INCREASING RETURNS

In the industrial economy success was self-limiting;

…it obeyed the law of decreasing returns. In the network economy, success is self-reinforcing; it obeys the law of increasing returns.

We see the law of increasing returns operating in the way areas such as Silicon Valley grow; each successful new start-up attracts other start-ups, which in turn attract more capital and skills and yet more start-ups. (Silicon Valley and other high-tech industrial regions are themselves tightly coupled networks of talent, resources, and opportunities.)

At first glance the law of increasing returns may seem identical to the familiar textbook notion of economies of scale: The more of a product you make, the more efficient the process becomes. Henry Ford leveraged his success in selling automobiles to devise more productive methods of manufacturing cars. This enabled Ford to sell his cars more cheaply, which created larger sales, which fueled more innovation and even better production methods, sending his company to the top.

That self-feeding circle is a positive feedback loop. While the law of increasing returns and the economies of scale both rely on positive feedback loops, there are two key differences.

First, industrial economies of scale increase value gradually and linearly. Small efforts yield small results; large efforts give large results. Networks, on the other hand, increase value exponentially–small efforts reinforce one another so that results can quickly snowball into an avalanche. It’s the difference between a piggy bank and compounded interest.

Second, and more important, industrial economies of scale stem from the herculean efforts of a single organization to outpace the competition by creating value for less. The expertise (and advantage) developed by the leading company is its alone. By contrast, networked increasing returns are created and shared by the entire network. Many agents, users, and competitors together create the network’s value. Although the gains of increasing returns may be reaped unequally by one organization, the value of the gains resides in the greater web of relationships.

These positive feedback loops are created by “network externalities.” Anything that creates (or destroys) value which cannot be appointed to someone’s account ledgers is an externality. The total value of a telephone system lies outside the total internal value of the telephone companies and their assets. It lies externally in the greater phone network itself. Networks are particularly potent sources of external value and have become a hot spot of economic investigation in the last decade. A parade of recently published academic papers scrutinize the fine points of network externalities: When do they arise? How do they break down? Are they symmetrical? Can they be manipulated?

 

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This is a blog version of a book of mine first published in 1998. I am re-issuing it (two posts per week) unaltered on its 10th anniversary. Comments welcomed. More details here.
-- KK