Brian Arthur's theory of "increasing returns" is revolutionizing economics. It's also why the DOJ stopped the Microsoft/Intuit merger.
__If the battle between the US Department of Justice and Microsoft is the geek version of the O. J. Simpson trial, then Brian Arthur is the star DNA expert. Arthur - a professor of population studies and economics at Stanford University, and external professor at the Santa Fe Institute - is the founding father of "increasing-returns economics," a new branch that is examining how dominant players in emerging markets can stifle innovation by locking people into inferior technical standards. Think of the old battle between VHS and Beta, and you begin to understand why superior technologies don't always win the tug of war for market share.
Arthur's ideas are beginning to make waves in academia and in the private sector. Earlier this year, when Microsoft was hoping to acquire Intuit, the Palo Alto-based law firm of Wilson, Sonsini, Goodrich & Rosati cited increasing-returns theory in an influential white paper that ultimately helped sway the Department of Justice toward blocking the proposed buyout.__
Wired: What do you mean by "increasing returns," and what does it have to do with technology?
Arthur: The economics described in textbooks was largely cooked up 100 years ago. It was developed in a different environment, one in which companies that produced goods like soybeans or coal began to get diminishing returns as they expanded in a market. But it also meant that a company could corner a market unfairly by buying up supplies all over the place. Most of the antitrust policies of the Justice Department were invented to work in a world like that.
Wired: So what's changed?
Arthur: Well, today our economy is based pretty heavily on high tech, not on soybeans or coal. High tech, so far as we can see, operates according to increasing rather than diminishing returns. The more volume you have out there in the market - the larger your installed base - the more market advantage you have. Until recently, economics didn't have any well-articulated theory to deal with this. With high-tech products that involve communications or hooking into a network, "network externalities" come into play. The more people use Unix, the more people feel compelled to adopt Unix over Windows. By the same token, people tend to "groove in" to dominant high-technology platforms, so that the more they use their software, the more they become enslaved to the software and all its upgrades.
Wired: In a recent interview, William Neucomb, Microsoft's senior vice president of corporate affairs, argues that such theories are "dangerous and untested."
Arthur: Increasing returns doesn't argue that bigness is wrong. It doesn't argue that Microsoft is evil. It's simply an economics that concerns itself with what happens in markets where there are advantages to market volume and market share. The theory itself is neutral. But to say it's unproven and untested is nonsense. It's been tested in all the academic ways - by publication, economic measurement, and so on. It's now undisputed within the economics community, and it's routinely taught at the best graduate schools.
Wired: Isn't it possible that technology markets are still in their relative infancy, and we eventually will reach a stage where returns do flatten and even diminish?
Arthur: No, I don't believe so. Let me take my logic a little bit further. Think of the market for computer operating systems, or for Beta versus VHS. Typically, we find that the market tilts to one product's advantage, and then that product can lock up a major part of the market. A lot of people ask me, So how come we're not all using Lotus 1-2-3, or how come we're not all using Visicalc? Well, new computer technology tends to come in waves. Right now, there's a wave of Internet-related technology. A new wave has to be 200 or 300 percent better than its predecessor before it can take over. Without that shift, the old product stays locked in. The best technology is not necessarily the winning one.
Wired: At the risk of misinterpreting economist Joseph Schumpeter, are the waves of technology you talk about similar to Schumpeterian waves of change?
Arthur: Kind of - in a micro sense. Schumpeter was talking about big, big waves that are measured in decades - things like the railroads, then oil power, then mass production of automobiles. I'm talking about high-tech product waves that are somewhat Schumpeterian but probably smaller and more year-by-year. For example, the kind of wave that rolled in when discs became 3.5 inches instead of 5.25. I focus upon new technological discoveries that translate into a slew of new products.
Wired: Jim Manzi of Lotus said that making a case to the Department of Justice based on theories of increasing returns was "interesting, but a little loony." He thinks antitrust legislation like the Sherman or Clayton Acts is a little more compelling. Is it appropriate to apply increasing returns in an antitrust context?
Arthur: Oh, absolutely. High-tech markets operate according to increasing returns. That is a fact of life that economists these days don't dispute. But it means that understanding the market is crucial to creating good government policy. It's not loony when lawyers such as Gary Reback at Wilson, Sonsini use the theory of increasing returns. It's courageous and sensible, because that's the way these markets work. In reply to Jim Manzi, I'd say that everything new and unfamiliar looks a bit strange at the start. This is the way cases are going to be argued from here on out; the legal profession will think nothing of it five or ten years from now.
Wired: Do you think the Department of Justice should have stopped the Microsoft/Intuit merger?
Arthur: If Microsoft/Intuit had gone through, then it's highly likely that the electronic banking world would have been dominated at the outset by Microsoft/Intuit. If there is an integrated highway that runs from your desktop to your bank account, you don't want one carrier collecting tolls all along the way. It's good to have a lot of competition. Secondly - and I think this is a subtle and much more important point - when a high-tech market is dominated by a single company, you end up with fewer new technologies, since competitors with smart new ideas have to battle against the huge advantages of increasing returns. So competitors, by and large, step back and don't upgrade the technology. You get these itty-bitty upgrades, and the upgrades have to be backward-compatible with your own product. We had 10 years' worth of DOS even though Apple had a better operating system available back in 1984. If Microsoft/Intuit had gone through, you probably wouldn't have seen radically new technologies wading in every two or three years.
Wired: Assistant Attorney General Anne Bingaman said that one implication of allowing Microsoft to buy Intuit and further consolidate the technology software market would have been higher prices. But even without Intuit, Microsoft has raised its dominance to something like 70 cents of every desktop-software dollar, and we've seen prices fall dramatically.
Arthur: The real question is whether prices are higher than they otherwise would be. Personally, I don't see pricing as the big issue here. The issue for me is technology. If competitors are shut out of the marketplace, they're keeping their radical innovations out of the marketplace. We end up with bad, cheap products that are priced higher than they should be. Is Microsoft charging more than they would if they had real competition in many of their markets? The answer is probably yes.
Wired: What would you do if you were Bill Gates?
Arthur: If I were Gates, I'd be paying an enormous amount of attention to perceptions of what Microsoft is all about. Unfortunately, the perception is that Microsoft is aggressive and will do whatever it can finish off the competition. I don't want to make this sound like a warning, but if I were in Bill Gates's shoes, I would lie low to make sure that I'm not perceived as the Leona Helmsley of the computing industry.
Wired: A bad landlord with leaky ceilings?
Arthur: Well, not quite. More like somebody who is regarded as arrogant and who attracts an awful lot of opposition. It would be a shame to see people go after Gates just because he's aggressive. If Microsoft tones down its stance and opens things up more to competitors, it'll be a major player for years to come. But the perception is that Microsoft is aggressively trying to stop other companies from getting off the ground, and that's fueling a lot of the fear and loathing. And that, in turn, fuels the Justice Department.
