Diminished to Death

"Increasing Returns and the New World of Business" by W. Brian Arthur, in Harvard Business Review (July–Aug. 1996), Boston, Mass. 02163.

The law of diminishing returns is one of the most useful contributions economics has made to humanity’s tiny stock of comfortable truisms. Now, however, economists may have to take their gift back.

The law holds that a producer who continually increases output will eventually encounter limits: pouring more resources into production will yield diminishing returns. A farmer, for example, will eventually be forced to put lowerquality land into production, cutting profits. Diminishing returns, in the writing of the great 19th-century economist Alfred Marshall, were a crucial force in bringing prices and market shares into equilibrium in a market economy.

The principle still largely fits the "bulk-processing, smokestack economy," argues Arthur, an economist at Stanford University, but in today’s high-tech economy, a new "law" is in effect: the law of increasing returns.

High-tech goods are different in large part because their production costs do not rise. High-tech producers put most of their money into research, not production. The first copy of Windows cost Microsoft $50 million; subsequent ones cost $3 apiece. The law of diminishing returns does not operate through costs alone. An automaker, for example, suffers diminishing returns when it exhausts the customer base for its brand. Beyond a certain point, Ford must cut prices to sell more Tauruses.

But such limits do not always completely apply to high-tech products, Arthur contends. "If a product or a company or a technology— one of many competing in a market—gets ahead by chance or clever strategy," he maintains, "increasing returns can magnify this advantage, and the product or company or technology can go on to lock in the market." That is what happened in the early 1980s, for example, in the market for operating systems for personal computers. Even though computer programmers regarded it as an inferior system, DOS eventually prevailed over its competitors. Users had too much invested in learning the ways of DOS to switch. Software developers put more of their efforts into writing programs for DOS. Microsoft got a lock on the market.

The law of diminishing returns still applies in the traditional, bulk-production part of the economy. In that environment, Arthur observes, a hierarchy of bosses and workers, planning, and controls are the rule, whereas in the high-tech world, the continual "quests for the next technological winner" require "flat" hierarchies and maximum freedom for employees.

The two worlds of today’s economy are not neatly divided, Arthur says. Hewlett-Packard, for example, designs knowledge-based devices in Palo Alto, California, and manufactures them in bulk elsewhere. Most hightech companies have both types of operations, but the firms often keep them separate, he says, because the "rules of the game"— and the underlying economic laws—are different for each.