Spiralling increase in returns

Until recently, most economists were firm believers in the theory of diminishing returns. But the evidence coming from everyday business is that companies should instead be looking towards increasing their returns in order to defeat their comp

Imagine a snooker table where the level playing field created by that piece of slate is replaced by a rubber sheet. What would happen? Balls that are close will roll together. They will bend the rubber more than single balls, attracting them to it. Each new ball will deepen the sag, making it even more “attractive”. With-in no time at all the balls will have rolled into one of a handful of major valleys it’s “to them that have…”

Does business work like this? Until recently, economists (who were born and bred on the theory of diminishing returns: the first Mars Bar to a starving man is heaven, the fifth will probably make him sick) have rejected the logic of increasing returns.

Yet wherever you look, you can see increasing returns at work. Because the City is a centre of financial expertise and power, it attracts financial firms, resources and talent. Likewise Silicon Valley with computing. Ditto ad agencies which lure the best and brightest because of their reputation as creative hot-shops.

Indeed, you could argue that the very reason why brands are so important is that they are increasing returns machines. A good brand means extra sales, which generates economies of scale in production and advertising, plus extra resources for research and development (R&D). These enable you to offer better value and improved products, which in turn generate further increased sales and so on – a classic virtuous spiral.

But applying increasing returns logic isn’t always easy. For example, today’s competitive battles can be seen as tests of the relative efficiency of different types of increasing returns machines. This suggests that initiatives should be judged not by the sales or profits they generate in their own right, but as a stepping stone up that virtuous spiral.

This is one of the secrets of the grocery multiples’ success. They started off with one advantage: cheap out-of-town sites.

They leveraged that advantage to offer improved range, lower prices and parking. This improved their market share, which they used to improve their negotiating position with suppliers (brands and own label alike). This allowed them to offer even better value for money, thereby improving share further – and so on.

A second attribute of increasing returns competition is that the best man doesn’t always win. Consider, for instance, the qwerty keyboard, Beta video, and the Microsoft operating system. The common factor is that they are all inferior products, which nevertheless came to dominate their markets by virtue of increasing returns.

The qwerty keyboard was deliberately created to stop typists typing faster than their primitive machines. The technical constraints disappeared long ago. But no manufacturer dares produce a better keyboard because qwerty is locked into the infrastructure.

The experts insisted that Sony’s Beta was technically superior to VHS. But JVC licensed VHS to the likes of Telefunken, Thomson, Thorn, RCA and GE, which made its format more popular, and thereby persuaded more content providers to opt for VHS, which attracted more consumers, and so on. MS/DOS never created the user-friendly interfaces that Apple was famous for, but Apple failed to recognise increasing returns logic, jealously kept its operating system to itself – and painted itself into a corner.

Increasing returns seem to work differently in the atom-based material economy, and the bit-driven information economy. Just compare the rules of software new product development (npd) with traditional npd.

Traditional npd concentrates on the creation of a proprietary unique selling point (usp), to be defended as long as possible as a sustainable edge. It then tries to recoup R&D investments by charging maximum prices to early adopters and bringing prices down as economies of scale kick in. Knowing that knowledge is power, it’s obsessed with secrecy.

In software, successful marketers do the opposite. Ubiquity not usp is what they seek. Power comes not from repelling those invading your “edge” but from inviting them to exploit your platform. Products such as the computer game Doom were successful not because they demanded high prices, but because they were given away free – and got users so hooked that they were prepared to pay for more.

And openness is as strong a weapon as secrecy: in zero-sum games “you always hide your strategy”, notes game theorist Robert Axelrod. “But in non-zero sum games you might want to announce your strategy so that other players need to adapt to it.”

What’s really intriguing is when the two worlds collide. For decades American Express was the epitome of exclusivity. Now, after a dramatic victory over Visa (which tried to bar member banks from issuing Amex cards) it’s recruiting new banks as partner issuers. It’s also launching co-branded cards such as the Hilton Optima Card.

At the back of its mind? The fate of companies like Apple that applied atom logic to bit economics. Amex’s president of international consumer marketing and product development, John Crewe, says: “We’ve moved away from the inward-looking attitude of a proprietary business, towards a more open minded, partnership approach, where we are willing to consider new ideas and share our strengths with others.”

Or take Procter & Gamble. It’s hardly renowned for trumpeting its secrets. But that’s what it’s doing. P&G knows it’s ahead of the game when it comes to efficient consumer response (ECR). But it is nevertheless preaching ECR’s benefits to its closest competitors. Why? Because, it wants to suck everyone into playing the marketing game by its rules – and ECR’s financial returns only start rolling if enough people in the industry embrace it to create critical mass.

In both these cases, strategy has been transformed by increasing returns thinking. Marketers have gone beyond narrow obsessions with product and technological superiority to formats and operating systems and leverage through sharing rather than exclusivity. New product developers look out – this is where the next big breakthroughs in innovation will probably come from.

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