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CHAPTER I Positive Feedbacks in the Economy This paper, written for a wide audience at a popular level, will serve as an introduction to many of the themes that follow in this book. It appeared in Scientific American (February 1990): 92-99. A few of the diagrams in the original have been omitted. Conventional economic theory is built on the assumption of diminishing returns. Economic actions engender a negative feedback that leads to a predictable equilibrium for prices and market shares. Such feedback tends to stabilize the economy because any major changes will be offset by the very reactions they generate. The high oil prices of the 1970s encouraged energy conservation and increased oil exploration, precipitating a predictable drop in prices by the early 1980s. According to conventional theory, the equilibrium marks the "best" outcome possible under the circumstances: the most efficient use and allocation of resources. Such an agreeable picture often does violence to reality. In many parts of the economy, stabilizing forces appear not to operate. Instead positive feedback magnifies the effects of small economic shifts; the economic models that describe such effects differ vastly from the conventional ones. Diminishing returns imply a single equilibrium point for the economy, but positive feedback-increasing returns-makes for many possible equilibrium points. There is no guarantee that the particular economic outcome selected from among the many alternatives will be the "best" one. Furthermore, once random economic events select a particular path, the choice may become lockedin regardless of the advantages of the alternatives. If one product or nation in a competitive marketplace gets ahead by "chance," it tends to stay ahead and even increase its lead. Predictable, shared markets are no longer guaranteed. During the past few years I and other economic theorists at Stanford University, the Santa Fe Institute in New Mexico and elsewhere have been developing a view of the economy based on positive feedback. Increasingreturns economics has roots that go back 70 years or more, but its application to the economy as a whole is largely new. The theory has strong parallels with modem nonlinear physics (instead of the pre-twentieth-century physical models that underlie conventional economics), it requires new and challeng- 2 Increasing Returns and Path Dependence in the Economy ing mathematical techniques and it appears to be the appropriate theory for understanding modern high-technology economies. The history of the videocassette recorder furnishes a simple example of positive feedback. The VCR market started out with two competing formats selling at about the same price: VHS and Beta. Each format could realize increasing returns as its market share increased: large numbers of VHS recorders would encourage video outlets to stock more prerecorded tapes in VHS format, thereby enhancing the value of owning a VHS recorder and leading more people to buy one. (The same would, of course, be true for Beta-format players.) In this way, a small gain in market share would improve the competitive position of one system and help it further increase its lead. Such a market is initially unstable. Both systems were introduced at about the same time and so began with roughly equal market shares; those shares fluctuated early on because of external circumstance, "luck," and corporate maneuvering. Increasing returns on early gains eventually tilted the competition toward VHS: it accumulated enough of an advantage to take virtually the entire VCR market. Yet it would have been impossible at the outset of the competition to say which system would win, which of the two possible equilibria would be selected. Furthermore, if the claim that Beta was technically superior is true, then the market's choice did not represent the best economic outcome (fig. 1). Conventional economic theory offers a different view of competition between two technologies or products performing the same function. An example is the competition between water and coal to generate electricity. As hydroelectric plants take more of the market, engineers must exploit more costly dam sites, thereby increasing the chance that a coal-fired plant will be cheaper. As coal plants take more of the market, they bid up the price of coal (or trigger the imposition of costly pollution controls) and so tip the balance toward hydropower. The two technologies end up sharing the market in a predictable proportion that best exploits the potentials of each, in contrast to what happened to the two video-recorder systems. The evolution of the VCR market would not have surprised the great Victorian economist Alfred Marshall, one of the...

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