product, and fat profits for the winner. Economies have bifurcated into two worlds—intertwined, overlapping, and different. The two worlds are not neatly split. 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 be able to make a killing. The Mac arrived later, but it was wonderfully easy to use. Added to these considerations, high tech is not a commodity industry. Harvard Business Publishing is an affiliate of Harvard Business School. It is only on account of several external as well as internal economies in the form of innovations; marketing, publicity, management etc. A new economics—one very different from that in the textbooks—now applies, and nowhere is this more true than in high technology. If a product locks in because it is superior, this is fair, and it would be foolish to penalize such success. It failed. Pharmaceuticals exist within a network of physicians, testing labs, hospitals, and HMOs. If industry does not make such provisions voluntarily, government regulation will impose them. Many managers have some intuitive grasp of this new increasing-returns world. 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 webs—loose alliances of companies organized around a mini-ecology—that amplify positive feedbacks to the base technology. Causes of Increasing Returns: Law of increasing returns applies due to following reasons: 1. It is evident from table 5, that with the application of the first unit of labour and capital, average cost is Rs. The terms 'economies of scale' and 'returns to scale' are related, but they mean very different things in economics. Although such discounting is effective—and widely understood—it is not always implemented. For example, when Internet-based retail banking arrives, regional demand limitations will vanish. Production tends to be repetitive—much the same from day to day or even from year to year. This curve rises upward from left to right. The data in Figure 8.2 show that marginal product continues to decline after the fourth worker as more and more workers are hired. And so, Marshall’s world tends to be one that favors hierarchy, planning, and controls. What strategic issues do you need to think about? Marshall said such a market was in perfect competition, and the economic world he envisaged fitted beautifully with the Victorian values of his time. Adaptation, in the proactive sense, means watching for the next wave that is coming, figuring out what shape it will take, and positioning the company to take advantage of it. But when the games themselves are not even fully defined, you cannot optimize. You cannot optimize in the casino of increasing-returns games. The additional workers allow even greater opportunities for specialization, but because they are operating with a fixed amount of capital, each new worker adds less to total output. High-tech products are typically difficult to use. Hierarchy dissipates and dissolves. Prodigy was first into the on-line services market but was passive in building its subscriber base to take advantage of increasing returns. How will a profit maximizing firm choose between these two inputs? In fact, the style in the diminishing-returns Halls of Production is much like that of a sophisticated modern factory: the goal is to keep high-quality product flowing at low cost. Neither world of business is for the fainthearted. The law can also be explained in term of diminishing costs. But in case of diminishing returns, it is not true because cost per unit increases with the increase in production. Services belong to both the processing and the increasing-returns world. The truth is that network or user-base effects often operate in services. "Cost of capital" may vary, that is, for funds raised with bank loans, the sale of bonds, or equity financing. And it renders such markets amenable to economic understanding. Let’s get a bit more sophisticated. Apple, in closing its Macintosh system to outsiders in the 1980s, opted not to create such a web. However, in the increasing-returns world, especially in high tech, re-everything has become necessary because every time the quest changes, the company needs to change. DOS was born when Microsoft locked up a deal in 1980 to supply an operating system for the IBM PC. It believed that with its superior technology, it could hold its increasing-returns market to itself. Internal and external economies relate to production, marketing finance and organisation. Novell managed these cross-product positive feedbacks actively to lock in its market. Success goes to those who have the vision to foresee, to imagine, what shapes these next games will take. Conversely, manufacturing companies have operations such as logistics, branding, marketing, and distribution, which belong largely to the knowledge world. The company enjoyed killer margins. Share Your PPT File, Diseconomies of Scale of Production: Internal and External. Java has competitors. Hicks felt repugnance not just because of unsavory properties but also because in his day no mathematical apparatus existed to analyze increasing-returns markets. It is a world of materials, of processing, of optimization. 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. , IBM achieved a huge user base and locked in the increasing-returns arena is more like.. Not as pronounced as in high tech in cost of production when an effort is made raise... 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