Download PDF Winter Issue of The Bridge on Complex Unifiable Systems December 15, 2020 Volume 50 Issue 4 The articles in this issue are a first step toward exploring the notion of unifiability, not merely as an engineering ethos but also as a broader cultural responsibility. The Complexity of Increasing Returns Friday, December 18, 2020 Author: César A. Hidalgo While the idea of increasing returns—the tendency for what is ahead to get further ahead—has been part of economics since the pin factory, it was long resisted by economists. The reasons were both simple and profound. For decades, economists had a strong preference for models with a single equilibrium. This preference was incompatible with the idea of increasing returns. Imagine a farmer choosing whether to use her land to grow food or raise cattle. She begins by planting her most fertile land. When that runs out, she moves into worse land, where the returns for her efforts will decrease. Eventually, the next patch of land is not worth tilling so she dedicates it to cattle instead. In this story, diminishing returns lead the farmer to allocate land optimally among crops and cattle. It follows that diminishing returns are the secret behind the invisible hand. They imply that economies allocate resources optimally among multiple activities, leading to a strong policy implication: markets find an equilibrium that is both efficient and fair. Increasing Returns: VHS vs. Betamax But there are also increasing returns. These lead to multiple equilibria, runaway monopolies, and sensitivity to initial conditions (chaos). Yet it was by embracing increasing returns that economists like Brian Arthur (1996) were able to transcend economics’ fear of complexity and blaze the trail that embraced it. Increasing returns can emerge from multiple sources, such as knowledge accumulation (learning) or network externalities. Remember the 1980s, when VHS and Betamax battled for home video dominance? This is a case where network externalities led to increasing returns. The more people used a standard (VHS), the more lucrative it became to produce content and hardware for it. In this case, markets do not reach a competitive equilibrium between both options. They select one of them in a symmetry-breaking dynamic. But increasing returns turned out to be unpalatable from both a theoretical and a policy perspective. They implied that economies had multiple equilibria and, even worse, that luck could play a role in choosing them. This meant that, in the presence of increasing returns, markets could no longer be argued to be optimal or fair, opening the door to a more proactive view of industrial policy. Cornering the Market In his 2018 address to the Schumpeter Society, Keun Lee, a professor of economics at Seoul National University, shared the story of Korea’s triumph in the LCD market.[1] He explained that LCD manufacturing technology was characterized by generations. This meant that every now and then a new way of printing LCDs was discovered. These changes in technology enabled the production of larger, better, and cheaper displays, but only after manufacturers climbed a learning curve in which they produced screens at a loss while learning the new technology. Although LCD technology first became available in the 1960s, it only became a commercially viable display technology in the ’90s. It was then that South Korea decided to outsmart Japan and skip an entire manufacturing generation. That meant producing LCDs at a higher cost than their competitors, in a bet to be the first to climb the next learning curve. Korea’s bet was risky, but it worked. During the 2000s the country became a dominant player in the LCD market, surging from about a 5 percent share in 1995 to about a 20 percent share in 2012. This was in a rapidly growing export market, which ballooned from less than $5 billion in 1995 to more than $80 billion in 2010.[2] Of course, there is more to this story than increasing returns. Korea was already involved in related activities that increased its chances of success (Hidalgo et al. 2018); it had, for example, executed similar industrial policies in the past (e.g., for auto manufacturing). Yet the moral of the story is not about Korea but about industrial policy in a world of increasing returns. Outpacing the Invisible Hand in the Knowledge Economy Back in the 1890s, putting an engine on a horse carriage was enough to become a cutting-edge car manufacturer. Thirty years later, that manufacturer had to compete with the industrial complex of Henry Ford. Knowledge, and more precisely learning, implies increasing returns and narrow windows of opportunity. Seizing these short-lived windows of opportunity requires timely industrial policies. This represents an extremely uncomfortable reality for developing nations, especially those that have enjoyed some success with policies that are compatible with decreasing returns. When business leaders are involved in industries where diminishing returns are the norm, they tend to resist policies that would make no sense in their sectors. But as the knowledge economy accelerates, those who wait to see how things play out will be left behind. By the time they know what is next, early adopters will be atop mountains of knowledge that will be even harder to climb. The challenge is to conquer a spot on the mountain before it grows taller, if one wants to escape the grip of the invisible hand. Acknowledgment The author acknowledges support from ANR-19-PI3A-0004. References Arthur WB. 1996. Increasing returns and the new world of business. Harvard Business Review, Jul-Aug. Hidalgo CA, Balland P-A, Boschma R, Delgado M, Feldman M, Frenken K, Glaeser E, He C, Kogler DF, Morrison A, and 5 others. 2018. The principle of relatedness. In: Unifying Themes in Complex Systems IX, pp. 451–57. Cham: Springer. [1] https://www.youtube.com/watch?v=xh7MvzCY8Xw [2] Observatory of Economic Complexity, “Which countries export LCDs? (1995–2018),” https://oec.world/en/visualize/stacked/hs92/export/show/ all/189013/1995.2018/ About the Author:César Hidalgo holds a chair at the Artificial and Natural Intelligence Toulouse Institute (ANITI) at the University of Toulouse, and has visiting appointments at the Harvard Paulson School of Engineering and Applied Science and the University of Manchester Business School.