The Emergence of High Sunk Costs Industries: Market...

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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This is a preliminary draft of work in progress, please do not quote or circulate without the author’s permission.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 PROC ESS ..............................................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, quasi-

unique 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’, data-

based 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-sunk-

costs 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 high-

sunk-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 This does not necessarily mean a longer text. 5 F. R. Ankersmit, Narrative logic (1983), and lectures of F. R. Ankersmit, Groningen 1992-1993.


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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]. 7 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.


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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.


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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 spectator-

hour 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


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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 multi-

dimensional 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 PROC ESS

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.


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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. 14 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.


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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 high-

technology 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.


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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]. 19 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.


15

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 quality-

adjusted price) results in a sharp increase in demand. Often, the traditional sector remains, and

21Or 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. 22Rising 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. 24This also adds an evolutionary perspective to economic survival.


16

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,


17

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


18

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.


19

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.


20

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.


21

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.


22

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-


23

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.


24

Table 1. Advertising or R&D-outlays as percentage of sales by industry (%), 1960-1990

Advertising Percentage Research and Development PercentageEntertainment 5.0 Entertainment 25.0Industrial/other chemicals 3.7 Software 20.0Pharmaceuticals 3.7 Office machines and computers 11.7Food and kindred products 2.3 Pharmaceuticals 8.2Electronic machinery 1.6 Electronic machinery 5.3Rubber products 1.5 Industrial/other chemicals 4.3Engines 1.0 Aerospace 3.8Office machines and computers 1.0 Motor vehicles 3.2Software 1.0 Rubber products 2.2Motor vehicles 0.8 Engines 2.1Paper and allied products 0.7 Petroleum 0.9Petroleum 0.5 Paper and allied products 0.8Aerospace 0.3 Food and kindred products 0.7Ferrous metals 0.3 Ferrous metals 0.7

Source: adapted from Helms 1996: 254-255.

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,


25

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


26

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-sunk-

costs 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, quasi-

unique 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


27

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.


28

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 self-

reinforcing 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 high-

sunk 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,


29

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 quasi-

unique 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).


30

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.


31

Figure 1: Qualitative overview of expected findings when investigating high-sunk-costs industries Category Industry Sub-

industries Strong market growth

Process � product

Automation, standardisation tradability

Structural change

Accelerating productivity growth

Sunk costs — exo/endo?

Quasi-unique organisations

Size ~ Concentration relationship

International diffusion

Strong endo Entertainment Film Music Radio/TV

1 1 1 1 1

1 1 Endo 1 1 1

Pharmaceuticals 1 1 1 1 1

0 1 Endo 1 1 1

Office automation (software)

1 1 1 1 1

1 1 Endo 1 1 1

Videogames 1 1 1 1 1

? 1 Endo 1 1 1

Warfare (WMD) 1 (productivity so enormous that game-theoretical need after 1 nation has it)

1 1 1 1

1 1 Endo 1 1 (obscured by government influence)

1

Network industries

Communications 1 Possibly 1 1 0.5

1 1 Exo + fixed only

1 Possibly 1

Transport Turnpikes Canals Railroads Motor cars Steamships Airplanes

1 1 1 1 0.5 (or 0)

1 1 Exo – networks Endo- car mfg Exo – hshlds + fixed only

1 1 (in long-run, pre-turnpike cpx nowadays)

1

Mixed or unclear cases

Household appliances

1 1 1 1 1

1 1 Endo – mfg Exo – hshlds + fixed only

1 Possibly 1

‘Normal industries’

Textiles (manufacturing)

(excl. branded textiles)

0 (?) Hardly 1 1 always tradable

1 1 (??) Exo – mfg Large part fixed only

0 Hardly Slow/slower?

Agriculture (excl. branded foods)

0 (?) Possibly (pesticides)

1 1 1

1 1 (enormously) Endo – chemicals, machinery Do branded food firms capture the rents?

1 Chemicals, machinery

Faster: pesticides; fast: machinery

Note: 1 = expected, 0 = not expected.


32

Figure 1 (continued): Qualitative overview of expected findings when investigating high-sunk-costs industries Causal

factors

Category Industry Unit of measurement Demand Effectiveness sunk outlays

Liberalisation/ deregulation

Market integration

Ability to capture rents

Strong endo

Entertainment Spectator-hour 1 1 1 1 1

Pharmaceuticals Quality-adjusted year of life

1 1 hmm 1 1

Office automation (software)

Overhead/total costs 1 1 0 1 1

Videogames 1 1 0 1 1 Warfare (WMD) Dollar of human and

physical capital incapacitated Win or lose (binary)

1 0.5 0 1 1

Network industries

Communications 1 1 1 1

Transport Hour/passenger-squarekilometer (hr/(pas*km*km/hr) = hr/(pass.*kilometre^2)

1 1 0.5 0 1

Mixed or unclear cases

Household appliances

1 0 0 1 1

‘Normal industries’

Textiles (manufacturing)

Standardised quantity of clothes/TFP

1? (elas ticity)

1 0 1 (machines tradable)

0.5 (machine mfg.)

Agriculture Calories (+vitamins etc.)

1 1 1 (inverse; presence regulation)

1 (pesticides; machinery)

1 (pesticides; machinery)


33

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.

US UK FR

1881-1938 2.51900-1938 2.71909-1938 2.31914-1938 2.61934-1938 -0.31900-1938 output 7.0 3.0 11.1

1881-19381909-1938 11.01914-1938 8.11934-1938 -1.2

1881-1938 0.81900-1938 0.01909-1938 -3.81914-1938 -1.31934-1938 1.4

Source: Bakker 2004a.

Cinema and live

Cinema

Live


34

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.

UK FR

1900 4.62 0.121938 1.22 1.261900 0.031938 1.03

1900-1938 US/… 3.40 1.001900-1938 UK/… 1.70

1900 4.62 0.121938 3.92 1.541900 0.031938 0.39

1900-1938 US/… 0.43 0.521900-1938 UK/… 0.53

Source: Bakker 2004a.

Tradability (PPP entertainment/exchange rate), US /….:Tradability (PPP entertainment/exchange rate), UK/….:Percentage decrease in PPP ent/exchange rate per annum (= percentage increase in tradability)

Modern and traditional sector combined

Traditional sector onlyTradability (PPP entertainment/exchange rate), US /….:Tradability (PPP entertainment/exchange rate), UK/….:Percentage decrease in PPP ent/exchange rate per annum (= percentage increase in tradability)

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


35

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.

US UK FREmployment in modern sector (%) 1900 3.0 2.4 3.6

1938 88.2 39.1 23.9

Net new jobs 1900-1938 traditional -77,719 -16,101 17,096modern 178,000 39,800 14,083

modern/all (%) 177.5 167.9 45.2

Modern capital/whole capital stock 1938 87.4 76.5 90.2Modern output/all output 1938 93.3 70.2 89.8Price per spectator hour (% change per annum)1900-1938 -2.3 0.1 -4.4

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.


36

Table 5. Productivity in the entertainment industry, US, Britain and France, 1900-1938.

US UK FR

1900 249 1,250 111938 7,038 3,863 6011900 2,453 15,028 2641938 34,879 36,152 8,4291900 1.8 10.0 0.61938 12.7 6.7 3.2

Output growth (% per annum) 1900-1938 9.2 3.0 11.1Labour growth (% per annum) 1900-1938 2.2 1.5 2.5Capital growth (% per annum) 1900-1938 5.0 4.1 6.4TFP growth (% per annum) 1900-1938 6.3 0.8 7.6

traditional 155 1,148 61modern 6,883 2,714 540

traditional 10,470 19,209 203modern 39,539 92,461 35,270

traditional 1.8 9.2 0.6modern 7.4 8.7 2.9

Source: Bakker 2004a, with corrections.

Disaggregated for 1938

Output (million spectator-hours)

Output per fte (spectator hours)

Output per $1,000 of capital (spectator hours)

Output (million spectator-hours)

Output per fte (spectator hours)

Output per $1,000 of capital (spectator hours)

Modern and traditional sector combined

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. 33 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.


37

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 four-

firm 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


38

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

10,000

100,000

1,000,000

10,000,000

1860 1870 1880 1890 1900 1910

10,000

100,000

Total

Average

Music hall capital, total and average per hall (£), 1858-1912

Figure 2. Source: Crowhurst 1991.

37 Possibly not unlike the relationship between the early motor cars and the railways.


39

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. 39 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.


40

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

100,000

1,000,000

10,000,000

1800 1810 1820 1830 1840 1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

(£10

00s

of p

ound

s of

200

2)

Consumption

Production

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.


41

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.

0

0.5

1

1.5

2

1900 1910 1920 1930 1940 1950 1960 1970

Dea

ths

per

1,0

00 p

op

ula

tio

n

pneumonia

tuberculosis

diphteria

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.


42

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1900 1910 1920 1930 1940 1950 1960 1970

Incr

ease

in y

ears

of

life

per

1,0

00 p

op

ula

tio

npneumonia

tuberculosis

diphteria

Figure 5. Increase in years of life per 1,000 population for three major conditions, UK, 1900-1970.

0.0001

0.001

0.01

0.1

1

10

1900 1910 1920 1930 1940 1950 1960 1970

Dea

ths

per

1,0

00 p

op

ula

tio

n

pneumonia

tuberculosis

diphteria

Figure 6. Death rates for three major conditions, UK, 1900-1970.


43

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 quality-

adjusted 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.


44

100

1000

10000

100000

1960 1965 1970 1975 1980 1985

Rea

l sal

es o

r m

edic

ine

qu

alit

y o

r q

ual

ity-

adju

sted

pro

du

ctiv

ity(

1960

-65=

100)

sales

quality of medicines

quality-corrected output

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.


45

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

100

1,000

10,000

100,000

1,000,000

1943 1944 1945 1946 1947 1948 1949 1950 1951

Pro

duct

ion

or c

ost (

$/bi

llion

uni

ts)

0.0001

0.001

0.01

0.1

1

10

100

Tre

atm

ent

(p

atie

nts

/mon

th in

mill

ion

s)

Cost

Production

Treatment

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].


46

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)

0

200

400

600

800

1,000

1,200

1,400

1950 1955 1960 1965 1970 1975 1980 1985 19900

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

To

tal R

&D

or

tota

l sal

es/1

0 ($

mill

ion

)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

Figure 9. Source: Achilladelis 1999.

45 Correlation done for Achilladelis [1999] dataset.


47

Average annual R&D/sales ratio (%) per decade ($ million of 1995)

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

1950 1955 1960 1965 1970 1975 1980 1985 1990

Abbott


Bristol-Myers

Johnson & Johnson

Lilly

Merck

Parke-Davis

Pfizer

Schering-Plough

Searle


Squibb

Sterling

Upjohn

Warner-Lambert

Average


Summary data US top-15 pharma firms

0

20

40

60

80

100

120

140

1950 1955 1960 1965 1970 1975 1980 1985 19900

200

400

600

800

1000

1200

Mar

ket

pat

ents

Average patents/$mln R&D * 100

Average $mln sales/Patent

Market patents


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


48

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).


49

US Market share of top-15 US pharmaceutical firms (%)

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

1950 1955 1960 1965 1970 1975 1980 1985 1990

Abbott


Bristol-Myers

Johnson & Johnson

Lilly

Merck

Parke-Davis

Pfizer

Schering-Plough

Searle


Squibb

Sterling

Upjohn

Warner-Lambert


C4-ratio vs. market size, US pharmaceutical industry 1950-1993

0.0

10.0

20.0

30.0

40.0

50.0

60.0

1,000 10,000 100,000

Real market size ($million of 1995)

Fo

ur

firm

co

nce

ntr

atio

n r

atio

(%

)

100.0

1000.0

10000.0

Her

fin

dah

l-H

irsc

hm

ann

Ind

ex (

*100

00)

C4-ratio

Census C4

HH index

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


50

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.


51

(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

0

50

100

150

200

250

1855 1860 1865 1870 1875 1880 1885 1890

Cos

t per

four

lette

r w

ord

($ o

f 200

2)

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.


52

Number of telegraph messages sent and real costs of telegrams and phone calls, US, 1850-1970

1,000,000

10,000,000

100,000,000

1,000,000,000

1850 1870 1890 1910 1930 1950 1970

Nu

mb

er o

f te

leg

rap

h m

essa

ges

sen

t

0

20

40

60

80

100

120

Rea

l co

st o

f 10

-wo

rd t

eleg

rap

h m

essa

ge

or

3-m

inu

te p

ho

ne

call

(in

d

olla

rs o

f 20

02)

telegraph messages US

real cost telegraph

real cost telephone

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


53

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

19th 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

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

1650 1670 1690 1710 1730 1750 1770 1790 1810 1830

£ of

200

2 pe

r pa

ssen

ger-

kilo

met

er p

er k

ilom

eter

per

hou

r

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.


54


0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

1650 1670 1690 1710 1730 1750 1770 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990

£ of

200

2 pe

r pa

ssen

ger-

kilo

met

er p

er k

ilom

eter

per

hou

r

Figure 17. Source: calculated from Gerhold 1996 and own calculation for 2005.


0.001

0.010

0.100

1.000

1650 1670 1690 1710 1730 1750 1770 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990

£ of

200

2 pe

r pa

ssen

ger-

kilo

met

er p

er k

ilom

eter

per

hou

r

Figure 18. Source: calculated from Gerhold 1996 and own calculation for 2005.


55

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, 1851-1931

30

35

40

45

50

1850 1860 1870 1880 1890 1900 1910 1920 1930

Do

mes

tic

serv

ants

/1,0

00 in

hab

itan

ts

0

5

10

15

20

25

30

35

40

45

Ad

op

tio

n r

ates

ap

plia

nce

s (%

of

ho

use

ho

lds)

dom.serv./1,000

UK vac cleaner est.

Clothes washers (US)

fridges (US)

vac cleaners (US)

Figure 19. Source: Bowden and Offer 1994; Thomas 2004.


56

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 high-

sunk-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


57

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.


58

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