Increasing Returns and the New World of Business by W. Brian Arthur

During my university days, W. Brian Arthur is one of my favorite thinkers. I’ll never forget discovering this article in my final year and having all these thoughts about how markets and business operates differently.

For those who have not read this article (it was written almost 20 years ago), here’s one of my favourite quotes;

Mechanisms of increasing returns exist alongside those of diminishing returns in all industries. But roughly speaking, diminishing returns hold sway in the traditional part of the economy — the processing industries. Increasing returns reign in the newer part — the knowledge-based industries. Modern economies have therefore bifurcated into two interrelated worlds of business corresponding to the two types of returns. The two worlds have different economics. They differ in behavior, style, and culture. They call for different management techniques, strategies, and codes of government regulation.

This is probably one of the most though provoking quote I find. Very intriguing and it gives me more items to keep in my tool kit to think about markets and businesses in general.

As I re-read it again last week, some thoughts about this article came to mind.

The first disk of Windows to go out the door cost Microsoft $50 million; the second and subsequent disks cost $3. Unit costs fall as sales increase.

I think that regular manufacturing will also the same issue. The law of huge numbers and economies of scale applies here. Producing 100 of product “A” might have a $10,000 unit cost, but producing 1 million might only have a $3 unit cost. However, the curve will be much steeper for software. And there is more pricing power in some cases (which really is the defining difference).

Except with technology stocks this effect is more pronounced.

Although there are loads of software stocks that are essentially commodities. So the good news is that it is not a defining trait of this new industry.

And 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.

He is basically describing exactly an ‘old world’ product. At first returns are high, when the first ones who move into the market make tons of profit for a little while, but then it is commoditized and margins stabilize to some equilibrium of near perfect competition. A similar thing probably happened to the first manufacturers of steam machines, or the first ones who figured out a way to produce aluminum at a lower cost.

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.

This has been around since the birth of capitalism! For example, chemical businesses have been around for a 100+ years and don’t forget rhe Bell Telephone company. I opined that the author failed to highlight that a lot of R&D went into creating such products. Take 3M for example, how is that different from Dell computers? They craft knowledge into products, and then after a while these products become commoditized.

The main difference, software is much harder to reverse engineer. Like a Tesla. You can pick apart a Tesla and get loads of info. But if you buy a software product or service, you cannot (for the most part) reverse engineer it when you buy it. Combine that with the fact that software often has higher returns on capital and can grow revenue faster as a result (because unit cost falls incredibly fast as soon as the initial product is finished), and it is harder to catch up and easier to gain a critical mass to build on the momentum.

Then add a network effect on top of that and voila, you get a large moat. Although even that sort of effect has been around in the past with local newspapers.

The thing is that you see it at a higher prevalence and often the new economy combines these effects much more than what usually happened in the old economy. And you get a ‘total is larger than the sum of its parts’ effect, where everything newer seems more incredible.

Well, these are just my thought. Otherwise, it was a great article.

Cheers