On this week’s post I would like to share with you a great theory that I have read this week about Increasing Returns and the new world of business. The theory, that complements Christensen’s Innovation Dilemma, try to describe how today’s business world operates and how the new technology companies such as Uber manage to overcome some of the incumbents in their industries.

In a nutshell the Brian Arthur’s theory argues that in today’s Economy companies that have a head start will only succeed more while ones that are behind will only get further behind. As a result, in contrary to the western approach of equilibrium, increasing returns creates exactly the opposite, instability. That means that every advantage that a young company achieves, actually can assist it to take over the industry.

Obviously, Alfred Marshall’s world of diminishing returns in which as one grows its operation its ability to use suitable resources will be reduced still exists. However, it exists mainly in industries that are heavy on resources and light o know-how. Nowadays, on the opposite industries shift towards favoring know-how as a means for differentiation, and hence the economics shifts.

The Uber Example  

In Brian Arthur’s original article, he refers to Apple and IBM to show how a company that got ahead will only get further ahead as it develops. However, I will argue that this theory is still relevant for us today by using Uber as a use case. The Taxi industry operated for a long time without any interference, however in 2009 Uber was founded and was launched by 2011. As Uber started to gain traction due to its positive attributes customers preferred using it instead of regular taxis. As a result more and more drivers decided to move into Uber as well as they understood that they’ll have more customers in the new platform, which obviously made Uber even more successful.

This example represents great how a company that had an initial head start on the incumbent (in this case it was ease of use, availability, driver review system and more) has multiplied its advantage as it progressed and took over this highly lucrative industry in less than 5 years.

How to Distinguish Between the Two Economies?

In order to determine in advance the futures of the different industries there are several factors that will enable us to determine whether the specific industry is part of the diminishing or Increasing Returns Economy.

1. Up-Front Costs: As the industry involves higher up-front costs it means that there is a higher emphasis on know-how and light on resources. Hence, it is part of the increasing returns. A good example for this is almost every start-up that require high initial investment.
2. Network Effects: The more emphasis there is on dependence on other complementary products the more it will be an increasing returns economy. A good example for this is Airbnb and how its increases its control as more users use the platform.
3. Customer Switching Costs: The more the customers are needed to adjust themselves to the new product/ technology it is more probable that the economy will act as an increasing return one. A great example for this is Apple and its unique Operating System and how these lock in its customers to its products.

Implications for Innovation

As always, what are the implications on developing innovations within these industries, especially as usually the split between the two types of economies are not always neatly split?

As in other fields, executives must understand that the two types of economies would act differently, should be managed differently and compete differently. As a result their employees in each unit need to fit their unique economy’s culture and characteristics.

Another huge impact of the new increasing Returns Economy is the high bets that incumbents need to do in order to maintain their initial edge that will ensure their future success. There are many strategies that can get you first to the market but usually these mean a lot of high volume betting. Incumbents must be aware of it, while remembering that not all bets will succeed.

Additional Thoughts

So what does it means for managers nowadays? As we progress to a highly know-how based economy, managers should as themselves several questions about this new type of economy:

1. Do I really understand the feedback that I get from the market and what it means about my company?
2. What type of economy am I in? As mentioned above, the split here is not always easy to do. Therefore, the faster managers will understand the reactions of their market the better they will be able to navigate their businesses.
3. Do I have enough resources to bet? The new economy requires placing large bets, can you handle it as a company?

What do you think? Are we facing a new type of economy? what are the implications on start-ups and larger corporations? Please comments and let me know what do you think!

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