In this blog post, we will examine how the traditional law of diminishing returns changes due to increasing returns and network externalities in the information technology era.
Traditional economics has long held that continuously increasing inputs will likely lead to diminishing rates of output growth at some point. This perspective was particularly common in traditional industries like agriculture and manufacturing. This is known as the law of diminishing returns, and it was accepted as valid in industrial economies centered around goods like grain or iron. For example, on a farm, adding more fertilizer or labor might initially boost production, but eventually, natural constraints like soil limitations cause yields to decline.
In such situations, output can certainly increase significantly at first as inputs rise. However, over time, the quality of labor is likely to decline, and the organization of labor or managerial efficiency is also likely to hit its limits. Furthermore, since there are limits to the efficient use of resources, one ultimately hits the wall of diminishing returns. This law has served as a warning to many businesses and economists striving to maximize resource efficiency. It also teaches the lesson that finding the optimal level of input is crucial, rather than endlessly increasing production factors.
When the law of diminishing returns takes effect, companies producing goods will set their production scale at an appropriate level to maximize profits. Rather than blindly increasing output, companies will seek to find and maintain the optimal production scale. Consequently, multiple firms producing the same product enter the market and compete. Ultimately, the firm capable of offering a superior product at a lower price gains competitive advantage in this market. This competition also benefits consumers, providing them with opportunities to purchase better quality products at lower prices.
However, the situation changed dramatically with the advent of the information technology era. The law of increasing returns, where output increases disproportionately as inputs increase, began to appear across various industries. The information technology era exhibits a trend diametrically opposed to the law of diminishing returns. Now, it has become common for output to increase more significantly as inputs increase. This phenomenon can be explained by the sharp decrease in the average cost of output as the scale of production expands. Average cost refers to the cost incurred to produce one unit of a good. Industries such as the information industry, software industry, cultural industry, and service industry—which represent the information technology era—are typical examples of sectors exhibiting the phenomenon of increasing returns. This is because, while initial development costs are high, additional costs are minimal even as production volume increases.
The phenomenon of increasing returns can be observed not only on the supply side but also on the demand side. The phenomenon of increasing returns on the demand side often arises due to network externalities. Network externalities occur when the value of a product increases as the number of users grows, providing unintended benefits to the producing firm without cost. This acts as one reason why firms that capture market share gain stronger competitive advantages, and these benefits, combined with economies of scale, reinforce market dominance.
Therefore, when network externalities emerge, a company that has already captured the market can continue to increase production without profits diminishing, following the law of increasing returns. Instead, its competitive advantage grows stronger over time, allowing it to solidify its monopolistic position in the market. This creates a situation where it becomes difficult for new companies to enter the market or gain a competitive edge. In such markets where the law of increasing returns operates, firms will seek to expand production to the maximum extent permitted by market size, aiming to completely drive competitors out of the market. Furthermore, when network externalities emerge, the first-mover firm gains a highly advantageous position. Even if new entrants possess competitive advantages in product quality or price, surviving in the market becomes extremely difficult.
Consequently, competition based on quality or price loses its effectiveness in such markets. This signifies that the economic structure of the information technology era is fundamentally different from that of the industrial society era, revealing limitations in applying traditional economic theories. The information technology era demands new economic models, making economic diversification and innovation increasingly crucial. Consequently, predicting and explaining the economy using methods from the industrial society era has become difficult in the information technology era. Establishing policies and strategies suited to this new economic environment has become an essential task for both businesses and nations.
