Journal of Socio-Economics 29 (2000) 127–145
A behavioral model of path dependency: the economics
of profitable inefficiency and market failure
Morris Altman*
Department of Economics, University of Saskatchewan, 9 Campus Drive, Saskatoon, SK Canada S7N 5A5
Abstract
In this article, a model of path dependency is developed, grounded in behavioral economics
(x-efficiency/efficiency wage theory), where it becomes possible and reasonable to expect a
multiplicity of equilibrium solutions to identical economic problems and for the dominant solution
to be sub-optimal and inefficient. Unlike in the pioneering work on path dependency by Paul
David and Brian Arthur, the sup-optimal outcomes generated in this model do not provide
economic agents with exploitable economic opportunities in the context of their particular
objective functions. Such opportunities constitute, from the perspective of the conventional
wisdom, the Achilles Heel of their work. © 2000 Elsevier Science Inc. All rights reserved.
Keywords: Path dependency; x-inefficiency; Efficiency wages; Market failure
1. Introduction
The conventional wisdom’s understanding of long run equilibrium paths of growth and
development as well as of equilibrium product market development has been challenged by
the pioneering theoretical research of Paul David (1985) and Brian Arthur (1989, 1990) on
path dependency.1 They argue that in a world of increasing returns to scale, there may be a
multiplicity of possible equilibrium solutions to identical economic problems and for the
dominant solution to be suboptimal. The prevalent economic outcome in terms of product
type, industry, or labor market institutions, for example, can itself be a product of some
seemingly inconsequential and random event that, through the process of increasing returns,
* Tel.: ⫹1-306-966-5198; fax: ⫹1-306-966-5232.
E-mail address: [email protected] (M. Altman).
1053-5357/00/$ – see front matter © 2000 Elsevier Science Inc. All rights reserved.
PII: S 1 0 5 3 - 5 3 5 7 ( 0 0 ) 0 0 0 5 7 - 3
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M. Altman / Journal of Socio-Economics 29 (2000) 127–145
ultimately gives this outcome a first mover advantage over other possible outcomes even if
the latter happen to be more economically efficient.
Path dependency theory has been critiqued on various levels. In particular, the view that
it is possible for an inefficient outcome to persist has been challenged as being implausible,
if it is at all reasonable to assume that economic agents eventually respond to economic
opportunities afforded to them by suboptimal economic outcomes by adopting the relatively
more efficient available and known solutions to particular economic problems.
In this article, a model of path dependency is developed that is grounded in behavioral
economics. The argument presented is that it is possible and reasonable to expect there to be
a multiplicity of equilibrium solutions to identical economic problems and for the dominant
solution to be suboptimal, even under the assumption of diminishing or constant returns to
scale. In a world where x-inefficiency is both possible and probable, and where productivity
and working conditions/labor relations as well as institutional and cultural parameters are
intimately related, inefficient or suboptimal economic outcomes might be the dominant long
run equilibrium outcome to particular economic problems.
In contrast to the David’s and Arthur’s’ modeling of path dependency, in the behavioral
model presented below, sup-optimal outcomes need not provide economic opportunities for
economic agents to exploit in the context of their particular objective functions. It is the
existence of such opportunities that go unexploited in equilibrium that constitute the Achilles
Heel of path dependency theory from the perspective of the conventional wisdom. The
behavioral approach to path dependency is, therefore, able to help address many of the
important questions tackled by David and Authur, such as the macro question of the
persistence of relative underdevelopment and the micro question of the survival on the
market of inefficiently produced products, while not being subject to the substantive critiques
levied at path dependency theory by the conventional wisdom.2
2. Path dependency theory: standard approaches and criticisms
The fundamental argument in the traditional path dependency literature is that the free
market typically generates suboptimal long run equilibrium solutions to a variety of economic problems and the probability of suboptimal equilibrium outcomes increases where
increasing returns (positive feedbacks) prevail. Increasing returns need not be firm specific
(local). They might very well be industry or even economy-wide (global)— of the variety
discussed in some detail by Allyn Young (1928)—thereby bringing into play the role of
positive externalities. The economic problem might be which product type or standard
should be adopted in an economy or which path of development should an economy follow.
This argument is couched in a discussion of there being possible multiple equilibrium
solutions to identical economic problems with suboptimal solutions being among a larger set
of solutions. A random shock to an economic system, be it large or small, will have a
determining impact on which equilibrium solution becomes the dominant one, where the
dominant solution can be the suboptimal one. Whichever solution is, in effect, chosen by the
random event, this solution might be locked-in or become a permanent or a stable equilib-
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129
rium. It is even possible for efficient and inefficient (suboptimal) solutions to prevail
simultaneously in the world of path dependency delineated by David and Arthur. For this
reason, one cannot expect the free market to force the economy to converge to unique
equilibrium solutions to economic problems. And, it follows, that in this case it becomes
impossible to predict which solution to a particular problem will be adopted, for the chosen
solution ultimately depends on random indeterminate events taken at some critical juncture
in the past. More specifically, one cannot predict that the eventual stable equilibrium solution
will be the optimal one, even under conditions of competitive markets.
That there might be a multiplicity of equilibrium solutions to a variety of economic
problems would not necessarily be a controversial one from the perspective of the conventional economic wisdom. Neoclassical economic theory clearly predicts that a variety of
products can exist to meet the needs of utility maximizing consumers characterized by
different preferences and incomes. It is even possible for chance events to result in the
dominance of particular products or systems as long as these are consistent with consumer
preferences. But in this world characterized by much variety, in equilibrium no product or
system would be suboptimal or inefficient.
In the David–Arthur world of path dependency, however, in equilibrium prevailing
products and economic systems might very well be suboptimal or inefficient. They argue that
increasing returns produce a first mover advantage to products or economic systems that are
chosen first, an advantage which increases over time. It is assumed that productivity and
related costs are time-dependent so that newcomers to a product market or to the development process would face a competitive disadvantage compared to the first movers and this
would preclude them from beginning the process of catch-up. This would hold true even if
the newcomers’ productivity would eventually, over time, rise above or, at least equal, that
of the first mover and this fact were known to the newcomers.3
In the conventional path dependency story, the first mover advantage, reinforced by
increasing returns and externalities, becomes a permanent roadblock to newcomers. The
obvious economic superiority of alternative equilibrium solutions that are known to economic agents do not generate the economic forces expected by the conventional wisdom to
challenge, and eventually, displace the inefficient economic regimes—it becomes too costly
for private economic agents to adopt the superior economic regimes. This argument is
illustrated in Fig. 1 where, ceteris paribus, average cost is assumed to be negative function
of historical time. Curves 1 and 2 illustrate a scenario where increasing returns to time
eventually level off. Curve 1 represents the initial and suboptimal economic regime. Curve
2 represents the optimal, least cost, economic regime. At time t1 the average cost of economic
regime 1 is 0C. If the economic regime represented by curve 2 were in place for the same
period of time (t0t1), its costs would be even lower, at 0D. However, if economic regime 2
comes on line at t0, only after economic regime 1 has been in place for t0t1, regime 2 would
faces an initial competitive disadvantage of BC. This disadvantage would be eliminated at
time t* if the suboptimal regime is given by curve 1.
The persistence of inefficiency is given by the dominance of the economic regime given
by curve 1 over time. This would represent a market failure. And, what is clearly suggested
by the David–Arthur paradigm is the likelihood of a free market dominated by such market
failures in spite of the clear and manifest superiority of existing and known alternatives to
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Fig. 1. Path dependency.
private economic agents, such as represented by curve 2 as compared to curve 1. Once
locked-in, the inefficient solutions to economic problems cannot be displaced by market
forces alone. Society becomes a prisoner to the inefficiencies established through increasing
returns, while externalities and the absence of perfect future markets play a crucial role in
locking-in the suboptimal equilibria in a world of increasing returns. Presumably, in a world
of no externalities and perfect futures markets economic agents would be able to take
advantage of the economic opportunities afforded by alternative and more efficient products
or systems.
That the market cannot eventually displace the type of inefficiencies elaborated upon in
the conventional path dependency story, given the incentives to economic agents to do so in
terms of the unexhausted gains from trade has been subject to severe criticism. The most
poignant of these critiques have been enunciated by Liebowitz and Margolis (1990, 1994).
They have systematically challenged the empirics underlying David’s and Arthur’s theoretical cases supporting inefficient equilibria. Moreover, they have raised questions with regards
to the theory of path dependency. Most generally, they argue that differences in efficiency
between standards or products should generate economic opportunities that would be typically taken advantage of, ultimately causing the elimination of inefficient standards even in
a world of imperfect futures markets. One should not simply assume that economic agents
will not exploit known potential gains from trade or that the marginal benefits from shifting
to a superior standard rarely, if ever, outweigh the marginal costs.
Liebowitz and Margolis argue that the David–Arthur modeling of the world ignores the
role of entrepreneurship that involves risk-taking in the expectation of profits in an uncertain
M. Altman / Journal of Socio-Economics 29 (2000) 127–145
131
future. They maintain that it is the expectation of future, albeit uncertain, profits by
risk-taking entrepreneurs that have driven the adoption and development of superior products
and systems, which has occurred over historical time. In Fig. 1, the profit opportunities are
given by the difference in cost between regime 1 and 2 after regime 1 has been in place for
more than t0t*of time. After this point, regime 2 captures the economic rents determined by
this difference so long as price is determined by the marginal suboptimal economic regime.
After an uncertain and unpredictable period of time a new equilibrium price is established
consistent with the costs of the optimal economic regime—this is the classic Schumpeterian
process of technical change (Schumpeter, 1974, ch. 4). For the optimal economic regime to
be chosen the anticipated losses, given by B*FH, must be exceeded by the anticipated but
uncertain rents. Liebowitz and Margolis (1994) conclude that: “A transition to a standard or
technology that offers benefits greater than costs will constitute a profit opportunity for
entrepreneurial activities that can arrange the transition and appropriate some of the benefits. . . Economies do, in fact, move from one state to another. This is not to say that mistakes
are never made, in markets or elsewhere. But we do have overwhelming evidence that
markets do make transitions to superior products and standards—from horses and buggies to
automobiles, from typewriters to computers, from mail to fax” (p. 146).
Central to the Liebowitz and Margolis critique is that the assumptions underlying the
predictions of the conventional path dependency theory are faulty largely because David and
Arthur presume that economic agents typically will not or cannot take advantage of known
economic opportunities and that this results in the prevalence of market failure in any given
point in time.4 It is assumed that known gains from trade exist in the form of superior
products and standards that economic agents fail to take advantage of even over the long
term. But is this particular assumption critical to the hypothesis embedded in path dependency theory, that suboptimal economic systems and products can persist over time after
being adopted for whatever reason? Is it possible for superior standards or products to exist
without there being the erstwhile gains from trade to attract economic agents to move
towards optimal equilibrium solutions?
3. A behavioral approach to path dependency
The David–Arthur configuration of path dependency theory assumes, along with conventional economic wisdom, that effort is not a discretionary variable and that the quantity and
quality of effort per unit of labor input is maximized at any given point in time. Since effort
inputs into the production process are assumed to be, in this sense, maximized, variations in
productivity are independent of variations of effort inputs and differentials in labor productivity are, in turn, independent of differentials in effort input. If effort discretion exists, labor
productivity is affected by the quantity and quality of effort inputted into the process of
production per unit of time. In this case, the traditional production function, where output is
a function of labor, capital and technology, is augmented by the quantity and quality of effort
inputted into the production process. What would be the implications for path dependency
theory if ones assumes no externalities and constant returns or constant cost industries while
at the same time assuming the existence of effort variability—that effort discretion exists—
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due, for example, to both informal and formal contracts being incomplete as a consequence
of the transaction costs involved in drawing-up, monitoring, and enforcing contracts (Akerlof
and Yellen, 1990; Altman, 1996; 1998a; Miller, 1992; Stiglitz, 1987)?
The introduction of effort discretion into the modeling of the economic agent and path
dependency theory allows for the existence and persistence of multiple suboptimal equilibria
and allows for the possibility and helps to explain the existence and development of
inefficient economic regimes even under severe competitive pressures. In a nutshell, in a
world of effort discretion there need not exist the private economic incentives for economic
agents to adopt superior economic regimes and for the inferior, suboptimal regimes to be
displaced. Under these circumstances, market failures can result that are consistent with the
constrained utility maximization of rational optimizing economic agents, thereby reducing a
society’s level of material welfare from what it might otherwise be. Assuming no externalities, constant returns and optimizing economic agents bias my results in favor of the
conventional wisdom and allow for the isolation of effort discretion as a causal variable in
the modeling of path dependency. Introducing externalities, increasing returns, and nonoptimizing economic agents, which characterize the David–Arthur world, would only
strengthen the case in favor of path dependency since, as discussed above, these characteristics provide some protection to the suboptimal economic regimes. In other words, the case
is made that even in a theoretical world favored by the conventional economic wisdom
persistent inefficiencies that are path dependent are possible and might even be pervasive.
Given effort discretion, the quantity and quality of effort supplied on the job can be
affected by important variables such as the organization of the firm, inclusive of the structure
and level of wage rates; working conditions; the state of competitive pressures; and an
individual’s, community’s or society’s work culture. Under these conditions, workers would
not automatically or mechanically maximize their effort inputs into the production process
nor could members of the firm hierarchy easily or mechanically induce workers into
maximizing effort per unit of time and, thereby, output per unit of labor. Indeed, they
themselves do not necessarily maximize the quantity and quality of effort that they supply
to the firm. Their behavior would be more in line with utility maximization as opposed to
profit maximization, where their objective includes arguments other than profit. Furthermore,
in a realistically modeled world of effort variability, there is no rational reason to expect
utility maximizing workers to choose to work as hard and as well as they can in an economy
characterized by noncooperative, if not outright antagonistic, industrial relations where they
are treated poorly and unfairly. In addition, utility maximizing members of the firm hierarchy
may prefer to live with or even develop more antagonistic industrial relations if such an
environment is consistent with their objective functions. This holds true even if it means that
labor productivity and even total factor productivity is lower than it would otherwise be.5
Why would “rational” members of the firm hierarchy not pursue policies designed to
maximize productivity? Higher productivity that is a product of more and higher quality of
effort inputs requires a more highly paid labor force and often the investment by members
of the firm hierarchy of more time, effort, and money to reorganize the effort inputs to
facilitate higher levels of productivity. These represent investments in organizational capital
(Tomer, 1987), which are largely the start-up costs of establishing a different organizational
environment. Moreover, it is also possible that members of the firm hierarchy would suffer
M. Altman / Journal of Socio-Economics 29 (2000) 127–145
133
a lower income if a more cooperative industrial relations regime is part of the package which
ultimately generates increased productivity. In addition, when all is said and done, in a
high-productivity regime unit costs need not be lower and profits need not be higher than in
a low productivity regime since the higher labor productivity is generated by increased
expenditures by the firm. Under these conditions, there are no definitive incentives for
members of the firm hierarchy to develop a higher productivity work environment. Unless
their utility function contains arguments related to improving the material and psychological
well-being of workers, it would be quite rational for members of the firm hierarchy to
maximize their utility in a low wage environment, increasing their earnings by redistributing
income away from labor into their own hands. In this case, the firm would be producing less.
It would realize a lower level of labor productivity than it would under a more conducive
system of industrial relations (Altman, 1996). In effect, they would be producing below their
potential or x-inefficiently.6
In the long run, under competitive product market conditions, firms can produce x-inefficiently if doing so does not threaten the survival of the firm by raising unit costs above or
reducing profits below competitive levels (Altman, 1996). For this reason, the x-inefficient
firm must keep input costs relatively low in order to compensate for its relatively low level
of productivity. Keep in mind that average costs (AC) are a product of the weighted input
costs deflated by the weighted average productivity of factor inputs. In a simple world with
labor (L) as the only factor input and the wage rate (w) as the only factor price, this translates
into:
AC ⫽
wL w
⫽ ,
Q
Q
L
(1)
where Q is real output. In this model, the wage rate also serves as a proxy for a particular
system of industrial relations, where a low wage is a proxy for a work environment that is
antagonistic and nonparticipatory with little investment in organizational capital, and a high
wage is a proxy for the opposite. One significant way of maintaining low unit costs is to keep
the rates of labor compensation relatively low, while low rates of labor compensation serve
to keep productivity at a relatively low level. For this reason, low rates of labor compensation
protect the x-inefficient firm from the relatively more productive firms, just as imperfect
product markets, tariffs or subsidies would. So long as the x-inefficient firm can be afforded
such protection, it can be viable over the long haul even in the face of severe competitive
pressures. And, x-inefficient levels of levels of production would constitute one option
available to utility maximizing members of the firm hierarchy. On the other hand, relatively
high wage firms could not survive on a competitive market unless these relatively high input
costs are compensated for by higher levels of labor productivity. The higher productivity
allows the higher wage firm to remain competitive even in the face of severe competitive
pressures. In fact, higher wages and a higher wage environment serve to induce higher levels
of labor productivity as a means of keeping the firm competitive.7 In this case, members of
the firm hierarchy would be facing the constraint of relatively high wages when maximizing
their utility.
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M. Altman / Journal of Socio-Economics 29 (2000) 127–145
As long as productivity rises and falls sufficiently with movements in the level labor
compensation, there is no reason for increasing labor benefits to generate higher production
costs or for lower benefits to yield lower costs. It is, in fact, possible for there to be a range
of labor benefits associated with a unique unit cost of production— changes in productivity
would just compensate for changes in labor benefits. This assumes, that there no unique wage
rate or labor compensation package that will minimize unit production costs, at least over a
significant range of wage rates (Akerlof and Yellen, 1990; Altman, 1996).8 In other words,
two identical plants producing the same output can produce at the same unit costs, even when
rates of labor compensation are relatively higher in one plant, if labor productivity is
sufficiently higher in the high wage plant. However, it also possible for low wage plants to
produce at a lower unit cost than high wage plants if labor productivity differential between
the two does not quite compensate for the wage differential. In this case, it pays the utility
maximizing members of the firm hierarchy to produce in the low wage plants and low wage
plants would dominate the market in long run equilibrium in spite of their being x-inefficient.
In a simple behavioral model of the firm, one assumes that labor and capital inputs as well
as technical change are constant and that wages and effort per unit of labor input varies.
Effort per unit of labor input is assumed to be positively related to the wage rate:
et
⫽ f共w兲,
Lt
(2)
where (e) is effort and (t) is time. This, in turn, causes variation in labor productivity:
冉冊
et
Q
,
⫽f
L
Lt
(3)
w
, variations in labor productivity can affect
Q
L
Q
w
when
given by q. The
average cost. The average cost equation can be denoted by
q
L
w
yields the elasticity of labor productivity relative to changes in the rate of
inverse of
q
labor compensation where this elasticity (␩) is given by:
From Eq. 1 since average cost is given by
␩⫽
dq w
ⴱ .
dw q
(4)
Only when (␩) is greater than 1 does an increase in wages, that is an improvement in the
system of industrial relations, yield a decrease in average cost through its impact on effort
and, hence, upon labor productivity. When (␩) is less than 1, average costs rise with
increasing wages. Finally, a (␩) of 1 yields no change in average cost as wages rise and at
this point average cost is at a minimum.
Conventional neoclassical theory assumes an (␩) of zero since changing the wage rate of
the work environment is assumed to have no effect on effort inputs and, therefore, upon labor
M. Altman / Journal of Socio-Economics 29 (2000) 127–145
135
Fig. 2. Wages and cost.
productivity. On the other hand, the well known result from efficiency wage literature is that
there is a unique wage rate, referred to as the efficiency wage, which minimizes unit costs
by rather mechanically maximizing effort in a world in which effort is variable. In this case,
it is assumed that (␩) is one for a unique value of w. In effect, the wage rate becomes
inflexible given the assumption that the logistic production function best reflects the reality
of the firm. In contrast, in the behavioral model of the firm discussed in this paper, there is
no unique wage, at least over a range of wage rates, which will yield a unique cost
minimizing level of effort. Therefore, in the behavioral model (␩) is one for a range of wage
rates and there is no unique point of cost minimization over this range.
This argument is easily illustrated, borrowing from Stiglitz’s (1987) treatment of efficiency wages. In Fig. 2, this unique wage or efficiency wage is given uniquely by W*
assuming a U-shaped average cost curve, relating changes in average costs as the wage rate
varies. The U-shaped cost average cost curve is, in turn, derived from a labor productivitywage curve which takes the form of a logistic function (Fig. 3). In this case, average
productivity is maximized (average cost is minimized) at e where the wage is W*. At this
point, ␩ is 1. To the left of e, ␩ exceeds one and, to its right, ␩ is less than 1. The logistic
productivity function yields a unique wage-productivity-average cost-effort set that is invariably and ultimately chosen by the firm. But the functional form of the productivity curve
underlying such a unique set is not the only possible functional form; the functional form of
the productivity curve is embedded in the assumptions one makes about the relationship
between changes in effort relative to changes in wages. In the behavioral model, discussed
above, one assumes that some linearity characterizes the production function, from 0 to e, for
example in Fig. 3. Along 0e the elasticity of changes in productivity to changes in wages is
unity. This, in turn, generates an L-shaped average curve in Fig. 2, with C*B becoming a
component of curve 1. In this case, over a certain range of wage rates, there is no unique
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M. Altman / Journal of Socio-Economics 29 (2000) 127–145
Fig. 3. Wages and productivity.
wage rate. A range of wage rates or systems of industrial relations is consistent with a unique
level of average cost such as 0C* in Fig. 2. There is no efficiency wage per se. Over this
range, changes in wages are just compensated for by changes in labor productivity. Moreover, over this space there is an array of firms, spanning from the most x-inefficient (low
wage) to the most x-efficient (high wage), all of which are cost competitive and, therefore,
economically viable.
How would the explicit introduction of technological change affect the arguments presented above? At the most basic analytical level, according to the conventional neoclassical
wisdom, a new technology to produce a particular product should dominate the old technology if it can produce that product at a lower cost, holding the quality of the product
constant. This argument should hold where factor prices are identical across all firms and
where x-inefficiency does not exist or where the level of x-inefficiency is the same for all
firms. In Fig. 1, if curve 2 represents the new technology, this technology should eventually
dominate the old technology represented by curve 1 for reasons of lower costs. In Fig. 4,
where capital and labor inputs are mapped out along the vertical and horizontal axes
respectively, technological change can be illustrated by a shift inward of the production
isoquant from Q0 to Q1, where the level of output produced by both isoquants are identical.
If the initial equilibrium is given by point A along Q0 and the new equilibrium is given by
point D along Q1—relative factor prices have not changed—the new technology should
dominate the old in terms of unit production costs as the isocost curve shifts inward from
B*C to point D. However, this type of scenario need not be the only reasonable representation of economic reality.
M. Altman / Journal of Socio-Economics 29 (2000) 127–145
137
Fig. 4. Technological change and path dependency.
In the tradition of Leibenstein (1973), one can assume that the pace of technological
change is affected by the extent to which x-inefficiency and, therefore, effort discretion exists
and can be expected to persist in the firm. If one begins with a scenario wherein the new
technology is exogenously introduced into an environment where x-inefficiency characterizes all firms in the economy, the new technology might not be viable if the level of
x-inefficiency prevents the new technology from realizing its potential. In other words, if the
new technology corresponds with a relatively high level of x-inefficiency such that the
production isoquant remains at Q0 unit production costs associated with the new technology
would not be less than those associated with the old technology and the new technology
would not dominate the old even though it is potentially a superior one in terms of unit costs.
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With no x-inefficiency, technological change would have shifted the production isoquant to
Q1 and the new technology would be expected to dominate the old.
If reducing the level of x-inefficiency requires changing and investing in the organizational capital of the firm, for example illustrated by a pivot in the isocost curve from BC to
BC⬘⬘, unit production costs for the old and the new technology would be identical. Producing
at point A along Q0 yields the same unit costs as producing at point A⬘ along Q1, where Q1
represents the new technology that is now incorporated into a relatively x-efficient firm. The
“high tech” firm fails to dominate the “low tech” firm even though the high tech firm serves
to increase the economy’s per capita output. Only if the new technology, inclusive of its
embodied level of x-inefficiency, serves to reduce unit costs, as can be illustrated by isoquant
Q2, would the old technology dominate the new. In this case, the lower costs are illustrated
by the shift in the isocost curve from BC⬘⬘ to B⬘C⬘⬘⬘ (Altman, 1996, ch. 4, 1998a).
As opposed to exogenously determined technological change, one might assume that
technological change as well as corresponding reductions in the level of x-inefficiency is
endogenously determined and one that is a costly process induced by changes in factor prices
(Altman, 1996, ch. 4, 1988a; Habbakkuk, 1962; Ruttan, 1997). Assume that the change in
factor prices is once again illustrated by a pivot in the isocost curve from BC to BC⬘⬘. If the
new technology, inclusive of the residual level of embodied x-inefficiency, is given by Q1
and the old by Q0, the new technology will once again fail to dominate the old since unit
production costs at point A would be the same as at point A⬘. This is given by isocost curves
BC and BC⬘⬘. In this case, for technological change along with the necessary reduction in the
level of x-inefficiency to transpire requires an investment in the firm. Technological change
is here a costly process. Without technological change cost minimizing production would
take place at point A* along Q0 generating higher unit production costs. Only if the change
in factor prices induced technical change and reductions in the level of x-inefficiency such
that the isoquant moves below Q1 to Q2, for example, will the new technology dominate the
old. In this sense, the old technology remains competitive if it is path dependent on a low
wage system of industrial organization while the new technology is path dependent on a high
wage system of industrial organization and, given these constraints, the new technology does
not yield lower unit costs than the old technology. Even in a world with no x-inefficiency,
a movement from point A to point A⬘ will not result in the dominance of the new technology
if technological change is a costly process since unit costs at point A would be the same as
at point A⬘.
How does the introduction of effort discretion and induced technical change impact upon
path dependency theory? Without deviating from the conventional assumptions of (constrained) utility maximizing individuals and long run competitive product markets, the
introduction of effort discretion into the modeling of the economic agent allows for the
existence of path dependent high and low productivity firms producing identical products in
long run equilibrium. At a more general level, it also allows for the existence of path
dependent high and low productivity economies in long run equilibrium. This is true even
without the assumption of increasing returns and externalities that provide some initial
advantage to the suboptimal economic regimes. To generalize further, there can exist in long
run competitive equilibrium an array of firms or economies characterized by an array of
productivities, producing at identical unit production costs, with only one component of the
M. Altman / Journal of Socio-Economics 29 (2000) 127–145
139
array of firms or economies being efficient. This is so for the simple reason that when
productivity is positively correlated with labor compensation packages that, in turn, encompass the industrial relations environment in which production takes place, different levels of
productivity need not be associated with different levels of unit cost or profit. Under these
circumstances, market forces cannot easily eliminate the low productivity economic entities
when they are no less competitive than their high productivity counterparts. This is true even
if one introduces into the argument technological change since technological change is a
costly process.
The crux of the Liebowitz and Margolis (1990) critique of path dependency theory’s
prediction of the persistence of inefficient economic outcomes is that the existence of known
relatively efficient alternatives should be expected to trigger an entrepreneurial response
which would take advantage of the lower unit costs and higher profits afforded by more
efficient alternatives. Their critique does not hold when the more efficient higher productivity
regime does not carry with it lower unit costs and higher profits and when the more efficient
regime is inconsistent with the utility function of members of the firm hierarchy. In this case,
it would be possible for both efficient and inefficient regimes to exist simultaneously in long
run equilibrium.
The economic opportunities that might trigger the elimination of the inefficient economic
systems or products need not exist when economic agents behave in a fashion consistent with
effort discretion or when induced technical change is a costly process. In fact, it would be
possible for the inefficient (low productivity/x-inefficient) system to dominate if the relatively low labor costs yield low unit production costs for an identical product. In addition,
even if the x-inefficient system yields the same unit costs as the more efficient system, the
former might dominate if it is consistent with the preferences of members of the firm
hierarchy since they have traditionally determined which path an economic regime should
follow. If the efficient system generates relatively higher unit costs, but also produces an
output of a higher quality the lower unit cost system need not dominate. In this case,
however, one would no longer be modeling identical outputs. The different economic
regimes could also be a product of past random events and would then be path dependent.
And, one could not easily predict the convergence of the economy towards the efficient
equilibrium. The modeling of the economic agent presented in this article is, therefore, able
to contribute towards addressing the critical question asked by Liebowitz and Margolis of
path dependency theory: why should we expect inefficient economic regimes to persist over
time? Of course, if productivity differentials between two systems generate lower unit costs
and higher profits to the high productivity system the critique of Liebowitz and Margolis
kicks in and market forces might very well, as they argue, displace the inefficient with the
efficient economic system.9
4. The persistence of inefficiency: some examples
The possibility, elaborated upon in this paper, that inefficient economic regimes can
dominate or exist simultaneously with the relatively inefficient regimes because the more
efficient regimes do not provide the mechanism to displace them—a mechanism which
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clearly exists in the David and Arthur modeling of path dependency in terms of known and
unexploited economic rents— helps to address a variety of important apparent paradoxes of
economic life such as the persistence of inefficient or low productivity economic regimes.10
Douglass North (1990), for example, has made the case that throughout world history
inefficient economic regimes have dominated:
I will approximate the conditions in many Third World countries today as well as those
that have characterized much of the world’s economic history. The opportunities for
political and economic entrepreneurs are still a mixed bag, but they overwhelmingly favor
activities that promote redistributive rather than productive activities, that create monopolies rather than competitive conditions, and that restrict opportunities rather than expand
them. The organizations that develop in this institutional framework will become more
efficient— but more efficient at making the society even more unproductive and the basic
institutional structure even less conducive to productive activity. Such a path can persist
because the transaction costs of the political and economic markets of those economies
together with the subjective models of the actors do not lead them to move incrementally
toward more efficient outcomes. (p. 9)11
But can low productivity regimes survive in the face of competitive pressures? They can,
but only under particular circumstances. Certainly, unproductive economic regimes can
survive if well protected from competitive pressures. Such protection was more easily
afforded in the past than in the present. However, in face of competitive pressures, unproductive economic regimes will have a difficult time of it, if relatively low productivity
translates into relatively high production costs. This need not be the case when low
productivity is balanced by low rates of labor compensation or low rates of investment in
organizational capital. And, as outlined above, the low rates of labor compensation and low
wage environment bundle, in itself, can be a key cause of low productivity. Members of firm
hierarchy or, more generally, of the economic hierarchy, can fare quite well under these
conditions even when their economic ventures remain competitive since their own incomes
can remain high through redistributive as opposed to productive activities. The existence of
low and high productivity regimes might be a product of history, of random or deliberate
actions taken sometime in the past. Once a particular path to development is taken an
economy might even be locked into that path due to the high costs of transition—a point
emphasized by North. But lock-in can be characterized by a certain degree of stability only
when a particular economic regime remains competitive. The behavioral modeling of the
economic agent presented above is suggestive of important mechanisms that might account
for multiple types of economic regimes in long run equilibrium.
Another intriguing and important paradox of economic life is related to labor market
structures. Of particular interest, is the survival of slavery in the United States into the late
nineteenth century and serfdom into the nineteenth century throughout most of Eastern
Europe as forms of labor organization that paralleled the existence of free labor in the United
States and Europe. Does the survival of slavery and serfdom suggest that these were both
efficient forms of labor organization which were close substitutes for free labor, where all
three general forms of labor organization contributed to equally efficient systems of production?12 The latter argument would follow from the conventional assumptions made about
the economic agent and the assumption that relatively inefficient regimes generate the
M. Altman / Journal of Socio-Economics 29 (2000) 127–145
141
incentives for their eventual displacement by relatively more efficient regimes. An alternative argument would be that unfree labor was relatively inefficient. But if it was inefficient,
how could unfree forms of labor organization persist over time; practically speaking for
centuries on end? Should they not have been displaced by their relatively more efficient
systems of free labor? The empirical debate on the subject is far from resolved.13
In terms of a behavioral modeling of the economic agent, one cannot predict the disappearance of slavery or serfdom in competition with free labor even if free labor is relatively
more productive. The self-interested landlord or slaveowner will refuse to institute a free
labor regime unless the productivity differential in favor of free labor exceeds the cost of
labor differential in favor of coerced labor. Only under these circumstances would the unit
costs of using free labor be less than the unit costs of using unfree labor. If unit costs under
both regimes of labor organization are equivalent, the profit maximizing landlord would be
indifferent between using free and unfree labor and both regime can exist simultaneously. In
addition, ceteris paribus, unfree labor remains viable in face of free labor becoming increasingly productive, if the income of the unfree labor can be further depressed without an
attendant fall in labor productivity. Suboptimal or inefficient regimes of labor organization
can persist over time or even dominate an economy as long as they remain cost competitive
and privately profitable for members of the economic hierarchy to choose such a solution.14
5. Conclusion
Scholars arguing on either side of the path dependency debate agree that producing at a
relatively low level of productivity, ceteris paribus, is indicative of a market failure, where
the opportunity cost to society of producing inefficiently is the loss of output incurred by the
inefficient economic regimes as compared to what could be produced by the relatively
efficient regimes. What has been subject to debate is the ability of the market to correct for
such market failures within a reasonable period of time, even under competitive conditions.
Modeling the economic agent in terms of more realistic behavioral assumptions allows for
the persistence of the inefficient economic regimes, either on a micro or macro level, even
in a highly competitive environment. Unlike in the David–Arthur modeling of path dependency, where inefficient paths can persist as a consequence of the inability of economic
agents to take advantage of available and known economic opportunities, in the model
presented above there need be no economic benefits to be gained by private economic agents
from shifting from inefficient to efficient economic regimes. Moreover, both efficient and
inefficient economic regimes can be cost competitive, and, inefficiencies in production can
be consistent with constrained utility maximization on the part of economic agents. In these
circumstances, there is no easy mechanism to direct economic agents from inefficient to
efficient paths. This results in a market failure. Ceteris paribus, society would be better off
if the economy produced x-efficiently as this would increase the standard of material
well-being of most individuals in society. In addition, x-efficient production could be
achieved by modifying the incentive system in the work place. However, if the members of
the firm or economic hierarchy prefer the inefficient economic regime and this utility
maximizing preference does not threaten the competitiveness of the firm, the economy will
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traverse along the inefficient path and such a path will continue to be chosen since it is the
members of the economic hierarchy who ultimately decide which path to take.15
Whether or not an economy moves along an inefficient path depends on the preferences
of members of the firm hierarchy given the constraints that they face and the economic
viability of choosing the inefficient path. The behavioral model of path dependency does not
predict that inefficient or suboptimal solutions to economic problems are inevitable but,
rather, that inefficient economic regimes can be viable and, if so, will be the chosen by
members of the firm hierarchy when such a regime is most consistent with their preferences.
Once locked into the inefficient path, there is no good economic reason to expect the
economy to break-out of this path, especially if there are economic or psychic costs involved
in a transition to a new more efficient path. Institutional factors can, therefore, play an
important role in affecting the capacity of the market to motivate economic agents to choose
the relatively more efficient path or, once on the inefficient path, to shift to the more efficient
path. Institutional factors, on the other hand, can also play a determining role in encouraging
economic agents to chose the inefficient path. Therefore, economic agents choosing optimal
solutions to particular economic problems is not inevitable. Chance events as well as
carefully crafted policy can affect whether society takes the efficient or inefficient route and
whether it locks in or breaks out of one particular equilibrium to another. A behavioral
modeling of path dependency suggests that one cannot predict that market forces, in and of
themselves, will consistently generate efficient solutions to important economic problems.
Moreover, one cannot predict which equilibrium solution from a subset of solutions economic agents will choose since economic agents are not necessarily constrained by the
market, even a highly competitive one, into choosing the most efficient of the available
solutions to economic problems.
Acknowledgments
This article is part of a larger project analyzing the economics choice (of human agency)
as a determinant of economic welfare. Thanks to an anonymous referee, Louise Lamontagne,
participants of the Society for the Advancement of Behavioral Economics Conference at the
Washington and Lee University, Lexington, Virginia, June 1997; the International Association for Research in Economic Psychology Conference in Valencia, Spain, September 1997;
and the Department of Economics Speaker’s Seminar at the Universities of Calgary and
Regina, for their comments and suggestions.
Notes
1. On a related argument with respect to the process of economic development, see
Krugman (1991).
2. An interesting perspective on the persistence of inefficiency story which, in turn, is
related to the path dependency literature, is presented by George (1989a). In (his
modeling, inefficient subsystems persist when they are nested within larger relatively
M. Altman / Journal of Socio-Economics 29 (2000) 127–145
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
143
efficient systems. See also Boyer (1997)and Boyer and Hollingsworth (1997), who
also discuss the question of persistent differences in economic and social regimes and
the need to better explain their concurrent viability.
If increasing returns existed without bound than the first mover would have a
permanent advantage over any and all newcomers unless unit costs fall at a faster pace
in the newcomer’s than in the first mover’s plant. In the former case, however, one
cannot make the case that the newcomers are more efficient than the first movers.
However, what characterizes path dependency theory is the assumption that the
newcomer’s product, firm, or industry is initially the relatively more efficient one.
See Witt (1997) for an elaborate and more technical critique of the Arthur-David
modeling.
See Altman (1996, 1998a) for more detailed discussion of the behavioral model of the
economic agent which underlies the model of path dependency presented in this
article. See Stiglitz (1987) and Akerlof and Yellen (1990) for a related discussion of
efficiency wage theory.
Harvey Leibenstein (1966, 1987); Frantz (1988); and Dean and Perlman (1998)
penned the term x-inefficiency to describe a level of output that fell below the
neoclassical ideal where all economic agents are maximizing effort per unit labor
input. Leibenstein believed that maximum labor productivity [x-efficiency] could
possibly be achieved only under conditions of an ideal system of industrial relations.
X-efficiency could not be achieved by simply writing an ideal contract and then
enforcing the terms of this contract. For a similar argument, focusing on a game
theoretic approach to production inefficiencies, see Miller (1992).
This argument is elaborated upon in, for example, Altman (1996); Card and Krueger
(1995); Levine and D’Andrea Tyson (1990); and Freeman and Medoff (1984).
A standard argument in the efficiency wage literature is that, although effort is a
discretionary variable with respect to wages, there exists a unique wage rate which
will serve to maximize effort per unit of labor thereby maximizing labor productivity
and thus minimize unit costs. This is the wage rate which efficiency wage theory
predicts will be selected by a profit maximizing firm. Any deviation from this unique
wage rate would serve only to increase unit production costs. For the classic statement
on this, see Solow (1986). Refer also to a detailed discussion in Stiglitz (1987).
In Altman (1996, chs. 2 and 4), the significance of relatively low wage rates and of
x-inefficiency to the persistence of suboptimal-low productivity technologies is discussed.
In Altman (1996, 1998a), I discuss the conditions for multiple long run equilibrium
wage and productivity paths of economic growth using the type of behavioral
modeling of the economic agent presented above.
On this point see also Lane (1958, 1975). It is important to note that North’s point is
empirically validated by the time series evidence on the absence of convergence in
terms of real per capita GDP in the world economy. See Altman (1998b) for a
summary discussion of the relevant literature.
A very basic definition of a slave is an individual who, by law, is a chattel or property
of his or her owner. The serf, on the other hand, is legally free with various legal rights
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which varied over time and space. But the serf was bound to his or her “master” by
institutional as opposed to contractual ties, which made the serf into a subset of unfree
labor. As with the slave, the relative freedom of the serf varied over time and space.
13. The debate on the relative efficiency of American slavery has been particularly
heated. Two critical articles on the subject are by Fogel and Engerman (1971) and
Wright (1975).
14. Evsey Domar (1970) provides considerable theoretical insight into the economics of
free versus unfree labor systems (see also Blum, 1957). He argues that unfree labor
becomes the norm when landlords are no longer able to earn a rent from their land on
the free market—when the income of the free peasant is driven up to the point where
the only rents earned is on land of superior quality—and when government provides
the landlord with the legal and political wherewithal to create a class of unfree labor.
Domar’s argues that the use of unfree labor would dominate the use of free labor even
if the latter is relatively more productive, if this productivity differential is outweighed by the relatively higher costs of free labor. Unlike in the behavioral modeling
of the economic agent, Domar assumes that productivity is independent of the wage
rate—there is no effort discretion and wages and working conditions have no effect
on labor productivity. For this reason, he argues that reducing wages is central to
making free labor relatively more attractive to the landlord since a fall in the wage rate
has no predictable impact on labor productivity. Labor productivity is assumed to be
a positive function of the extent to which labor is legally free, irrespective of the
working conditions of such labor.
15. See Ichniowski et al. (1996), for a detailed accounting of the literature discussing
relatively innovative productivity enhancing alternative modes of work place organization which consistently fail to be adopted for material and utility cost considerations.
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