Monday, 2 March 2009
Those unfamiliar with theoretical physics may not have come across one of the most beautiful derivations in all of science: the results of statistical thermodynamics. I would like to introduce them to more people, not just because they are an intellectual tour de force in themselves, but because they hold very interesting lessons for economists.
In short, these results extrapolate from some very simple rules about low-level structure and statistics to derive powerful results about the behaviour of the whole system. This is also a common theme of economics.
General equilibrium results start from basic assumptions about rational market agents and efficient prices, and derive a result about the efficiency of the whole economy. The problem is that if the original assumptions are wrong, the results are wrong. And experiments show that the assumptions are indeed wrong.
Economics has two possible directions from here. It can change the assumptions and recalculate the consequences. An appealing option is to work out alternative models of rationality which better approximate real behaviour; the problem being that these usually make the mathematics very hard, and it becomes almost impossible to scale up the predictions to a whole economy.
The other option is to take a leaf out of the thermodynamics book, and extrapolate from some simple assumptions about the states a person or firm can be in, instead of from the detailed behaviour of each person.
My feeling is that this may let us generate substantive macroeconomic results from the micromodels of Thomas Schelling, or even the reflexivity concept of George Soros. And I expect that other cognitive biases can be incorporated in a similar way.
More updates to come on this...