Management
practitioners have their own jargons. Without doubt these terminologies
developed help conceptualize ideas and their implementation in practice. While
the observations lead to the formation of theory, it is equally true that the
theoretical formulations thus developed play an input in strategy and tactics
of a firm. Many management jargons and concepts owe their origin to concepts or
models elucidated in economics. It would be prudent to discuss these concepts
often used in management to their roots in economics. It must be stated that
these roots might have often emerged subconsciously without a reference to the
economic underpinnings. The current post will deal with a couple of such
concepts.
One of the
critical understandings that practitioners seek to pursue in product
development is the product life cycle. It conceptualizes the journey of the
product from its inception to its end cycle or the decline or perhaps death. It
does give insights to the practitioners on reinvigorating the product at the
appropriate times to stretch its shelf life. It does given pointers on the need
to cannibalize the products as they make way for their successor generations to
take over. Yet the product life cycle or PLC as it popularly called perhaps
traces its origins to the understanding of the economics. To decode PLC through
the prism of economics, one takes refuge in the concept of returns to scale.
PLC is
conceptualised in four stages. Its advocates believe the product finds itself
first in the introduction stage. Once it is introduced and finds itself placed
in the market, it experiences a growth stage following which it attains certain
maturity. Implied is the growth cannot be sustained for long periods at high
levels. It slowly comes to certain sustained levels of growth. This is followed
by the decline perhaps driven by demand side diminishing marginal utility or
the supply side law of diminishing returns.
The idea of
returns to scale on the other hand is driven the responsiveness of output to
changes in input. In some ways, it is analogous to the concept of elasticity of
output. A percentage change in inputs across board will lead to a percentage
change in output. This is what the returns to scale seeks to illustrate. If the
output increases more than proportional to the changes in input, then one
describes the case as increasing returns to scale. If the output increases in
the same proportion as the increase in inputs it is described as the concept of
constant returns to scale. If the output increases less than proportional to
the increase in inputs, it is described as decreasing returns to scale. In
production economics literature, it is recognized that increase in an input
without changes in other inputs will take us to a point wherein any further
addition of input will cause the output to decline. In other words, it is the
case of marginal product turning negative what one terms as a case of
diminishing returns. To avoid diminishing returns, it is suggested to increase
inputs across board, yet one finds diminishing returns playing its part in this
context too.
In the product
life cycle, the product when it gets introduced, it experiences an increasing
returns. In the growth stage too, the increasing returns are in full play. It
is not surprising. The market is barely touched while the margins are low and
bound to expand. With small increases in inputs, the changes in output with
respect to the market share growth as also its contribution in terms of margin
will naturally increase more than proportional. Therefore the increasing
returns are witnessed. Yet the market share growth has its limits. While there
is a significant growth in the initial days, it is bound to reach certain
limits wherein it moves from zone of elasticity to a zone of inelasticity while
navigating the terrain of constant growth in between. The experience of
constant returns to scale is what is observed during the maturity stage. The
product has captured significant market share while contributing equally
significant margins to the firm, yet the growth rate in both market share and
margins is somewhat reduced. The impact of diminishing returns and the
diminishing marginal utility will perhaps cause the rise of decline stage
wherein the product begins to experience the cycle of decreasing returns to
scale.
This can also be
compared to the positioning adopted in Boston Consulting Group matrix,
something popularly termed as BCG matrix. Formulated by Bruce Henderson, it was
essentially a matrix model trying to capture the links between market growth
and market share. It was the portfolio management model for strategy and
marketing. It conceptualised the entire product portfolio into four different
quadrants of question marks, stars, cash cows and dogs. The question marks have
high growth rates but low market shares. These are the one who do demonstrate
the increasing returns to scale since every addition of input would perhaps
lead to more than proportional change in output (in this context the market
growth rate). Yet there is no certainty that the returns to scale will on an
increasing order and thus the term question marks. The stars given their high
market share and high growth represent best the case of increasing returns.
These give away to cash cows which while commanding high market share have low
market growth. These are the products that experience the constant returns to
scale. The beginning of diminishing returns is visible during the stage of
dogs. Dogs are ones which have low market share and low growth rates. It is
possible that the question marks might morph into dogs thus the uncertainty
with respect to sustaining their increasing returns.
The above two
examples are mere illustrations of the concept of returns to scale being used
to construct different concepts in management. As the product life cycle goes,
it is essentially a journey through which a product evolves while following the
dictums of the returns to scale. Earlier stages, the growth will remain high
since it changes more than proportional to rise in inputs whether marketing or
production or any other element. Yet, the sustenance is a question mark and
hence every product reaches a constant returns to scale or maturity stage. This
is because market size is finite. The same logic is observed in deconstructing
BCG matrix through the prism of economics. While stars no doubt yield
increasing returns, cash cows experience the instance of constant returns. In
fact they are classic illustration of the manifestation of economies of scale.
The linkages between returns and economies are quite interesting but would be a
subject matter of some other post.
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