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Contemporary Economics

Spencer and Amos Worth Publishers

posted on 01 October 2001

reviewed by Joe McCauley

A colleague who knows standard finance theory told me recently that he wanted to
take my econophysics class. He added, `Your course outline is controversial'. I
asked what he meant, since I had only written a one-page description for
prospective students. He responded, `You assume that markets are not in
equilibrium.' His viewpoint is typical of what is taught in economics and finance
courses. This summarizes the whole reason for the existence of Econophysics as a
field, which goes back to Osborne, especially his 1977 book [1] challenging the
nonempiric supply-demand cartoons drawn as `curves' in Samuelson's popular text.
As Osborne learned from querying marketing people, it is impossible to extract
price as function of either demand or supply, the data are too noisy. Black later
independently repeated this assertion. Recently, Ormerod [2] has explained that
data are too noisy to justify the drawing of a `Phillips curve'. He might have
done the same for so-called `Laffer curves'. Osborne also points out that the
supply-demand relations supposedly supposedly extracted from data by economists
are model-dependent, are not pure reliable analyses, because they follow from
regression analysis, and a regression analysis can not yield functional
relationships without extra assumptions. I have explained why, even in
neo-classical economic theory, excess demand dynamics teaches us that there is no
reason to believe in the existence of supply-demand curves [3], in qualitative
agreement with Osborne.





The text by Spencer and Amos [4] is a readable source of the misconceptions that
are taught to students and seemingly believed by many economists. As a review I
will mainly quote from a few sections of the text with comments. This text may be
noteworthy in that it contains a chapter on `General Equilibrium Theory' (or
`Welfare Economics'), which explicitly states misconceptions about the notion of
stability of equilibrium. It also includes a section explaining that the Lagrange
multiplier in utility maximization can be interpreted as the marginal utility of
money in neo-classical theory. The book seems to have been written with from a
supply-side rather than Keynsian angle. Reading this text reenforces my opinion
that would be useful for a physicist or someone with a like-minded viewpoint about
`falsification' to write an economics textbook, one that presents graphs from real
data and not as meaningless cartoons, and which completely abandons the notion of
utility and utility maximization.



The text starts by defining `capital' in such a loose way that trees, e.g., are
defined as capital (maybe people could also be defined as capital, not labor, or
just as `people'). This is also a value-judgement, one that is widely accepted in
the US (excepting the Sierra Club and other Greens) but not always in various
parts of W. Europe where there are remain strong restrictions on the economic
`development' of farm and forest land. The `curves' in the book, as in Samuelson,
represent no dynamcs and generally are not derived from real data. Instead they
are drawn to represent the standard stable equilibrium expectations of
neo-classical theory. From the beginning, equilibrium is presummed to be the
normal state of affairs and it is assumed to be stable, in disagreement with real
liquid market data [5,6,7]. The quotes from the text and my commentary follow
next.



"Is Perfect Competition a Fantasy?" (pg 536): " ..no, ... like the assumption of a
frictionless state in physics..this assumption creates an idealized situation that
permits simplification of a problem so that it may be analyzed." This assertion
represents a deep, perhaps the worst, misconception that an economist can believe
[8]. In physics we have real data from local motion representing free fall in a
gravitational field where the assumption of force-free motion can be tested and
verified as a good approximation (on the moon even better than on earth). As
Wigner has explained, force-free motion is not merely a good approximation but
lies at the foundation of physics [9]. The other side of the coin is that perfect
competition, as defined in the text (requiring stable equilibria) does not exist
in the world as a good approximation to anything that occurs socio-economically.



From chapter 30 (pp 632-3) on General Equilibrium Theory: "Equilibrium was defined
in earlier chapters as a state of balance between opposing forces. An object is in
equilibrium when it is at rest. ... In economics "objects" may be prices,
quantities, incomes, or other variables. You cannot consider a problem solved if,
at the point you terminate your analysis, the variables are still changing. Only
when the variables settle down to steady levels, or only when the future
equilibrium positions can be predicted, can you consider the solution complete."
Do real economic data behave even approximately in this way? Doubtful. I would
expect that a data analysis can be `forced' to approach equilibrium only by
abandoning real data and replacing it by a model with stable equilibria.
Continuing with the text, "The study of equilibrium is not an end in itself.
Economics is concerned with understanding the forces that can disturb an
equilibrium and the policy measures that may have to be undertaken to restore it."
In other words, the role of economists in modern government is analogous to the
role played by astrologers in advising kings in medieval times: the method doesn't
work, cannot work, so that presidents, chancellors, dictators and their economic
advisors are all blinded by the same fog. Continuing with the text, on page 633
Exhibit 1 shows three figures, (a) a cone sitting upright on it's flat base, (b)
the cone balanced perfectly on it's point, and (c) the cone lying on it's side.
Figure (a) is compared with the authors' cartoon of a price vs quantity `graph'
showing the intersection of supply and demand curves as equilibrium. That is, the
existence of the equilibrium point in the cartoon is advertised by the authors as
`stable', but there is no implication of stability in the existence of any
equilibrium point. The authors go on, " Figure (a) illustrates a case of stable
equilibrium. this represents the normal situation. In physical terms, it may be
depicted by a cone resting on it's base. In economic terms, it can be represented
by the intersection of ordinary supply and demand curves. If the system is
subjected to an external "shock" or disturbance sufficient to dislodge it from
equilibrium, self-corrective forces will cause it to return to it's initial
position." Real markets never behave even approximately in this way. Whenever
anything likeAdam Smith's hand can be found in the data, which is seldom, it is
destabilized by noise [7]. There are no equilibria indicated by finance data for
liquid markets, which are so far the best economic data available. I define a
liquid market is one where you can approximately reverse the trade over a short
enough time scale, as in the stock market when it's not crashing. Before the
advent of PCs and discount brokers with internet trading sites there were no
liquid markets in this sense for small traders.



I asserted in my Brussels talk in July 2000 that economists assume that utility
maximization describes `equilibrium'. An economist in the audience retorted
confidently that this is not true. Therefore, one last quote: On page 488 the
equation following from utility maximization is written down. The statement
explaining it is:



"This equation expresses your market equilibrium...defines the conditions that
exist when you have allocated your money and commodities, in the face of market
prices, in such a way as to maximize your total utility."





References




1. M.F.M. Osborne,
The Stock Market and Finance from a Physicist's Viewpoint (Crossgar, Mineapolis, 1977).




2. P. Ormerod, The Death of Economics (Wiley, NY, 1997).




3. J. L. McCauley, Physica A285, 506 2000.




4. M. H. Spencer and O. M. Amos, Contemporary Economics (Worth, NY, 1993).




5. J. Peinke, Geilo lectures on turbulence and finance (2001).




6. L-H Tang, Hefei lectures on finance (2001).




7. J. L. McCauley, Geilo lectures on econophysics (2001).




8. J. l. McCauley, Physica A237, 387, 1997.




9. E. P. Wigner, Symmetries and Reflections (Indiana, Bloomington, 1967).









Hardcover - 897 pages 8th edition (February 1993)

Worth Publishing;
ISBN: 0879016140 ;
Dimensions (in inches): 1.80 x 10.68 x 8.84

Amazon price: $89.75