The simple idea that lies behind Microsoft's aim to rule the world

Diane Coyle on the debate over economies of scale

THERE IS a new passion in economics, the passion for increasing returns or economies of scale. You can tell this is the cutting edge of research because it is starting to generate some juicy academic rows. There is an entertaining internet exchange in progress* between Professor Paul Krugman of MIT, one of the superstars of the profession, and fans of Professor Brian Arthur, a technology expert at the Santa Fe Institute in California, over how long and how seriously economists have been exploring the implications of widespread economies of scale - or positive feedback, as an engineer would describe it.

To start at the beginning, what is this phenomenon that is generating so much excitement? It is one of those very simple, commonsense ideas that any non-economist is amazed to discover is at the cutting edge of the discipline. Increasing returns just means that the more of some activity takes place, the cheaper or more profitable it becomes. Economies of scale in industry are the obvious example. The unit cost of an aircraft falls rapidly the more planes a company builds, thanks to the huge research, design and start-up costs, so the aerospace industry is naturally dominated by a few large companies.

The economies of scale do not need to apply within one company, however. Another widespread form is the geographical clustering of certain industries like the car industry around Detroit. It is not just GM that enjoys economies of scale, but all the suppliers of parts, and all the skilled workers, giving Motown and its hinterland in Michigan a dominant role in car manufacture.

This is a phenomenon that economists have investigated since the 19th Century, but it fell out of fashion when the subject became very much more mathematical in the 1970s because the mathematics was so much harder than assuming there were constant returns to scale. By the early 1980s, however, economists had improved their maths, and several researchers like Professor Krugman started to apply increasing returns to several areas from the theory of international trade to growth and investment.

The real excitement, however, has come about because increasing returns are widespread in many new, hi-tech industries like consumer electronics and computer software. Professor Arthur, with his technological expertise, was prominent among the experts who wrote about this aspect.

To take one very topical case, the existence of a particular type of increasing returns makes the software industry very vulnerable to dominance by a market leader. Microsoft's attempt to rule the world is aided by network externalities: the more people use its programmes, the more valuable the software becomes to any new user because of the need for compatibility.

This is true of, say, fax machines as well - it was not worth people buying faxes until lots of other people had them and then, when there were lots, the cost of the machines nose-dived. But it is innate to software, which has little value if few people can use it. The "lock-in" benefits of becoming the market leader, as Microsoft has in desktop computer operating systems and hopes to in a whole range of other areas, are enormous.

As the prospect of a full-blown anti-trust case against Microsoft looms in the US, where competition legislation is far more muscular than it is here, the hi-tech computer industries look like the most exciting real world manifestation of increasing returns. But the phenomenon is far more pervasive than that, and carries serious implications for how governments should be regulating competition.

In modern economies more and more of the value of output, even of manufactured products, is weightless. Intangibles such as service quality, product design, even creative and imaginative content are what people pay money for.** Profit margins come increasingly from style and image.

The result is that, in virtually any market you can think of, there are huge advantages to being the market leader and having the dominant brand. The most prevalent increasing returns these days are to be found not in manufacturing but in marketing.

A whole slew of threatened or pending anti-trust suits in the US demonstrates that this is becoming a hot issue. The current issue of the US journal Business Week lists half a dozen cases smaller companies would like to bring against giant competitors, like brewer Anheuser-Busch which manufactures Budweiser beer and is blamed for persuading bars not to stock beers from micro-breweries, or crisp manufacturer Frito-Lay which is accused of trying to muscle less well-known brands off store shelves.

In the UK a good example is the ice-cream war over whether big manufacturers could tie retailers into stocking only their brands of frozen goodies in the refrigerators provided. (Still unresolved, with a decision due from the MMC and Unilever promising to challenge any unfavourable ruling anyway.) The broad principle is the same as Microsoft trying to tie PC manufacturers into bundling its internet browser rather than rival Netscape with the operating software.

The difficulty for competition policy arising from the pervasiveness of markets where increasing returns create a natural leader, for which companies will of course compete fiercely in the first place, is two-fold. First, it is harder to be sure that it is bad for consumers, most of whom do prefer the products of the market leader. This is especially true in hi-tech markets where prices tend to fall anyway. Secondly, it is hard to see what the competition authorities can do about it. If they did manage to prevent one company from dominating a market, another big bad giant would come along to replace it because of the underlying increasing- returns economics.

Defenders of Microsoft rely on this argument, which is essentially that the natural creative destruction of market capitalism and product innovation form consumers' best defence. They say Bill Gates, its chairman, is making the most of what history suggests will be a small window of opportunity to make big profits. There is something in this, although their moral high ground is eroded by Mr Gates' famously aggressive tactics to lengthen his historical opportunity.

Existing competition law was drawn up in the early part of this century when the US government decided to humble the original "robber barons" of capitalism. They, too, had exploited economies of scale and natural monopolies, but of a more tangible variety. It will be harder for policymakers to tackle the weightless forms of increasing returns, in the battlegrounds of marketing and distribution and intellectual property rather than production. But that is the nettle they need to grasp.

*http://www.slate.com/Features/ Krugman/Krugman.asp available via the ``Life of Brian: a symposium'' link on Paul Krugman's web page at http://web.mit.edu/krugman/www

** I have written about this in my own book, The Weightless World, Capstone 1997.