When a small snowball travels down a snow-covered slope, it gets bigger by gathering more snow around its core. Eventually, it may get so big that it starts an avalanche. Similarly, if rising demand for a firm's product raises efficiency (by lowering the average total cost) that allows lower prices, which in turn increases demand that leads to even greater efficiency, the firm will eventually monopolize that market. This is the so-called natural monopoly¹.

To economics students who have been brought up with the staple diet of diminishing returns, this snowball effect sounds like science fiction. The theory of diminishing returns says that as a firm expands, it hits a limit where unit costs of output start to rise and unit profits fall.

Traditional industries such as wheat and steel are obviously subject to diminishing returns, but the new knowledge-based industries are more likely to be characterized by increasing returns for three reasons. First, they have high fixed costs, such as R&D, but low variable (i.e., marginal) costs. For example, the cost of writing a computer program is the same regardless of the number of copies sold, so the higher the sales, the lower the unit costs, and the greater the profit margin. The same is true for many other industries that are heavy on know-how and light on material resources, from pharmaceuticals to defense (see Cost curves under increasing and diminishing returns).

Second, products with increasing returns generate "network externalities". In the software industry, for example, this means that the more widely an operating system is used, the more likely it is to become a standard for the industry and the more people will want to use it to ensure that their software is compatible with that of other network users.

Third, many high-tech products that are difficult to use tend to lock in their customers because it is costly to switch to other competing products.

The problem for policy makers in such a world of increasing returns is that it's not clear you can rely on Adam Smith's invisible hand to look after society's interests. Smith imagined a world in which competition among producers would drive prices down to something close to marginal cost. But the marginal cost for increasing-returns is close to zero. Smithian competition destroys the business. The only way to make money is to have monopoly power.

Such a natural monopoly is in fact welcomed by consumers, who prefer the products of the market leader that is relentlessly cutting prices to gain market share. Also, it is hard to see what the regulatory authorities can do about it. If they did manage to prevent one company from dominating a market, another big bad giant would come along to replace it because of the underlying increasing- returns economics.

The challenge to increasing-returns industry with high fixed R & D cost and very low marginal cost is to sell enough units at premium prices before the market is eroded by piracy or knockoff products.