Increasing Returns and Path Dependence in Economics

Increasing Returns and Path Dependence in the Economics

  • Increasing Returns
  • Self Reinforcement
  • Positive Feedbacks
  • Lock-in

 

Key People:

  • W. Brain Arthur
  • Ken Arrow
  • Scott Page
  • Paul David

 

From Increasing Returns,  Path Dependence in Economy 

Forward to the book by K Arrow

The concept of increasing returns has had a long but uneasy presence in economic analysis. The opening chapters of Adam Smith’s Wealth of Nations put great emphasis on increasing returns to explain both specialization and economic growth. Yet the object of study moves quickly to a competitive system and a cost-of-production theory of value, which cannot be made rigorous except by assuming constant returns. The English school (David Ricardo, John Stuart Mill) followed the competitive assumptions and quietly dropped Smith’s boldly-stated proposition that, “the division of labor is limited by the extent of the market,” division of labor having been shown to lead to increased productivity.

 

Other analysts in different traditions, especially the French mathematician and economist, A. A. Cournot (1838), saw clearly enough the incompatibility of increasing returns and perfect competition and developed theories of monopoly and oligopoly to explain the economic system implied by increasing returns. But this tradition acts like an underground river, springing to the surface only every few decades. Alfred Marshall expanded broadly, if vaguely, on the implications of increasing returns, including those for economic growth, irreversible supply curves, and the like, as well as the novel and far-reaching concept of externalities, where some, at least, of the increasing returns are captured, not by the producer but by others.

 

The implications of increasing returns for imperfect competition were developed, though far from completely, by Edward Chamberlin and Joan Robinson in the 1930s. There was sporadic emphasis on the role of increasing returns in economic growth by Allyn Young (1928) (but only in very general terms) and then by Nicholas Kaldor in the1950s. Many developmental theorists, particularly in the 1950s, advocated radical planning policies based on vague notions of increasing returns.

 

From Path Dependence

 

A survey of the literature on path dependence reveals four related causes: increasing returns, self-reinforcement, positive feedbacks, and lock-in. Though related, these causes differ. Increasing returns means that the more a choice is made or an action is taken, the greater its benefits. Self-reinforcement means that making a choice or taking an action puts in place a set of forces or complementary institutions that encourage that choice to be sustained. With positive feedbacks, an action or choice creates positive externalities when that same choice is made by other people. Positive feedbacks create something like increasing returns, but mathematically, they differ. Increasing returns can be thought of as benefits that rise smoothly as more people make a particular choice and positive feedbacks as little bonuses given to people who already made that choice or who will make that choice in the future. Finally, lock-in means that one choice or action becomes better than any other one because a sufficient number of people have already made that choice.

 

From Positive Feedbacks in the Economy

 

Conventional economic theory is built on the assumption of diminishing returns. Economic actions eventually engender a negative feedback that leads to a predictable equilibrium for prices and market shares. Negative 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 1970’s encouraged energy conservation and increased oil exploration, precipitating a predictable drop in prices by 198x. 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 effect 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—make for multiple equilibrium points. There is no guarantee that the particular economic outcome selected from among the many alternatives will be the “best” one. Furthermore, once chance economic forces select a particular path, it may become locked in regardless of the advantages of other paths. 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.

If increasing-returns mechanisms are important, why have they been largely ignored until recently? Some would say that complicated products—high technology—for which increasing returns are so prevalent, are themselves a recent phenomenon. This is true, but only part of the answer. After all, in the 1940’s and 1950’s economists like Gunnar Myrdal and Nicholas Kaldor identified “cumulative causation” or positive feedback mechanisms that did not involve technology. Orthodox economists avoided increasing returns for deeper reasons.

Some economists found the existence of more than one solution to the same problem distasteful—unscientific. “Multiple equilibria,” wrote Josef Schumpeter in 1954, “are not necessarily useless, but from the standpoint of any exact science the existence of a uniquely determined equilibrium is, of course, of the utmost importance, even if proof has to be purchased at the price of very restrictive assumptions; without any possibility of proving the existence of uniquely determined equilibria—or at all events, of a small number of possible equilibria—at however high a level of abstraction, a field of phenomena is really a chaos that is not under analytical control.”

Other economists could see that increasing returns would destroy their familiar world of unique, predictable equilibria and along with this the notion that the market’s choice was always best. Moreover, if one or a few firms came to dominate a market, the assumption of perfect competition, that no firm is large enough to affect market prices on its own (which makes economic problems easy to analyze), would also be a casualty. When John Hicks surveyed these possibilities in 1939 he drew back in alarm. “The threatened wreckage,” he wrote, “is that of the greater part of economic theory.” Economists restricted themselves to diminishing returns, which presented no anomalies and could be analyzed completely.

Studying such problems in 1979, I believed I could see a way out of many of these difficulties. In the real world, if several similar-sized firms entered a market together, small fortuitous events—unexpected orders, chance meetings with buyers, managerial whims—would help determine which ones achieved early sales and, over time, which firm came to dominate. Economic activity is quantized by individual transactions that are too small to foresee, and these small “random” events could cumulate and become magnified by positive feedbacks over time to determine which solution was reached. This suggested that situations dominated by increasing returns should be modeled not as static, deterministic problems, but rather as dynamic processes with random events, and with natural positive feedbacks or non-linearities. With this strategy an increasing-returns market could be recreated theoretically and watched as its corresponding process unfolded again and again. Sometimes one solution would emerge, sometimes (under identical conditions) another. It would be impossible to know in advance which of the multiple solutions would emerge in any given run, but it would be possible to record the particular set of random events leading to each solution and to study the probability that a particular solution will emerge under a certain set of initial conditions. The idea was simple and it may well have occurred to economists in the past. But making it work called for non-linear random-process theory that did not exist in their day.

 

 

Key Sources of Research:

 

Competing Technologies, Increasing Returns, and Lock-In by Historical Events

W. Brian Arthur

The Economic Journal, Vol. 99, No. 394. (Mar., 1989), pp. 1

 

http://tuvalu.santafe.edu/~wbarthur/Papers/Arthur_1989.pdf

 

Path Dependence

Scott E. Page

Center for the Study of Complex Systems, University of Michigan, Ann Arbor 48104,

 

http://dev.wcfia.harvard.edu/sites/default/files/Page2006.pdf

 

Increasing Returns and the Two Worlds of Business 

by W. Brian Arthur

April 27, 1996

 

http://www.iwp.jku.at/born/mpwfst/02/BArthur/Arthur_B.pdf

 

Path Dependence in Decision-Making Processes: Exploring the Impact of Complexity under Increasing Returns

Jochen Koch,Martin Eisend,  Arne Petermann,

 

https://www.researchgate.net/profile/Martin_Eisend/publication/39018662_Path_Dependence_in_Decision-Making_Processes_Exploring_the_Impact_of_Complexity_under_Increasing_Returns/links/0a85e5395b8bf886d7000000.pdf

 

“Lock-in” vs. “critical masses” – industrial change under network externalities

Ulrich Witt

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.336.6781&rep=rep1&type=pdf

 

Complexity and the Economy

W. Brian Arthur

http://www.uvm.edu/~pdodds/files/papers/others/1999/arthur1999a.pdf

 

Arrow, Kenneth J.

“Path dependence and competitive equilibrium.”

History Matters. Essays on Economic Growth, Technology, and Demographic Change, Hrsg. Timothy W. Guinnane (2003): 23-35.

http://www-siepr.stanford.edu/conferences/Arrow.pdf

 

 

“Silicon Valley” Locational Clusters: When Do Increasing Returns Imply Monopoly?

W. Brian Arthur

SFI WORKING PAPER: 1989–007

https://www.semanticscholar.org/paper/-silicon-Valley-Locational-Clusters-When-Do-Arthur/435d47aad77998366d32924e8c1b9988c31c4380/pdf

 

David, Paul A.

“Why are institutions the ‘carriers of history’?: Path dependence and the evolution of conventions, organizations and institutions.”

Structural change and economic dynamics 5.2 (1994): 205-220.

https://www.researchgate.net/profile/Paul_David2/publication/222275225_Why_are_institutions_the_carriers_of_history_Path_dependence_and_the_evolution_of_conventions_organizations_and_institutions/links/00b7d529bc11dee673000000.pdf

 

Increasing Returns,  Path Dependence and Study of Politics

 

https://www.unc.edu/~fbaum/teaching/PLSC541_Fall06/Pierson%20APSR%202000.pdf

 

Increasing Returns and Path Dependence in the Economy

by W. Brian Arthur,

Univ. of Michigan Press,

Ann Arbor, 1994.

http://tuvalu.santafe.edu/~wbarthur/Books/Preface.html

 

Complexity economics:
a different framework for economic thought

W. Brian Arthur

2013

 

http://tuvalu.santafe.edu/~wbarthur/Papers/Comp.Econ.SFI.pdf

 

Increasing Returns and the New World of Business

by W. Brian Arthur

1996

 

http://tuvalu.santafe.edu/~wbarthur/Papers/HBR.pdf

 

COMPETING TECHNOLOGIES, INCREASING RETURNS,

AND LOCK-IN BY HISTORICAL EVENTS

W. Brian Arthur

http://tuvalu.santafe.edu/~wbarthur/Papers/EJ.pdf

 

 

Positive Feedbacks in the Economy

W. Brian Arthur

26 November 1989

 

http://tuvalu.santafe.edu/~wbarthur/Papers/SciAm_Article.pdf

 

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Author: Mayank Chaturvedi

You can contact me using this email mchatur at the rate of AOL.COM. My professional profile is on Linkedin.com.

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