Increasing returns. Wrecking the greater part of economic theory.

Let’s go back to beginnings- to the diminishing-returns view of the past century. In the world of the early 1900s, business was about bulk production. Metal ores, aniline dyes, pig iron and black coal. Heavy chemicals, cattle, corn and coffee—commodities heavy on resources, light on know-how. In that world, as a corn plantation expanded production, it would ultimately have to use land less suitable for corn. In other words, it would run into diminishing returns. If corn 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. Planters would produce corn 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. Alfred Marshall - chief economic thinker of the time - said such a market was in perfect competition. The economic world he envisaged fitted beautifully with the values of his time. It was at equilibrium and orderly, predictable and amenable to scientific analysis, stable and safe, slow to change and continuous. Not too rushed, not too profitable. It was dignified. It was mannerly. It was genteel. Steadily, continuously, and with increasing rapidity: economies have undergone a transformation. From bulk-material manufacturing, to design and use of technology. From the processing of resources to the processing of information. From application of raw energy to the application of ideas. As this shift has occurred, so has a shift from diminishing returns to one of increasing returns. Increasing returns: to get ahead, is to get further ahead; to lose advantage is to lose further advantage. Within markets, businesses, and industries—it is 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. 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. It inverts many of our notions of how businesses operate. Modern economies have bifurcated into two interrelated worlds of business corresponding to the two types of returns. The two worlds have different economics. They differ in behaviour, style, and culture. They call for different management techniques, strategies, and codes of government regulation. They call for different understandings. They call for different investors. Investing in diminishing-return markets is like investing in 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 comfortable. By contrast, the style of competition in the increasing-returns arena is more like gambling. Where part of the game is to first choose which games to play, as well as playing them with skill. Picture the top operators in tech — Zuckerberg, Bezos, Page — milling in a large casino. At one table, a game is underway called social media. Over at that one, a game called cloud services. In the corner is A.I. There are many such tables. You sit at one. How much to play? you ask. Seven 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. Shall I deal you in? High technology, pursued at this level, is not for the timid. 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. Zuckerberg, Bezos, Page and Gates are not so much wizards of technology as masters of precognition, of discerning the shape of the next game. These properties, then, have become the hallmarks of increasing returns: market instability (the market tilts to favour a product that gets ahead), unpredictability, the ability to lock in a market, the possible predominance of an inferior product, and massive profits for the winner. Where does all this leave us? In the last century, industrial economies were based on the bulk processing of resources. Now they are based on the processing of resources and on the processing of knowledge. Economies have bifurcated into two worlds—intertwined, overlapping, and different. These two worlds operate under different economic principles. Marshall’s world is characterised by planning, control, and hierarchy. It is a world of materials, of processing, of optimization. The increasing-returns world is characterised by observation, positioning, flattened organisations, missions, teams, and strategy. It is a world of psychology; of cognition; of adaptation. Many investors have some intuitive grasp of this new increasing-returns world. Few understand it thoroughly. In the processing world, understanding markets means understanding consumers’ needs, distribution channels, and rivals’ products. In the knowledge world, success requires a thorough understanding of the self-negating and self-reinforcing feedbacks in the market—the diminishing-and increasing-returns mechanisms. These feedbacks are interwoven and operate at different levels in the market and over different time frames. Technologies exist not alone but in an interlinked web, or ecology. It is important to understand the ecologies a company’s products belong to. Success or failure is often decided not just by the company but also by the success or failure of the web it belongs to. Active management of such a web can be an important magnifier of increasing returns. In technology, economics, and the politics of nations, wealth in the form of physical resources is steadily declining in value. The powers of the mind are everywhere ascendant over the brute force of things. New economics—one very different from that in the textbooks—now applies, and nowhere is this more true than in high technology. Success will strongly favour those investors who understand this new way of thinking.