A. 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. Increases in LABOR PRODUCTIVITY. It would be difficult to separate out each thread and to regulate it. Marshall said such a market was in perfect competition, and the economic world he envisaged fitted beautifully with the Victorian values of his time. In the processing world, strategy typically hinges upon capitalizing on core competencies, pricing competitively, getting costs down, bringing quality up. The firm … Market research indicates the possibility of a large volume of demand and a significant amount of additional capital will be needed to finance production. 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 case of 2, 3, 4, 5 units, average cost declines to 8, 6.6, 5.7 and 5 respectively. A new economics—one very different from that in the textbooks—now applies, and nowhere is this more true than in high technology. In the manufacturing industry, there is a wider scope for the division of labour. 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. But because of the Internet’s dominance, it is not yet clear whether it can transform this huge base into later profits. Neither world of business is for the fainthearted. America Online, Compuserve, Prodigy, and Microsoft Network have all ceded dominance of the on-line computer networking market to the Internet. 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. Processing, in the service or manufacturing industries, has its own risks. 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. Netscape handed out its Internet browser for free and won 70% of its market. Above all, it is a world of optimization. Some routes have become virtual monopolies, with resulting higher fares. It is important to note that these … Man by his technical knowledge and far sightedness has succeeded in deferring the operation of the law of diminishing returns for a long period. The data in Figure 8.2 show that marginal product continues to decline after the fourth worker as more and more workers are hired. Consider these pros and cons: Convenience. Increasing returns reign in the newer part—the knowledge-based industries. The great managers have a knack for consistently lowering their weighted average cost of capital by increasing productivity, seeking out higher-return products, and more. This fact is clear from table 5 and Figure 5. This law is nothing but an improvement over the law of diminishing returns. Why are we seeing this new management style? Increasing the opportunities for future growth and returns through, for example, investments in innovation, new-product launches, and market entries can … Law of Increasing Returns: Definitions, Assumptions, Explanation, Causes and Similarities and Dissimilarities! America Online built up a lead of more than 4.5 million subscribers by giving away free services. The terms 'economies of scale' and 'returns to scale' are related, but they mean very different things in economics. 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. 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. Arrangement of fixed as well as variable factors can be made more effective. Let’s expand on the idea that the Marginal Cost of Capital repre… What would happen if Marshall’s diminishing returns were reversed so that there were increasing returns? It is a mistake to think that what works in one world is appropriate for the other. This law is also known as the Law of Diminishing Costs. Now it can profit from spin-off software and applications. The knowledge-based part of the economy demands flat hierarchies, mission orientation, above all a sense of direction. And because such products are normally substitutable for one another, something like a standard price emerges. Technology comes in successive waves. At first, each modest increase in resources results in a corresponding increase in production. Often there are several such mechanisms—interbraided, operating over different time frames, each needing to be understood, observed, and actively managed. Certainly, retail franchises exist because of increasing returns. 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. It shows that marginal production will increase as the units of capital and labour increase. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. It is on account of this that an organizer or machinery or building or even labourer is lumpy or indivisible. 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. 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. The term " returns to scale " refers to how well a business or company is producing its products. Added to these considerations, high tech is not a commodity industry. Thus, the producer has to decide at every stage whether he should increase the production or not. You can observe. Not poker, where the game is static and the players vie for a succession of pots. No moves need be made in this strategy of premarket facedown. You can be cunning. 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. The profit for a business owner is the difference between the return on capital and the cost of capital. Disclaimer Copyright, Share Your Knowledge 10. Using sophisticated techniques from qualitative dynamics and probability theory, I and others have developed methods to analyze increasing-returns markets. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. For example, when Internet-based retail banking arrives, regional demand limitations will vanish. 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. 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. Java has competitors. "Cost of capital" may vary, that is, for funds raised with bank loans, the sale of bonds, or equity financing. Over at this table, a game is starting called multimedia. 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. In manufacturing sector, the nature is not as strong as it is in agriculture sector. In other words, it would run into diminishing returns. The fourth worker adds less to total output than the third; the marginal product of the fourth worker is 2 jackets. CEOs need to understand which positive and negative feedback mechanisms are at play in the market ecologies in which they compete. And once DOS locked in the market, its sponsor, Microsoft, was able to spread its costs over a large base of users. Economies have bifurcated into two worlds—intertwined, overlapping, and different. 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. We can also fathom the mystery of what I’ve alluded to as re-everything. But this ecology is now only 8% of the personal computer business. We can now begin to see that the new style of management is not a fad. If one additional unit is employed, total production increases to 10. When, in the mid-1980s, Novell introduced its network-operating system, NetWare, as a way of connecting personal computers in local networks, Novell made sure that NetWare was technically superior to its rivals. A good manager should be constantly studying the market. It takes place when economies of scale no longer function. Yet even smart discounting to seed the market is ineffective unless the resulting installed base is exploited later. A firm that just has increasing returns to scale may not have economies of scale because even though output increased at a higher rate than the increases in input, scarcity of resources may have resulted in higher raw material cost and, therefore, higher per unit cost. If a product locks in because it is superior, this is fair, and it would be foolish to penalize such success. High technology, pursued at this level, is not for the timid. Increasing returns cause products that are ahead to get further ahead. As more and more units of the commodity are produced, the cost per unit goes on steadily falling. The theory was roughly valid for the bulk-processing, smokestack economy of Marshall’s day. 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. The increasing return is the better analysis of price effect as the cost per unit falls when production increases. Causes of Increasing Returns: Law of increasing returns applies due to following reasons: 1. 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. A new product often has to be two or three times better in some dimension—price, speed, convenience—to dislodge a locked-in rival. The marginal and average production of the fourth unit will be 10 and 7 respectively. 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. So it favors a hierarchy of bosses and workers. The final case, in financial services, illustrates the power of HCM to drive stock performance. The new IBM PC—DOS’s platform—was a kludge. The use of machinery reduces the cost per unit. 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. But increasing-returns games provide large payoffs for those brave enough to play them and win. Although such discounting is effective—and widely understood—it is not always implemented. Internal and external economies relate to production, marketing finance and organisation. And it renders such markets amenable to economic understanding. But the more it gains prevalence, the more likely it will emerge as a standard. If a clunker such as DOS locks up the PC market for ten years, there is little incentive for other companies to develop alternatives. Companies often err by pricing high initially to recoup expensive R&D costs. It favors an environment free of surprises or glitches—an environment characterized by control and planning. 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. The Law of diminishing returns and increasing returns have similar as well dissimilar characteristics with each other. 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. Hanging on to a losing position that is being further eroded by positive feedbacks requires throwing reinforcements into a battle already lost. 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. Example: Company X is willing to introduce a new product. Likewise the employment of third unit of capital and labour will raise the marginal production to 8 and average production to six. There is little need to watch the market every day, and when things are going smoothly the tempo can be leisurely. The answer to this question helps … It believed that with its superior technology, it could hold its increasing-returns market to itself. Hence we see psychological jockeying in the form of preannouncements, feints, threatened alliances, technological preening, touted future partnerships, parades of vaporware (announced products that don’t yet exist). In the increasing-returns world, things are more complicated. What strategic issues do you need to think about? To lock in, a product usually has been discounted, and this established low price is often hard to raise. And if they did exist, they would last for only a few seconds before being arbitraged away. It is a world of psychology, of cognition, of adaptation. IBM erred in the other direction. Institute a Layaway Program The key in web building is active management of the cross-company mutual feedbacks. The result is impeded technological progress. In such firms, it’s important to effectively manage liquidity to avoid problems. Our understanding of how markets and businesses operate was passed down to us more than a century ago by a handful of European economists—Alfred Marshall in England and a few of his contemporaries on the continent. But when the games themselves are not even fully defined, you cannot optimize. And adaptation never stops. Does this mean that hierarchy should disappear in meatpacking, steel production, or the navy? They require training. Prodigy was first into the on-line services market but was passive in building its subscriber base to take advantage of increasing returns. 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. Hence, it can be concluded that the law of increasing returns operates as a result of division of labour and specialisation. Let’s get a bit more sophisticated. Services belong to both the processing and the increasing-returns world. The law of returns to scale describes the relationship between variable inputs and output when all the inputs, or factors are increased in the same proportion. Conversely, manufacturing companies have operations such as logistics, branding, marketing, and distribution, which belong largely to the knowledge world. The question is tricky. The Law of Increasing Returns was propounded in the seventeenth century by Antonia Seera. 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. Second, where locality is unimportant, network effects can transform competition toward the winner-take-most character we see in high tech. Better to exit with financial dignity. Service providers become hitched into software networks, regional limitations weaken, and user-base network effects kick in. 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. The fifth unit will raise the marginal production to 12 and average production to 8. Bill Gates is not so much a wizard of technology as a wizard of precognition, of discerning the shape of the next game. CiteSeerX - Document Details (Isaac Councill, Lee Giles, Pradeep Teregowda): This paper reviews various types of increasing returns from a critical perspective. Why? It will become an increasing-returns business. Let us look at the two cultures of competition. Is there a way we can exploit this unexpected success? But the growing base of DOS/IBM users encouraged software developers such as Lotus to write for DOS. Due to this advantage production is more than the proportionate increase in factors. Margins are thin and nobody makes a killing. These internal and external economies are helpful in reducing the cost of production and increasing the amount of production. They call for different management techniques, strategies, and codes of government regulation. The truth is that network or user-base effects often operate in services. And of course it may be impracticable to regulate a market before it forms—before it is even fully defined. One of the marks of our time is that in services everything is going software—everything that is information based. As this reengineering of services plays out, centralized software facilities come to the fore. The increasing-returns world is characterized by observation, positioning, flattened organizations, missions, teams, and cunning. Or physicians tied in to an HMO. 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. And it still thrives in today’s economics textbooks. Apple indeed dominates its Mac-based ecology. At the close of the century, they are based on the processing of resources and on the processing of knowledge. Both laws show the change in cost of production when an effort is made to raise production. Diseconomies of scale occur when a business expands so much that the costs per unit increase. For any firm, it is likely that diminishing marginal returns will set in when the firm gets out of the range of production levels in which economies of scale can be realized. Increasing returns mean lower costs per unit just as diminishing returns mean higher costs. There are several forms of financing that utilize a firm’s inventory as collateral for a loan. Over at that one, a game called Web services. They surprised me when I first perceived them in the late 1970s. 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. What has to happen if we want to convert this success into an opportunity? Are these new insights or are they fads? 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. And by building NetWare’s success, they ensured their own. According to this law, “Production of a commodity increases in a larger proportion as compared to the increase in the units of factors of production.” For instance, we want to increase the production of shoes. Active management of such a web can be an important magnifier of increasing returns. Privacy Policy3. DOS was born when Microsoft locked up a deal in 1980 to supply an operating system for the IBM PC. 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. The U.S. airline business, for example, processes passengers day to day. Production tends to be repetitive—much the same from day to day or even from year to year. Competition is different in knowledge-based industries because the economics are different. In the early days of my work on increasing returns, I was told they were an anomaly. According to the law of diminishing costs as the output increases, average cost per unit goes on diminishing. An aircraft’s safe arrival depends on the captain, not on the flight attendants. Such businesses are patronized not just for their quality but also because people want to know exactly what to expect. For example, if we double the fishing fleet, the number of fish Catch will not double because the availability of fish may decrease when fishing is carried out on an increasing scale. Welcome to EconomicsDiscussion.net! So it set up incentives for software developers to write for NetWare rather than for its rivals. For a year or two, it was by no means clear which system would prevail. “An increase of labour and capital leads generally to improved organization, which increases the efficiency of the work of labour and capital. 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. Some factors of production should be divisible or variable. Why should this be so? 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. One source of this power is increasing returns to scale. So it seemed in 1981 that deregulation should enhance competition, as it normally does under diminishing returns. Increasing Returns and Path Dependence in the Economy. 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. Success goes to those who have the vision to foresee, to imagine, what shapes these next games will take. 2. Hence they typically have R&D costs that are large relative to their unit production costs. Increasing returns to scale, and economies of scale, are internal to a firm and may allow for the establishment of more of the same firm outside the area or region. What is needed is active management of increasing returns. 5.71 and Rs. Share Your PDF File This interdependence has deep implications for strategy. But these tactics were not enough. Of course, lock-in is not forever. So monopoly pricing—of great concern in bulk-processing markets—is therefore rarely a major worry. So if coffee plantations competed, each one would expand until it ran into limitations in the form of rising costs or diminishing profits. In bulk processing, a set of standard prices typically emerges. Some products—like the IBM PC—start in the increasing-returns world but later in their life cycle become virtual commodities that belong to Marshall’s processing world. Copyright © 2020 Harvard Business School Publishing. Generally, in the manufacturing industry, factors of production have elastic supply. They have lost the main game. He plays a vital role for using the factors of production in a more proper way. Pharmaceuticals exist within a network of physicians, testing labs, hospitals, and HMOs. All this is a matter not just of resources but also of courage, resolution, will. 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. Updated July 29, 2019. Further Reading 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. 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. Another reason for the operation of this very law in the manufacturing industry is that there is more use of machinery than in the agricultural sector. 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. Success will strongly favor those who understand this new way of thinking. The two worlds have different economics. C. economics of scale. Increasing returns are the tendency for that which is ahead to get further ahead, for that which loses advantage to lose further advantage. It means demand of each factor can be increased whenever required. 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. Thus man is supreme. These maxims are true but do not guarantee success. At the beginning of this century, industrial economies were based largely on the bulk processing of resources. 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. Effects can transform this huge base into later profits to recognize that a different kind of is! 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