When the academic W. Brian Arthur arrived at Stanford in 1982, he found its proximity to the energy of the nascent technology centre of the world much to his liking. A polymath, he had trained as an engineer and mathematician specialising in algorithmic theory. He also possessed a skill set less commonly encountered in the Valley: he was a gifted economist.
At the time, one of the great battles of the home electronics market – Betamax versus VHS – was ongoing. Betamax was the superior format, but over time it had become increasingly clear that, either by strategy or some unpredictable series of events, VHS was beginning to dominate the market. Within a few years, it was impossible to find a Betamax-formatted film in a video store: VHS had triumphed, despite its comparative mediocrity.
Around the same time, Arthur noticed a phenomenon in the area’s technology companies that didn’t fit the accepted rules of economics. Traditional theory advocated the imperative of diminishing returns, the understanding that, at a certain point, output would not increase in-line with inputs. Simply put, if you hire another salesperson, they might add another ten per cent in revenue, another sales person would add another seven per cent, an additional one just five per cent. The law suggested that there was a point at which firms would reach a state of optimal output; after this there would be a decline, even if more resources were invested.
Arthur’s observation of Silicon Valley suggested that technology companies might be different. In 1983, he wrote a paper, “Positive Feedbacks and Increasing Returns”, and sent it to four leading economic journals. Academic publishing had yet to reach the speed of the internet, and the paper was eventually published in 1989. In it, he argued that – in some instances – if a product or service gained some advantage this advantage would lead to further gains, a cycle that would repeat itself until it was “locked in” as the dominant player, in the way that VHS had triumphed. There weren’t diminishing returns for VHS, in fact its dominance made it hard to dislodge as the dominant player in its market.
Taking a wider view of the technology industry, it was possible to extrapolate that a new category of product – software – intensified this characteristic; any product that got ahead and developed an advantage would only get further ahead. This played out at companies such as Microsoft and Sun Microsystems where traditional business people – who had been schooled in the accepted thinking of marginal returns – argued that products should be priced at market rates; after all, the company needed to make a return on the years of R&D and development, the intensely expensive processes by which software came to market.
However, Arthur’s paper, and the intuition of the emerging breed of technology entrepreneurs flipped that model; although the initial costs of developing software are high, the costs of replicating it are minimal, meaning that there is a cost advantage. In the mid nineties, for instance, AOL realized that, if it sent CDs of its dial-up internet software to as many people as possible – through the post, no less – then it would develop market dominance. Today, there are still people with AOL email addresses. More importantly, we understand this way of establishing advantage as the guiding economic principle of every large technology company; and, instead of being known as increasing marginal returns, it’s called the network effect.
Think of it this way: if you were joining a dating platform, would you join the one with two members, a thousand members or a million members? Clearly, you would join the one with the largest membership as it would offer the best opportunity to find a match. Others would make the same decision for the same reason. Similarly, Google is the dominant search engine because its volume of users generate more data than any of its competitors, which makes it superior to other search engines, which attracts more users; Facebook is the most significant social network because it has a “locked in” advantage, and Uber subsidises every journey in order to grow its user base, which increases the amount of data it has, which improves its services, which attracts more riders…
When Arthur published his paper, it gained few plaudits from his fellow economists as it undermined their core belief that the principle of diminishing returns was what helped to balance markets. Today, so-called network effects in the tech industry are the guiding principles of private equity and venture capitalists. But there is also a nascent, but growing, thread of economic thought that suggests a move beyond the winner-takes-all model of dominating marketplaces, one that seeks to look at growth in a different way, one that advocates that the best economic approach for any business is to ensure that the startup has purpose at its core. This might be committing to ensuring a sustainable supply chain, providing financial services to underserved markets or low-cost toys that develop children’s cognitive skills.
The impact investors Mustard Seed, who has invested in companies such as what3words published a report in which they outline a strategy they have named the Virtuous Venture Cycle, one that replaces the notion of “locked in” with the idea of “lock-step” ventures, in which – according to a 2017 blog post – “the vicious cycle of negative externalities is replaced by a system of value creating positive impact aligned with commercial return, whereby the bottom line and impact are not only strongly correlated but also mutually reinforcing”.
In other words, positive economic returns reinforce positive social outcomes. This model, which combines profit and purpose, means that category winners don’t just strive to prevail, but also drive a broader ecosystem of positive effects. In turn, this has a positive impact on the business. Similarly, there are ways that internal changes can be implemented that have comparable outcomes – higher levels of diversity on teams is linked to higher business performance. Research by McKinsey suggests that “companies in the top quartile for gender or racial and ethnic diversity are more likely to have financial returns above their national industry medians. Companies in the bottom quartile in these dimensions are statistically less likely to achieve above-average returns. And diversity is probably a competitive differentiator that shifts market share toward more diverse companies over time.”
There is similar thinking going on by, among others, Sarah Lacey, who spoke at WIRED’s annual festival of ideas, WIRED Live, last year. In her book, A Uterus is a Feature, Not a Bug, she offers a compelling research on the business impact of diverse teams. As anyone working in technology knows: the data doesn’t lie: diversity and gender equality aren’t just the right thing to do, they’re good for business.