Three Longs & Three Shorts

Increasing returns and the new world of business

Author: W.Brian Arthur
Source: Harvard Business Review ( )

This piece was published in HBR 25 years ago and was referenced in Howards Marks’ famous January 2021 memo (where he explained why traditional value investing based on looking for low P/E, P/B stocks has lost its relevance). As Marks explained in January, even a quarter of a century on from its publication date this prescient piece by Brian Arthur remains super relevant because of the way it explains how over the past century changes in technology have altered the way successful firms scale and how as they scale, their Return on Capital (and hence Free Cashflows) expand.
Arthur begins the piece by explaining that most investors carry in their heads outdated mental models about now businesses and markets work: “Our understanding of how markets and businesses operate was passed down to us more than a century ago by a handful of European economists—Alfred Marshall in England and a few of his contemporaries on the continent. It is an understanding based squarely upon the assumption of diminishing returns: products or companies that get ahead in a market eventually run into limitations, so that a predictable equilibrium of prices and market shares is reached. The theory was roughly valid for the bulk-processing, smokestack economy of Marshall’s day. And it still thrives in today’s economics textbooks. But steadily and continuously in this century, Western economies have undergone a transformation from bulk-material manufacturing to design and use of technology—from processing of resources to processing of information, from application of raw energy to application of ideas. As this shift has occurred, the underlying mechanisms that determine economic behavior have shifted from ones of diminishing to ones of increasing returns.”
So why do successful firms in the modern era benefit from increasing returns? Why do the market leaders keep pulling from the rest? Arthur explains: “Increasing returns are the tendency for that which is ahead to get further ahead…They are mechanisms of positive feedback that operate—within markets, businesses, and industries—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, and the product or company or technology can go on to lock in the market….”
Arthur explains that whilst in some sectors of contemporary economies you still see decreasing returns to scale, these tend to be traditional industries (grains, agri products, metals & mining, retail goods), often smokestack, heavy engineering & heavy chemicals industries. As a result: “At the beginning of this century, industrial economies were based largely on the bulk processing of resources. At the close of the century, 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 characterized by planning, control, and hierarchy. It is a world of materials, of processing, of optimization. The increasing-returns world is characterized by observation, positioning, flattened organizations, missions, teams, and cunning. It is a world of psychology, of cognition, of adaptation.”
Arthur then uses the example of the operating system wars of the 1980s to explain how different modern industries are to the traditional industries: “Let’s look at the market for operating systems for personal computers in the early 1980s when CP/M, DOS, and Apple’s Macintosh systems were competing. Operating systems show increasing returns: if one system gets ahead, it attracts further software developers and hardware manufacturers to adopt it, which helps it get further ahead. CP/M was first in the market and by 1979 was well established. The Mac arrived later, but it was wonderfully easy to use. DOS was born when Microsoft locked up a deal in 1980 to supply an operating system for the IBM PC. For a year or two, it was by no means clear which system would prevail. The new IBM PC—DOS’s platform—was a kludge. But the growing base of DOS/IBM users encouraged software developers such as Lotus to write for DOS. DOS’s prevalence—and the IBM PC’s—bred further prevalence, and eventually the DOS/IBM combination came to dominate a considerable portion of the market. That history is now well known. But notice several things: It was not predictable in advance (before the IBM deal) which system would come to dominate. Once DOS/IBM got ahead, it locked in the market because it did not pay for users to switch. The dominant system was not the best: DOS was derided by computer professionals. And once DOS locked in the market, its sponsor, Microsoft, was able to spread its costs over a large base of users. The company enjoyed killer margins.”
So which sectors benefit from increasing returns? Increasing returns are not just limited to tech industries; all Services sectors and light industrial manufacturing such a Pharma, Specialty chemicals, basically anything where the knowledge intensity is high relative to capital intensity can benefit from increasing returns. Arthur cites 3 factors which can help identify such industries:
Up-front Costs: High-tech products—pharmaceuticals, computer hardware and software, aircraft and missiles, telecommunications equipment, bioengineered drugs, and suchlike—are by definition complicated to design and to deliver to the marketplace. They are heavy on know-how and light on resources. Hence they typically have R&D costs that are large relative to their unit production costs. The first disk of Windows to go out the door cost Microsoft $50 million; the second and subsequent disks cost $3. Unit costs fall as sales increase.
Network Effects: Many high-tech products need to be compatible with a network of users. So if much downloadable software on the Internet will soon appear as programs written in Sun Microsystems’ Java language, users will need Java on their computers to run them. Java has competitors. But the more it gains prevalence, the more likely it will emerge as a standard.
Customer Groove-in: High-tech products are typically difficult to use. They require training. Once users invest in this training—say, the maintenance and piloting of Airbus passenger aircraft—they merely need to update these skills for subsequent versions of the product. As more market is captured, it becomes easier to capture future markets.”