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 / First Quarter 1997 / Issue 6(originally published by Booz & Company)


An Interview with Paul M. Romer

Paul Romer: Yes. Let's take a particular piece of knowledge, such as a piece of software, and think about the costs of production that a supplier faces. If we do that, we see that this piece of knowledge is very unusual from a traditional economic point of view.

To make the first copy of Windows NT, for example, Microsoft invested hundreds of millions of dollars in research, development, testing and so forth. But once Microsoft got the underlying bit string right, it could produce the second copy of Windows NT for about 50 cents -- the cost of copying the program coded in this string of bits onto a floppy disk. Since then, all subsequent copies of the program have the same cost or even lower costs. For example, if Windows NT is distributed over the Internet, the cost of every additional copy is basically nil. So the first copy costs you hundreds of millions of dollars, but all other copies are free, no matter how many you produce.

This kind of falling cost per unit is a different manifestation of increasing returns. This is very different from the physical economy, where an important part of the cost of each good comes from the process of making an additional copy of that good.

S&B: Paul, is this kind of increasing return the same as or different from the standing-on-the-shoulders-of-giants effect that you mentioned before?

Paul Romer: These two kinds of increasing returns are logically distinct. For example, we could have falling costs of production for copies of a specific piece of software even if the standing-on-shoulders effect were not operating.

Suppose, for a moment, that Windows NT were the last piece of useful software that could ever be written. Once it is finished, it will be impossible to develop any new pieces of software. I know this sounds crazy, but bear with me. This would be an extreme case that is the opposite of the shoulders-of-giants effect.

But even if this were true, the production costs for NT would still have the unusual character of huge costs up front and very, very low costs for each subsequent copy. That feature is very important for understanding what we call the industrial organization of the economy, because it means that you are going to see a great deal of monopoly power in the new economy.

S&B: How does knowledge lead to monopolies?

Paul Romer: Traditionally, in economics, you would assume that there would be a couple of leaders in a field, that their success would make it attractive for other people to come in, that there would be rivalry among all the firms and that the industry segment as a whole would grow and benefit as competition intensified.

For example, in the physical economy, suppose you've got a firm that owns a big ore deposit somewhere in the world, and there are other firms that own other ore deposits in other parts of the world. Each of these firms will operate under conditions of increasing costs and diminishing returns. One of those firms may be able to produce 100,000 tons of refined ore per year. But it can't easily scale up to 200,000 or 300,000 tons because of the nature of its physical resources. There's only one way to mine the ore and it gets more expensive as you do it faster. The physical structure of your assets means that there's a limit on how fast you can exploit it.

So you might ask: Will one company take over the whole world's supply of ore and become a monopolist in world copper?

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