Increasing Returns: Innovate to Remain Relevant

Increasing returns are the tendency for that which is ahead to get farther ahead, for that which loses advantage to lose further advantage. 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.

William Brian Arthur, recipient of the International Schumpeter Prize in Economics and the Lagrange Prize in Complexity Science

In his Increasing Returns and the Two Worlds of Business, W. Brian Arthur talks about positive feedbacks in the economy: the mechanisms that underlie them, their consequences, and how businesses can take advantage of them.

Can our Modern Industrial Companies Benefit from Increasing Returns? #

Following Arthur’s framework, industrial companies can indeed take advantage of increasing returns. That is because they can leverage the three following factors.

1. Up-front costs: high-tech products are, by definition, complicated to design and to deliver to the market place.
   
   • An important barrier to entry exists in most industrial endeavors, such as the development of a new helicopter or the development of the first driverless car.
2. Network effect: the more a high-tech product is prevalent and the more it emerges as a standard.
   
   • More electric cars = more charging stations = more coverage = more electric cars
     
   • More drones = more available equipment = more mission capability = more drones
3. Customer lock-in: in high-tech, a product that gains market advantage stands to gain further advantage.
   
   • From the customer’s point of view: training of pilots and mechanics, and stocks of spare parts are an incentive to keep using compatible products.
     
   • From the manufacturer’s point of view: this creates an incentive to sell products at a loss in order to lock-in the market, sell more support and services, and sell even more products.

But do our Modern Industrial Companies Take Advantage of Increasing Returns? #

Not always.

Modern industrial companies compete in winner-take-most, increasing returns type markets. But it is not as easy to see as in the computer startup world, because of the much longer lead times and product cycles.

As an example, in the aerospace industry, product life cycles are measured in decades. And more than 50 years separated the Wright Brothers’ first flight from the Boeing 707’s.

Of course, in our high-tech markets, winners do not get to keep their title forever. Technology–whether web-based or industrial–comes in waves. And watching for the next wave is key.

The main strategic differentiator, and the ever-present question in these markets, is whether the current players will catch the next wave.

Who, if anyone, of the current car manufacturers, aircraft makers, or computer companies will catch the next wave? And what will that wave be: Driverless or electric cars? Unmanned, high speed or space transportation systems? Wearable, implant or ubiquitous computers? Or something completely different?

The Trap we Routinely Fall Into #

It sounds like common sense for industrial companies to spend energy in optimizing costs and continuous product improvement; to reduce production and supply chain costs by 5% each year while iterating on existing products and improving their performance by 10% each year.

But a very optimized business can still become irrelevant in an instant. Many lean and well-run businesses disappeared in the blink of an eye: from horse-drawn cart makers, to steam trains and steam ships producers, to telegraph manufacturers and AM/FM Radio companies, all the way to cassette, film, camera, computer and cellphone makers. Once seemingly invincible brands can suffer if they don’t catch the next wave—think Kodak, Polaroid, Compaq, Nokia, BlackBerry…

If they are to survive and prosper, high-tech industries must always be on the look-out for the next technological wave.

The new product must be 2x, 3x or even 10x better (in noise, price, speed, range…) rather than 10% or 20% better.

In this environment, if a company holds a losing hand–not the right technology, product, or service–then the alternatives are: slow death or graceful exit.

The Way Forward for Production Industries #

From the moment a business recognizes that it operates in an increasing returns ecosystem, its strategy must be to innovate, to innovate, and to innovate.

It must strive to catch the next wave.

But since production industries have operations to manage efficiently, and in order to avoid imposing unnecessary constraints on the increasing returns parts of their business, they must separate their activities.

• Increasing returns: knowledge-based design and marketing, on the look-out for the next wave
• Diminishing returns: supply chain and manufacturing operations, driven by process and continuous improvement

That is because different rules of the game apply in the two worlds. And different cultures and mindsets must be adopted in each of them.

• Increasing returns: flat hierarchies, mission orientation, flexibility in strategy, reinvention, repositioning, re-everything
• Diminishing returns: control and planning, hierarchy of bosses and workers, constant improvement, constant optimization, lean manufacturing, high quality at low cost

It is a mistake to think that what works in one world is appropriate for the other.

So in which world is your company operating? Which mindset is prevalent, and which one should be?

Author: E. Dib #

Further Reading #

• W. Brian Arthur, Increasing Returns and the Two Worlds of Business
• E. Dib, Freedom and Responsibility Culture: Is the Manufacturing Industry Doomed?