Classroom Companion: Business

 
Chapter 11 · Path Dependence

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11
Polya urns—that, in general, several equilibrium states may exist in systems with 
positive feedback (Brian et al., 
1986
). This implies that these systems may settle in 
an arbitrary equilibrium state depending on initial conditions or internal and exter-
nal forces acting on the system. This is called path dependence or “history matters” 
(Liebowitz & Margolis, 
1995
). The chosen equilibrium is quite arbitrary and may 
not be the best choice. This is contrary to standard economic theory postulating 
that the market’s choice is always best.
Definition 11.2 Path Dependence
Path dependence means that the path of evolution of the market of a good depends 
on the initial state of the market (e.g., number of early adopters), network effects 
(e.g., bandwagon effects), and external events taking place during the evolution of 
the market (e.g., product visibility and searching costs). The different paths may end 
up in different equilibrium states.
Network effects are common in the digital economy. Therefore, it is reasonable to 
assume that path dependence will be common in digital markets and that these 
markets may end up in one out of several equilibrium states. There is no universal 
rule by which the market picks any such state as in standard economic theory: the 
choice is quite arbitrary. The path the evolution will follow depends on customer 
preferences, random external events, actions taken by stakeholders, and the timing 
of these random events.
Definition 11.3 Law of Increasing Returns in Classical Economic Theory
The law of increasing returns in classical economy states that the returns from one 
period to the next are more than proportionate. This is also referred to as economies 
of scale (Bannock et al., 
1998
).
The law of increasing returns implies that if the returns during a period T are R, 
then the returns during the next period T are larger than R. One common cause of 
increasing returns in the production industry is that the revenues per unit produced 
increase because the production cost per unit is reduced as the production volume 
increases (at least up to a certain point). Sometimes this law is referred to as the law 
of diminishing cost.
The law of increasing returns must be treated differently in the digital economy 
since the cost of production is of no relevance for most digital goods. As explained 
in 
7
Chap. 
6
, the marginal cost of digital goods is zero so that the cost of produc-
ing one unit of a digital good is also zero. In the digital economy, increasing returns, 
therefore, usually mean that the number of users adopting a digital good during a 
period T is larger than the number of users who adopted the good during the previ-
ous period of length T. Returns do not refer to revenues in terms of money or 
valuables since, because the marginal cost is zero, the revenue per user may also be 
zero (ARPU = 0; see 
7
Chap. 
6
). As explained in 
7
Chap. 
9
, increasing returns are