Financial Management

Increasing Returns and

the New World of
Business
by W. Brian Arthur

From the Magazine (July–August 1996)

Our understanding of how markets and

businesses operate was passed down to us
more than a century ago by a handful of
European economists—Alfred Marshall in
England and a few of his contemporaries on
the continent. It is an understanding based
squarely upon the assumption of
diminishing returns: products or companies
that get ahead in a market eventually run
into limitations, so that a predictable
equilibrium of prices and market shares is
reached. The theory was roughly valid for
the bulk-processing, smokestack economy
of Marshall’s day. And it still thrives in
today’s economics textbooks. But steadily
and continuously in this century, Western
economies have undergone a
transformation from bulk-material
manufacturing to design and use of
technology—from processing of resources to
processing of information, from application
of raw energy to application of ideas. As this
shift has occurred, the underlying
mechanisms that determine economic
behavior have shifted from ones of
diminishing to ones of increasing returns.

Increasing returns are the tendency for that

which is ahead to get further ahead, for that
which loses advantage to lose further
advantage. They are mechanisms of positive
feedback that operate—within markets,
businesses, and industries—to reinforce that
which gains success or aggravate that which
suffers loss. Increasing returns generate not
equilibrium but instability: If a product or a
company or a technology—one of many
competing in a market—gets ahead by
chance or clever strategy, increasing returns
can magnify this advantage, and the product
or company or technology can go on to lock
in the market. More than causing products
to become standards, increasing returns
cause businesses to work differently, and
they stand many of our notions of how
business operates on their head.

Mechanisms of increasing returns exist

alongside those of diminishing returns in all
industries. But roughly speaking,
diminishing returns hold sway in the
traditional part of the economy—the
processing industries. Increasing returns
reign in the newer part—the knowledge-
based industries. Modern economies have
therefore bifurcated into two interrelated
worlds of business corresponding to the two
types of returns. The two worlds have
different economics. They differ in behavior,
style, and culture. They call for different
management techniques, strategies, and
codes of government regulation.

They call for different understandings.

Alfred Marshall’s World

Let’s go back to beginnings—to the

diminishing-returns view of Alfred Marshall
and his contemporaries. Marshall’s world of
the 1880s and 1890s was one of bulk
production: of metal ores, aniline dyes, pig
iron, coal, lumber, heavy chemicals,
soybeans, coffee—commodities heavy on
resources, light on know-how. In that world
it was reasonable to suppose, for example,
that if a coffee plantation expanded
production it would ultimately be driven to
use land less suitable for coffee. In other
words, it would run into diminishing
returns. So if coffee plantations competed,
each one would expand until it ran into
limitations in the form of rising costs or
diminishing profits. The market would be
shared by many plantations, and a market
price would be established at a predictable
level—depending on tastes for coffee and
the availability of suitable farmland. Planters
would produce coffee so long as doing so
was profitable, but because the price would
be squeezed down to the average cost of
production, no one would be able to make a
killing. Marshall said such a market was in
perfect competition, and the economic
world he envisaged fitted beautifully with
the Victorian values of his time. It was at
equilibrium and therefore orderly,
predictable and therefore amenable to
scientific analysis, stable and therefore safe,
slow to change and therefore continuous.
Not too rushed, not too profitable. In a
word, mannerly. In a word, genteel.

With a few changes, Marshall’s world lives

on a century later within that part of the
modern economy still devoted to bulk
processing: of grains, livestock, heavy
chemicals, metals and ores, foodstuffs, retail
goods—the part where operations are
largely repetitive day to day or week to
week. Product differentiation and brand
names now mean that a few companies
rather than many compete in a given
market. But typically, if these companies try
to expand, they run into some limitation: in
numbers of consumers who prefer their
brand, in regional demand, in access to raw
materials. So no company can corner the
market. And because such products are
normally substitutable for one another,
something like a standard price emerges.
Margins are thin and nobody makes a
killing. This isn’t exactly Marshall’s perfect
competition, but it approximates it.

The Increasing-Returns World

What would happen if Marshall’s

diminishing returns were reversed so that
there were increasing returns? If products
that got ahead thereby got further ahead,
how would markets work?

Let’s look at the market for operating

systems for personal computers in the early
1980s when CP/M, DOS, and Apple’s
Macintosh systems were competing.
Operating systems show increasing returns:
if one system gets ahead, it attracts further
software developers and hardware
manufacturers to adopt it, which helps it get
further ahead. CP/M was first in the market
and by 1979 was well established. The Mac
arrived later, but it was wonderfully easy to
use. DOS was born when Microsoft locked
up a deal in 1980 to supply an operating
system for the IBM PC. For a year or two, it
was by no means clear which system would
prevail. The new IBM PC—DOS’s platform—
was a kludge. But the growing base of
DOS/IBM users encouraged software
developers such as Lotus to write for DOS.
DOS’s prevalence—and the IBM PC’s—bred
further prevalence, and eventually the
DOS/IBM combination came to dominate a
considerable portion of the market. That
history is now well known. But notice
several things: It was not predictable in
advance (before the IBM deal) which system
would come to dominate. Once DOS/IBM
got ahead, it locked in the market because it
did not pay for users to switch. The
dominant system was not the best: DOS was
derided by computer professionals. And
once DOS locked in the market, its sponsor,
Microsoft, was able to spread its costs over a
large base of users. The company enjoyed
killer margins.

These properties, then, have become the

hallmarks of increasing returns: market
instability (the market tilts to favor a
product that gets ahead), multiple potential
outcomes (under different events in history,
different operating systems could have
won), unpredictability, the ability to lock in
a market, the possible predominance of an
inferior product, and fat profits for the
winner. They surprised me when I first
perceived them in the late 1970s. They were
also repulsive to economists brought up on
the order, predictability, and optimality of
Marshall’s world. Glimpsing some of these
properties in 1939, English economist John
Hicks warned that admitting increasing
returns would lead to “the wreckage of the
greater part of economic theory.” But Hicks
had it wrong: the theory of increasing
returns does not destroy the standard
theory—it complements it. Hicks felt
repugnance not just because of unsavory
properties but also because in his day no
mathematical apparatus existed to analyze
increasing-returns markets. That situation
has now changed. Using sophisticated
techniques from qualitative dynamics and
probability theory, I and others have
developed methods to analyze increasing-
returns markets. The theory of increasing
returns is new, but it already is well
established. And it renders such markets
amenable to economic understanding.

In 1939, English
economist John
Hicks warned that
admitting
increasing returns
would lead to “the
wreckage of the
greater part of
economic theory.”
But Hicks had it
wrong.

In the early days of my work on increasing

returns, I was told they were an anomaly.
Like some exotic particle in physics, they
might exist in theory but would be rare in
practice. And if they did exist, they would
last for only a few seconds before being
arbitraged away. But by the mid-1980s, I
realized increasing returns were neither rare
nor ephemeral. In fact, a major part of the
economy was subject to increasing returns
—high technology.

Why should this be so? There are several

reasons:

Up-front Costs.

High-tech products—pharmaceuticals,
computer hardware and software, aircraft
and missiles, telecommunications
equipment, bioengineered drugs, and
suchlike—are by definition complicated to
design and to deliver to the marketplace.
They are heavy on know-how and light on
resources. Hence they typically have R&D
costs that are large relative to their unit
production costs. The first disk of Windows
to go out the door cost Microsoft $50
million; the second and subsequent disks
cost $3. Unit costs fall as sales increase.

Network Effects.

Many high-tech products need to be

compatible with a network of users. So if
much downloadable software on the
Internet will soon appear as programs
written in Sun Microsystems’ Java language,
users will need Java on their computers to
run them. Java has competitors. But the
more it gains prevalence, the more likely it
will emerge as a standard.

Customer Groove-in.

High-tech products are typically difficult to

use. They require training. Once users
invest in this training—say, the maintenance
and piloting of Airbus passenger aircraft—
they merely need to update these skills for
subsequent versions of the product. As more
market is captured, it becomes easier to
capture future markets.

In high-tech markets, such mechanisms

ensure that products that gain market
advantage stand to gain further advantage,
making these markets unstable and subject
to lock-in. Of course, lock-in is not forever.
Technology comes in waves, and a lock-in
such as DOS’s can last only as long as a
particular wave lasts.

Some products—
like the IBM PC—
start in the
increasing-returns
world but later in
their life cycle
become virtual
commodities that
belong to Marshall’s
processing world.

So we can usefully think of two economic

regimes or worlds: a bulk-production world
yielding products that essentially are
congealed resources with a little knowledge
and operating according to Marshall’s
principles of diminishing returns, and a
knowledge-based part of the economy
yielding products that essentially are
congealed knowledge with a little resources
and operating under increasing returns. The
two worlds are not neatly split. Hewlett-
Packard, for example, designs knowledge-
based devices in Palo Alto, California, and
manufactures them in bulk in places like
Corvallis, Oregon, or Greeley, Colorado.
Most high-tech companies have both
knowledge-based operations and bulk-
processing operations. But because the rules
of the game differ for each, companies often
separate them—as Hewlett-Packard does.
Conversely, manufacturing companies have
operations such as logistics, branding,
marketing, and distribution, which belong
largely to the knowledge world. And some
products—like the IBM PC—start in the
increasing-returns world but later in their
life cycle become virtual commodities that
belong to Marshall’s processing world.

The Halls of Production and the

Casino of Technology

Because the two worlds of business—

processing bulk goods and crafting
knowledge into products—differ in their
underlying economics, it follows that they
differ in their character of competition and
their culture of management. It is a mistake
to think that what works in one world is
appropriate for the other.

There is much talk these days about a new

management style that involves flat
hierarchies, mission orientation, flexibility
in strategy, market positioning, reinvention,
restructuring, reengineering, repositioning,
reorganization, and re-everything else. Are
these new insights or are they fads? Are
they appropriate for all organizations? Why
are we seeing this new management style?

Let us look at the two cultures of

competition. In bulk processing, a set of
standard prices typically emerges.
Production tends to be repetitive—much the
same from day to day or even from year to
year. Competing therefore means keeping
product flowing, trying to improve quality,
getting costs down. There is an art to this
sort of management, one widely discussed
in the literature. It favors an environment
free of surprises or glitches—an
environment characterized by control and
planning. Such an environment requires not
just people to carry out production but also
people to plan and control it. So it favors a
hierarchy of bosses and workers. Because
bulk processing is repetitive, it allows
constant improvement, constant
optimization. And so, Marshall’s world
tends to be one that favors hierarchy,
planning, and controls. Above all, it is a
world of optimization.

Competition is different in knowledge-

based industries because the economics are
different. If knowledge-based companies are
competing in winner-take-most markets,
then managing becomes redefined as a
series of quests for the next technological
winner—the next cash cow. The goal
becomes the search for the Next Big Thing.
In this milieu, management becomes not
production oriented but mission oriented.
Hierarchies flatten not because democracy
is suddenly bestowed on the workforce or
because computers can cut out much of
middle management. They flatten because,
to be effective, the deliverers of the next-
thing-for-the-company need to be
organized like commando units in small
teams that report directly to the CEO or to
the board. Such people need free rein. The
company’s future survival depends upon
them. So they—and the commando teams
that report to them in turn—will be treated
not as employees but as equals in the
business of the company’s success.
Hierarchy dissipates and dissolves.

Does this mean that hierarchy should

disappear in meatpacking, steel production,
or the navy? Contrary to recent
management evangelizing, a style that is
called for in Silicon Valley will not
necessarily be appropriate in the processing
world. An aircraft’s safe arrival depends on
the captain, not on the flight attendants. The
cabin crew can usefully be “empowered”
and treated as human beings. This approach
is wise and proper. But forever there will be
a distinction—a hierarchy—between cockpit
and cabin crews.

In fact, the style in the diminishing-returns

Halls of Production is much like that of a
sophisticated modern factory: the goal is to
keep high-quality product flowing at low
cost. There is little need to watch the market
every day, and when things are going
smoothly the tempo can be leisurely. By
contrast, the style of competition in the
increasing-returns arena is more like
gambling. Not poker, where the game is
static and the players vie for a succession of
pots. It is casino gambling, where part of the
game is to choose which games to play, as
well as playing them with skill. We can
imagine the top figures in high tech—the
Gateses and Gerstners and Groves of their
industries—as milling in a large casino. Over
at this table, a game is starting called
multimedia. Over at that one, a game called
Web services. In the corner is electronic
banking. There are many such tables. You
sit at one. How much to play? you ask.
Three billion, the croupier replies. Who’ll be
playing? We won’t know until they show
up. What are the rules? Those’ll emerge as
the game unfolds. What are my odds of
winning? We can’t say. Do you still want to
play?

High technology, pursued at this level, is

not for the timid.

In fact, the art of playing the tables in the

Casino of Technology is primarily a
psychological one. What counts to some
degree—but only to some degree—is
Sign In
technical expertise, deep pockets, will, and
courage. Above all, the rewards go to the
players who are first to make sense of the
new games looming out of the technological
fog, to see their shape, to cognize them. Bill
Gates is not so much a wizard of technology
as a wizard of precognition, of discerning
the shape of the next game.

Adaptation means
watching for the
next wave and
positioning the
company to take
advantage of it.
Adaptation is what
drives increasing-
returns businesses,
not optimization.

We can now begin to see that the new style

of management is not a fad. The knowledge-
based part of the economy demands flat
hierarchies, mission orientation, above all a
sense of direction. Not five-year plans. We
can also fathom the mystery of what I’ve
alluded to as re-everything. Much of this
“re-everything” predilection—in the bulk-
processing world—is a fancy label for
streamlining, computerizing, downsizing.
However, in the increasing-returns world,
especially in high tech, re-everything has
become necessary because every time the
quest changes, the company needs to
change. It needs to reinvent its purpose, its
goals, its way of doing things. In short, it
needs to adapt. And adaptation never stops.
In fact, in the increasing-returns
environment I’ve just sketched, standard
optimization makes little sense. You cannot
optimize in the casino of increasing-returns