Path dependence

Path-dependence exists when the outcome of a process depends on its past history, on the entire sequence of decisions made by agents and resulting outcomes, and not just on contemporary conditions. A closely related concept is hysteresis, a property of systems (usually physical systems) whose states depend on their immediate history. These principles tell us that "history matters" in understanding social and physical sciences.

Consider as an example the technological development of videocassette recorders (VCRs) for home use. It is argued that management errors and minor design choices by Sony led to its Betamax format being defeated in market competition by VHS in the 1980s. Two mechanisms can explain why the small but early lead gained by VHS became larger over time. The first is the bandwagon of VCR manufacturers in favour of the VHS format in the U.S. and Europe, who switched because they expected VHS to win the standards battle. The second was a network externality: videocassette rental stores observed that more people had VHS players and stocked up on VHS tapes, this in turn lead other people to buy VHS players, and so on until there was complete vendor lock-in to VHS. An alternative explanation, of course, is that VHS was better adapted to market demands and that path dependence had nothing to do with its success (note that Beta actually came to market first) and there is some considerable support for this latter claim.

Positive feedback mechanisms like bandwagon and network effects are at the origin of path-dependence. They lead to a reinforcing pattern, in which industries 'tip' towards one or another product design. Uncoordinated standardisation can be observed in many other situations. A classic example is the rules of the road: whereas cars in most countries drive on the right and have steering wheels on the left side of the cars, cars in the U.K. and countries that were part of the British Empire continue to drive on the left, and to have the steering wheels on the right side. Technically, the two options are equivalent. The initial choice to drive on a particular side was accidental, but remains a legacy in these countries. Once this social convention emerged, though, it became permanent because of the huge switching costs involved in modifying it.

Examples from economics, history, software, and biology are presented below.

Economics

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 its expectation. 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 the 1980s, the U.S. dollar exchange rate appreciated, lowering the world price of tradable goods below the cost of production in many (previously successful) US manufactures. Some of the factories which closed as a result could now be run at a (cash-flow) profit, because the dollar has declined. However, re-opening them is too expensive. This is an example of hysteresis and irreversiblity.

• In economic development, it is said (initially by Paul David in 1985) that a standard which is first-to-market can become entrenched (like the QWERTY layout in typewriters still used in computer keyboards). He called this "path dependence", and argued that inferior standards can persist simply because of the legacy they have built up. The case against QWERTY has been criticized (e.g. by The Fable of the Keys), but standards are clearly very important in modern economies, and the significance of path dependence in determining how they form is the subject of economic debate.

• Economists since Adam Smith have noted that businesses of a certain type tend to congregate geographically, attracting workers with skills in that business, which draw in more businesses looking for employees with experience. There may not have been any particular reason to prefer one place to another before the industry developed, but as it has become concentrated in one place any new entrants elsewhere are at a disadvantage, and will tend to move into the hub if possible, further increasing its relative efficiency. The proposition that the original location is random is known as "path dependence", and the advantage of concentrating production is a network effect. New Trade Theory is based partly on this story.

• 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 long-lasting high rate of unemployment, say during a recession, can lead to a permanently higher unemployment rate. Persistently high cyclical unemployment may cause actual skill loss (or skill obsolescence) along with a deterioration of work attitudes, encouraging structural unemployment to rise. The effects of this skill loss gets reinforced by potential employers' negative view of the capacities of job-seekers who have been out of a job for a long time. 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 randomly. Since structural unemployment is endogenous, the NAIRU is also endogenous (see the article by Hargreaves Heap cited below).

Confusingly, the use of "path dependent" to describe labour market hysteresis has the opposite sense to the term's meaning in the adaptive expectations model of inflation, or in finance. In labour market economics, some "path dependent" models have unemployment following a driftless random walk, based solely on its previous level (a Markov process). However, this year's inflation isn't enough to predict next year's expected inflation in the adaptive expectations model, which is said to be "path dependent" precisely because it does not follow a Markov process.

Therefore, the technical econometric definition of path-dependence as "a non-ergodic stochastic process", or a process having "an asymptotic distribution as a consequence of its history." does not apply strictly to some of the models to which it is applied.

History

The history of humanity is almost by definition path-dependent. Accidental events such as the death at an early age of major historical figures like Napoleon or Hitler would surely have altered the political geography of Europe and even the languages spoken in different countries today.

Technology

In the computer and software markets, legacy systems indicate path dependence: customers' needs in the present market often include the ability to read data or run programs from past generations of products. Thus, for instance, a customer may need not merely the best available word processor but rather the best available word processor that can read Microsoft Word files. Such limitations in compatibility contribute to lock-in, and more subtly, to design compromises for independently developed products if they attempt to be compatible. It is not clear, however, that there is any inefficiency involved in the costs of remaining compatible with past decisions.

Biological evolution

Evolution is considered by some to be path-dependent: random mutations occurring in the past have had long-term effects on current life forms, some of which may no longer be adaptive to current conditions. For instance, there is a controversy about whether the panda's thumb is a leftover trait or not.

External links

• "Path dependence" (http://www.eh.net/encyclopedia/?article=puffert.path.dependence) is a comprehensive description of path-dependence and the economic literature in this area written by Douglas Puffert for the encyclopedia featured at the Economic History Net.
• "QWERTY, Lock-in, and Path Dependence" (http://cscs.umich.edu/~crshalizi/notebooks/qwerty.html) argues that lock-in leads to market failure and provides a good list of references.
• "Path Dependence, Lock-In, and History" (http://www.utdallas.edu/~liebowit/palgrave/palpd.html) is an article written by Margolis and Liebowitz that is highly critical of some uses and claims for path dependence.
• "Path Dependence, its critics, and the quest for 'historical economics'" (http://ideas.repec.org/p/wop/stanec/00011.html) is an article by Paul David about the meaning and implications of path-dependency in economics and his response to Liebowitz and Margolis.
• "The Fable of the Keys" (http://www.utdallas.edu/~liebowit/keys1.html) is an article that refutes the claim that the typewriter keyboard is an example of getting locked into the wrong standard.
• Shawn Hargreaves Heap's 1980 article, "Choosing the Wrong 'Natural' Rate: Accelerating Inflation or Decelerating Employment and Growth?" Economic Journal 90(359) (Sept): 611-20 (ISSN: 0013-0133) develops the idea that persistently high unemployment can cause the "natural" rate of unemployment to rise.