Positive Feedbacks in the Economy

Positive Feedbacks in the Economy A new frugal theory elucidates mechanisms whereby fiddling chance events first in the history of an industry or technology can tilt the competitive balance by W. Brian Arthur onventional economic theory is built on the assumption of fall renrrns. Economic actions engender a negative feedback that leads to a predictable equilibrium for prices and trade sh ares. 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 ncouraged energy conservation and increased oil exploration, precipitat- ing a predictable drop in prices by the betimes 1980s. According to conventional theory the equilibrium marks the best outcome possible under the cir- natives will be the best one. Furtherto a greater extent, once random economic events select a particular path the choice may become locked-in regardless of the advantages of the alternatives. If one product or nati onin a competitive emailprotected gets ahead by chance, it tends to stay ahead and even increase its lead. hedictable, shared markets are no longer guaranteed.During the past few years I and other economic theorists at Stanford University, the Santa Fe Insurute in New Mexico and elsewhere have been developing a view of the economy based 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, luclC and corporate maneuvering. Increasing returns on early gains eventually tilted the competitor toward VHS it accumulated enough of an advantage to take vhrually the entire VCR market.Yet it would have been impossible at the outset of the rivalry to vocalize which system would win, which of the two possible equilibria would be se- Such an agreeable picture often on convinced(p) feedback. Increasing-returns economics has roots that go back 70 ye ars or more, but its application to the economy as a whole is does violence to reality. In many move bigheartedly new. The theory has powerful lected. Furthermore, if the claim that Beta was technically superior is true, then the markets choice did not represent the best economic outcome. Conventional economic theory of- stabilizing forces arallels with advanced(a) nonlinear physics (instead of the pre-ZOth-century physical models that underlie conventional economics), it requires new and challenging mathematical techniques in the midst of two technologies or products performing the same function. An ex wide is the competition between water and coal to generate electricity. As cumstances the most efficient use and allocation of resources. of the economy, 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 equilibr ium point for the economy, but positive feedback- change magnitude returns-makes for many possible equilibrium points. on that point is no guarantee that the particular economic outcome selected from among the many alterW. BRIANARTHUR is Morrison hofes- sor of Population Studies and Economics at Stanford University. He obtained his Ph. D. from the University of California, Berkeley, in 1973 and holds graduate degtees in operations research, economics and mathematics. Until belatedly Arthur was on leave at the Santa Fe Institute, a research insdrute dedicated o the srudy of complex systems. There he directed a team of economists, physicists, biologists and others investigating behavior of the economy as an evolving, complex system. and it appears lTth history of the videocassette I recorder furnishes a simple exI ample of positive feedbaik. the vcR market started out with two competing formats selling at about the same price VIIS and Beta. Ehch format could realize increasing rerur ns 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 WIS ecorder and leading more people to buy one. (The same would, of course, be true for Beta-format players. ) Ir this way, a small gain in market share would improve the competitive rate of one system and help it further increase its lead. 92 Scrrmrrc AMERTcAN to be the appropri- ate theory for understanding modern high-technology economies. February 1990 fers a different view of competition 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 f the market, they bid up the price of coal (or trigger the imposition of costly pollution controls) and so tilt the balance toward hydropower. The two technologies end up sharing the market in a predictable proportion that best e qploits 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 founders of todays conventional economics. In his 1890 Prnciples of Economics, he noted that if firms production be fall as their arket shares increase, a firm that simply by good fortune gained a high proportion of the market early on would be able to best its rivals uhatever firm first gets a good start would corner the market. Marshall did not follow up this observatior however, and theoretical economics has until recently largely ignored it. Marshall did not believe that increasing returns applied everywhere agriculture and mining-the mainstays of the economies of his timewere subject to diminishing returns caused by limited amounts of fertile shoot down or high-quality ore deposits.Manufacturing, on the other hand, eqioyed increasing returns because large plants allow ed improved organization Modern economists do not see economies of scale as a certain source of increasing returns. Sometimes large plants have proved more economical often they have not. would update Marshalls insight by observing that the parts of the economy that are resource-based (agficulI ture, bulk-goods production, mining) are still for the most part subject to diminishing returns. Here conventional economics rightly holds sway.The parts of the economy that are knowledge-based, on the other hand, are largely subject to increasing retums. Products such as computers, pharmaceuticals, missiles, aircraft, automobiles, software, telecommunications equipment or fiber optics are complicated to design and to manufacture. They require large initial investments in research, development and tooling, but once sales begin, incremental production is relatively cheap. A new airframe or aircraft engine, for example, typically costs between $2 and $3 billion to design, develop, certify and put into production.Each copy thereafter costs perhaps $50 to $100 million. As more social units are built, unit costs continue to fall and profits increase. Increased production brings additional benefits producing more units means gaining more experience in the uct so as to be able to exchange information with those using it already. manufacturing process and achieving greater understanding of how to produce additional units even more mechanisms that did not involve technology. Orthodox economists avoided increasing returns for deeper reasons. cheaply. Moreover, er