Apr 012001

In the late 1990s, a term "New Economy" was in fashion. According to Brian Arthur, the pioneer of economics of complex systems, while the Old Economy was based on the law of diminishing returns, the New Economy is based on the law of increasing returns, and it means the growth without inflation that boosts up the eternal rally of NASDAQ. What is wrong with this theory?

NASDAQ Composite 1993-2002. Google Finance.

1. The law of increasing/diminishing returns

Before examining it, I’ll explain the law of increasing/diminishing returns. The return is the function whose variables are such factors of production as land, labor, capital, intellectual properties and so on. Although every factor is variable input in the long run, in the short run you can make only one factor variable with the others fixed.

Suppose, for example, a farmer is increasing only the input of fertilizer with the other factors constant. When the input is small, the increase in fertilizer has an effect that beats the increase in the cost of fertilizer. But the gradual increase in the input decreases the effect gradually until the returns are reduced to zero. This is the law of diminishing returns.

2. The law of increasing/diminishing returns to scale

Then, what will happen, if the farmer increases the other factors, land, labor etc. at the same time? If s/he improves efficiency by introducing large machinery, s/he can expect increasing returns to scale. It is a biased view that diminishing returns to scale always dominates the Old Economy. On the contrary, many countries, whether capitalism, communism or fascism, had concentrated means of production until the Information Revolution, as economies of scale usually reigned in the industrialized countries.

However, returns do not increase forever. First of all, resources necessary for production is limited. As the Earth is limited, the increase in production raises the scarcity, i.e. cost of ingredients and diminishes returns. The limitation of resources is also the limitation of population, namely demand does not increase to an unlimited extent.

The more important cause that brings about diminishing returns to scale is the swollen middle management. An initial input of additional labor as a factor of production increases returns, since the division of labor improves efficiency. But further input has a less effect and results in diminishing returns to scale, as it enlarges the management cost necessary to supervise workers. The inefficiency of gigantic government enterprises is typical diseconomies of scale.

The best way to reduce the management cost is to make individual workers independent and manage them. If all workers as independent experts devote themselves to their strong points and outsource the other field, the decentralization does not decrease the efficiency.

3. The essence of New Economy

The pursuit of scale since the 18th century Industrial Revolution broke down in 1970s, when the exhaustion of natural resources and the environmental destruction on one hand and the inefficiency of bureaucratic organization on the other came to the surface. Since 70s, the change from the energy intensive industry to the knowledge intensive industry that wastes fewer natural resources has coincided with the structural transformation from the hierarchical organization to the network specialization.

The knowledge intensive network economy has produced a new type of economy of scale, the Winner-Take-All Economy brought about by the network externality of defacto standard. The defacto standard sells the better, the better it has sold.

The positive feedback of defacto standards, whose typical example is the OS of PC, is based on the interdependent network economy. IBM had once the overwhelming share in the world computer market. However, as the global network of computers did not developed those days, NEC could build their own kingdom in Japan. When the information processing function is decentralized from mainframe to PC and the global network of information exchange has developed, the monopoly by a defacto standard becomes possible.

As the reproduction and distribution of digital contents on line costs almost nothing, the increase in sale is believed not to diminish returns. This is the background of the myth of New Economy: the more a dotcom company sells, the more returns it can get. Actually, a rise in sale also increases the cost of advertisement, customer support, a lawsuit against the invasion of copyright and so on. The software industries do not consume so many resources as the hardware industries, but it is just a matter of degree. Owing to the limit of demand itself, a new industry, though it grows rapidly at first, soon reaches full growth and diminishes returns.

The newness of the New Economy consists not in what it makes but how it makes. Classifying Microsoft as a New Economy and Coca-Cola as an Old Economy is superficial. Whether the products are software or soft drinks, first the law of increasing returns and then the law of diminishing returns holds sway over the industry. Increasing returns are inessential to the New Economy. People often say, "NASDAQ is slumping. The New Economy was an illusion." Such a commonplace criticism of the New Economy is not to the point as well.

The essence of the New Economy lies in the knowledge intensiveness. The interdependent network structure that enables the defacto standard and the energy saving economy that enables low inflation are derivatives from the knowledge intensive economy.

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