SYNOPSIS: Examines how Increasing Returns in the Technology sector is not the great cure-all some suggest. Suggests that it could lead to market breakdown and a need for necessity.
Will capitalism go Hollywood?
Thirty years ago, when John Kenneth Galbraith published The New Industrial
State, he was sure he knew where the modern economy was going and was
contemptuous of economists who clung to their old ideas about the primacy
of markets. Clearly giant corporations, driven by the imperatives of technology,
were replacing the chaos of the market with bureaucratic order. The age
of business heroes was over: "With the rise of the modern corporation,
the emergence of the organization required by modern technology and planning
and the divorce of the owner of capital from control of the enterprise,
the entrepreneur no longer exists as an individual person in the mature
industrial enterprise." The economy of the future would be run by
faceless organization men, whose ability to manipulate pliable consumers
would eliminate the traditional uncertainties associated with market competition.
In effect, capitalism was evolving spontaneously into socialism without
Instead, of course, only the paranoid survived, or something like that. And yet Galbraith's mistake--believing that one can discern the shape of tomorrow's economy by extrapolating from today's iconic corporations--is one that each generation seems to repeat. Yesterday every industry was going to look like automobiles, and every company like General Motors; today every industry is going to look like software, and every company like Microsoft.
Like Galbraith, the prophets
of what is variously called the "business revolution," the Knowledge
Economy, the Network Economy, and the "new economy" (not to be
confused with the New Economy I wrote about last month) are likely to be disappointed. Even though information technology
may well be the main driving force behind future economic growth, it's
very unlikely that the information-technology industry is ever going
to be more than a fairly small share of the economy. In its day electricity
changed everything, too, but there was never a time when most people worked
for electric utilities or even for employers who looked anything like electric
utilities. Still, even if every industry isn't about to look like
software, it is worth asking what is special about those industries that
It's important to get past the obvious, but mainly irrelevant, surfaces of things. Of course information technology is nifty; but the latest technology always seems nifty (At the 1876 Philadelphia Centennial Exposition, triumphant banners proclaimed "All By Steam!"). The real question is whether there really are, as Wired's Executive Editor Kevin Kelly put it in the title of a widely read recent article, "New Rules for the New Economy."
Kelly manages to come
up with no less than 12 such rules, ranging from the more or less incomprehensible
("Embrace dumb power") to the basically silly ("Follow the
free"), all wrapped in trendy rhetoric about living "on the edge
of chaos" and all that. But most of his rules amount to variations
on two themes: In the Network Economy supply curves slope down instead
of up, and demand curves slope up instead of down. At least, that's what
I think he's saying. To the extent that he is, he is actually on to something--though
not something new.
True, traditional economic theory--the stuff that occupies the first 10 or so chapters of most introductory textbooks--does assume "diminishing returns" in both production and consumption. That is, the more units of something the economy is already producing, the harder it is to produce one unit more; the more units of something people are already consuming, the less they are willing to pay to consume one unit more. That is why the conventional supply curve, which shows how much will be produced at any given price, slopes up; and the demand curve, which shows how much people will buy at any given price, slopes down.
But even Alfred Marshall--the
Victorian economist who invented supply and demand as we know it--was well
aware that while diminishing returns are a good assumption for agriculture
(The more wheat you try to grow, the worse the land on which the marginal
bushel is grown), elsewhere in the economy it is quite possible to have
increasing returns, in which the more you produce, the easier it
gets. Way back in 1890 he explained that concentrations of industry (yes,
they existed before Silicon Valley--his prime example was the Sheffield
cutlery district) can create a virtuous circle in which the availability
of skilled labor, the presence of specialized suppliers, and the diffusion
of knowledge progressively lower costs. Increasing returns to consumption are probably less
common, but can result among other things from "network externalities"--a
bit of useful jargon for what happens when the usefulness of a product
depends on how many other people possess something similar. A telephone
is a toy when only a few people have one; it is a necessity when everyone
The old-fashioned examples are deliberate: Increasing returns have been around for a long time. And while economists may historically have downplayed their importance, those days are long past. In fact, by now, increasing returns are rather old hat. Everybody knows that sufficiently strong increasing returns can cause discontinuous change, with markets exploding when they reach a "critical mass," that small events can have big effects when a market is near a "tipping point," that economic choices (like VHS vs. Betamax, or Silicon Valley vs. Route 128) can be subject to "lock-in" by past accidents, and so on. Everybody also knows that while it is easy to tell good stories along these lines, it's a lot harder when you get down to real cases: It's amazingly hard to identify a critical mass or a tipping point for an actual industry, even after the fact.
So what's new about Kelly's
New Rules? Well, for one thing, they may be new to him. Cybercritic Paulina
Borsook has pointed out to me that technology enthusiasts like Kelly are
prone to "Luke Skywalker fantasies," imagining themselves heroic
rebels against the empire of orthodoxy. (The quintessential example of
the Luke Skywalker Syndrome is the story of Brian Arthur, as described
in my column last week. They are so sure that boring conventional thinkers could
not have anticipated their radical ideas that it would never occur to them
Or maybe what's new about the rules is the claim that now, for the first time, they apply to a large part of the economy. However, technology boosters, who won't stop thinking about tomorrow, often forget to think about yesterday: It's not at all clear that increasing returns are any more important in software than they were in the early days of railroads, electricity, telephones, radio, even automobiles (What good is a car without gas stations? Why open a gas station if nobody has a car?). And it's very unlikely that in the future everything will look like software--indeed, it's much more likely that eventually the information sector itself will turn into a boring mature industry.
If there is something
new in the writings of Kelly and other cyberprophets, it is the fact that
they don't just predict a future in which the curves slope the wrong
way, they endorse it. That is, along with the gee-whiz pronouncements
about how the economy supposedly works goes a pronounced libertarian bent,
a belief that the new economy is too dynamic, organic, or whatever to be
regulated from above.
What is odd about these libertarian conclusions is that they do not at all follow from the premises. On the contrary: A world in which increasing returns are prevalent is one in which markets are likely to get it wrong. Products that should be developed never get off the ground, or do so much later than they should, because everyone is waiting for other people to move. (I'll buy a fax machine only when enough other people have them to make it worthwhile.) Industries can get locked into the wrong technology (Macintosh is better than DOS, but everyone uses DOS because everyone else uses DOS). Waste occurs because of coordination failures (In the early days of railroads each line had a different gauge). Indeed, increasing returns have traditionally been used as arguments against free markets, for government intervention. You may not believe that such intervention will work in practice, but that's a judgment about the rules of politics, not economics.
Of course the information-technology
sector has been wonderfully successful--but that is because it has been
in a position to exploit the extraordinary possibilities offered by photolithography,
not because of any special virtue in the way it operates. Other sectors
in which increasing returns to both production and consumption prevail--and
there are quite a few outside what is normally thought of as high technology--do
not seem especially admirable.
Consider, in particular, an industry few would regard as a role model: Hollywood. It is obviously characterized by increasing returns to production: Once you've made a movie, showing it to another person costs virtually nothing. It is also characterized by increasing returns to consumption: Many people want to see a movie because other people have seen it. In fact, by my reckoning, the movie business handily fits 11 of Kelly's 12 rules. It even fits "Follow the free," which I think means "Sell your signature product cheap, and make money off accessories"; major blockbusters make much of their money off product placements and toy sales, and even theater owners depend on sodas and snacks to turn a profit. The only rule I can't apply to Hollywood is "Embrace dumb power"--but then again, some of those studio bosses ...
So think of it this way: While the prophets of the "new economy" may seem to be telling us that we're heading for a future in which every industry looks like Silicon Valley, what they are really saying is that we are on our way to an era in which there's no business that isn't like show business. Let's hope they're wrong.