An important new theory about how small chance events early in the history of an industry or technology can tilt, forever, its competitive balance Economic theory still rests on century-old notions of equilibrium, diminishing returns, and the single optimal outcome -- concepts that were useful in the bulk manufacturing and agrarian economy of the 1800s, but that fail to illuminate the dynamics of today's technology-intensive industries. Writing originally in Scientific American, W. Brian Arthur, Dean and Virginia Morrison Professor of Population Studies and Economics at Stanford University and Citibank Professor at the Santa Fe Institute in New Mexico, describes an alternative economics based on increasing returns, which can significantly affect the way today's companies are organized and operated. CONVENTIONAL ECONOMIC THEORY is built on the assumption of diminishing returns. Economic actions engender a negative feedback that leads to a predictable equilibrium for prices and market shares. Such feedback tends to stabilize the economy because any major changes will be offset by the very reactions they generate. The high oil prices of the 1970s encouraged energy conservation and increased oil exploration, precipitating a predictable drop in prices by the early 1980s. According to conventional theory, the equilibrium marks the "best" outcome possible under the circumstances: the most efficient use and allocation of resources. Such an agreeable picture often does violence to reality. In many parts of the economy, stabilizing forces appear not to operate. Instead, positive feedback magnifies the effects of small economic shifts; the economic models that describe such effects differ vastly from the conventional ones. Diminishing returns imply a single equilibrium point for the economy, but positive feedback -- increasing returns -- makes for many possible equilibrium points. There is no guarantee that the particular economic outcome selected from among the many alternatives will be the "best" one. Furthermore, once random economic events select a particular path, the choice may become locked in, regardless of the advantages of the alternative. If one product or nation in a competitive marketplace gets ahead by "chance," it tends to stay ahead and even increase its lead. Predictable, shared markets are no longer guaranteed. A new theory During the past few years, I and other economic theorists at Stanford University, the Santa Fe institute in New Mexico, and elsewhere have been developing a view of the economy based on positive feedback. Increasing-returns economics has roots that go back 70 years or more, but its application to the economy as a whole is largely new. The theory has strong parallels with modern nonlinear physics (instead of the pre-20th-century physical models that underlie conventional economics). It requires new and challenging mathematical techniques, and it appears to be the appropriate theory for understanding modern high-technology economies. The history of the videocassette recorder furnishes a simple example of positive feedback. The VCR market started out with two competing formats selling at about the same price: VHS and Beta. Each format could realize increasing returns as its market share increased: large numbers of VHS recorders would encourage video outlets to stock more prerecorded tapes in VHS format, thereby enhancing the value of owning a VHS recorder and leading more people to buy one. (The same would, of course, be true for Beta-format players.) In this way, a small gain in market share would improve the competitive position of one system and help it to further increase its lead. Such a market is initially unstable. Both systems were introduced at about the same time and so began with roughly equal market shares; those shares fluctuated early on because of external circumstance, "luck," and corporate maneuvering. Increasing returns on early gains eventually tilted the competition toward VHS: it accumulated enough of an advantage to take virtually the entire VCR market. …