Path Dependence - Economics

Economics

Path dependency theory was originally developed by economists to explain technology adoption processes and industry evolution. The theoretical ideas have had a strong influence on evolutionary economics (e.g., Nelson and Winter 1982).

There are many models and empirical cases where economic processes do not progress steadily toward some pre-determined and unique equilibrium, so that the nature of any equilibrium achieved depends partly on the process of getting there. The outcome of a path dependent process will often not converge towards a unique equilibrium but instead reach one of several equilibria (sometimes known as absorbing states).

This dynamic vision of economic evolution is very different from the neo-classical economics tradition, which in its simplest form assumed that only a single outcome could possibly be reached, regardless of initial conditions or transitory events. With path dependence, both the starting point and 'accidental' events (noise) can have significant effects on the ultimate outcome. In each of the following examples it is possible to identify some random events that disrupted the ongoing course, with irreversible consequences:

• In economic development, it is said (initially by Paul David in 1985) that a standard that is first-to-market can become entrenched (like the QWERTY layout in typewriters still used in computer keyboards). He called this "path dependence", and said that inferior standards can persist simply because of the legacy they have built up. That QWERTY vs. Dvorak is an example of this phenomenon has been re-asserted, questioned, and continues to be argued. Economic debate continues on the significance of path dependence in determining how standards form.

• Economists from Adam Smith to Paul Krugman have noted that similar businesses tend to congregate geographically ("agglomerate"); opening near similar companies attracts workers with skills in that business, which draws in more businesses seeking experienced employees. There may have been no reason to prefer one place to another before the industry developed, but as it concentrates geographically participants elsewhere are at a disadvantage, and will tend to move into the hub, further increasing its relative efficiency. This network effect follows a statistical power law in the idealized case, though negative feedback can occur (through rising local costs).
• Buyers often cluster around sellers, and related businesses frequently form Business clusters, so a concentration of producers (initially formed by accident and agglomeration) can trigger the emergence of many dependent businesses in the same region.
• In the 1980s, the US dollar exchange rate appreciated, lowering the world price of tradable goods below the cost of production in many (previously successful) U.S. manufacturers. Some of the factories that closed as a result could later have been operated at a (cash-flow) profit, after dollar depreciation, but reopening would have been too expensive. This is an example of hysteresis, switching barriers, and irreversibility.
• If the economy follows adaptive expectations, future inflation is partly determined by past experience with inflation, since experience determines expected inflation and this is a major determinant of realized inflation.
• A transitory high rate of unemployment during a recession can lead to a permanently higher unemployment rate because of the skills loss (or skill obsolescence) by the unemployed along with a deterioration of work attitudes. In other words, cyclical unemployment may generate structural unemployment. This structural hysteresis model of the labour market differs from the prediction of a "natural" unemployment rate or NAIRU, around which 'cyclical' unemployment is said to move without influencing the "natural" rate itself.

Liebowitz and Margolis distinguish types of path dependence; some do not imply inefficiencies and do not challenge the policy implications of neoclassical economics. Only "third degree" path dependence—where switching gains are high but transition is impractical—involves such a challenge. They argue that such situations should be rare for theoretical reasons and that no real-world cases of private locked-in inefficiencies exist. Vergne and Durand qualify this critique by specifying the conditions under which path dependence theory can be tested empirically.

Technically, a path-dependence stochastic process has an asymptotic distribution that "evolves as a consequence (function of) the process's own history". This is also known as a non-ergodic stochastic process.

In The Theory of the Growth of the Firm (1959), Edith Penrose analyzed how the growth of a firm both organically and through acquisition is strongly influenced by the experience of its managers and the history of the firm's development.