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The Emergence of High Sunk Costs Industries: Market
Structure, Technological Change and Productivity Growth in
Services, 1750-2000
Gerben Bakker, London School of Economics
This is a preliminary draft of work in progress, please do not quote or circulate without the
author’s permission.
Abstract
This paper, a speculative and open-ended inquiry into the nature of sunk costs, argues that,
when combining sunk costs with proper industry and market definition and proper output
measures, productivity growth may have been far larger than previously thought. The
industrialisation process appears to be something that did not exclusively happen to
manufacturing, but that also could be discerned in service industries, and enabled a sharp rise
in productivity growth in services. This paper argues that the industrialisation of service
industries came as a thief in the night because it was brought about by the emergence of new,
high-sunk-costs industries that industrialised services by automation, standardisation and
making the service tradable and that coincided with a shift from process to product
innovations, from low sunk costs to high sunk costs, from many identical ‘typical’,
‘representative’ firms to singular, quasi-unique firms, from small markets to large markets,
and from fragmented to highly concentrated industries. The paper makes a beginning with
empirical tests by investigating the entertainment and pharmaceutical industries in detail, and
by briefly discussing relevant aspects of the telecommunications, transport and domestic
services industries.
Dr Gerben Bakker
Departments of Economic History
London School of Economics and Political Science
Houghton Street
London WC2A 2AE
Tel.:
+ 44 - (0) 20 – 7955 7047
Fax:
+ 44 - (0) 20 – 7955 7730
Email: [email protected]
Website: http://www.essex.ac.uk/AFM/staff/bakker.shtm
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CONTENTS
1. INTRODUCTION............................................................................................................................................. 3
2. METHODOLOGY............................................................................................................................................ 5
2.1 INTRODUCTION AND HEALTH WARNING ........................................................................................................ 5
2.2 GENERAL APPROACHES: SCIENTIFIC AND NARRATIVE ................................................................................... 6
2.3 MEASUREMENT ............................................................................................................................................. 8
3. A CHARACTERISATION OF THE INDUSTRIALISATION PROCESS .............................................. 11
3.1 MARKET GROWTH ....................................................................................................................................... 11
3.2 THE SHIFT FROM PROCESS TO PRODUCT INNOVATIONS ................................................................................ 12
3.3 THE INDUSTRIALISATION PROCESS .............................................................................................................. 13
3.3.1 Automation, standardisation and tradability...................................................................................... 13
3.3.2 Like a thief in the night: Structural change in service industries ....................................................... 14
3.3.3 The shift to higher productivity growth .............................................................................................. 17
3.3.4 Other perspectives on industrialisation .............................................................................................. 18
3.4 THE SHIFT TO HIGH SUNK COSTS .................................................................................................................. 19
3.4.1 The sunkness of costs.......................................................................................................................... 19
3.4.2 Relevant industrial organisation theory ............................................................................................. 20
3.4.3 The dynamics of sunk costs................................................................................................................. 21
3.5 THE SHIFT TO QUASI-UNIQUE ORGANISATIONS ............................................................................................ 24
3.6 INTERNATIONAL DIFFUSION OF THE INNOVATION ........................................................................................ 26
3.7 CAUSAL FACTORS........................................................................................................................................ 27
4. INDUSTRY STUDIES.................................................................................................................................... 29
4.1 EMPIRICAL RESEARCH ................................................................................................................................. 29
4.2 OVERVIEW OF EXPECTED FINDINGS ............................................................................................................. 30
5 THE EMERGENCE OF THE FILM INDUSTRY ....................................................................................... 33
5.1 MARKET GROWTH ....................................................................................................................................... 33
5.2 INDUSTRIALISATION .................................................................................................................................... 34
5.2.1 Tradability .......................................................................................................................................... 34
5.2.2 Structural change ............................................................................................................................... 34
5.2.3 Higher productivity growth ................................................................................................................ 35
5.3 THE SHIFT TO SUNK COSTS........................................................................................................................... 36
5.4 THE EMERGENCE OF QUASI-UNIQUE ORGANISATIONS .................................................................................. 37
5.5 CAUSAL FACTORS........................................................................................................................................ 37
6 THE EMERGENCE OF THE PHARMACEUTICAL INDUSTRY........................................................... 39
6.1 MARKET GROWTH ....................................................................................................................................... 39
6.2 THE SHIFT FROM PROCESS TO PRODUCT INNOVATION .................................................................................. 40
6.3 INDUSTRIALISATION .................................................................................................................................... 43
6.3.1 Higher productivity growth ................................................................................................................ 43
6.4 THE SHIFT TO SUNK COSTS........................................................................................................................... 45
6.5 THE EMERGENCE OF QUASI-UNIQUE ORGANISATIONS .................................................................................. 47
7 OTHER INDUSTRIES.................................................................................................................................... 50
7.1 COMMUNICATIONS ...................................................................................................................................... 50
7.2 TRANSPORTATION ....................................................................................................................................... 52
7.3 HOUSEHOLD APPLIANCES ............................................................................................................................ 55
8. CONCLUSION................................................................................................................................................ 56
BIBLIOGRAPHY ............................................................................................................................................... 58
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The Emergence of High Sunk Costs Industries: Market
Structure, Technological Change and Productivity Growth in
Services, 1750-2000
Gerben Bakker, London School of Economics
This is a preliminary draft of work in progress, please do not quote or circulate without the
author’s permission.
1. INTRODUCTION
In the long-run, economic development has been characterised by sharp structural change. At
one point, by far the large majority of the working population was employed in agriculture,
now that is only a tiny fraction. Once, a large share of the population worked in
manufacturing, now that share is decreasing sharply and moving towards agriculture. Scholars
and people alike have been fascinated by these transitions, and often the name
industrialisation has been given to the first transition, or ‘industrial revolution’.1 A language ,
a conceptual framework emerged to discuss the changes taken place during industrialisation,
including words such as industrialisation, mechanisation, automation, etc.
Yet the transition did not stop with the shift from labour and capital out of agriculture
and into manufacturing, and from manufacturing into services. Many shifts followed, and
gradually society became accustomed to the occurrence of these shifts themselves. Corner
stores gave way to supermarkets, horse-drawn carriages to the railway and the motor car,
sailing boats to steamships and airplanes, letters to telegrams, telephone calls and emails,
doctors’ treatments to pills, three storey houses to skyscrapers. The process of structural
change became something that Western society got used to. Traditionally, ‘industrialisation’
is most closely associated with the shift from capital and labour out of agriculture and into
manufacturing, and also the continuous productivity increase in manufacturing. Yet, the
1
For Raymond Aron, for example, industrialisation is the separation from the household from the firm, the
technical division of labour within the firm with a hierarchical structure, capital accumulation, rational cost
accounting, and concentration of labour on one location [Aron, quoted in Vaags and Wemelsfelder 1983].
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transition did not stop there, and there were many subsequent transitions that have been less
clearly identified and did not involve manufacturing.
It is these subsequent shifts that are the topic of this article. Many of these shifts
involved services, and this article will be investigating productivity growth in service
industries. While some economists have argued that several service industries have inherent
characteristics that inhibit productivity growth, this article notes that structural change did as
well take place in many services, and investigates whether a similar industrialisation process
can be identified to services, and whether the perceived stagnation in some service industries
may simply depend on inadequate conceptualisation, such as how industry and market are
defined, and inadequate measurement methods (such as using inputs as a proxy for output).
This article argues that the industrialisation process was not something that
exclusively happened to manufacturing, but that the same process can also be discerned in
service industries, and enabled a sharp rise in productivity growth in services. It will argue
that this rise was brought about by automation, standardisation and making the service
tradable and coincided with a shift from process to product innovations, from low sunk costs
to high sunk costs, from many identical ‘typical’, ‘representative’ firms to singular, quasiunique firms, from small markets to large markets, and from fragmented to highly
concentrated industries.
This research is worthwhile, first, because nowadays, the largest part of the population
works in services and rapid structural change is taking place in services. It would be helpful to
have a conceptual framework to talk about this change. Second, a notion widely prevails that
productivity increase is often more difficult in services than in manufacturing, and this article
tries to defuse this perceived problem by showing that the manufacturing/services dichotomy
is not so sharp as it appears and that many of the things that happened in manufacturing may
also be happening in services.2 Third, the wide variety of activities we have labelled ‘services’
together constitute the area of our ignorance. We have generally characterised long-run
structural change as a shift from the primary to the secondary to the tertiary sector (with some
adding a quartiary sector of public services), and therefore may not capture all the structural
change that takes place within the white space we have called ‘tertiary sector’, changes that
may be just as pronounced as the transition from secondary to the tertiary sector. By throwing
2
In fact, this article will also investigate whether the concept of high sunk cost industries can be used to explain
industrialisation in manufacturing (which may be more of an exceptional case than the industrialisation of
services).
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our nets of hypotheses into this vast unconceptualised, under-examined, dark area of
structural change, we may arrive at a finer theory.
The emergence of high sunk cost industries may also contribute to our understanding
of and explain the sharp increase in consumer well-being over the twentieth century, in terms
such as real income, life expectancy, consumer surplus, human capital per consumer, etc.
Fifth, if the hypotheses remain standing, they may have important implications for the shape
of things to come, i.e. further structural change and paths of development and productivity
growth, in the twenty-first century.
To explore these research questions, the next section will discuss the methodological
issues, and a subsequent theoretical section will hypothesize the industrialisation process by
which a shift to high sunk costs industrialises services. It is followed by a section that
speculatively investigates this constellation of hypotheses for the entertainment industry and
the pharmaceutical industry, and that also includes a few observations on other industries.
2. METHODOLOGY
2.1 Introduction and health warning
This paper differs from many other papers in economic history, in that it is rather
experimental, and focuses more on the building of dynamic hypotheses and theory than on
empirical testing. Sometimes works in economic history use theory from elsewhere and focus
on detailed empirical work to test the theory, and sometimes works in economic history are
entirely crafted around empirical observations, available data and standard ‘descriptive’, databased regression models, not always daring to depart from the data towards theories that can
be far wider, that do not need to be verified by data, and that only need a few instances in
which they can potentially be falsified by targeted deductive tests.3 This paper attempts to
develop a theory that is largely economic-historical in that it attempts to explain the long-run
dynamics of economic development, and would work less well (would be less testable) in a
static situation (i.e. a specific point in time). It is rather speculative and experimental, and at
times a research agenda. Readers are warned that at times they may find it highly unusual and
may feel uncomfortable about specific sections. Nevertheless, it is hoped that this paper will
contributed to more daring theory building within economic history, especially of (dynamic)
theories that are inherent to the field and could make an impact on social science in general.
3
Popper 1935.
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The rest of this section will discuss the nature of the ideas developed in this paper as
well as the issue of measurement.
2.2 General approaches: scientific and narrative
This paper tries to characterise the industrialisation process for specific service industries that
were industrialised by technologies involving high sunk costs. An important question is what
the hypotheses developed in this paper (see section 3 below) actually constitute, i.e. the
question whether they are real hypotheses that lead to empirical predictions that are testable
and can potentially be falsified/rejected or whether they simply constitute a story,
metaphysics, thoughts that cannot be falsified, and thus always can be construed as ‘true’. It is
argued here that the thoughts in this paper are hypotheses that can potentially be rejected by
deductive empirical tests. Together the hypotheses do characterise a certain pattern of
developments that one can observe in the development of high-sunk-cost industries, and one
should be able to test whether or not one does see those patterns.
Nevertheless, part of the empirical content will depend on the conceptual content of
the theory, on the use of language and specific words used to define or denote specific
developments. Examples of such words are high-sunk-costs industries, industrialisation,
industrialisation of services, automation, standardisation, tradability, process innovations,
product innovations, quasi-unique organisations. It will be argued below that these concepts
are clear, and developments can be unequivocally named with such a concept or not; the
concepts are objectively attributable to (groups of) empirical occurrences. Yet in a dynamic
framework, some conceptual issues may arise: when we call certain industries high-sunkcosts industries, do we mean the entire industry all the time, the industry and service from the
time when it industrialised the service, or only the new high-sunk-costs part of the industry?
Since all these things change over time, these kind of issues are important. (In this paper highsunk-costs industries refer only to the latter, as will be explained below).
One could argue, on the contrary, that the theory simply forms a narrative that gives
meaning to the historical facts and that connects, configures historical facts into a certain
configuration. If this is accepted, then narratives with a larger scope, i.e. implicitly and
explicitly connecting and configuring more historical facts, words, theories,4 are to be
preferred over narratives with a smaller scope.5 These narratives would be inherently
4
5
This does not necessarily mean a longer text.
F. R. Ankersmit, Narrative logic (1983), and lectures of F. R. Ankersmit, Groningen 1992-1993.
6
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unfalsifiable by deductive testing, and they would not constitute science but metaphysics, or
history, philosophy. Narratives could only be rejected by other narratives with larger scope, it
seems, not by a single deductive test, as in scientific research. This does not mean however,
that these narratives would not be useful, and could not contribute to science (for example in
the generation of future hypotheses and theory).6 This may also connect to Patrick O’Brien’s
notion of meta-narratives7 that give meaning to large and global swings of historical
development.8
One specific problem in the constellation of hypotheses below is causality. In
economics and economic history theory sometimes unidirectional causality and unique
equilibria are assumed and regression models used to test for it. For many economic
phenomena, this may not be the most useful kind of approach. In social science, many
variables are affected by the choices that agents make, and this makes it difficult to fully
separate factors into causes and effects. In industrial economics, for example, John Sutton has
shown how variables that were initially thought to have a causal relationship, were in fact
jointly determined by the games of agents in relation to more basic features of the patterns of
technology and tastes in a market. Using a game-theoretical model, Sutton is able to predict
lower bounds to concentration, but not unique equilibria, which may depend on historical,
institutional, legal and other factors. In the constellation of hypotheses below, it is sometimes
not possible to pinpoint which factors are causes and which effects, which endogenous and
which exogenous. The factors often interact with each other, and have a two-way cause and
effect relationship, and are sometimes jointly determined. Some factors can also act as
catalysts and accelerate the interaction between other factors. It is difficult for regression
models to be of much use in such a situation.
One issue is whether the theory developed in this paper is relevant only to the special
case of services and high-sunk-costs industries or whether the theory can be more general.
Instead of working only on a theory on the industrialisation of services, we could also say that
we are developing a new theory of industrialisation, one that not only can explain what we see
happening in service industries, but at the same time can also explain what we see happening
in manufacturing, i.e. the theory is wider than the older theory, but envelopes the older theory.
The older theory would then simply be a special case of the new theory. This would make the
6
See also Popper’s stance on metaphysics, who considered it very useful, although not science [Popper 1935].
Papers presented by Patrick O’Brien at the London School of Economics, 2002-2003.
8
This distinction between hypotheses and narrative should not be taken as a distinction between quantitative and
qualitative research, of course. One think of Popper’s classic black swan, for example.
7
7
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theory significant, as it then would have a higher explanatory power than the existing theory,
and thus should be preferred, as long as it stands up to falsification attempts.9
2.3 Measurement
When analysing long-run changes in industries, the way changes are measured affect what is
actually observed. Especially the distinctions between different sections of the economy and
between industries become far less clear when using a dynamic perspective than a static
analysis at a specific point in time. The current research may develop a unifying perspective
that would be somewhat less dependent on the (sectoral) labels put on economic activities and
the grouping of economic activities. First definitions of sectors will be discussed, then
definitions of industries.
Usually economic activities are divided in sectors, such as agriculture, industry and
services. Sectoral measurement has sometimes faced some problems, such as the
circumstance whether large firms provide their own services or buy them affecting economy
level statistics. Nevertheless, it does seem possible to distinguish between an industry and a
service in the sense that services are consumed at the moment they are delivered. Other
definitions sometimes include intangibility, inseparability (it cannot be stored), variability
(same service can never be 100% guaranteed), perishability and verifiability.10 However, all
these characteristics to demarcate services from industry have some problems. The most
strong characteristics seems to be intangibility, and then inseparability from production and
consumption. Inseparability, however do have some problems: an architect works separately
from the consumers, and only over time is a final design ready, and one could argue that the
services of the architect are ‘stored’ in the final design and blueprint. High-sunk-costs
industries have moved in the same direction: the production cost of the individual pill or the
individual film roll is infinitesimal compared to the cost of developing the information
contained in the product.11 One can reason similarly about academics writing research papers,
and consultants writing advisory reports. One could argue that the outputs—the design, the
9
On the natural sciences, see Popper, The logic of scientific discovery. The general progress in the natural
sciences has been characterised by continuous development of more general theories of which the older theories
become special cases that approximately hold for specific parameter values.
10
See Kotler 2001, who also mentions also ‘lack of ownership’.
11
It seems that several other manufacturing industries may be moving into this direction, especially in cases
where factory capacity is not asset-specific and can easily be switched from one product to the other.
Nevertheless, even then often substantial costs are involved in the manufacturing of the products, and the
manufacturing capacity is a significant constraint for the firm, while it is not in high-sunk-costs industries such
as entertainment and pharmaceuticals.
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journal article, the report—are also tangible, but generally the physical paper is nearly
worthless, while the information exclusively determines the value and can be infinitely
reproduced. So intangibility seems the strongest definition so far for the demarcation of
services from industry.
For long-run analysis of economic growth and productivity growth, this paper argues,
how one distinguishes between industry and services can potentially determine what one
measures. This paper will argue that what really matters is the final end-use of a
product/service, the need this product/service fulfils, and that this final end-use can always be
expressed in terms of services. For example, clothes provide warmth, social distinction and
shelter from the elements, a dish-washer provides dishwashing services, a radio provides
spectator-hours of entertainment, food provides calories, vitamins, and a taste experience, etc.
William Nordhaus forcefully argues for using this hedonic way to look at long-run
productivity growth. Analysing the history of light, he focused on the light services that the
sun, the moon, fires, candles, oil-lamps, light bulbs, etc. deliver, which can be measured in
lumen, and then estimates the long-run changes in real prices, and potentially productivity
growth (Nordhaus 2001). Instead of treating the lighting industry exclusively as a whole new
industry, it is analysed as a configuration of assets that could provide lighting services in a
different way than before. These end-services can then be a common denominator to measure
long-run changes in inputs and outputs.
This discussion also hinges a bit on the nature and definition of capital. One could
argue that the output of the non-household sector, as far as they are not services, are the
capital goods of households. These capital goods provide services to the household during a
specific period of time in which the capital depreciates, just as human and physical capital
provides services to non-household organisations. I.e. the only things that can be consumed
are services. A washing-machine, CD-player, tables, chairs, beds, can thus potentially be
considered capital goods that provide certain services to households. Baskets of food and
other perishable products purchased by households could also be considered capital invested
in stocks, depreciating by the amount of perishables actually consumed during a given
interval. A pronounced development during the nineteenth and twentieth centuries, and
possibly not unrelated to the increasing importance of high-sunk-costs industries, was the
sharply increasing capital intensity of households.12
12
But the price paid for many of those capital goods has come down considerably.
9
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The second issue of definition, which cuts across the first definitional issue, is the
definition of industries and markets. Often cross-price elasticities are used to determine
whether two products are in the same markets. Using present-day cross-price elasticities is
deceptive, because they change significantly during industrialisation of a service: initially, the
old and new service industry have a high cross-price elasticity, but gradually the traditional
part differentiates itself. While the modern part often becomes ‘high sunk costs—high
volume—low unit costs—high profits’ (such as the film industry, the pharmaceutical industry
or modern telecommunications), the traditional part either differentiates into ‘high value
added—low volume—high margins—high profits’ (such as Broadway shows/musicals,
private hospitals or express courier services) or into a highly subsidised industry (such as
symphony orchestras, public hospitals or universal postal service). Again, to define the proper
industry and market, the end-services provided by both services and physical products could
be used as a common denominator.
These definitional issues also get us back to the issue of science versus metaphysics
and hypotheses versus narration; in theory in many industries similar patterns can be
observed. One could argue, for example, that textiles has been further ‘industrialised’
nowadays by a shift to high sunk costs: the modern, high-sunk costs part of the industry (high
margin, high volume, high profits) is then branded fashion, that incurs high sunk costs in
designing the fashion and in a high advertising-to-sales ratio. The post-traditional, high value
added (low volume, higher margin) part would then be the traditional tailors that would cater
for a wealthy clientele, and the post-traditional highly subsidised/protected industry (low
margin high volume) would be textile manufacturing, which is murderously competitive if
unprotected.
An objective measure of output [Bailey 2001] should encompass the pre-existing and
industrialised service industries, as well as the ‘post-traditional high value added’ and the
‘post-traditional highly subsidised’ industries. For entertainment, for example, the spectatorhour has been developed [Bakker 2004a]. For communications, the bit-distance-velocity per
second (bits.km2/s2) could possibly measure output all the way from the eighteenth century
optical telegraph [Field 1992, 1994] to modern email-systems.
However, some quality changes are difficult to capture. One way around this would be
that all quality-changes are assumed to be for the better and be a bonus; thus any measures of
productivity will actually underestimate the real growth in output/welfare/well-being. So
increase in quality when one switches from the wobbling on a horse carriage to the steady seat
in a modern car is not captured in the cost per passenger-kilometre per kilometre/hour, which
10
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means that the latter may actually understate productivity growth. The problem is present
everywhere; Suslow 1996, for example, finds as much as eleven different dimensions along
which to measure the quality of an anti-ulcer drug. The problem with a lot of these multidimensional hedonic indexes is that they are difficult to use to measure very long-run quality
changes. They also often ignore the minimum unit-size requirement and a lot of the hedonics
focus on inputs, not outputs. For example, the frequency of dosage per day of a medicine is
an important quality attribute, but only because it sharply affects patient compliance, and thus
the percentage of people cured. Nevertheless, finding a single measure along which to analyse
very long-run change is challenging.
A final issue is how to measure one-off, qualitative changes, such as the tradability
and the shift from process to product innovations discussed below. They could be dated and
pinpointed, and the share of tradable products and product innovations in the entire services
could be used.
3. A CHARACTERISATION OF THE INDUSTRIALISATION PROCESS
3.1 Market growth
During industrialisation sharp market growth takes place; the industry shifts from a small
market to large and growing markets. This is caused by several different things. Exogenously,
before the industrialisation, often a liberalisation of the industry takes place (see below),
which would lead to a sharp growth of the market, because the service could be provided
where previously its supply was severely limited. Endogenously, during the industrialisation
several factors increased the ‘absolute size’ of existing markets: 1) decreased prices 2)
increased perceived quality 3) new quality aspects that did not exist before 4) changes in
consumer demand. These first three changes could also lead to substitution, to consumers
replacing other expenditures by expenditures on the industrialised services. Second, because
the new technology often makes the services tradable, previously isolated markets become
more integrated: this increases the effective size of the market, especially in relation to the
size of the sunk expenditures that the escalating companies can incur.
11
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3.2 The shift from process to product innovations
It is argued that decreasing returns to process innovations at some point will lead to the
adoption of product innovations.13 The occurrence of decreasing returns may show some
similarities to Malthus’ characterisations: it seems that the service industry is reaching a
productivity ceiling, with bottlenecks emerging, such as a shortage of specialised labour.
In the US entertainment industry, for example, process innovations such as centralised booking and
centrally planned routing, railway transport, high capacity steel frame theatres, and higher quality stages
and sets were all process innovations that massively increased productivity and output of the existing
live entertainment industry. Towards the end of the nineteenth century these innovations, however,
reached decreasing returns, and expansion was only possible by adding labour and capital, the more
specialised inputs, such as actors and actresses, becoming more and more scarce. The product
innovation of cinema subsequently put the industry on a new path of sharp output and productivity
growth.14
Although strictly speaking these new technologies were embodied in product innovations
(such as films, medicines, software packages), they also had characteristics of Schumpeter’s
four other types of innovations [Schumpeter 1948]. They had some characteristics of process
innovations in the sense that they fundamentally changed certain processes and super-inflated
their outputs. They had some characteristics of organisational innovations because the new
products needed new types of organisations to develop and make them and fundamentally
changed existing organisations in the industry. They had characteristics of market innovations
because of the lower costs and prices of the output often sharply expanded the markets,
reaching many buyers that had not bought the service before. They also had characteristics of
supply innovations, because the products often were new kind of supplies to existing
organisations in the industry.
13
The author has benefited from the work of Jean-Pierre Dormois [1997] to develop these ideas.
This paper argues that intentitionality is irrelevant: it does not matter whether the product innovators had a
clear purpose to increase productivity with their innovation or not. Often it were simply entrepreneurs who
wanted to make profits, and often they were not even positioned within the industry that their product innovation
would industrialise. Many of the innovators in cinema technology, for example, did not come from the live
entertainment industry. It may also be considered quite natural that not all people inside the industry always
benefit from these innovations, and therefore they were not necessarily the first to develop the innovation.
14
12
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3.3 The industrialisation process
3.3.1 Automation, standardisation and tradability
The second coincident change was the industrialisation process itself. The new product
innovation generally automated, standardised and made tradable the service. Automation can
be characterised as dividing the production process in specific routines and then add hightechnology capital to decrease the labour and old capital inputs necessary for those routines,
i.e. try to automate most of them away.
In cinema, for example, on the level of the individual theatres, the players, make-up artists, production
managers, set designers, directors but also the sets themselves, the stage machinery, the real estate
occupied by the stage, backstage and dressing rooms were all replaced by (automated away by) a
projection machine and a screen. In healthcare, for example, on the level of the individual health
practice, for many diseases, the labour and routines of the doctors, nurses, supporting staff, but also
beds/hospital real estate, medical equipment, was at least partially replaced by medicines, resulting in
far lower costs and patient-days in hospital per treatment. In communications, the labour of workers
transporting the mail, and postmen sorting and delivering the mail, and the capital invested in vehicles
for transport, sorting centre real estate was at least partially replaced by optical and electronic
telegraphs, telephone calls, faxes and emails, sharply reducing the cost per standard message.15 In
domestic services the labour of predominantly housewives and domestic servants (and old capital such
as preservation jars, washing boards, washing buckets, brooms etc.) was at least partially replaced by
appliances such as the fridge, vacuum cleaner and washing machine, resulting in far lower labour hours
per domestic routine (and costs if supplied through the market by domestic servants).16 In office work,
labour of typists, clerks, secretaries, human calculators and capital such as paper, desks, real estate
taken up by these persons, storage space was at least partially replaced by software (such as word
processors, spreadsheets, databases, planning software), sharply reducing the cost per office routine.17
Standardisation can be characterised as standardising most quality aspects of the service, i.e.
making sure that for every consumer these quality aspects of the service are the same, that
consumers will know what quality they will experience for the specific service.
In live entertainment, for example, the cast of a specific play or act can be different, the same cast can
have good nights and bad nights, understudies can be used in cases of illness, the sets have to be
adapted to the specific characteristics of each theatre, and the sets can also differ per play/act, as those
for provincial tours may be of lower quality than the metropolitan versions. Film standardised all these
aspects and made sure that the same title referred to exactly the same product, even more exactly after
the arrival of sound cinema automated away the last service aspect, musicians and live acts. Similarly,
15
Sceptics should realise that in the nineteenth century in many large cities mail was delivered to homes six
times a day.
16
This whole paragraph understates the decrease in cost brought about by automation, because it does not take
into account changes/increases in product quality.
17
On an earlier wave of office automation see Broadberry and Goshal 2002.
13
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 14 of 59
in healthcare medicines standardised the patient experience, first since they all received similar
treatment, and second since the manufacturer would develop clear instructions to the medical personnel
what to do in each case and the manufacturer was a central point for collection of experience with the
medicine and universal dissemination of that knowledge. In communications, while letters could be
handled in different ways and at different speeds, the telegraph and telephone standardised the way
local personnel could influence the delivery, the speed of messages, their format, and also standardised
the time it took sender and recipient to do the message. In domestic services, variability in performance
by domestic servants/household members was standardised away at least partially by appliances and the
household routines themselves were standardised by the appliances and started to vary less between
households.18 In the office, variability of office personnel was at least partially standardised away, and
office routines were also more standardised, because the software provided common formats for many
routines (for example databases, spreadsheets, word processors).
Industrialisation made the services also at least partially tradable. This meant that, whereas the
original services used to be location-bound, and trading was inherently not possible (only an
input, the service personnel themselves, could travel), the industrialised services were at least
partially tradable. Generally, this trade was still somewhat at the input level of the service, but
since it were now the capital components of the service that were tradable, rather than only
the labour, and these capital goods as such replaced many of the labour that otherwise would
have to travel to provide the service, we can talk about tradability in a real sense (because
without slavery, trading in persons was hardly a possibility).
In cinema, for example, films were capital goods used by cinemas to produce spectator-hours. In
healthcare, medicines were used by doctors to provide treatments. In communications, transmission
capacity/bandwidth, was used by providers to produce messages.19 In domestic services, appliances
were capital goods used by household members/servants to produce domestic services such as cleaning,
washing, preservation of food, etc.20
3.3.2 Like a thief in the night: Structural change in service industries
Besides automation, standardisation and tradability, the industrialisation process also entailed
a flow of workers from the traditional service to the modern, industrialised service.
Nevertheless, in service industries often a large number of workers remained employed in the
traditional part. First, the flow often was not really a flow: often many workers in the new,
modern sector of the industry did not come from the old, traditional sector. Second, because
18
But they did vary a lot between countries [see the work of Charles Baden-Fuller].
We would argue that transmission capacity/bandwidth could be traded: it could be bought and sold, and in
principle be resold by buyers.
20
Oulton [2001] discusses how the intermediate good aspect of services changes can affect productivity.
19
14
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 15 of 59
the industrialisation process was instigated by a product innovation, a large traditional sector
with older products still remained, although this traditional sector changed revolutionary
because of the competition with the new sector.
After the advent of cinema, for example, most of the enormously large supply of cheap, vulgar', small
town live entertainment was automated away. The live entertainment that remained was either
commercial, metropolitan, high-value added market live entertainment, at ticket prices an order of
magnitude above cinema ticket prices, or low-value-added, non-commercial heavily subsidized live
entertainment, often supplied at relatively low prices.21 Within healthcare over time a lot of routine
treatments provided by doctors and nurses (such as those of infections, diabetes, etc.) were largely
automated away by medicines, with high-value added commercial healthcare providing premium
services, and large public hospitals providing subsidised treatment for all the treatments that could not
(yet) be automated away by medicines. Within communications virtually all the mundane every day
postal messages were automated away by telecommunication (such as telegraph, telephone, email),
while commercial courier express firms provided high-value-added premium services and heavily
subsidized or protected postal firms provided universal postal service at low cost. Within domestic
services, appliances automated away a lot of the domestic servants and work of household members.22
The traditional sector remained in high-value added commercial services for high income groups, such
as butlers, occasional (as opposed to living-in) domestic servants within the grey economy, and
subsidised domestic care by the government for people in need of medical conditions.23
The sharp changes taking place in the traditional sector after industrialisation make it difficult
to use present-day, ex-post cross-price elasticities to define markets (and industries).
People sometimes complain that treating live entertainment and cinema as being part of the same
markets put Shakespeare on an equal footing with popcorn blockbusters, and ignores the enormous
differences in ticket prices. However, most pre-industrialization live entertainment was extremely
vulgar and low-priced: those Shakespeare plays and musicals simply are still here today exactly because
they differentiated themselves from cinema, exactly because they are so different. The current low
cross-price elasticity is a result of the industrialisation process, not a disproof.24
Another problem in these industries is that demand grows very sharply throughout the
industrialization phase: there is a relative industrialisation instead of an absolute one. In
general, the decrease of price and the increase in quality (i.e. the decrease of the qualityadjusted price) results in a sharp increase in demand. Often, the traditional sector remains, and
21
Or non-subsidized avant-garde entertainment at the margins, the fringe. This may have been significant in an
artistic sense, but in a commercial sense this subsistence economy of live entertainment may not have been that
important.
22
Rising real wages, falling working hours and opportunity costs also played a large role (see section 7, below).
23
The question remains in how far this industrialization pattern is unique to services. Could this same pattern be
applied to the industrialisation within manufacturing? It could be argued that textile factories automated,
standardised and made tradable the services of individual local tailors, and that after industrialisation tailors
remained in a high-valued added sector, catering to the highest income classes or special occasions, and possibly
lower-value added tailors that simply adapted and repaired factory-made clothing.
24
This also adds an evolutionary perspective to economic survival.
15
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 16 of 59
its workers are not always automated away in a strict and absolute sense: a substantial part of
the traditional sector still remains, but in relative terms the traditional sector becomes less and
less important, both as a percentage of the total population (i.e. number of live entertainers,
postmen, domestic servants per 100,000 inhabitants), but especially, and also, as share of the
industry. This is one of the reasons why the industrialisation of services often comes as a thief
in the night: a lot of the hardships go unnoticed or are prevented because of the sharp growth
in overall demand, which still leaves place for a (rapidly changing and differentiating) part of
the traditional sector. But nevertheless, people still did get unemployed.
For example, the advent of sound cinema and radio resulted in massive unemployment among
musicians. Also, the unemployment of service workers may often be less noticed than that of industrial
workers. The resulting new products and product innovations also became so every day, such an every
day part of our life, that we hardly realise anymore the revolutionary changes that have taken place. In
this sense, service industrialization also comes like a thief in the night.
An important process in the industrialisation is structural change, in which employment in the
traditional sector is replaced by employment in the modern sector. This is also important for
the industrialisation of services.
In the film industry, a lot of employment in live entertainment and music was replaced by cinema. In
the pharmaceutical industry, a lot of labour in nursing and doctoring was replaced by medicines,
although it should be noted that in this industry, industrialisation generally came as a thief in the night,
because the industry grew so much, that the traditional labour was generally not literally replaced, but
its proportion changed because of the growth rate, and maybe not even that, as the output of the
industry increased so much, and quality-adjusted lives increased enormously, new medicines that cured
people could also result in more demand for nursing, doctoring etc. (otherwise they would be dead, now
they live on and may require more nursing, especially when old). In office automation, also a lot of
office workers were replaced by machines, yet you do not read a lot about this.
It could be argued that the mechanism by which labour is transferred from the traditional
sector to the modern sector is very important. How will this matter for our hypothesis? First of
all, regulation is important, as that can hamper structural change. Only when entertainment
was liberalised, did the modern live entertainment industry emerge and was traditional
employment replaced by more modern employment. Countries that were first in deregulation,
such as the US, did very well. Second, the dynamism of the whole society may be important;
if people prefer to stick to old ways of living, it may not help that much to stimulate structural
change. Third, the industrialisation of services generally brings about a very mild form of
structural change, because 1) the employment in the services (entertainers, nurses, domestic
servants, post deliverers) that it industrialises is not always very well organised and may not
have a very strong voice in national politics 2) because it industrialises by product innovation,
16
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 17 of 59
the new industrialising industry is generally in a new part of the market and considered a
different industry, and therefore, at least initially, not considered a threat to the interests of the
old, traditional industry, and the new companies also do not have to lay off old workers.
Because the new product is also different and of a different quality, it is not so soon and often
noticed that the new product threatens the old product, like in the textile industry. The
superior quality of the new products also make protest difficult: who is going to protest
against cinema, against new medicines, against the telegraph, against domestic appliances?
Not that there will be no protest at all, but it will almost certainly be much milder in these
services that are being industrialised, partially because the industrialisation comes as a thief in
the night.
So the industrialisation of services through high sunk cost industries could be a
mechanism of structural change that is relatively painless, or at least the pain does not seem to
be experienced that heavily.
3.3.3 The shift to higher productivity growth
One aspect of the hypothesis or model is that before the industrialisation increasing returns set
in to further process innovations and this reduces/decelerates the productivity growth. This
does not imply that productivity growth is stagnant in these industries before industrialisation,
far from it. These industries were not static, stagnant, traditional sector industries at the
moment of industrialisation. Generally, they had already experienced rapid growth and
development before the moment of industrialisation, and industrialisation simply emerged
when further returns to process innovations decreased. This pre-industrial development was
often linked to an increasing involvement of the market and market transactions in the
specific sector, often to the abolishment of many rules, regulations and customs that limited
the extent and influence of the market in this sector.
In entertainment, for example, the liberalisation of the entertainment industry led to rapid
commercialisation of the sector. The sector grew rapidly, and all kinds of innovations were developed
and adopted by entrepreneurs to further develop the sector. In the US this liberalisation started during
the war of independence, in Britain in the 1840s and in France in the 1860s. In many countries, cinema
took off at least half a century after liberalisation, if not more. In telecommunications, state involvement
in messaging remained important, but it generally took off in the nineteenth century when state
censorship on messages etc. was somewhat less and bounded, i.e. when it became easier for companies
to invest large amount of capital in networks. Also, innovations in financing, such as company law and
17
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 18 of 59
joint stock companies were necessary to obtain the large amounts of capital necessary to build these
costly networks.
Productivity/benefits can be measured in different ways, such as TFP, labour productivity,
and social savings approach. Essential is that output is measured in the right way, i.e.
independent of inputs, and that close attention is paid as to if goods/services are intermediate
or final.
It is argued that the process innovations eventual led to bottlenecks that could hardly
be solved by further process innovations anymore; further growth of the industry from that
point onwards could only be increased by adding more labour and more capital, but the
productivity of both inputs could hardly be increased any further.
3.3.4 Other perspectives on industrialisation
Sceptics could say that the concept of ‘industrialisation’ may not be characterised as above.
They may say that the characterisation above is very much an economic perspective on
industrialisation, while especially from a Marxist or Weberian point of view industrialisation
is in the first instance a social process. Thus factories in the early period of the industrial
revolution (in Britain) were distinguished by their social relations: the labour of a workforce
controlled by a capitalist employer and concentrated in a single building superseded that of
independent artisans. They need not, initially, have been more technologically advanced or
capital intensive than the system they replaced, and rapid technological change was the
consequence, not the cause, of industrialisation.25
Thus the above characterisation involved several elements: 1) a capitalist
employer/entrepreneur 2) a workforce concentrated in a single location(s) 3) separation of
work from the household 4) control of the work by the capitalist, i.e. this person can somehow
(try to) coordinate the workers in the location. In a dynamic way, it then says that
technological change followed from these social/organisational changes.
How would such a characterisation connect to our concept of industrialisation above?
First of all, one could argue, the above held mainly for manufacturing industries, were
products roughly remained the same, and then costs were reduced first by a different
organisation of production, and then by continuous process innovations, such as the water
25
The author is grateful to Sean McCarthy for these comments. See also Joel Mokyr [2002: 119-62], who
discusses four different explanations for the factory system: fixed costs and scale economies, information costs
and incentives, labour effort, and the division of knowledge.
18
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frame, steam engine etc. In service industries, it were the product innovations that became
really important (after a period of process innovations).
Second, we could say that the first part, the process innovation part in service
industries, partially had similar characteristics.
In entertainment, for example, independent theatres often became part of circuits, and independent
theatre groups often held long-term contracts to specific booking offices or circuits. Although the
relation was less direct, it was different from a situation with independent groups travelling around.
Theatres from the beginning already had a high degree of organisation with a group of workers and
artists controlled by managers. It was already quite a complex, project-focused organisation, with
creative persons, manual workers, unskilled service workers, financial accountants, all in one
organisation. Although the organisation focused on projects, the execution of each project was partially
routinised. In communications the visual telegraph was the first technology that organised labour and
capital in very specific, capitalist organisations. In pharmaceuticals, you had had hospitals since long as
a kind of ‘capitalist’ organisations, in which professional labour was somehow concentrated and
coordinated. In office automation/software, you already had the offices.
The above raises a problem of terminology. If we use this kind of social definition of
industrialisation, then one could argue that the services we discuss, those that eventually
became high sunk cost service industries were already industrialised even before
manufacturing, and that rather than being latecomers that we now reveal were also
industrialised, they actually were the earliest examples of industrialisation in social terms;
unseen, unnoticed, long before textile making was industrialised.26
3.4 The shift to high sunk costs
3.4.1 The sunkness of costs
Another characteristic of the industrialisation process is the shift from low sunk costs to high
sunk costs. Sunk costs are usually defined as investment costs that have to be incurred to enter
a business and have no residual value on exit of the business. Differences with fixed costs,
(costs that do not increase with output) in general are that they are often incurred periodically
(such as lighting, wages etc.), and that these are often not considered capital investments.
According to Schumpeter [1948], the ‘fixedness’ of costs is a matter of degree and depends
on the time period one is studying. Although Schumpeter does not discuss sunk costs, some
26
If that would be true, then their switch to high sunk costs could be part of a general model that not only
characterises services, but characterises all economic activities. It could mean that manufacturing industries may
go through the same shift to high sunk costs industries, later than services. This would also put the work of John
Sutton [1991, 1998] in a new perspective, who observed these kind of things in manufacturing.
19
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matter of degree may also be present there, although probably to a lesser extent. The residual
value may not always be exactly zero, the necessity of incurring the fixed costs may not
always be 100 percent, and some sunk costs may have in the longer term something that has
some elements of a periodical incurrence of costs. For example, although advertising are
generally considered sunk expenditures, companies generally incur them periodically, and
likewise, film studios generally make portfolios of films.
3.4.2 Relevant industrial organisation theory
The industrial economics strand will draw strongly on John Sutton’s work on endogenous
sunk costs and market structure [Sutton 1991, 1998, 2005]. While in many industries the lower
bound to concentration falls to zero as the market size increases, because there is ‘room’ for
more companies to enter the market, John Sutton has shown that in some endogenous sunk costs
industries concentration is bounded from below when market size tends to infinity, and does not
asymptotically converge to zero, but to some other value [Sutton 2005].27 Market growth raises
profits for any given quality level, making room for new entrants, but also stimulating firms to
raise their R&D investments to improve their quality level (while the marginal cost of an
increase in R&D-spending is unchanged, the marginal benefit from it is now higher), leading
to higher fixed sunk costs and limiting the number of firms as the market tends to infinity
[Motta 1992]. Which of the two effects has the upper hand depends on the distribution of the
willingness-to-pay and shape of R&D-costs associated to quality improvements [Motta and
Polo 2003]. This mechanism limits the degree to which a fragmented industry structure can
survive: if escalation is possible, one (or more) firms can break the fragmented configuration
by escalating their fixed and sunk outlays (i.e. making a quality jump). In other words, these
breaks, or escalation phases, are often characterised by ‘quality races’.
Although Sutton’s approach is industrial economic, it is close to the qualitative and
business and management side, and individual companies and historical circumstances do
have a role in three ways: using a bounds approach to market structure, Sutton only predicts a
lower bound to concentration, and agrees that the actual level of concentration can be
dependent on different, more idiosyncratic aspects, such as institutions, history or tradition.
Second, Sutton observed that, in high sunk costs industries, often ‘one smart agent’ escalates
spending, becomes market leader and changes the industry [Sutton 1997]. Sutton allows this
27
‘Exogenous’ sunk cost industries are industries in which the costs of raising product quality are prohibitively
high; they form simply a limiting case of the endogenous sunk costs model.
20
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happening in his models by using the ‘arbitrage principle’, stating that a profitable
opportunity will be filled by definition, but pays little attention as to how this happens. Third,
Sutton’s approach focuses on the long-term evolution of industries, thus stressing the dynamic
character of industrial organisation and the importance of history and singular events on
market structure. While Sutton’s approach employs an exact model predicting bounds and is
often quantitative in nature, it makes room for qualitative phenomena.28
3.4.3 The dynamics of sunk costs
It is argued here that during the industrialisation process service industries shifted from low
sunk costs to high sunk costs. One reason could be the importance of product innovations,
which generally require large, one-off up-front outlays. Both to develop the technology itself
(such as the R&D outlays on developing cinema technology, or developing techniques to
derive medicines from dye stuffs and coal tar) and once the technology has been developed to
continuously make the products/product innovations that are generated by the new
technologies (outlays on film production or on developing individual medicines). In a sense
one could say that some service industries institutionalised the innovation process, and instead
of only developing new products, they pioneered organisational innovations that
institutionalised the innovation process itself. Lamoureaux and Sokoloff discuss this for
example when they examine the emergence of large R&D labs in the US between 1900 and
1950, that needed a lot of time to develop organisational systems/routines that enabled
innovations inside the R&D lab, rather than using the lab exclusively to develop outside
inventions.
Coincident with this increase in sunk costs, often the variable and marginal costs were
very low in comparison.
Making a film costs a lot, while delivering another spectator-hour costs close to nothing, at the margin.
Inventing/discovering and developing a medicine cost a lot, but manufacturing another pill cost close to
nothing. Building a telephone network cost a lot, but selling another bit-second-km-second cost again
nearly nothing.
The importance of sunk costs had several financial and economic consequences. First, interest
rates/the cost of capital became an issue, since sometimes large investments over a period of
time were necessary before the first products/services were sold.
Within film production, this period was initially small, but over time increased to a few months, a
season, a year and even longer. Within telecommunications, it could be at least a few years. Within
28
For a fuller summary of the theory, see the theory section in Bakker 2005b.
21
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medicines it could be several years, sometimes as much as ten to fifteen years. During the period
before the first ticket/message transfer/pill was sold, the whole sunk capital was outstanding and
became larger and larger, and in economics term somewhere an interest rate was paid on this.
If the company that made the investments wanted to make sure that it was itself the one that
could lay claim to the future revenues of the investment, it needed to keep up interest
payments, or needed to keep its suppliers of equity happy and convinced that the eventual
returns would offset the large initial opportunity costs of their investment. One could
speculate whether long-term fluctuations in the cost of capital, as well as differences between
countries, affected sunk investments.
A second financial implication is that the marginal revenue of sunk investment
projects largely equals marginal gross profits, i.e. profits before the sunk costs are amortised,
interest payments on the debt have been made. This means that in principle a firm would keep
spending on marketing until marginal costs equalled marginal revenues. It also has
implications for the vertical structure of the industry: producers have to make sure that they
get the additional marginal revenues caused by their additional sunk expenditures, and that it
is not the retailer or the distributor who gets these marginal revenues. Solutions have
traditionally been vertical integration or percentage contracts. Patents and copyrights at least
partially help protect the sunk expenditures against competitors and are instrumental in having
some control over the downstream activities, i.e. having control over distributors, being able
to enforce percentage contracts.
That marginal revenues equal marginal profits also often has as a result price
discrimination. Because marginal costs are virtually zero, the firms also want to serve
consumers with low willingness to pay. (Sunk cost outlays generally lead to
monopolist/oligopolistic situations; i.e. expenditures are so large that not all pre-existing firms
will do it; property rights will protect part of the sunk expenditure, as will the sunk
commitments themselves).
In cinema, for example, before television there was a complicated system of runs, and after television
several windows on TV. For medicines, prices generally vary per country, and national health systems
often vary the costs to consumers, depending on the ability to pay. Telecommunications system use
many different devices, such as peak and off-peak hours, distance of the call, subscription vs. Call rate
etc.
The third financial/economic consequence of sunk costs is their effect on the kind of
competition in an industry. The sunk nature of the investments in effect resemble sunk
'capacity' commitments. In this context, it does not concern production/manufacturing
capacity, but more the capacity to do R&D and develop a certain product (although this R&D-
22
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outlay will affect the quantity and prices that can be sold of final products---e.g. if you invest
a lot in developing a new medicine and widely announce it, you increase the probability that
you will be able to sell a lot of medicines at high prices (if you are successful)). Thus having
invested a large amount of sunk expenditures into a new investment project may 1) make
clear that you can charge at marginal cost (i.e. close to zero) if a competitor would arrive in
the same field and 2) that for your investment decisions the sunk expenditures do not matter
anymore so you may even substantially add to the sunk expenditures you have already done
when a competitor enters the field.
In the film industry, for example, just a few producers-distributors eventually came to dominate the
industry. Potential entrants knew that if they wanted to enter seriously, they would have to incur
investments to make an entire portfolio of feature films, go into large contractual commitments with
cinemas, build a large studio complex, a distribution system, and that even while they were doing these
investments, the existing Hollywood producers-distributors could 1) offer their films at more
advantageous conditions to cinemas 2) add to their existing sunk expenditures on their film [portfolio to
increase the quality.
A lot of entrants into industries that are very profitable underestimate these issues, and often
soon after they enter an escalation of sunk outlays is triggered; while the entrants prepared to
match and imitate existing sunk industry outlays it is often unprepared for these escalations
[Sutton 1998]. These issues following from sunk R&D/quality/product innovation
commitments may often make it far cheaper and far less risky for potential entrants to acquire
an existing firm (i.e. with existing sunk commitments) than to prepare a greenfield entry into
the industry, or if acquisition is difficult, simply be a financial investor in existing firms in the
industry.
One difference would be that in many manufacturing industries, the marginal cost of
production would not be negligible, even if R&D outlays would be substantial, and therefore
would need to be taken into account, and capacity commitments really mattered.29
Table 1 gives a rough indications of the importance of sunk outlays in various
industries. It should be notes these concern average ratios, and that in practice the ratios of the
market leaders can be very much higher than the industry average.
29
And could limit the sunk R&D outlays a certain participant would be willing to incur, since it could only serve
part of the market, would be faced by sunk capacity of competitors, and even if would grow at rapid rates it
would take years before it could serve a substantial part, and licensing would be imperfect. See for example the
case of Sony vs. Matsushita in video.
23
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Table 1. Advertising or R&D-outlays as percentage of sales by industry (%), 1960-1990
Advertising
Percentage
Entertainment
5.0
Industrial/other chemicals
3.7
Pharmaceuticals
3.7
Food and kindred products
2.3
Electronic machinery
1.6
Rubber products
1.5
Engines
1.0
Office machines and computers
1.0
Software
1.0
Motor vehicles
0.8
Paper and allied products
0.7
Petroleum
0.5
Aerospace
0.3
Ferrous metals
0.3
Source: adapted from Helms 1996: 254-255.
Research and Development
Entertainment
Software
Office machines and computers
Pharmaceuticals
Electronic machinery
Industrial/other chemicals
Aerospace
Motor vehicles
Rubber products
Engines
Petroleum
Paper and allied products
Food and kindred products
Ferrous metals
Percentage
25.0
20.0
11.7
8.2
5.3
4.3
3.8
3.2
2.2
2.1
0.9
0.8
0.7
0.7
3.5 The shift to quasi-unique organisations
During the industrialisation process, in many service industries, a few specific quasi-unique
organisations emerge that bring about the industrialisation. While large numbers of small
firms often remain, they decrease in importance and become a small fringe around these large
organisations. These small organisations generally make up the 'post-traditional' sector, the
traditional sector that remains after industrialisation but is also radically transformed by the
industrialisation.
In entertainment it are the highly commercial metropolitan enterprises and the highly subsidized
enterprises. In healthcare the doctors' practices, other independent health professionals, hospitals and
clinics. In communications this is a different issue: before and after there are large postal organisations;
it has to be investigated whether small courier services existed before and after. In domestic services,
the work of many individual domestic servants and household members was partially replaced or made
more productive by the emergence of large firms with large factories and R&D labs that turned out
household appliances. In software the work of many individual office workers and business services
was replaced by larger firms focusing on R&D of new office software that made the workers far more
productive and automated away many of them.
Why did these larger organisations emerge and why did they come to dominate the industry?
First of all, these product innovations required quite large amounts of new capital, because
often existing capital could not be used to develop and produce them; this in itself may have
been a reason for the emergence of large organisations. Often this new capital was indivisible:
it could not be done by a number of firms, and it also was a sunk commitment.
In telecommunications, for example, a telegraph line between two cities had to be operated by one firm,
and once one line was in existence, new entrants would be cautious to build a second line. In medicine,
24
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developing one specific medicine was not easy to divide between different organisations, both in terms
of the R&D work necessary and R&D-capital (laboratory equipment, library, buildings etc.) and in
terms of appropriating the stream of rents generated by a successful medicine. So, as the capital
requirements increased, the providers of capital became more dispersed and more fragmented, while the
users of capital became more concentrated and a few.
Also, during industrialisation in industries often 'quality races' took place, in which firms
escalated their sunk expenditures. In the long term, especially when these expenditures were
endogenous, often the industry became highly concentrated. Unsuccessful escalators went
bankrupt, were taken over, dissolved (in these cases their assets often merged with those of
other firms), or dropped out of the race and focused on an existence in the margins. These
quality races also resulted in fewer firms, and once clear winners appeared, the number of
new entrants often declined as they realized the enormous existing commitment through sunk
expenditures of the dominant firms.
In terms of the management of these firms, this means that they had to invent new
ways of management. Since there were so few organisations, standard practice from which
they could borrow may not have been that important. They often had to invent new ways to
manage this large amount of assets, ways to deal with the enormous sunk commitments these
companies had already made, ways to deal/decide on future sunk commitments, ways to deal
with the suddenly emerging market power--- the realisation of managers that their actions
would have a direct effect on the whole industry and market, competitors and consumers,
because they had such a large market share.
For research, the implication is that simply taking a sample of firms and studying
theory management, history etc. Is not sufficient, and may not lead to robust results.
Examining the few organisations that dominate the industries may provide a researcher with
just 5-10 cases that could be nearly the entire universe (in terms of market share and novelty,
dynamic importance of the firms). So, for example, just studying three firms in an industry
with three hundred firms may still give a good indication of what is happening ion the
industry. I.e. the emergence of large, specific, unique organisations has implications for the
notion of representativeness and taking a sample.
This also partially connects to evolutionary theories of the firm, as you could say that
those large organisations somehow had superior characteristics which made them survive and
grow large where other organisations disappeared. Since these organisations sometimes also
bought less successful organisations and/or their personnel, they also collected a large amount
of routines and of knowledge. As far as the changed management methods resulted in a higher
25
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 26 of 59
output without an increase in total inputs, they could be captured by TFP growth (but a large
part may have gone hand to hand with large increases in (sunk) capital).
Management science, the business history approach and the case study method [for
example Bakker 2004b] will be used to link external strategies to internal organisation and
innovation approaches. This approach is essential to understand how and when (how soon)
profitable opportunities were filled that emerged when industries shifted from a low-sunkcosts to a high-sunk-costs character. The long-run analysis of strategy linked to the unique
and distinctive capabilities of singular firms and embedded in an environment which can be
understood with industrial organisation theory builds on an approach pioneered by Leslie
Hannah and John Kay [Hannah and Kay 1977, Kay 1993, 1996]. Linking this to Sutton’s
theory, the companies are not considered ‘representative’ or ‘typical’, but singular, quasiunique organisations, existing within the bounds of industrial organisation models and at the
same time shaping those bounds.
The importance of quasi-unique organisations means also that scale is important:
changes at the level of the individual organisation do affect the industry as a whole, an the
industry as a whole in its turn does have an effect on the total welfare and economic
development of a nation. Coincident changes at different economic levels interact: at the
industry level, at the level of specific organisations that command larger and larger shares of
the assets and sales of an industry, and the effects on the economy at large. The linking of
these three different scales, which is hardly ever done, is essential to understanding the
evolution of high sunk costs industries.
3.6 International diffusion of the innovation
Another characteristic is the rapid international diffusion of industrialised services. Often,
many if not most countries in the Western world adopted the innovations in quite a short
period of time. Two reasons were probably important for this. First of all, the industrialised
services involved high sunk costs, so further marginal revenues equalled further marginal
profits (before amortisation of the sunk costs). The companies that industrialised the services
would make every effort to sell their products/services as widely as possible, and could adjust
prices in countries with less willingness/ability to pay (for example film rental prices and
26
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 27 of 59
medicine prices); i.e. countries became an instrument to price discriminate between buyers.30
Second, often the services are intermediate goods that are used as capital goods inside the
national markets, such as film, telegraph lines, etc. This means that generally entrepreneurs in
countries are willing to exploit the new service in a country, as they will not let dollar bills
float around and will try to fill clear profit opportunities.
3.7 Causal factors
This section will discuss what were the wider factors in society that enabled the emergence of
high-sunk costs industries, focusing on changing demand, effectiveness of sunk outlays,
deregulation, market integration and the ability to capture rents.
A major factor was probably the changes in consumer demand and consumer
preferences because of increasing disposable income, increasing disposable leisure time (and
a clearer definition of leisure time) and population growth. Rapid urbanisation focused this
demand spatially, while secularisation and the homogenisation of preferences effected by the
rise of the nation state affected the nature of demand (Bakker 2001b).
A second factor was the changing effectiveness of sunk outlays. Sunk outlays needed
to reach a certain quality level could decrease because of a rise in the effectiveness of R&D.
This could be affected by the way R&D is organised, by specialisation within R&D, for
example between individual inventors and corporate R&D labs (see Sokoloff and
Lamoureaux), by new discoveries and knowledge itself (for example, once the method to
synthesize medicines from coal tar was there, the schedule of sunk outlays to quality changes
became less steep), or by the fall in costs of R&D inputs (for example salaries for scientists
with a certain level of education/experience). Wider changes in society, such as an increase in
human capital, and in research in non-profit institutions such as universities and governments,
may also have decreased sunk outlays needed.
Within advertising, important innovations that led to the increasing effectiveness of
advertising were the emergence of daily newspapers, the yellow press, weekly magazines,
cinema, radio, television and the internet. Quality and perceived quality often coalesce in the
design of products, where it is not always easy to distinguish perceived quality from
functional quality. One think for example of the clamshell mobile phone.
30
This could also be something that made industrialised services attractive. The traded capital good could
circumvent protection in many cases, as only the capital good received a tariff, not the services it generated
inside a country.
27
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 28 of 59
A third factor was deregulation/liberalisation. Liberalisation matters as regulation can
prevent the growth of an industry, and make too risky to incur large sunk investments,
especially if they would be illegal.
Within live entertainment, entrepreneurs generally would use tents or at most wooden theatres that
lasted one season, as the risk of confiscation was always there. Liberalisation in the US in the 1770s,
Britain in the 1840s and France in the 1860s, led to sharp booms in investment in entertainment, that set
in motion a large series of process innovations and sharp productivity growth that finally reached
decreasing returns towards the end of the nineteenth century. Likewise, deregulation of television in
Europe led to a large boom in the television market, and a sharp increase in sunk outlays that limited the
number of suppliers as the market tended to infinity (Motta and Polo 2003). In telecommunications,
possibly something similar took place.
A fourth factor was market integration. Market integration increases the market by connected
previously unconnected markets. Sometimes market integration can be exogenous (for
example made possible by new regulation), sometimes it can be endogenous, i.e. the result of
new technologies that reduce transport costs (such as the railway) or make goods more
tradable (such as refrigeration, medicines, films).
In telecommunications for example, the market for switching equipment was fragmented into national
market until the early 1980s, after which more and more national carriers used international tenders
rather than buy nationally. A few smart agents, especially Northern Telecom from Canada, incurred
massive sunk costs in developing digital switching technology, which seemed irrational given the small
fragmented national markets. However, in the face of an integrating international market, Northern
Telecom was able to rapidly increase it markets share and make huge profits form its bet [Sutton 1998].
In the case of endogenous market integration, technological change may set in motion a selfreinforcing process, by which additional investments in the technology improving integration
are made because of the benefits of earlier investments (i.e. the sunk costs of the additional
integrative innovations could now be amortised over a larger market, and subsequently would
increase that market, after which the sunk costs of another additional integrative innovation
could be amortised over an even larger market and so on). Nevertheless, sometimes product
innovations that integrate markets by making services tradable do so in a bang rather than
several small steps; one think for example of cinema technology or penicillin.
Market growth/integration also brings previously unconnected assets in touch with
each other and in the long run could equalise the rate of return on those assets.
A fifth factor was the ability to capture the rents generated by sunk outlays. For highsunk costs industries to emerge, it was important that companies were able to capture the rents
generated by their sunk investments. Several mechanisms were important for this. On the
legal side (and more on a horizontal level), intellectual property rights such as copyrights,
28
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 29 of 59
patents and trademarks, as well as their enforcement, could protect sunk investments. On the
organisational side, vertical integration could prevent the capturing of the rents by upstream
or downstream companies. On the contractual side, percentage based contracts and their
enforcement/enforceability could make sure that sunk investments were protected.
In the early film industry, for example, cinemas bought films; this meant that a large part of the
marginal revenues created by an additional sunk investment by the film producer, would be captured by
the cinemas. Renting, first for a flat fee and then on a percentage basis, and vertical integration, solved
these problems, and led to sharp escalation of sunk outlays.
The existing or expected market structure can also be a factor; if a firm has a large market
share (for example because of a brand name and a high advertising/sales ratio), then it could
potentially capture some share of the rents of its innovation, even if competitors would
undercut it on price. Legal monopolies could also be a solution, although there would be no
dynamic incentives.
4. INDUSTRY STUDIES
4.1 Empirical research
The following sections will try to empirically investigate the theory above. Not the whole
theory can possibly be tested in one go, but several parts can be subjected to deductive tests.
The empirical section at present, however, is partially exploratory, and for the moment will
only try to argue that the sunk costs theory can explain developments more fully than other,
competing theories. On a qualitative level, it can be examined whether the developments
characterised above coincided, i.e. whether the timing is as predicted. Several aspects can be
tested quantitatively, such as the growth of the market, the shift from product to process
innovations, industrialisation by automation, standardisation and tradability (especially the
latter), structural change (in terms of input and output shares in the modern and traditional
sectors), productivity growth, the shift to sunk costs, and, finally, the emergence of quasiunique organisations (by looking at measures of market structure, such as four-firm
concentration ratio or Herfindahl-Hirschmann index).
It should be notes that these are will not all be razor-sharp tests, but merely rough tests
that, if not falsified, will indicate that the current theory at the moment better explains what
we see happening in the industries than other theories (that it has more explanatory power,
possibly is more general, simpler).
29
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 30 of 59
4.2 Overview of expected findings
Figure 1 gives a stylised overview of expected findings for various industries. They are
divided in industries with strong endogenous sunk costs, network industries, industries in
which the nature of sunk costs would need to be further investigated, and ‘normal’ industries,
like textiles and agriculture. The warfare case is quite an extreme case where the industry
appears to have evoluted towards an escalation of sunk outlays that resulted in a singularity
that was reached in 1945, where productivity in one discontinuous jolt approached infinity, as
nuclear weapons lowered the marginal cost to incapacitate a certain amount of physical and
human capital to virtually zero.31 The sunk costs were probably the largest incurred ever at
that time, amounting to $2.2 billion ($40 to $50 billion dollars in today’s money). Although
the political effects of these new weapons were widely noted, the enormous productivity
effects appear hardly to show up in the productivity growth estimates. Again, the productivity
increase this singularity brought about came as a thief in the night.
The case of agriculture again touches upon whether or not this is actually a theory or
metaphysics. It appears one could argue that product innovations such as artificial fertilizer,
pesticides, and farm tractors and machines, whose inventions involved substantial R&D
outlays, have ‘industrialised’ farming. One could even argue that if food is seen as part of the
same industry, the high-sunk-costs (advertising to sales ratios) branded foods manufactures
captured all the rents in the industry, and became the modern (high margin—high volume—
high profits) part, while farming and unbranded foodstuffs became the post-traditional
commercial part (low margin-high volume-low profit) or the post-traditional highly
subsidized part, in many cases of farming.
31
One could speculate whether or not this has reduced the costs and improved the quality of defence for
countries.
30
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 31 of 59
Figure 1: Qualitative overview of expected findings when investigating high-sunk-costs industries
Category
Industry
SubStrong
Process
Automation,
industries
market
product
standardisation
growth
tradability
Strong endo
Entertainment
Film
1
1
1
Music
1
Radio/TV
1
Pharmaceuticals
1
1
1
1
1
Office automation
1
1
1
(software)
1
1
Videogames
1
1
1
1
1
Warfare (WMD)
1 (productivity 1
1
so
enormous
1
that
game1
theoretical
Structural
change
Sunk costs
—
exo/endo?
Endo
Quasi-unique
organisations
1
Accelerating
productivity
growth
1
International
diffusion
1
Size
~
Concentration
relationship
1
0
1
Endo
1
1
1
1
1
Endo
1
1
1
?
1
Endo
1
1
1
1
1
Endo
1
1 (obscured by
government
influence)
1
1
1
0.5
1
1
0.5 (or 0)
1
1
Exo
+ fixed only
1
Possibly
1
1
1
Exo
–
networks
Endo- car
mfg
Exo
–
hshlds
+ fixed only
Endo – mfg
Exo
–
hshlds
+ fixed only
Exo – mfg
Large part
fixed only
1
1 (in long-run,
pre-turnpike cpx
nowadays)
1
1
Possibly
1
0
Hardly
Slow/slower?
1
Chemicals,
machinery
Faster:
pesticides; fast:
machinery
1
need after 1
nation has it)
Network
industries
Communications
Transport
Mixed
unclear
cases
‘Normal
industries’
or
Turnpikes
Canals
Railroads
Motor cars
Steamships
Airplanes
Household
appliances
Textiles
(manufacturing)
Agriculture
(excl.
branded
textiles)
(excl.
branded
foods)
1
Possibly
1
1
1
1
1
1
1
1
1
0 (?)
Hardly
1
1 (??)
0 (?)
Possibly
(pesticides)
1
1
always tradable
1
1
1
1
1 (enormously)
Endo
–
chemicals,
machinery
Do branded food
firms capture the
rents?
Note: 1 = expected, 0 = not expected.
31
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 32 of 59
Figure 1 (continued): Qualitative overview of expected findings when investigating highsunk-costs industries
Category
Industry
Unit of measurement
Causal
factors
Demand
Strong
endo
Entertainment
Spectator-hour
1
Pharmaceuticals
Quality-adjusted year
of life
Overhead/total costs
Office
automation
(software)
Videogames
Warfare (WMD)
Network
industries
Communications
Transport
Mixed or
unclear
cases
‘Normal
industries’
Dollar of human and
physical
capital
incapacitated
Win or lose (binary)
Hour/passengersquarekilometer
(hr/(pas*km*km/hr) =
hr/(pass.*kilometre^2)
Household
appliances
Effectivene
ss
sunk
outlays
Market
integration
Ability to
capture
rents
1
Liberalisati
on/
deregulatio
n
1
1
1
1
1
hmm
1
1
1
1
0
1
1
1
1
1
0.5
0
0
1
1
1
1
1
1
1
1
1
0.5
0
1
1
0
0
1
1
0.5
(machine
mfg.)
1
(pesticides;
machinery)
1
Textiles
(manufacturing)
Standardised quantity
of clothes/TFP
1?
(elas
ticity)
1
0
1 (machines
tradable)
Agriculture
Calories
etc.)
1
1
1 (inverse;
presence
regulation)
1
(pesticides;
machinery)
(+vitamins
32
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 33 of 59
5 THE EMERGENCE OF THE FILM INDUSTRY
Throughout section 3, the industrialisation of entertainment by cinema technology has been
discussed on a qualitative level. This section will briefly look at quantitative indications and is
largely based on previous research done by the author on the US, Britain and France.
5.1 Market growth
Market growth before and during the emergence of cinema was substantial, with the entire
entertainment market growing with about 2.5 percent per annum in real revenue terms, and
with between 3.0 and 11.1 percent per annum in output terms (the number of spectator-hours
sold) (see table 2). This shows that despite cinema leading to a sharp fall in average costs and
prices, the market for entertainment grew enormously. As for firms with largely sunk
investments average costs keep falling even if sales (theoretically) would reach the total size
of the market, the quasi-unique entertainment production organisations that emerged had a
strong incentive to expand the market. It can be considered as a kind of interactive process:
the general demand for a certain product category (such as entertainment) increased and
encouraged some entrepreneurs to sink large sums in R&D, and the resulting products in their
turn further increased the market by a) offering a higher quality b) offering a lower price than
the traditional industry.
Table 2. Average annual growth of real entertainment expenditure, US, Britain and France 1881-1938.
1881-1938
1900-1938
1909-1938
1914-1938
1934-1938
1900-1938 output
1881-1938
1909-1938
1914-1938
1934-1938
1881-1938
1900-1938
1909-1938
1914-1938
1934-1938
Source : Bakker 2004a.
US
UK
Cinema and live
2.5
2.7
2.3
FR
2.6
7.0
-0.3
3.0
Cinema
11.1
11.0
8.1
-1.2
Live
0.8
0.0
-3.8
-1.3
1.4
33
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5.2 Industrialisation
No quantitative data is available on automation and standardisation. This section will focus on
tradability and structural change.
5.2.1 Tradability
The convergence of PPP-ratios and exchange rates confirm a sharp increase in tradability after
the emergence of cinema. Initially differences varied widely, as entertainment could hardly be
traded. When cinema made entertainment partially tradable, entertainment PPP-ratios and
exchange rates started to converge, partially because tradability itself made prices (measured
in the price per spectator-hour) converge, and partially because the modern, tradable sector
could be expected to exert a similar competitive pressure on the traditional, non-tradable
sector in all three countries, thus also bringing the differences for the traditional sector down.
The latter is confirmed by the lower half of table 3, which shows that live entertainment price
differentials were substantially closer to the exchange rate in 1938 than they were in 1900, for
all three countries.
Table 3. Entertainment prices at PPP ratios and exchange rates, US, Britain and France, 1900-1938.
Modern and traditional sector combined
Tradability (PPP entertainment/exchange rate), US
1900
/….:
1938
Tradability (PPP entertainment/exchange rate),
1900
UK/….:
1938
Percentage decrease in PPP ent/exchange rate per 1900-1938 US/…
1900-1938 UK/…
annum (= percentage increase in tradability)
Traditional sector only
Tradability (PPP entertainment/exchange rate), US
1900
/….:
1938
Tradability (PPP entertainment/exchange rate),
1900
UK/….:
1938
Percentage decrease in PPP ent/exchange rate per 1900-1938 US/…
1900-1938 UK/…
annum (= percentage increase in tradability)
Source : Bakker 2004a.
UK
FR
4.62
1.22
0.12
1.26
0.03
1.03
1.00
1.70
3.40
4.62
3.92
0.43
0.12
1.54
0.03
0.39
0.52
0.53
5.2.2 Structural change
Despite the modern sector providing the bulk of output, employment in the modern sector
remained below 50 percent in both France and Britain. In France, no net job loss took place in
the traditional sector, and modern jobs were just over half of all new jobs (table 4). This
34
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 35 of 59
probably smoothed the industrialisation of entertainment, as without massive job losses, the
consequences did not seem that adverse; population growth and the resulting price decrease
brought about by cinema created far larger markets, and product differentiation meant there
remained a place for differentiated live entertainment products. The share of the modern
capital stock in the whole capital stock came closer to the modern output share. In the US it
still was substantially below it, meaning that cinema in general was far more efficient than the
traditional sector. In France, the capital share was roughly the same as the output share,
meaning that with the same capital intensity, cinema needed far less labour. In Britain, the
capital share was higher than the output share, indicating that the lower need for labour was
compensated by higher capital intensity.
Table 4. Indicators of sectoral shift in the entertainment industry, US, Britain and France, 1900-1938.
1900
1938
US
3.0
88.2
UK
2.4
39.1
FR
3.6
23.9
traditional
modern
modern/all (%)
-77,719
178,000
177.5
-16,101
39,800
167.9
17,096
14,083
45.2
1938
1938
1900-1938
87.4
93.3
-2.3
76.5
70.2
0.1
90.2
89.8
-4.4
Employment in modern sector (%)
Net new jobs 1900-1938
Modern capital/whole capital stock
Modern output/all output
Price per spectator hour (% change per annum)
Source : Bakker 2004a, with corrections.
5.2.3 Higher productivity growth
Cinema made possible a large growth in output with a far lower growth in inputs. The
increase in output during the first half of the twentieth century was massive: it increased
between three and fifty times in the three countries (table 5). The output per worker grew
phenomenally. In both the US and France the output per $1,000 of capital grew substantially,
while in Britain the picture was mixed. Part of the British figures could be explained by its
early development of commercial live entertainment and the high urbanisation levels. The
result was substantial TFP-growth, although the growth was not extraordinary in the US and
Britain compared to the whole economy.
35
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 36 of 59
Table 5. Productivity in the entertainment industry, US, Britain and France, 1900-1938.
US
UK
FR
Modern and traditional sector combined
1900
249
Output (million spectator-hours)
1938
7,038
1900
2,453
Output per fte (spectator hours)
1938
34,879
1900
1.8
Output per $1,000 of capital (spectator hours)
1938
12.7
Output growth (% per annum)
1900-1938
9.2
Labour growth (% per annum)
1900-1938
2.2
Capital growth (% per annum)
1900-1938
5.0
TFP growth (% per annum)
1900-1938
6.3
1,250
3,863
15,028
36,152
10.0
6.7
3.0
1.5
4.1
0.8
11
601
264
8,429
0.6
3.2
11.1
2.5
6.4
7.6
1,148
2,714
19,209
92,461
9.2
8.7
61
540
203
35,270
0.6
2.9
Disaggregated for 1938
traditional
Output (million spectator-hours)
modern
traditional
Output per fte (spectator hours)
modern
traditional
Output per $1,000 of capital (spectator hours)
modern
Source : Bakker 2004a, with corrections.
155
6,883
10,470
39,539
1.8
7.4
5.3 The shift to sunk costs
Available evidence for the US shows that a few entrepreneurs incurred substantial sunk costs
in film production, and increased these costs over time as the market expanded. The real
average cost of Fox feature films increased sevenfold between 1914 and 1927, the last year
before sound technology became adopted,32 those of Cecil B. de Mille, one of Paramount’s
producers, increased eightfold between 1913 and 1920,33 and those of Warner Brother’s
nearly doubled between 1922 and 1927.34 Average industry real production outlays more than
doubled between 1919 and 1921, and grew fourteen percent annually thereafter.35 The ratio of
film production costs to total gross rentals, the ‘R&D-to-sales ratio’ increased substantially
between the early 1910s and the mid-1920s. The ratio for Paramount, the market leader, was
52 percent in 1919,36 and the ratios of others increased from about twenty percent to between
30 and 50 percent.
32
Figures in 1913 dollars.
Figures in 1913 dollars.
34
Koszarski, Evening’s Entertainment, p. 85; Glancy, “Warner.” Between c. 1907 and 1917 cost increases are
partially due to the increase in average film length, from ca. 500 feet to about 5000 feet (c. 75 minutes) for
feature films.
35
Census; 1913 dollars.
36
First six months. “Gilmore,” p. 69.
33
36
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 37 of 59
Besides the increase in market size that enabled this escalation of sunk costs, the film
industry also developed and improved the organisation of film production during the 1910s,
probably leading to a higher effectiveness of R&D-expenditure, making it cheaper to reach a
given level of perceived quality (selling capacity; capacity to sell spectator-hours) of a film.
Analysis of average R&D outlays and film revenues for four Hollywood studios between
1914 and 1940 suggest that the costliness of raising quality (i.e. the value of beta) was not
very high in the film industry, thus making a quality race feasible [Bakker 2005b].
5.4 The emergence of quasi-unique organisations
In the film industry indeed the emergence and then dominance of quasi-unique organisations
has been observed. Initially, in the first few years after the invention of film, concentration is
very high because of legal and technological entry barriers. In the US for example, the fourfirm concentration ratio (C4) was nearly 100 percent. Subsequently, concentration declined as
market size increased, a pattern that would normally be expected using ‘traditional’ industrial
economics. Then however, in the mid-1910s, as the market continues to grow rapidly,
concentration stabilises and then slightly increases. In the US, concentration initially declined
to about twenty percent, and then increased to about 55 percent. In Britain, it declined to 20
percent and then increased to c. 45 percent. In France, it declined to 30 percent and increased
to c. 45 percent. In all three countries, the jump in concentration took place in the face of a
phenomenal market growth [Bakker 2005b]. In the US, from the mid-1920s onwards, five
large vertically integrated studios and three smaller ones received well over 90 percent of all
film distribution revenues, and a substantial part of exhibition revenues as well. In the 1930s
their gross margins were substantial, confirming that the behaviour of a single firm could
substantially affect price and/or demand.
5.5 Causal factors
Several factors have been identified in Bakker 2001b. A rapid increase in the quantity and
value (opportunity cost) of leisure time increased the demand of entertainment. Increasing
disposable income increased the demand for entertainment (and the value of leisure time).
Urbanisation and the emergence of urban transport networks concentrated demand spatially
and integrated markets at the regional level, making it easier for scale-sensitive entertainment
37
High sunk costs industries, paper SSHA Conference, Minneapolis, November 2006, Gerben Bakker, LSE, page. 38 of 59
venues to be built. Demand was further stimulated by strong population growth in Britain and
the US, though not that much in France.
A long-run factor that boosted market growth was liberalisation, which made it far
safer for entrepreneurs to invest in entertainment. The US liberalised the entertainment
industry in the late 18th century, Britain in the 1840s and France in the 1860s. Little
quantitative data is available on the effect of the liberations, but unusually good data on
investments in music halls in Britain, collected by Crowhurst, gives some indication of the
revolutionary effects the freedom to invest in entertainment had on the growth of the industry
(figure 2). Between 1862 and 1900 investments grew with 12.0 percent per annum, and it
seems that investments started to reach decreasing returns in the early 20th century, at the time
cinema emerged. The decrease of average investments per hall suggest that eventually music
halls were built in smaller and smaller towns, and especially in those places, cinema could be
an important competitor.37
Music hall capital, total and average per hall (£), 1858-1912
10,000,000
1,000,000
100,000
Average
100,000
Total
10,000
1860
10,000
1870
1880
1890
1900
1910
Figure 2. Source: Crowhurst 1991.
37
Possibly not unlike the relationship between the early motor cars and the railways.
38
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6 THE EMERGENCE OF THE PHARMACEUTICAL INDUSTRY
This section will briefly and speculatively look at some of the data available. Measurement
appears to be somewhat less straightforward than for the entertainment industry. One can
measure the output of medical care among many different dimensions, and often one could
use disease-specific productivity data. Many different quality dimensions have been used
along which one could measure productivity in healthcare. Helms [1996: 59], for example,
contains no less than eleven quality aspects of anti-ulcer drugs.38 Yet it is argued here that it is
in important to find a simple measure that could capture output and productivity growth both
long ago and nowadays, a measure that would focus on outcomes and not the inputs. The best
measure so far appears to be the quality-adjusted year-of-life, although this inquiry may
compare that measure with other ones in the future.39
6.1 Market growth
It is clear that the market for medicines, as for healthcare in general, has grown enormously,
but it is useful, though not always easy, to get some insight into the patterns of growth. For
Britain in the nineteenth century, particularly good, annual data have been collected by Corley
[2003] and Chapman [1973] from sources on the medicine duty.40 The market for medicines
barely grew (in real terms) between 1800 and the early 1860s, and even was in decline during
the middle of the century (figure 3). Then, from 1862 demand recovered, and five years later
the market started to growth at an unprecedented pace, increasing fivefold, or 6.6 percent per
annum in the quarter century between 1868 and 1893. By the late 1900s, demand stabilised
somewhat, but soon after it increased again, and kept increasing (in the long run) all through
the twentieth century.41 Between 1907 and 1992, it increased at a fairly constant pace of 4.3
percent per year, in real terms.
The increasing demand may reflect increasing disposable income, increasing
prevalence of health insurance schemes and public health institutions. To counter this
demand-based story, one could also argue that a singularity appeared in the 1860s that in one
38
See section 2.3 below.
The quality-adjusted year of life, roughly speaking, has been the prevailing outcome so far of a long-running
debate on how to measure productivity in healthcare.
40
The author also made use of a working paper of T. A. B. Corley on the development of the British
pharmaceutical industry in the 19th century (University of Reading Working Papers in Business History 2001).
41
The data after 1915 are somewhat less reliable because they concern production, not consumption, but should
give a rough indication of the long-term trend. It is hoped this data can be replaced by detailed annual
consumption data.
39
39
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big bang set in motion a growth process that is still going on today. A candidate for this
singularity could be the development of synthetic drug development from coal tar. Further
research is necessary to establish the relative importance of demand and supply and their
interaction.
Medicine sales and production UK 1800-1992
10,000,000
(£1000s of pounds of 2002)
Production
1,000,000
Consumption
100,000
10,000
1800 1810 1820 1830 1840 1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Figure 3. Source: Chapman 1973 and Corley 2003.
6.2 The shift from process to product innovation
It has been hypothesised that only after process innovations in health care reached decreasing
returns, product innovations in the form of medicines became widely adopted and
counteracted the decreasing returns. Data for three diseases, pneumonia, tuberculosis and
diphtheria give some insight in this pattern. The death rates for these three diseases fell
significantly during the first three decades of this century, and sometime before the
emergence of highly effective curative medicines (figure 4).42 The arrows show the instances
in which a new effective medicine was introduced, and the reduction in the death rate (or
increase in the years of life, figure 5), was far greater in the time of the process innovations
before the introduction of these medicines. These were sulphonamide in the case of
pneumonia, izoniazid in the case of tuberculosis and toxoid in the case of diphtheria. It seems
these medicines only took care of the last few months, and had a far smaller effect than the
process innovations.
42
It should be noted that around 1900 the death rate for diphtheria was already quite low because of antitoxins.
40
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If one reasons that the last deaths are the most difficult to prevent, and one looks at the
percentage decline in the death rate, it suddenly becomes clear that Ionazid and the
sulphonamides had an important effect on productivity, and constituted a discontinuity in the
productivity growth, leading to higher productivity growth (a steeper downward slope of the
death rate in the semi-logarithmic figure 6) after the introduction of these medicines. Further
research is necessary to resolve the proper measurement issues.
This data appears also to suggest that technological development was not autonomous
but clearly responded to market demand, and to rates of returns of alternative technologies.
One could argue that in the long-run these rates of returns would be equalised, and one pound
spend developing new medicines should have the same return as one dollar spend developing
process innovations, for example in hospital management. The switch then simply takes place
when the relative rate of return for investments in process innovations dives below the that for
potential product innovations.
2
pneumonia
tuberculosis
diphteria
Deaths per 1,000 population
1.5
1
0.5
0
1900
1910
1920
1930
1940
1950
1960
1970
Figure 4. Death rates for three major conditions, UK, 1900-1970.
Note: first arrow from the left refers to toxoid, second to sulphonamide, and the third to izoniazid.
Source: Melville and Johnson 1982.
41
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1.4
pneumonia
tuberculosis
diphteria
Increase in years of life per 1,000 population
1.2
1
0.8
0.6
0.4
0.2
0
1900
1910
1920
1930
1940
1950
1960
1970
-0.2
Figure 5. Increase in years of life per 1,000 population for three major conditions, UK, 1900-1970.
10
Deaths per 1,000 population
1
0.1
0.01
0.001
pneumonia
tuberculosis
diphteria
0.0001
1900
1910
1920
1930
1940
1950
1960
1970
Figure 6. Death rates for three major conditions, UK, 1900-1970.
42
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6.3 Industrialisation
6.3.1 Higher productivity growth
A crucial issue is how to measure productivity. If we would measure it in quality-adjusted
years-of-life, it would slow down quite certainly. If we would measure it in the (inverse of)
number of deaths as a percentage of the number of deaths in the previous year (i.e. we
measure the extent to which healthcare limits the downward effect of disease on the qualityadjusted years of life, then it may have gone up).
Another approach is to look at productivity growth in the pharmaceutical industry in
general. Cockburn and Henderson (1999) using a measure from Ward and Dranove (1995)
have tried to estimate the output of the pharmaceutical industry. They use a specific scale to
measure the importance of new drug approvals, which includes many different characteristics
of a medicine. They conclude that although the output of the pharmaceutical industry in terms
of real sales between 1960 and 1990, grew 5.2 percent annually, on average, if this output is
corrected for the substantial increase in the ‘importance’ of the new drug approvals, it actually
grew with a stunning 21.2 percent annually (figure 7). This shows the tricky issue of
measuring quality change in output, and also the disproportionate effect hedonics can have on
productivity statistics. One point of criticism is that such a quality-adjusted output measure
would not really focus on the outcome of the product, the additional quality-adjusted years of
lives of which consumers would benefit, but on characteristics that more or less characterise
the inputs of this process. Second, the fact that the quality of a dollar’s worth of medicines
may have gone up revolutionary, may be of little significance for consumers if the minimum
bundle they need to purchase (the minimum price per package of medicines) has also gone up
revolutionary. This minimum unit size effect is often ignored by those working with hedonic
price indexes.
43
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Real sales or medicine quality or quality-adjusted productivity(1960-65=100)
100000
sales
quality of medicines
quality-corrected output
10000
1000
100
1960
1965
1970
1975
1980
1985
Figure 7. Sales, medicine quality, and quality-adjusted output in the US pharmaceutical industry, 1960-1985.
Note: years refer to a five year period starting in that year.
Source: Cockburn and Henderson 1999; Ward and Dranove 1995.
One reason for the high productivity of medicines, was the fast adoption of a new product
innovation. It might take a long time and large sums to develop a new medicine, once the
compound has been developed, the manufacturing costs of the compound are small, and the
marginal costs (i.e. ignoring the set-up and fixed costs of manufacturing) infinitesimal. One
example is penicillin, that revolutionary lowered the death rate (in percentage terms) from
infectious diseases. Once the compound was developed, initially large sums had to be spend
to develop processes to manufacture it on a large scale, but after that the average costs came
down enormously, and use of the medicine grew very rapidly to approach eventually all
people who could benefit from it. Production costs reached as little as $20 per billion
(medical, molecular) units in 1965, reflecting an annual average decrease in average
production costs per billion units of 36.8 percent (figure 8)!43 It underlines the fact that
product innovations in high-sunk-costs industries were sometimes something one could call
singularities, strong discontinuities in which an innovation very quickly became adopted
43
One could speculate whether the innovation of penicillin, just like the innovation of the atomic bomb, both
benefited from the preparedness of governments to incur astronomous amounts of sunk costs to develop these
innovations, and whether both these innovations could have occurred under different circumstances.
44
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almost universally in the Western world. The rapid adoption was made possible because of
the infinitesimal marginal costs of manufacturing. It also depended on the pre-existence of a
distribution delivery system—in the early film industry cinemas, in pharmaceuticals local
doctors and health institutions. On the contrary, the absence of a distribution delivery system
could delay an escalation of sunk costs, as it strongly decreased the profitability.44
The miracle of penicillin, 1943-1965
Cost
100
10
Treatment
100,000
1
10,000
0.1
0.01
1,000
0.001
Treatment (patients/month in millions)
Production or cost ($/billion units)
1,000,000
Production
100
1943
1944
1945
1946
1947
1948
1949
1950
0.0001
1951
Figure 8. Source: Wei 1979: 352.
6.4 The shift to sunk costs
A sharp increase in sunk costs took place. These involved two kinds of sunk costs, those in
advertising/marketing and those in research and development. Corley 2003 discusses how
during the 19th century a substantial rise in advertising to sales ratios took place. It is expected
that towards the end of the century the R&D/sales ratios also increased, although it is
difficulty to get good data for that period. This section will focus on the US market after the
Second World War, for which relatively good data is available.
To keep the paper concise, this and the following subsections limit themselves to
analysing the data provided in Achilladelis [1999] for the top-15 pharmaceutical firms. It is
immediately clear that real R&D outlays increased enormously for the leading pharmaceutical
44
One example is the frozen food industry, where competitive escalation of advertising outlays happened only in
the 1950s, when retail refrigeration systems had become widely adopted [Sutton 1991].
45
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companies (figure 9), while the market also grew rapidly. On average, R&D outlays increased
about 7.5 percent in real terms annually, for the firms in the dataset, while sales only
increased by 5.8 percent per annum. Substantial differences existed between firms. The
differences in the R&D/sales ratio could very from five to two and a half times between the
lowest and highest spending firm.
Apparently, R&D also changed in character: the average number of patents per million
dollars real R&D expenditure declined nearly ten fold, from one to one tenth (figure 10),
while the average sales per patent skyrocketed (figure 11). Numbers of patents, however, are a
very bad indicator for the effectiveness of R&D, as patents are idiosyncratic and of sharply
differing quality. For the period 1950-1993, the correlation between the number of patents and
the market share of a company was virtually zero.45
The sunk costs data confirms that a sharp increase in sunk costs took place as the
market grew rapidly, and it appears that this increase in sunk costs resulted in a lower limit to
market fragmentation; i.e. it prevented that new entry would lead to industry concentration
approaching zero as the market tended to infinity.
Real average annual R&D outlays per firm per decade ($ million of 1995)
1,400
10000
9000
1,200
1,000
7000
6000
800
5000
600
4000
3000
400
Total R&D or total sales/10 ($million)
8000
Abbott
American Home Products
Bristol-Myers
Johnson & Johnson
Lilly
Merck
Parke-Davis
Pfizer
Schering-Plough
Searle
Smith Kline and French
Squibb
Sterling
Upjohn
Warner-Lambert
Total R&D
Total sales/10
2000
200
1000
0
1950
1955
1960
1965
1970
1975
1980
1985
0
1990
Figure 9. Source: Achilladelis 1999.
45
Correlation done for Achilladelis [1999] dataset.
46
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Average annual R&D/sales ratio (%) per decade ($ million of 1995)
18.0
Abbott
American Home Products
Bristol-Myers
Johnson & Johnson
Lilly
Merck
Parke-Davis
Pfizer
Schering-Plough
Searle
Smith Kline and French
Squibb
Sterling
Upjohn
Warner-Lambert
Average
16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0.0
1950
1955
1960
1965
1970
1975
1980
1985
1990
Figure 10. Source: Achilladelis 1999.
Summary data US top-15 pharma firms
140
1200
Average patents/$mln R&D * 100
120
1000
Average $mln sales/Patent
100
Market patents
80
600
60
Market patents
800
400
40
200
20
0
1950
1955
1960
1965
1970
1975
1980
1985
0
1990
Figure 11. Source: Achilladelis 1999.
6.5 The emergence of quasi-unique organisations
Anecdotal estimates from the literature, such as the work of Corley [for example 2003],
suggest that concentration increased during the nineteenth century and specific organisations
had a strong influence on the industry (i.e. had large market shares, and also often substantial
47
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market power, i.e. high margins). Again, for the period after 1945, more detailed data is
available. The market shares of the top-15 companies were significant, and despite individual
fluctuations, most companies maintained quite significant market shares (figure 12).
Interestingly, the relative positions within the market changed sometimes, while market
concentration was not much affected. This concurs with the demand-based, endogenous
approach to industrial organisation, where it does not matter that much who fills a certain
position (something that can depend on history, institutions, strategy, intelligence, luck, etc.),
but that a certain position will be filled. The US market leader in the 1950s, for example, was
Merck, in the 1960s and 1970s it was American Home Products, and from the 1980s it was
Johnson & Johnson.
Interestingly, while the market grew enormously—it increased eleven-fold in real
terms between 1950 and 1993—concentration did hardly decline. It remained stable and in the
early 1990s appeared to be slightly above the 1950s levels. Given the huge pharmaceutical
merger boom, it can be expected to be substantially more above the 1950s level nowadays,
even though the market has grown even more. This confirms Sutton’s theory on sunk costs
and market structure, where a competitive escalation of sunk costs, a ‘quality race’, results in
concentration being bound from below as the market grows very rapidly. I.e. concentration
does not converge to zero, as one would expect (market growth will result in many new
entrants), but to some other value greater than zero [Sutton 1998]. This pattern is confirmed
both with the four firm concentration ratio (C4-ratio) and the Herfindahl-Hirschmann Index
for the Achilladelis dataset (which only include the innovative pharmaceutical firms), and also
with the C4-ratio from the US census (which also includes generic drugs), taken from Sutton
1998 (figure 13).
48
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US Market share of top-15 US pharmaceutical firms (%)
18.0
Abbott
American Home Products
Bristol-Myers
Johnson & Johnson
Lilly
Merck
Parke-Davis
Pfizer
Schering-Plough
Searle
Smith Kline and French
Squibb
Sterling
Upjohn
Warner-Lambert
16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0.0
1950
1955
1960
1965
1970
1975
1980
1985
1990
Figure 12. Source: Achilladelis 1999.
C4-ratio vs. market size, US pharmaceutical industry 1950-1993
60.0
C4-ratio
Census C4
HH index
10000.0
40.0
30.0
1000.0
20.0
Herfindahl-Hirschmann Index (*10000)
Four firm concentration ratio (%)
50.0
10.0
0.0
1,000
10,000
100.0
100,000
Real market size ($million of 1995)
Figure 13. Source: Achilladelis 1999; US Census as quoted in Sutton 1998.
It should be noted that Sutton [1998] argues that for the pharmaceutical industry, the limits to
fragmentation in the face of a rapidly growing market are not caused by the nature of the
49
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R&D process itself,46 but the by the marketing effort needed to sell medicines profitably and
by the portfolio effect, that firms need portfolios of medicines. This paper argues that the
marketing effort actually depends on the nature of the R&D process, as given the level of
sunk costs, marginal revenues largely equal marginal profits, so large expenditures on
marketing will take place per definition. Also, branded drugs of which the patent has expired,
often retain a revenue share of over 50 percent of the sales of specific molecule [Helms 1996]
(but a far smaller share in quantity terms), suggesting that R&D and marketing had significant
effects beyond the patent life.47 In addition, this paper argues, following the point made in
Bakker 2005b, based on Sedgwick and Pokorny 1998, that given the economies of scale and
scope in R&D and given the way the companies plan their outlays, the R&D outlays in the
pharmaceutical industry are only meaningful on a portfolio basis, by which risks are
diversified, and not on an individual medicine/submarket basis. The development of a new
medicine was not an independent bet. Following these two points, it appears that Sutton’s
theory applies just as well to the pharmaceutical industry as to the film industry.
7 OTHER INDUSTRIES
This section will discuss some anecdotic data for other industries, to give some speculative
ideas of how the theory of the paper could be applied to those industries.
7.1 Communications
In communications also a massive increase in productivity seems to have taken place, all the
way from postal service to email. In section 3 some observations have been made about the
development of the communications industry. Here some data confirm a substantial decrease
in the costs per message. Between 1866 and 1882, when many international telegraph lines
came online, the average price per message decreased 17.4 percent annually in real terms
46
For example, drugs have a limited patent-life, can be imitated fairly easily afterwards, and the largest drugs
still have a low market share of the whole market.
47
Quality of post-patent branded medicines, in terms of, for example, the consistency of the quantity and quality
of the active compound and how it is absorbed by the body, also appears to be higher than that of their generic
competitors. Tests of the antibiotic ciproflaxine in Germany, for example, showed that patients using generic
drugs sometimes only received 50 percent of the active compound compared to patients receiving Bayer’s
branded off-patent version [author’s conversation with a global product manager of a large pharmaceutical firm,
2005]. It could be the case that after patent expiry, the brand continues to be important in terms of guaranteeing
quality and uniformity, in its own right and by attaching the medicine to the reputation of a large firm (that
stands to lose if the quality is sub-standard, to a far larger extent than generics manufacturers), like in many other
industries.
50
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(Hugill 1999: 35). The real price of transatlantic telegrams also declined substantially, from
$217 dollars (of 2002) in 1858 per word, to $4.70 per word in 1888, which amounts to 12.3
percent per annum (figure 14). Figure 15 illustrate the decrease in real prices of telegraph
messages and telephone calls in the US. Nowadays, email has made the price per written
message about two orders of magnitude lower than in the early 1970s.48 Interestingly, while
telephone was growing rapidly, the absolute number of telegraphy messages did not decline
initially; it only started to decline after 1950. This suggests that industrialisation involving
high sunk costs was partially demand-led, and focused on applications that were differentiated
from existing sunk investments, and that therefore they met less resistance than traditional
industrialisation, as it had not always a direct observable effect in the form of job losses on
the older industry (see section 3).
Real cost of telegrams over the transatlantic cable, 1858-1888
250
Cost per four letter word ($ of 2002)
200
150
100
50
0
1855
1860
1865
1870
1875
1880
1885
1890
Figure 14. Source Hugill 1999.
48
If one writes 90 messages of 50 words a month and pays $20 for internet connection, and $20.83 for
equipment depreciation ($1500/3/2/12), then the average price per 10 words message would be $0.09, or 9.1
cents.
51
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Number of telegraph messages sent and real costs of telegrams and phone calls, US, 1850-1970
120
telegraph messages US
real cost telegraph
real cost telephone
Number of telegraph messages sent
100
100,000,000
80
60
10,000,000
40
20
1,000,000
1850
1870
1890
1910
1930
1950
Real cost of 10-word telegraph message or 3-minute phone call (in
dollars of 2002)
1,000,000,000
0
1970
Figure 15. Source: Nonnenmacher 2001.
7.2 Transportation
In section 3 it has been argued that technological change in transport networks may well have
been also demand-led, and that each new system emerged when the process innovations of the
old network reached decreasing returns. Again, product innovations replaced process
innovations so that the long-run returns to the two types of innovations was equalised.
Gerhold [1996], for example, shows how in Britain substantial productivity change took place
in the road network before turnpikes. One could argue that when these process innovations
reached decreasing returns, turnpikes were adopted as a new product innovation that led to
new increasing productivity growth, and when this started to run into decreasing return during
the first half of the nineteenth century, railways and canals were adopted to achieve further
productivity growth. This pattern is confirmed by figure 16, which has been calculated based
on figures from Gerhold [1996]. The price per passenger-mile per kilometre/hour decreased
from £0.58 in 1658 to £0.06 in 1820, an average annual decrease of 1.4 percent.
Assuming that in 2005 one can get from London to Exeter in 4 hours for £50, the real
price per passenger-km per km/h is £50/(200*50) = 0.5 pence, amounting again,
coincidentally, to an average annual price decrease of 1.4 percent annually, in real terms.49
49
Flight have been left out of the comparison, because travel from and to the airport and long check-in and
check-out times do not make them terribly good alternatives on these types of routes. If for a ticket of £100 one
52
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Like with medicines and death rates, the cost reduction that is left to be brought about by
railways looks very tiny in figure 17, and is only significant in percentage terms of the costs at
the moment railways are introduced (figure 18). I.e. it appears railways only brought about the
last marginal increases in productivity that could not be brought about by turnpikes.
When decreasing returns to further process innovations in railways set in by the late
th
19 century, the motor car was adopted to achieve further productivity growth for the last
few miles from stations to final address, and later the airplane for the very long distances (see
also Fogel [1962, 1964], who has a similar perspective on technological change in transport
networks).
Again, each subsequent product innovation (a new type of transport network) was
slightly differentiated from the existing network, and only partially competed directly with it.
Often the existing network remained in existence and useful, while most growth took place in
the new network.
Real price per passenger mile per km/h on London to Exeter coaches, 1658-1820
£ of 2002 per passenger-kilometer per kilometer per hour
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
1650
1670
1690
1710
1730
1750
1770
1790
1810
1830
Figure 16. Source: calculated from Gerhold 1996.
could travel to Exeter in 3 hours by plane, an exceptional achievement, then the price per passenger-km per km/h
would be £100/200*66.7 = 0.75 pence, 50 percent more expensive than travel by rail.
53
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Real price per passenger mile per km/h on London to Exeter coaches, 1658-2005
£ of 2002 per passenger-kilometer per kilometer per hour
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
1650
1670
1690
1710
1730
1750
1770
1790
1810
1830
1850
1870
1890
1910
1930
1950
1970
1990
1950
1970
1990
Figure 17. Source: calculated from Gerhold 1996 and own calculation for 2005.
Real price per passenger mile per km/h on London to Exeter coaches, 1658-2005
£ of 2002 per passenger-kilometer per kilometer per hour
1.000
0.100
0.010
0.001
1650
1670
1690
1710
1730
1750
1770
1790
1810
1830
1850
1870
1890
1910
1930
Figure 18. Source: calculated from Gerhold 1996 and own calculation for 2005.
54
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7.3 Household appliances
As argued in section 3, it is expected that the decrease in domestic servants will coincide with
the growth in the use of household appliances. When we look at the UK data in figure 19, it
seems that the decline in domestic servants partially preceded the rise of the use of appliances.
Only for the vacuum cleaner some estimated adoption rates are available. Rates for clothes
washers and refrigerators were probably well below one percent in Britain before 1930
[Bowden and Offer 1994]. It could be possible other, intermediate forms of household capital
were used before the electric appliances were adopted. It could also be the case that some
appliances, such as vacuum cleaners, were used/shared in more household. Further research is
necessary in this area, as well as data on domestic servants in the US, and data on real wages.
If real wages increased and working hours declined, as they did, it could well be the case that
initially household replaced the work of domestic servants by labour by members of the
household, and later automated away the last few hours of domestic servants by electric
household appliances.
Domestic servants per 1,000 inhabitants, England and Wales, and adoption rates appliances, 18511931
50
45
Domestic servants/1,000 inhabitants
35
45
30
25
40
20
15
35
dom.serv./1,000
10
UK vac cleaner est.
Adoption rates appliances (% of households)
40
Clothes washers (US)
fridges (US)
5
vac cleaners (US)
30
1850
0
1860
1870
1880
1890
1900
1910
1920
1930
Figure 19. Source: Bowden and Offer 1994; Thomas 2004.
55
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8. CONCLUSION
This paper has been an open-ended, and at times speculative, inquiry into the nature of sunk
costs and how it affects the long run evolution of organisations, industries and economies.
First, it has argued that the distinction between services and industry matters far less than
many economists think, and that this distinction can be treacherous and actually obscure
measurement and perception. As alternative approach this paper proposed to view everything
in terms of the final services delivered, not unlike the proposals of Nordhaus [2001]. Second,
the paper has argued that productivity increases brought about by the emergence of highsunk-costs industries often have been substantial, but often have not been noted very much.
They largely came as a thief in the night. The reasons for this may be that a) because they
involved product innovations and new industries, they did not always directly and observably
threaten existing industries, but sometimes simply marginalised them by superior growth and
b) that often substantial advances in productivity had been achieved by process innovations,
and that the contributions of high-sunk-costs industries only concerned the last few miles of
productivity growth that could not be done by further process innovations. Nevertheless, these
last few miles were large compared to the productivity levels immediately before the adoption
of the product innovation.
Third, this paper has argued that the understanding of industrialisation can be made far
wider than previously thought, that the industrialisation process is still going on, and that the
development of a wider theory would make certain cases, such as the classical example of the
textile industry, special cases of a far wider theory. Fourth, this paper has argued that sunk
costs matter, that sunk costs are economic history as they are the mechanism that extend past
economic decisions into the present, and so contribute to economic history as a separate
discipline. This also connects somewhat to Chandler’s [1962] notion of slack resources, to
explain the long-run development of large corporations that command large and significant
shares of assets in an industry.
Fifth, this paper has argued that individual, specific, quasi-unique organisations matter
far more in economic history than previously thought. In high-sunk costs industries these
organisations came to command and reconfigured decisively large amounts of assets in an
industry and an economy. A renewed focus on the role of organisations, using for example
endogenous, game-theoretic models, would also reconnect economic history with business
history. Sixth, this paper has argued that technological and economic change is largely
demand-driven, and that the role of demand has often been underestimated. Specifically
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urbanisation, which concentrated demand spatially, seems to have played an essential role in
many high-sunk-costs industries.
Seventh, although this paper would like to move away from exclusively looking at
cause and effect, it seems that several slightly more exogenous factors influenced the
emergence of high-sunk-costs industries, such as increasing demand, changing effectiveness
of sunk outlays (because, for example, of new ways of organising R&D), deregulation, market
integration, and the ability to capture rents (for example, intellectual property rights). These
factors could, however, be influenced by the emergence of high-sunk-costs industries. Market
integration made possible by product innovations that make services tradable, for example,
could partially, in a self-reinforcing process, stimulate further sunk outlays on product
innovations leading to higher quality, further market integration, and so on. Entertainment, for
example, was initially only partially integrated by the silent films of the 1900s, but became
much stronger integrated with the emergence of sound film in the 1920s.
This paper has been highly experimental and speculative. Future research could focus
on the role of stories/narratives versus testable theories in economic history, on a discussion
of the role of measurement methods that moves beyond hedonics, on the problem of industry
and market definition and the role of concepts and languages in testing hypotheses in
economic history, and the usefulness of partial deductive testing of economic-historical
theories. The industry studies would need to get far more detailed and elaborate to really
make a start with testing the wide hypotheses set in this paper. Further research could also
focus on developing new ways of testing theories in economic history that move beyond
description and beyond the correlations of regression analysis.
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