What the economists call "increasing returns" industries fly in the face of free-market thinking. Knowing how to identify those markets can make the difference between a winning product strategy and one that's bound to fail

Build a better mousetrap, so the adage goes, and people will beat a path to your door. But according to current economic thinking, if you develop a better typewriter keyboard or a better computer spreadsheet or a better videocassette player, you're likely to starve to death. That's due to the market dynamics of "increasing returns" industries.

Many high-technology industries, such as telecommunications, broadcasting, ATMs, fiber optics, computers, and software, exhibit what's called increasing returns. In such industries, the market doesn't necessarily allocate resources in the most efficient way -- as traditional economics would lead us to expect. Moreover, there's no reason to believe that superior products will prevail in those markets. Rather, in increasing-returns industries, consumers get locked into the technologies that appear first in the marketplace, even if those technologies are inferior to what comes later.

Correctly identifying increasing-returns situations permits entrepreneurs to avoid the frustration and financial loss of producing superior products that are foreordained to fail. Conversely, business opportunities abound for those who understand and can exploit market factors that competitors fail to grasp.

Only within the last decade has mathematics progressed to the point at which economists can create reliable models for predicting behavior in increasing-returns markets. Early economic research in the area focused on what were thought to be anomalies -- particular standards that had become locked in, their obvious inferiority notwithstanding. Stanford economist Paul David identified several such examples, the most famous of which is the layout of the common typewriter keyboard, known as the QWERTY configuration because of the peculiar order of the keys in the third row of the keyboard.

Primitive typewriters were unreliable mechanical devices, and the QWERTY keyboard was designed, according to folklore, to be dysfunctional so that typists would not strike the keys so rapidly that the keys would jam. Obviously, modern software and computers can process keystrokes far more quickly, but consumers are locked into the QWERTY standard. There are even lawsuits alleging that the QWERTY keyboard physically harms those who use it, but we go right on teaching it in elementary schools. Superior keyboard layouts were developed years ago but were unsuccessful in dislodging the clearly inferior design that had established itself as an early standard.

By the late 1980s economic analysis was finally able to explain such situations more clearly. Economists at Stanford and the University of California at Berkeley published leading articles demonstrating that market characteristics that had long been viewed as anomalous were, in fact, widespread in high-technology industries. In the mid-1990s, the increasing-returns theory has become widely accepted in mainstream economic analysis.

Increasing returns are present in many leading industries, but two high-tech-market situations in particular give rise to them. First, users of high-tech products are frequently physically connected in a network. Because the purpose of a network is to enable communication with others, the value of the network increases with the total number of users. Consequently, once a network, such as a telephone network, is in place, a competing network would have to enter the market with at least as large a number of users in order to displace (or even compete meaningfully with) the first network.

Economists call a second basic characteristic of increasing returns "compatibility." A technology's value to end users in increasing-returns industries grows with the number of people who use compatible technology. While the network factor draws its force from physical interconnection, the compatibility factor depends on mutual use. For example, although manual typewriters were not connected in a physical network, new users adopted the QWERTY keyboard because it was in wide use by others.

Increasing-returns markets are easily susceptible to "tipping" -- in which some event causes the market to move quickly toward a single standard that dominates. Small, early market fluctuations toward the VHS format, for example, resulted in the entire videocassette market's adapting that standard, despite the arguable superiority of the Beta format. Obviously, clever competitors can tip markets intentionally by using their established presence in related markets or by merely buying off early adopters to create a bandwagon effect for a particular standard in the market.

The secrets of markets that exhibit increasing returns have long been known to a few of the most successful entrepreneurs in high-tech industries. When a group of engineers working on an improved disk drive approached then venture capitalist Ben Rosen in 1981, he urged them to make an IBM-compatible personal computer instead. Although IBM had only recently introduced its own personal computer, Rosen recognized that IBM's market power in mainframe computers would quickly translate into market power for the smaller, desktop computers. Rosen is now chairman of Compaq Computer Corp. Similarly, Larry Ellison, now chief executive of Oracle Corp., correctly foresaw that the market for a sophisticated type of software, relational-database-management system software, would cohere around an early standard set by IBM, known as Structured Query Language, or SQL. Ellison is now one of the richest men in America. And Microsoft's Bill Gates knows a thing or two about increasing returns as well.

But Microsoft's competitors, although they're some of the most sophisticated corporations in the world, seem slow to grasp the realities of increasing-returns markets. IBM, for example, continues to invest heavily in its OS/2 operating-system software, which has achieved less than a 10% share in a market now dominated by Microsoft's Windows software. Most economists would advise IBM to spend its money elsewhere. There's little sense in continuing to invest in an increasing-returns market that's already close to being locked up by a competitor.

Entrepreneurs would do well to analyze the markets they intend to enter. Increasing-returns markets require a very different strategy. When it comes to standards in them, whoever gets there first has such a huge advantage that if you're not going to set the standard, then you must try to make a product that's compatible with it rather than try to establish an alternative. There's greater room to maneuver when a new platform or method of tapping the installed base presents itself, such as when computer users switched from mainframes to PCs -- or when, in the future, data input shifts from keyboard entry to voice entry. Timing, as always, is crucial. If you're there and ready to jump in when a standard is being established, you will thrive. Otherwise, you should respect the power of networked markets. The failure to do so will be painful and expensive.

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Gary L. Reback is a partner at the law firm of Wilson, Sonsini, Goodrich, & Rosati, in Palo Alto, Calif. He has filed a brief opposing the Microsoft purchase of Intuit.