McCauley, Joseph l. (2004): Thermodynamic analogies in economics and finance: instability of markets. Published in: Physica A , Vol. 329, (2003): pp. 199212.

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Abstract
Interest in thermodynamic analogies in economics is older than the idea of von Neumann to look for market entropy in liquidity, advice that was not taken in any thermodynamic analogy presented so far in the literature. In this paper we go further and use a standard strategy from trading theory to pinpoint why thermodynamic analogies necessarily fail to describe financial markets, in spite of the presence of liquidity as the underlying basis for market entropy. Market liquidity of frequently traded assets does play the role of the ‘heat bath‘, as anticipated by von Neumann, but we are able to identify the noarbitrage condition geometrically as an assumption of translational and rotational invariance rather than (as finance theorists would claim) an equilibrium condition. We then use the empirical market distribution to introduce an asset’s entropy and discuss the underlying reason why real financial markets cannot behave thermodynamically: financial markets are unstable, they do not approach statistical equilibrium, nor are there any available topological invariants on which to base a purely formal statistical mechanics. After discussing financial markets, we finally generalize our result by proposing that the idea of Adam Smith’s Invisible Hand is a falsifiable proposition: we suggest how to test nonfinancial markets empirically for the stabilizing action of The Invisible Hand.
Item Type:  MPRA Paper 

Institution:  University of Houston 
Original Title:  Thermodynamic analogies in economics and finance: instability of markets 
Language:  English 
Keywords:  Economics; utility; entropy and disorder; thermodynamics; financial markets; stochastic processes; 
Subjects:  D  Microeconomics > D5  General Equilibrium and Disequilibrium A  General Economics and Teaching > A2  Economics Education and Teaching of Economics 
Item ID:  2159 
Depositing User:  Joseph L. McCauley 
Date Deposited:  09. Mar 2007 
Last Modified:  11. Feb 2013 18:39 
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URI:  http://mpra.ub.unimuenchen.de/id/eprint/2159 