I have noticed that hospitals focus more on lock-out than on a lock-in strategy for their partner bases. Economist W Brian Arthur’s paper on increasing returns may help change their hospital strategy. Arthur has noticed that economic activity has bifurcated into ‘Halls of Production’ and the ‘Casino of Technology’. The halls of production are traditional businesses that are subject to diminishing returns. In the casino of technology, after a period of instability business experience increasing returns.
The bridge between these two worlds can be formed by the service industry. Service exemplifies aspects of both business worlds. With the use of software, the center of gravity in service businesses is crossing over from traditional business to technology businesses. In services, everything is moving to software. As software use increases, regional limitations weaken and network effects kick in bringing hospitals the best of both worlds.
Arthur says technology comes in successive waves. Those who have lost in the current wave can position themselves for the next wave. Those that succeed must not become complacent. The ability to profit under increasing returns is only as good as the ability to see what’s coming next.
Although the casino of technology is seen as a high-tech response, it is about leadership psychology and cooperation. Success goes to those who have the vision to imagine and to shape mission and purpose. But first, a bit of background.
The diminishing returns world
Arthur says that in the world of 1880s and 1890s the focus was on resource-heavy bulk production. This was for commodities like metal ores, pig iron, coal, lumber, heavy chemicals, soybeans and coffee. Using the example of a coffee plantation he shows that if the plantation expanded it would eventually be forced to use land less suitable for coffee. In other words, it would run into rising costs and diminishing profits. Such a market would be shared by many plantations, and a market price would be established at a predictable level, depending on the taste for coffee and the availability of suitable farmland. Plantations would continue to produce coffee as long as it was profitable. Because price would be squeezed down to the average cost of production, no one would make excessive profits.
This market still exists today for bulk processing. Brand differentiation reduces the number of competitors in a given market. Typically if brands try to expand they run into limitations. This is a form of a lock-out which approximates perfect competition.
The increasing returns world
To demonstrate the world of increasing returns, Arthur uses the example of operating systems in personal computers. In the early 1980s, there were three players CP/M, DOS, and Apple’s Macintosh. CP/M was first in the market and was well established. The Mac arrived later and was easy to use. DOS was introduced when Microsoft successfully contracted to supply the operating system for IBM PCs. For a year or two, it was unclear which system would prevail. The DOS platform was clunky to use.
The growing base of DOS/IBM PC users from the lock-in contract with IBM encouraged software developers to write for DOS. Eventually, the IBM/DOS combination came to dominate the market. Microsoft began to enjoy increasing returns. Microsoft’s strategy can form the template for service organisations to incur increasing returns.
The template for increasing returns
The market for increasing returns starts during market instability. There are many potential outcomes. The market tilts in favour of a product that gets ahead. If this product, even if it’s an inferior product, can get lock-in from its base of users, it goes on to reap increasing returns. There are several reasons for eventual success:
In many knowledge-based industries, the R&D costs are large compared to the unit of production costs. The first disk of Windows to produce cost $50 million; the second and subsequent disks cost $3. Unit costs decrease as sales increase. Such industries are heavy on know-how and lighter on resources.
For a product to be successful, it needs a critical mass of users. It must first build up its user base to the point where the value produced by the network exceeds the value of the product itself. For Windows to succeed, Arthur explains that Microsoft leveraged its 60-million-person user base.
Historically new high-tech products are difficult to use. Once users get over the hurdle of learning to use the product they become less willing to switch to different products. Customers get locked in. As the user base grows it becomes easier to capture more of the market. We see this happening in healthcare EMR and ERP systems. In other words, products that gain market advantage stand to gain further advantage. But lock-in doesn’t last.
Linking and leveraging
Some products start in the world of increasing returns but later in their life cycle become commodities. Hence, the two economic worlds operate in parallel.
According to Arthur an effective strategy to extend lock-in is to transfer a user base built upon one product (node) to neighbouring products. This is what Microsoft did with its 60-million-person-user base in DOS onto Windows and then onto Window 95 and then onto Microsoft Network.
Extending network effects
Simply put, networks effects are the basic unit for strategy in a knowledge-based world. Players can compete not by locking in a product on their own but by building webs – loose alliances of companies organised around a mini-ecology that amplify positive feedback to the base technology.
There are several examples of this in the increasing margins world. We know that Apple has done this for Apps. Airbnb for homes. Waze for GPS and maps and Uber for rides. Hospital executives must now ask how they can monetise their networks and build bridges to enter the world of increasing returns.
How hospital leaders can build bridges
Hospitals are the central hubs for many different network effects. To build bridges they must capitalise on the importance of such hubs. Loosely defined hubs connect networks. Franchises exist because of increasing-returns. The more branded hospitals there are the better known they become. Such hospitals are patronised not just because of their quality, but because people want to know what to expect.
Hospital executives need to recognise that by extending network effects a different kind of economics is at work. They need to understand which negative or positive feedback loops can be harnessed. Negative feedback loops can focus on cost reduction while positive feedback loops can focus on increasing margins.
Hospitals must not be too closed, yet not too open. This means making a careful choice of partners. It also means that they should allow dependent players to lock-in their dependent products by piggybacking on the value of hospital hubs. By allowing access, hospitals ensure that all partners remain committed to the alliance. It’s not the lock-out but the lock-in that matters.
If you find this point of view is useful, please share this with your colleagues. I’d like to hear if you agree or disagree with the views expressed in this post. Please comment. I encourage you to join me to help increase hospital margins. Please download a free copy of my book, ‘Hidden Hospital Hazards: Saving Lives and Increasing Margins.’