(FORTUNE Magazine) – Anyone who's taken freshman economics knows how economists cherish the concept of diminishing returns. It's one of those theoretical pillars that keeps the dismal science dismal: The more you make or sell, the harder it gets. If there are profits to be had in, say, the dog food business, you won't be the only one fighting for the spoils, and whatever spoils there are to start with won't last long.

But there's a problem with the diminishing-returns version of the world. Sometimes, markets do just the opposite of what diminishing returns says they should, and all the rewards gravitate toward one winner at the expense of everyone else--and sometimes that winner doesn't even have the best product. How did we end up with the awkward QWERTY configuration on our typewriters and computer keyboards? Why did VHS become the standard for videocassette recorders, when Betamax was the better technology?

In other words, in some cases, the more someone makes or sells something, the easier it gets. Obviously, something other than diminishing returns is going on in the economy--namely, increasing returns. This insight can explain many otherwise puzzling phenomena in the modern world, and a growing school of thought has formed around increasing returns. The idea may become as central a tenet of modern economics as supply and demand, and is already well on its way to achieving buzzword status. Microsoft's Bill Gates, for instance--never far from the cutting edge--devotes a good chunk of his recent book, The Road Ahead, to increasing returns, although he refers to the idea as "positive feedback."

ACCORDING TO ONE of the foremost theorists of this new school, W. Brian Arthur, an economist at both Stanford and the Santa Fe Institute, increasing returns is essentially the tendency for something that gets ahead to get further ahead. "The more people use your product," he says, "the more advantage you have--or, to put it another way, the bigger your installed base, the better off you are."

The QWERTY keyboard, named for the first six letters in the upper row, is a simple example Arthur uses to illustrate this principle. QWERTY didn't become standard because it was more efficient than other possible layouts. In fact, the configuration was designed to slow typists down, because early typewriters kept jamming. The historical event that made this inefficient layout ubiquitous was Remington Sewing Machine Co.'s decision to manufacture its typewriters using QWERTY. Remington made a lot of typewriters and the configuration eventually achieved "lock-in." The more Remington typewriters that were on people's desks and the more typists got used to the layout, the less willing users would be to switch to a different one. The larger the population of crack QWERTY typists, the more important it became for aspiring typists to learn to use it. And we've muddled along ever since.

The most extreme examples of the way increasing returns works in the real world today appear in the computer software business, where establishing a big user base is the key to success. It's the reason that Microsoft wins virtually every market share battle it enters, even when its products aren't necessarily the best. Microsoft set a standard for personal computer operating systems that "locked in" and consequently gave it a huge advantage in selling its spreadsheet and word-processing software.

Other characteristics of the software business, and high tech in general, amplify the effects. First, there's the upfront cost of development. High-tech products require enormous investment in R&D, but once the products are ready to roll, manufacturing costs are relatively low. Microsoft, Arthur says, spent hundreds of millions developing Windows 95, but it costs Microsoft almost nothing to make more copies. And in fact, the more copies the company puts on the shelves, the more it sells, because the more people use Windows 95, the more software gets developed for it. The more software is available, the more people buy Windows 95.

Complicating all this, says Arthur, is that despite lock-in, increasing returns doesn't necessarily lead to stability. VHS may have beaten out Betamax, but some other totally new technology may overtake VHS someday, like watching movies via the Internet.

To those in the high-tech world, the idea that a marketplace can become a frantic winner-take-most game isn't exactly news. (William Gurley, a computer analyst at CS First Boston, titled a recent report, "Stunningly Obvious: The Secrets of Software Economics.") You might even say that reduced to it's simplest form--"Unto every one that hath shall be given"--this nugget of economic wisdom is clear to most people by age 9.

Economists--especially economic theorists--have long known about increasing returns; they just never did anything with the idea. (The great British economist Alfred Marshall, who laid the foundation for much of modern economics, wrote about the phenomenon in his seminal textbook published in 1890.) It took the advent of high tech and the personal computer for increasing returns to get the respect it deserves.

Mainstream economists shunned the idea of increasing returns for both methodological and ideological reasons. Practically, increasing returns turns out to be exceedingly difficult to deal with mathematically; it muddies the mechanics of supply and demand, which in classical theory meet at a final price that clears the market. Ideologically, increasing returns runs against a general point of departure for orthodox economists: that, other things being equal, market forces automatically yield the best possible outcome--the best product at the best price--and no one runs away with the market because the minute you make a profit, someone else sees an opportunity and enters the fray.

INCREASING RETURNS isn't completely mainstream yet--it isn't taught as part of standard introductory economics courses. But at least the mere mention of the concept no longer causes economists to grimace and inhale sharply. Arthur's work has provided much of the mathematical rigor needed to make the idea legitimate. Significant contributions also come from Stanford's Paul Krugman, and Paul Romer at the University of California at Berkeley--two of the young turks among modern macroeconomists. Krugman's work has concentrated on how increasing returns plays out in international trade and challenges another deeply held conviction of economists: that free trade among nations always produces the best economic outcome. Romer has been working the concept into his theories of general economic growth.

Increasing-returnists are not looking for a complete rewrite of economics textbooks, just a few new chapters. The fact that increasing returns exists does not mean that diminishing returns doesn't. Far from it. In a forthcoming article in the Harvard Business Review, Arthur argues that the two phenomena will always coexist and are complementary. Most businesses, especially mature ones, from dog food to steel to oil, will forever remain in the competitive and unforgiving world of diminishing returns. But the new thinking about increasing returns helps us to understand why the Microsofts, Mercks, and Intels of the world operate by rules that economists either had long believed impossible or had chosen to ignore.

REPORTER ASSOCIATE Lenore Schiff