PATH DEPENDENCE AND TRANSITION STRATEGIES Robin Matthews Kingston Business School Academy of National Economy Under the Government of the Russian Federation [email protected]

1. ABSTRACT The paper is concerned with application of some new theoretical developments to Russia’s emerging market economy. The theoretical contribution is based upon complexity theory and its connection to path dependence or reinforcing mechanisms, or as they are sometimes termed, Polya processes. Two principles are illustrated; outer dynamics and inner dynamics 2. INTRODUCTION One of the most interesting aspects of the scientific study of business strategy is that it opens up the possibility of an interdisciplinary approach. The use of such an approach should be governed by the utility of the insights that it provides. As with any new endeavor, the end result cannot be predicted. Often seemingly abstruse theories give rise unexpectedly to ideas of enormous practicality. The English mathematician G. H. Hardy once boasted in a patrician way, that his researches in number theory had no use whatsoever. It turned out that his investigations are highly relevant to cryptography, a science that facilitated the development of secure codes for financial transactions in electronic commerce. 3. THEORY AND APPLICATION Both have the implication of evolving to a new order; a less probable state. Outer dynamics are exemplified by Darwinian selection. In the strategy literature they are embodied in the notion that it is external factors, in the business environment that determine performance. Inner dynamics are expressed in self-organization, or emergence (Anderson Arrow and Pines, 1988, Arthur, 1994; Holland, 1998; Kauffman, 1995, 1993); the idea that organizations can learn to overcome obstacles and take advantages of the environment. At an expected 4%, Russia currently is experiencing the highest annual growth rate since the fall of communism. Lower inflation should continue, prices rising annually at between 15-16%. The main factors driving the performance of Russian markets are the devaluation of 1998, the rapid rise in the price of crude oil, positive response to government economic reforms, the closing of the London Club restructuring deal, and the immanent upgrade of Russia’s credit rating. Confidence in the domestic economy has been reflected in the performance of the Russian stock market and especially in telecommunications and utilities. Important economic reforms by the Russian government, especially the reform of personal taxation and social security, should help to create the institutions needed in a market economy (Table 1).

The current approach to economic transition in Russia focuses on outer dynamics. The paper outlines the problems of this approach, passionately advocated, for example by Sachs (1994, 1990). It contends that transition should be effected by opening up Russia to the global economy (Gowan, 1995; Krugman 1996; Matthews, 2000). This involves freeing up capital movements and trade; transfer of ownership through privatization; liberalization of markets (market pricing, cutting state subsidies); stabilization (tight monetary policy and credit squeeze). KEY INDICATORS GDP growth (real)% Inflation % Unemployment % Refinancing rate (end of year)% EPS growth % P/E ratios Current Account balance (billion US$) FDI inflow (billion US$) Gross external Debt gross (billion US$) External debt service(billion US$) Exchange rate/US$ (average)

1998 (actual) -4.9

1999 (actual) 3.2

2000 (expected) 4.0

2001 (expected) 4.0

27.7 13.3

85.8 14.2

17.9 13.8

14.0 12.4

58.0

55.0

24.0

20.0

na na 2.4

Na 24.9 25.0

207.2 8.1 33.0

10.2 7.4 21.0

1.2

0.7

4.0

7.0

180.0

185.4

179.4

181.1

21.6

22.0

22.0

22.0

9.9

24.7

28.9

31.3

Source ABN-AMBRO

Table 1 4. PATH DEPENDENCE Path dependence as illustrated by Polya processes captures many of the ideas in the paper. To understand them, consider the following thought experiment. Imagine an urn of infinite capacity. Starting with one red and one white ball in the urn, add another ball indefinitely according to the following rule: choose a ball at random and replace it. If the chosen ball is red, replace with a red ball: if it is white, replace it with a white ball. Carry on the game in this way indefinitely. Let the proportion of red (or white balls) signify evolutionary processes. What can be said about the proportion of red balls that result from the game? We can say little about the exact proportions of red (or white) balls. We can say other things though. The process will converge and early decisions are critical. In the experiment illustrated in Figure 1 the process converges at around 0.3, but it might occur at 0.7762 or 0.3596 or 0.0539. We cannot say where except that it will be somewhere between a proportion of zero and one. Polya processes simulate complex adaptive systems in this respect; we cannot predict outcomes.

Polya with 1000cycles

Outer dynamics Consider outer dynamics. Random variation and natural selection are the roots of Darwin s evolutionary theory (1971). Natural selection results in the adaptation of an organism to its environment by selectively reproducing changes in its genetic constitution (genotype). Random variations in the genotype that increase an organism’s chances of survival are preserved by interactions with the environment, and multiplied from generation to generation at the expense of less advantageous ones (Dawkins, 1986). We can adapt Darwin’s argument to the global economy (Holland, 1988). The diversity of capitalist firms, together with the impact of competition, explains the dominance of market economies in the modern world; Joseph Schumpeter ((1987) described capitalism vividly as creative destruction. In Polya terms, the outer dynamics are thus: natural selection, in the form of competitive pressures of the global economy (the rules of the game), act upon the random capabilities of firms or nations, determining outcomes. Outcomes are defined according to the problem addressed; survival or competitive advantage of firms, the wealth of nations and so on. The competitive dynamics of global capitalism are transformed by new technologies. We can think of Polya processes beginning again, and driving towards a new convergence in which new firms and industries evolve, and existing firms and industries adapt of perish: outcomes are driven by external pressures, acting upon the random capabilities possessed by firms or nations. 5. INNER DYNAMICS Complex adaptive systems encompass inner as well as outer dynamics. The appearance of emergent properties is probably the most distinctive feature of complex systems. Self-adaptation or emergence is the result of non-linear interactions. Non linearity means that the system as a whole has greater potential than the parts viewed separately. Kauffman (1995,1993; Bak, 1997) thinks that we are entering a new era when life itself will be seen as the emergence of order spontaneously - in a universe that is far from equilibrium. The essence of non-linear systems is that they are not reducible; the whole has much more potential than the parts viewed separately. In physical systems spontaneous order is familiar; an oil droplet forming a sphere, snowflakes ordered in six-fold symmetry. Kauffman’s work is related to that of the Russian chemist and physicist Ilya Prigorgine (1980; Prigorgine and Stengers, 1984) on dissipative structures. The term dissipative structure highlights the close connection between order and structure on the one side, and entropy or dissipation of energy on the other. Prigorgine realized that open systems interacting with their environment and operating far from equilibrium must be described by non linear equations. They are capable not only of maintaining a stable state (avoiding dissipation) far from equilibrium, but of adapting and evolving into new structures; self

973

937

901

865

829

793

757

721

685

649

613

577

541

505

469

433

397

361

325

289

253

217

181

145

73

109

1

37

1.000 0.900 0.800 0.700 0.600 0.500 0.400 0.300 0.200 0.100 0.000

organizing themselves into less probable states. In Prigorgine’s dissipative systems, evolution is achieved as a result of inner and outer dynamics; selfadaptation and interaction with the environment. Similarly capitalist firms compete in a turbulent environment, in a process of Darwinian selection: but inner dynamics are also important. In Polya terms, inner dynamics mean that organizations, (firms or nations depending on the problem) have the potential to determine the path they take in Figure 1. They exercise degrees of choice; in selecting balls from the urn, and determining the rules of the game. So choices made particularly in the early stages of a Polya process enable them to influence the probabilities of outcomes. The important point is that probabilities are not entirely determined by outer dynamics. Inner dynamics can affect probable evolutionary paths. 6. TRANSITION STRATEGY There are a number disturbing aspects of the obsession with outer dynamics. Consider two of them; variability, and competition. Natural selection works upon random variations and established capitalist firms have greater diversity than firms in a planned economy that have been driven historically by a monolithic state. So, in Polya terms, there is a danger of Russian firms converging upon a marginal position in the development of global capitalism; pushed into a concentration upon natural resources. The competitive dynamics of the natural resource industry are driven by the need to reduce cost (Porter, 1990). Again in terms of Polya processes they converge upon low margins, and low economic profitability; a vivid illustration of the entropic aspects of convergence. Global companies, (BP Amoco, Shell, Exxon, for example) are diversifying away from dependence upon natural resources; self adapting on the basis of their networks of assets and capabilities. Metaphorically they are exercising degrees of choice: in selecting balls from the urn, and determining the rules of the game, they are focussing on inner dynamics.A number of writers have recognized the importance of non linearities, especially external economies in the development of industries and nations (Marshall, 1891; Rosenstein-Rodan, 1943; Porter 1990. To reach a self-sustaining state, the network must create payoffs that are sufficient to encourage appropriate coalitions to be formed. The problem facing Russia is encapsulated by the the supposition above; suppose the Polya process is well underway (say on the 500th iteration). What can be done? This is a commonplace but often intractable strategic problem of balance between planning and decentralization. The path of transition was set by the shock therapy of the early 1990’s. The key issue now is the transition to a new path based on inner dynamics; identifying key agents and coalitions; determining their payoffs and the tradeoffs between them; distributing payoffs to coalitions.

7. REFERENCES Anderson, P.W, Arrow K.J. and Pines D Eds. (1988) The Economy as an Evolving Complex System: The Proceedings of the Evolutionary Paths of the Global Economy Workshop, held September 1987 in Santa Fe New Mexico, Addison-Wesley Publishing Company,.. Arthur, W.B. (1994), Increasing Returns and Path Dependence in the Economy, University of Michigan Press, Ann Arbor. Bak, Per, (1997), How Nature Works: The Science of Self Organized Criticality, Oxford University Press, Oxford. Dawkins, R. ((1986), The Blind Watchmaker, Penguin Books, London. Georgescu-Roegen, N. (1970), The Entropy Law and the Economic Process, Harvard University Press. Golov, R.S. and Matthews, R., (1999) The Russian crisis: Causes, Consequences, and Implications for the Future, Occasional Paper, Kingston University Business School, London. Gowan, Peter (1995) Analysing Shock Therapy, New Left Review, 213, London. Holland J.H, (1998), Emergence: From Chaos to Order, Oxford University Press, Oxford. Kauffman, S. (1993), The Origins of Order: Self Organization and Selection in Evolution, Oxford University Press, New York. Kauffman, S., (1995), At Home in the Universe, Oxford University Press. Krugman, P (1996), The Self-organizing economy. Oxford: Basil Blackwell. Marshall, A (1891), Principles of Economics 8th Edition, London, Macmillan. Matthews, Robin, (2000) A New Model of Strategy Applied to the Russian Situation, Economic Strategy Vol.1. 2000 (Moscow). March. Matthews, Robin, (1999), Firms, Strategies and Co-operative Games: Elements of a Stakeholding Approach, Arestis, P., Daniel, S.S. and Grahl, J. Ed. Festschrift in Honor of Maurice Peston and Bernard Corry, Edward Elgar, London. Matthews, R, (1996), Competition and complexity in organizations: paper delivered at special session on Organizational Complexity, Informs Conference, Atlanta (1996b) Porter, M. E. (1990), Competitive Advantage of Nations, Macmillan, London. Prigorgine, Ilya, (1980) From Being to Becoming, Freeman, San Francisco. Prigorgine, Ilya, and Isabelle Stengers, (1984), Order Out of Chaos, Bantam, New York. Rosentein-Rodan, P.N. (1943), Problems of Industrialization of Eastern and South eastern Europe, Economic Journal, 55: 202-11 Sachs, Jeffrey, (1994), Understanding Shock Therapy, Social Market Foundation, London. Sachs, Jeffrey, (1990), What is to be Done? Economist,13. January. Schumpeter, Joseph A, (1987), Capitalism Socialism and Democracy, Unwin, London.