Classroom Companion: Business

Path Dependence
Contents
11.1 
 Definitions – 166
11.2 
 Competition and Path
Dependence – 168
11.3 
 Impact of Churning – 169
11.4 
 Path Dependence
and Lock-In – 172
11.5 
 Conclusions – 174
 References – 176
11

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166
11
 
n Learning Objectives
After completing this chapter, you should be able to:
5
Understand the concepts of diminishing returns, increasing returns, and path 
dependence in the context of the digital economy.
5
Explain why some economic systems—contrary to standard microeconomic 
theory—may end up in one out of several equilibrium states depending on inter-
nal and external forces acting on the market.
5
Analyze how path dependence is generated by positive feedback from the market 
or by external forces.
11.1 
 Definitions
The general assumption in conventional economic theory is that the markets are 
controlled by negative feedback that reduces any deviation away from market equi-
librium. This is referred to as markets with diminishing returns in standard eco-
nomic theory. These markets are in fine-tuned dynamic equilibrium, in which no 
change takes place in the composition of the market. The law of diminishing 
returns ensures that this equilibrium state always will be reached and that this state 
always is the best choice.
Definition 11.1 Law of Diminishing Returns
If additional units of one production factor are employed, with all other held con-
stant, the output generated by each additional unit will eventually decrease (Bannock 
et al., 
1998
).
The traditional view in microeconomics is that the market is governed by the bal-
ance between supply and demand and that all competitors have perfect knowledge 
about the market. In this simple market theory, an evolving market (e.g., the mobile 
phone market) will end up in a single predetermined equilibrium state, regardless 
of initial conditions and events taking place as the market evolves. In accordance 
with the law of diminishing return, any deviation away from this equilibrium will 
quickly be counteracted by negative feedback such that the market returns to the 
equilibrium state. If a new competitor is added to the market, the market will ini-
tially be out of balance but will soon reach a new equilibrium state uniquely deter-
mined by the new number of competitors.
In 1990, Brian Arthur wrote an article in Scientific American in which he claimed 
that many dynamic markets will not settle in an equilibrium state predicted by con-
ventional economic theory (Arthur, 
1990
). This is the case for products where there 
is positive feedback from the market (or network effects; see 
7
Chap. 
8
) resulting 
in increasing returns (sales stimulate more sales). As explained above, diminishing 
returns imply that the market contains a single stable equilibrium state. The evolu-
tion of markets with increasing returns due to market feedback is different. Already 
in 1986, Arthur and coworkers had shown mathematically—using a method called