Network Externalities and "Lock-In"

One factor that produces increasing returns to scale is the presence of positive network externalities. A market exhibits a network externality when the value of each unit of a product increases with each unit sold.

For example, the value of owning a telephone comes from being able to communicate with other people who also own telephones. If very few people own telephones, then a telephone is not particularly useful. If almost everyone owns a telephone, then it becomes valuable for you to own one.

Network externalities can lead to a condition which economists such as Paul Krugman and W. Brian Arthur have labelled "path-dependency" or "lock-in". ""Lock-in" occurs when a particular technology emerges as a standard and remains one for reasons other than the quality of the technology.

An amicus brief filed in the Microsoft case gives a good explanation of "lock-in":

In an increasing returns industry, such as the software industry, consumers may become "locked in" to a particular standard, even if it is technologically inferior -- a phenomenon recently explained by Judge Boudin in Lotus Dev. Corp. v. Borland Int'l., Inc., 1995 LEXIS 4618 (1st Cir. Mar. 9, 1995). The most common example given by economists is the standard QWERTY keyboard, which was deliberately designed in the 19th century to slow typists down so that they did not jam the typewriter's keys. Superior keyboard layouts subsequently have been developed, but they have never succeeded in denting QWERTY's dominance.

"Lock-in" is possible in increasing returns markets because the value of a good to an individual is directly proportional to the number of other people using it. For example, persons purchasing VHS videocassette recorders depend upon the widespread use of the VHS standard to make VHS cassettes readily available. These effects account for the central importance of an "installed base" in the operating systems market.

The brief continues by developing the connection between market "tipping" and the presence of increasing returns to scale and network externalities:

Increasing returns markets are particularly susceptible to "tipping," meaning that once the market is moved off of equilibrium by a particular event, it will rapidly and decisively move toward the product favored by the event. (JA320-23) This phenomenon has obvious antitrust implications: in an increasing returns market, anti-competitive conduct may have a far more decisive impact than would similar conduct in a conventional industry. Indeed, there is an extensive economic literature explaining that behavior that might be benign in conventional markets will have significant anti-competitive effects in increasing returns markets.