From a return vs effort perspective, there are two kinds of domains we deal with – Decreasing returns and increasing returns domains.
Decreasing Returns domains are ones, where the Law of Diminishing Marginal Utility applies. Simply put, there is a deceleration of returns or output, with every incremental unit increase in input. Whenever an attempt to increase the output is made, by increasing the input, it is met with countervailing deceleration. For example, consider a simplistic case of two competing power generation technologies – Hydro & Coal. Let’s say, hydro power plants take precedence. It will eventually lead to a capacity issue, such that the expansion of hydro power generation capacity into new not so economical sites. This will lead to the other alternative, coal based technology, to catch up. Thus, there is an equilibrium in such cases, which is unique and can be predetermined.
Increasing Returns domains, on the other hand, have accelerated gains. They benefit from scale. In these domains, processes are driven by some form of self reinforcement. One thing leads to the other in such a manner that the system becomes stronger at every stage. As an example, as against competing power generation technologies, consider the competing video recording and playing technologies in 1970s-80s – VHS & Betamax. These two competing technologies did not settle for a predetermined equilibrium of market share. Rather, it turned out to be a “winner takes all” scenario, where VHS ended up on the winning side. The point to note here is the unpredictability of indeterminacy of the scenario to the extent that not only it was not possible to predict the winner in hindsight, but also, apparently, the market ended up picking an inferior technology as winner. It is claimed that Betamax was a superior option with better resolution and better image & sound quality.
Here are some more examples of increasing returns – Networking Effects & its winners like Facebook, Whatsapp, Google etc; Countries – England after Industrial Revolution, USA after WW-II, China as the world’s manufacturing hub, evolution of species, epidemics & spread of viruses including Covid-19, fame, fashion trends
How Increasing Returns Domains work?
These domains work on the principle of self reinforcement, or cumulative causation or positive feedback loops. There is a stochastic character in the scheme of things, i.e. there are random deviations or variations, which trigger next level events, which is followed by further random deviations. With each such loop, the situation becomes favourable for some incumbent. This loop works in a self reinforcing way, such that the incumbent in the advantageous position becomes stronger & stronger in an evolutionary way. Such a development cannot always be predicted. Each random variation causes multiple solutions, one of which gets selected in a probabilistic way. This selection creates further deviations and opens up new possibilities of fresh equilibria.
A passage in the Gospel of Matthew reads, “For unto every one that hath shall be given, and he shall have abundance. But from him that hath not shall be taken away even that which he hath.” In other words, The Matthew Effect is the situation where those who receive opportunity tend to acquire additional opportunities. Those who receive initial disadvantages tend to accumulate further disadvantage.This is a phenomenon, sometimes summarised by the adage, “ The Rich get richer and the poor get poorer”. The concept is applicable to matters of fame & status, but also applies literally to cumulative advantage of economic capital. Early opportunities are important because they tend to snowball into greater and greater opportunities over time.
Let’s understand this with a simple example from Probability:
There is a bag with 4 different coloured balls – pink, blue, green and yellow. A ball is picked from the bag. That ball is replaced in the bag, along with another of the same colour.
For the first pick, the probability of any of the four colours is 1/4. Let’s say the first ball picked is pink. This ball is replaced in the bag and another ball of the same colour (pink in this case) is added.
For the second pick, the pink coloured ball has a higher probability of being picked (⅖), compared to the other three colours (⅕).
What such a system does is, that it rewards the winner by making its chances of winning further even higher. Every time a pink ball is picked, its probability of being picked in the next round increases, while that of the other balls decreases. At a certain inflection point, when one of these coloured balls, say pink, exceeds a certain share, you start adding more than one ball every time a pink ball is picked. This is a simple example of a typical Increasing Returns Scenario. If things fall in place, one thing leads to another, one win leads to more wins, and you may end up with your bag full of pink Balls. This is akin to seeing a monopolistic winner like Google or Microsoft or VHS.
Apart from studying such monopolies and how they emerged, a great subject to understand Increasing Returns is evolution of the various life forms on Earth. The millions of life forms that we observe on Earth and that existed much before Homo Sapiens evolved, were not separately created by God. All forms of life started with small filaments of proteins. Luca, the last known common ancestor of all species, was a single cell organism that lived four billion years ago. All forms of life emerged and evolved from this organism, one step at a time, one variation at a time, one species at a time. As explained by Charles Darwin, there were natural variations. Some of these variations were advantageous – were in fitment with the environment. These variations were passed on to the subsequent offsprings. Generations later, these variations became wider and different species emerged. Darwin termed this massive process of Trial & Error as “Natural Selection”. Over millions of years and billions of iterations, simplest life forms have undergone variations and compounded them. The human form, that we are today, is a result of Increasing Returns, that our species has undergone over billions of iterations.
Keep the terminology – random variations, Natural Selection, cumulative causation, and self reinforcements – and use the same narrative for Businesses, stocks, epidemics, ideas, fashions, bubbles, and propaganda. It is the same story. One win (even accidental or random) opens the door for more wins. Sometimes, the winner takes it all, resulting in monopolies. Sometimes, even an inferior incumbent takes advantage because of random mutations and locks in the gains. Some examples – QWERTY keyboard, VHS Video Player
What are the characteristics of Increasing Return Regimes?
Cumulative Causation – Increasing Return Regimes are characterised by cumulative causation or self reinforcements, or simply positive feedback loops. Success begets success.
Path Dependence (non-ergodicity) – There are natural random variations. Most of these get averaged away. However, some of these (it can’t be predicted which ones) cumulate and trigger a non-linear process.
Unpredictability – There are multiple equilibria possible. These random outcomes are unpredictable and so are their outcomes. The Path Dependence and cumulative features combine to create this unpredictability. The outcomes can only be observed and followed, not predicted. The creation of Earth in today’s form is a very looooong path dependent process that underwent billions of years. If the story is replayed, a minor variation in one of the steps billions of years back, could have easily set up life on Mars, and not Earth.
Lock-in – Minor random variations offer several possible paths for long term self reinforcement. Sometimes, the cumulation of small events early on pushes the dynamics into the orbit of one of these far enough and this selects the structure that the system eventually locks into. Someone into fitness can easily relate to this. Successive progressive overload in Resistance Training leads a person’s muscles to a path of increasing returns. After some consistent hard work, the muscles get locked into a higher strength level. More on this here…
How to benefit from Increasing Returns in Life
1) Wind In Your Sails – “Being in the right place at the right time” is more apt than imagined. Practically, this can be attributed to every big successful person. This is best explained by Malcom Gladwell in his splendid book, Outliers: The Story of Success. Here are few of the most powerful statements I’ve culled out and stitched together…
“Success is not a random act. It arises out of a predictable and powerful set of circumstances and opportunities. Success is the result of what sociologists like to call “accumulative advantage. Success is not exceptional or mysterious. It is grounded in a web of advantages and inheritances, some deserved, some not, some earned, some just plain lucky–but all critical to making them (the successful ones) who they are. It is those who are successful, in other words, who are most likely to be given the kinds of special opportunities that lead to further success. The outlier, in the end, is not an outlier at all.”
From Outliers: The Story of Success by Malcom Gladwell
The super successful people, we admire, are a cumulative result of headstart over others, followed by a series of opportunities that they capitalised through their dedication & hard work. Dedication & hard work is a fundamental imperative, but what separates the super successful ones from the ordinary is the cumulative causation.
Thus, in order to succeed, it is important to identify these long term tailwinds and be at the forefront of the ride. The challenge is that the path dependent nature of such domains make it very difficult to foresee such tailwinds. One needs an evolutionary mindset of Trial & Error with a keen sense of observation – try as many snow formations as one can, and ride the ones which snowballs, for as long as they last.
Countries, Businesses and Stock prices also undergo Increasing Returns Scenarios. Britain after the Industrial Revolution went on to colonise much of the world; USA, after the WW-II emerged as the leader and enjoyed Increasing Returns right through the Silicon Valley Establishment all the way to creating business behemoths like Microsoft, Apple, Google and Amazon; China as a manufacturing hub in the post GATT liberal trade world.
Businesses and Stock prices also undergo similar patterns. This is exploited to their benefits by all successful businessmen and investors. That is why you see the market leaders in any industry taking a sizable lead over the laggards. In most cases the top 1-3 players have 80% of the market share. In some acute cases, this phenomenon even creates monopolies when the winner takes all. In the field of investing, one of the most important quote comes from the wisest of all, Warren Buffett
“Life is like a snowball. The important thing is finding wet snow and a really long hill.”
2) Create your own wind – Sometimes, you can create your own wind. I mean to say that you can kickstart your own cumulative causation cycles and benefit from them.
The best example is that of fitness. By getting into a fitness regime, you can send your body into a positive feedback loop – exercise creates stress in muscles, muscles look to rebuild for greater strength with available nutrients, muscles emerge stronger, you are able to train harder, that creates stress….and we emerge stronger & stronger.
Politicians and corporations have used this phenomenon in creating propagandas for decades…more so in today’s networked world.
Even social media following undergoes this. The person with a larger following keeps growing.
I summarise the point that I’m trying to make is as under:
There are domains which work on the principle of Increasing Returns – Strength Begets Strength. One can benefit from these by either being at the right place at the right time or by inducing this effect in their favour by triggering some actions.