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


An Interview with Paul M. Romer

The answer is no, because the firm that wants to do that would produce up to a point where it would become more and more expensive. Other firms would be drawn into the market and might produce and sell their ore more cheaply. When firms face increasing costs and diminishing returns, no single firm can supply the whole worldwide market. If it tries, it faces increasing cost disadvantages relative to its competitors.

S&B: So there are limits to monopoly power in the physical world?

Paul Romer: Yes. In the physical economy, there is a natural equilibrating process. If one firm tries to take over the whole market, other firms would gain an advantage and will enter. When this whole process settles down, there will be many firms and a competitive market.

S&B: How does this differ in the knowledge economy?

Paul Romer: Let's think about operating systems and the world of computers for a moment. Let's say you have one firm, like Microsoft, which is going to produce Windows NT. Once it produces its first copy, it then faces no cost disadvantage. It can produce millions or billions of copies of NT at little additional cost. It truly can supply the entire worldwide market for operating systems. If anything, it probably gets even easier for Microsoft because the larger its market size gets, the more attractive it is to adopt its software because of what we call bandwagon effects. If everybody else is using a particular piece of software, it usually makes it advantageous for you to use it, too.

Now this difference between diminishing-returns industries and increasing-returns industries completely changes the dynamic of competition. Under conditions of increasing returns, competition is driven by various firms trying to capture as much market share as possible as quickly as possible and by being the first to develop a product and to flood the market with it, even -- at least initially -- at a loss. To see how different this is, think again about mining. If you discover a large deposit of copper ore, do you think you would want to give lots of it away for free to increase your market share? Of course not.

S&B: What does this mean in a business sense?

Paul Romer: First of all, it means that the kind of strategies you see in the knowledge economy are those like Netscape's. In that strategy, a new company comes into a new market and gives away its browser and tries to move very rapidly to supply a large part of the market. Netscape did this and it ended up with a large percentage of the total market for browsers. It is now trying to leverage that advantage into a larger advantage in the more lucrative market for server software. That kind of competition is driven by falling costs and increasing returns in the information economy. That is the way competition unfolds in the information economy.

So we are talking about two extremes: One is software, the other is resource extraction. A lot of traditional business fits somewhere in between.

S&B: How are monopolies sustained in the knowledge economy? Don't new companies come along with new products that replace the old ones?

Paul Romer: Yes, that is true and it brings us back to the two notions of increasing returns that we were discussing a minute ago. Recall the thought experiment where we shut down the increasing returns associated with the shoulders-of-giants effect but assumed that the increasing returns associated with cheap copies were still present. This leads to a rather pessimistic implication. A firm like Microsoft would become the monopoly supplier of operating systems software. It would remain a monopolist forever because no entrant could compete with it with a similar product and, according to our assumptions, there was nothing better that was left for someone else to discover.

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