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

PDF
MPRA_paper_2159.pdf Download (625kB)  Preview 
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  Economic Education and Teaching of Economics 
Item ID:  2159 
Depositing User:  Joseph L. McCauley 
Date Deposited:  09 Mar 2007 
Last Modified:  08 Dec 2016 11:39 
References:  1. G. Guillaume, E. Guillaume, Sur le fundements de l’economique rationelle, GautierVillars, Paris, 1932. 2. P. Samuelson, Collected Economics Papers, Vol. 5, MIT Pr., Cambridge, 1986. 3. P. Mirowski, Machine Dreams, Cambridge, Cambridge, 2002. 4.E. Smith, D.K. Foley, Is utility theory so different from thermodynamics? SFI preprint, 2002. 5. D. Ruelle, Statistical Mechanics, Thermodynamic Formalism, AddisonWesley, Reading, Mass., 1978. 6. P. Cvitanoviç, G.H. Gunaratne, I. Procaccia, Phys. Rev. A38 (1988) 1503. 7. J.L. McCauley, Classical Mechanics: flows, transformations, integrability and chaos, Cambridge, Cambridge, 1997. 8. M. Dacorogna, et al, An Intro. To High Frequency Finance, Academic, N.Y., 2001. 9. J. Hull, Options, Futures, and Other Derivatives, PrenticeHall, Saddle River, N.J., 1997. 10. M. Baxter, A. Rennie, Financial Calculus, Cambridge, Cambridge, 1996. 11. J.L. McCauley, Dynamics of Markets and Volatility: economics and finance from a physicist’s standpoint, forthcoming book on econophysics, Cambridge, Cambridge, 2003. 12. J. L. McCauley, G.H. Gunaratne, An Empirical Model of Volatility of Returns and Option Pricing, Physica A, 2003. 13. G.H. Gunaratne, J.L. McCauley, A Theory for Fluctuations in Stock Prices and Valuation of their Options, submitted, 2002. 14. Z. Bodie, R.C. Merton, Finance, PrenticeHall, Saddle River, N.J., 1998. 15. A. Kirman, The Economic J. 99 (1989) 395 (supplement) 126. 16. R. Radner, Econometrica 36 (1968) 31. 17. H.P. Varian, Microeconomic Analysis, Norton, NY, 1992. 18. P. Bak, S.F. Nørrelykke, M. Shubik, The Dynamics of Money, arXiv:condmat/9811094 v2, 25 May 1999. 19. G.A. Ackerlof, An Economic Theorist’s Book of Tales, Cambridge, Cambridge, 1984. 20. J.E. Stiglitz, A. Weiss, Oxford Economic Papers 44, 2 (1992) 694. 21. L.I. Nakamura, Economics and the New Economy: the Invisible Hand Meets Creative Destruction, Federal Reserve Bank of Philadelphia Business Review 15, July/August 2000. 22. N. Wax, Selected Papers in Noise and Stochastic Processes, Dover, NY., 1954. 23. P. Cootner, The Random Character of Stock Market Prices, Cambridge, MIT Pr., 1964. 24. F. Black, M. Scholes, J. Political Economy 81 (1973) 637. 25. Y.M. Kaniovski, J. Evolutionary Econ. 10 (2000), 545. 26. H. Föllmer, in S. Howison, P.R. Kelly, P. Wilmott, Math. Models in Finance, Chapman & Hall, London, 1995. 27. J.L. McCauley, Physica A285 (2000) 506. 28. E.F. Fama, J. Finance 383 (1970) 29. J. Stiglitz, Globalization and its Discontents, Norton, NY, 2002. 30. J.D. Farmer, Market Force, Ecology, and Evolution (preprint, the original version, 1994). 
URI:  https://mpra.ub.unimuenchen.de/id/eprint/2159 