This article is Part 3 in a 3-Part Series.
Laws of returns
There are two laws related to increasing and diminishing returns about how markets and businesses operate.
- Law of diminishing returns
- Law of increasing returns
Law of diminishing returns
This law states that after a point, increases in effort or investment results in diminishing returns : that is, the incremental value declines.
This law was misused by classical economists to claim about predictable equilibrium between prices and market shares, perfect competition.
Bruce Henderson and his Boston Consulting Group (BCG) challenged the traditional economic consensus thinking with new insights:
- Firms do not have equal costs. The costs of market leaders are usually significantly lower than followers.
- Costs and prices do not reach a steady equilibrium. In competitive markets, costs and prices continue to come down. Cost and price decreases are characteristics of high growth markets.
- A firm with high relative market share should and usually have high return on capital and intrinsic competitive advantage compared to other firms in the same market. High market share can lead to virtuous cycle by reinforcing competitive advantage by providing better products and services at lower prices while still earning higher returns than competitors.
Law of increasing returns
The new economy, especially the hi-tech is subjected to increasing returns.
Increasing returns are characteristics , whenever markets have following attributes :
- High Up front costs , especially in R&D rather than production. The first sale of Microsoft windows cost Microsoft 50 million $ ; the second $3. These economics make leadership extremely valuable and difficult to challenge.
- Network effects : Many hi-tech products must be compatible with network of users. Therefore a popular product or system is likely to become the standard. Also, network economics are different from traditional economics.
- Customers groove-in : Hi-tech products are difficult to use, and also have several generations of product. Users have to invest in training. This training grooves or locks customers into the leading product.
Metcalfe’s law (Network Effect)
Bob Metcalfe, the inventor of Ethernet, noticed that small networks are not viable, but that putting together small local networks sharply multiplied their value. The value of a network equals n squared ( N * N ), where n is the number of people in the network. Thus , a 10 person network is worth 100, but a 20 people network is worth 400. A linear increase in membership means an exponential or geometric increase in value.
Networks typically spend quite a while reaching their tipping point, and there is no stopping then. For e.g. Fax machines struggled to reach their tipping point for 20 years , then from about 1985, almost everyone was installing them.