Case 1 – Public sectors costing decision
A particularly controversial example of the law of diminishing returns is in the area of state, or public, spending. Some recent studies indicate that diminishing returns have been very much in evidence in developed countries in recent decades, with returns even being negative in some cases. An example is the IMF paper by Tanzi and Schuknecht,5 which examined the growth in public spending in industrial economies over the past 125 years and assessed its social and economic benefits.
At the beginning of this period, 1870, governments confined themselves to a limited number of activities, such as defence and law and order. Public spending was only an average of 8% of GDP in these countries at this time. The higher taxes that were introduced to pay for the First World War allowed governments to maintain higher spending afterwards. Public spending rose to an average of 15% of GDP by 1920. This spending increased again in the years after 1932 in the surge of welfare spending to combat the Great Depression. By 1937 the average for industrial countries had reached nearly 21% of GDP.
The three decades after the Second World War witnessed the largest increase in public spending, mainly reflecting the expansion of the welfare state. By 1980 the proportion of GDP accounted for by state spending was 43% in industrial countries, and by 1994 this had risen to 47%. By this time there were large variations between countries: the EU average was 52%, in the UK it was 43%, in the USA 33%. In the newly industrializing countries (NICs) the average was only 18%. These variations over time and area allow some interesting comparisons regarding the benefits of additional spending.
Tanzi and Schuknecht found that before 1960 increased public spending was associated with considerable improvements in social welfare, such as in infant-mortality rates, life expectancy, equality and schooling. However, since then, further increases in public spending have delivered much smaller social gains, and those countries where spending has risen most have not performed any better in social or economic terms than those whose spending has increased least. In the higher-spending countries there is much evidence of ‘revenue churning’: this means that money taken from people in taxes is often returned to the same people in terms of benefits. Thus middle-income families may find their taxes returned to them in child benefits. Furthermore, in many of those countries with the lowest increase in public spending since 1960, efficiency and innovation appear to be greater; they have lower unemployment and a higher level of registered patents.
Another study found a similar pattern in Canada specifically.6 In the 1960s public spending, at modest levels, helped the development of Atlantic Canada. Most of the money went into genuinely needed roads, education and other infrastructure. Later large increases in spending not only had a smaller effect, but in general had a negative effect. For example, generous unemployment insurance reduced the supply of labour and impeded private investment. Subsidized industries, like coal, steel and fishing, involved using labour that could have been employed in more productive areas, as well as in the last case decimating the cod stocks. Even the roads eventually deteriorated, as local politicians had little incentive to spend public funds wisely, and voters felt unable to discipline them.
1. In what areas of public spending do there appear to be increasing returns? â€¨
2. In what areas of public spending do there appear to be diminishing or negative returns? â€¨
3. Explain the difference between diminishing and negative returns in the context of public spending, giving examples. â€¨
4. Explain what is meant by‘revenue churning’, giving examples. â€¨
5. Why do local politicians have little incentive to spend public money wisely? â€¨
6. Is it possible to talk about an optimal level of public spending? How might this level be determined? â€¨
Case 2 - Marginal costing and decision
In some industries, securing the adoption of an industry standard that is favourable to one’s own product is an enormous advantage. It can involve marketing efforts that grow more productive the larger the product’s market share. Microsoft’s Windows is an excellent example.2 The more customers adopt Windows, the more applications are introduced by independent software developers, and the more applications that are introduced the greater the chance for further adoptions. With other products the market can quickly exhibit diminishing returns to promotional expenditure, as it becomes saturated. However, with the adoption of new industry standards, or a new technology, increasing returns can persist.3 Microsoft is therefore willing to spend huge amounts on promotion and marketing to gain this advantage and dominate the industry. Many would claim that this is a restrictive practice, and that this has justified the recent anti-trust suit against the company. The competitive aspects of this situation will be examined in Chapter 12, but at this point there is another side to the situation regarding returns that should be considered.
Microsoft introduced Office 2000, a program that includes Word, Excel, PowerPoint and Access, to general retail customers in December 1999. It represented a considerable advance over the previous package, Office 97, by allowing much more interaction with the Internet. It also allows easier collaborative work for firms using an intranet. Thus many larger firms have been willing to buy upgrades and pay the price of around $230.
Case study 5.1: Microsoft – increasing or diminishing returns?
However, there is limited scope for users to take advantage of these improvements. Office 97 was already so full of features that most customers could not begin to exhaust its possibilities. It has been estimated that with Word 97 even adventurous users were unlikely to use more than a quarter of all its capabilities. In this respect Microsoft is a victim of the law of diminishing returns.4 Smaller businesses and home users may not be too impressed with the further capabilities of Office 2000. Given the enormous costs of developing upgrades to the package, the question is where does Microsoft go from here. It is speculated that the next version, Office 2003, may incorporate a speech-recognition program, making keyboard and mouse redundant. At the moment such programs require a considerable investment in time and effort from the user to train the computer to interpret their commands accurately, as well as the considerable investment by the software producer in developing the package.
1 Is it possible for a firm to experience both increasing and diminishing returns at the same time?
2 What other firms, in other industries, might be in similar situations to Microsoft, and in what respects? 3 What is the nature of the fixed factor that is causing the law of diminishing returns in Microsoft’s case?
4 Are there any ways in which Microsoft can reduce the undesirable effects of the law of diminishing returns?