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The Virtues and Vices of Equilibrium and the Future of Financial Economics

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Author Info
J. Doyne Farmer (Sante Fe Institute)
John Geanakoplos () (Cowles Foundation, Yale University)
Abstract

The use of equilibrium models in economics springs from the desire for parsimonious models of economic phenomena that take human reasoning into account. This approach has been the cornerstone of modern economic theory. We explain why this is so, extolling the virtues of equilibrium theory; then we present a critique and describe why this approach is inherently limited, and why economics needs to move in new directions if it is to continue to make progress. We stress that this shouldn’t be a question of dogma, but should be resolved empirically. There are situations where equilibrium models provide useful predictions and there are situations where they can never provide useful predictions. There are also many situations where the jury is still out, i.e., where so far they fail to provide a good description of the world, but where proper extensions might change this. Our goal is to convince the skeptics that equilibrium models can be useful, but also to make traditional economists more aware of the limitations of equilibrium models. We sketch some alternative approaches and discuss why they should play an important role in future research in economics.

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Publisher Info
Paper provided by Cowles Foundation, Yale University in its series Cowles Foundation Discussion Papers with number 1647.

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Length: 68 pages
Date of creation: Mar 2008
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Handle: RePEc:cwl:cwldpp:1647

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Postal: Yale University, Box 208281, New Haven, CT 06520-8281 USA
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Web page: http://cowles.econ.yale.edu/
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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

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Related research
Keywords: Equilibrium Rational expectations Efficiency Arbitrage Bounded rationality Power laws Disequilibrium Zero intelligence Market ecology Agent based modeling

Find related papers by JEL classification:
A10 - General Economics and Teaching - - General Economics - - - General
A12 - General Economics and Teaching - - General Economics - - - Relation of Economics to Other Disciplines
B0 - Schools of Economic Thought and Methodology - - General
B40 - Schools of Economic Thought and Methodology - - Economic Methodology - - - General
B50 - Schools of Economic Thought and Methodology - - Current Heterodox Approaches - - - General
C69 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Other
C9 - Mathematical and Quantitative Methods - - Design of Experiments
D5 - Microeconomics - - General Equilibrium and Disequilibrium
D1 - Microeconomics - - Household Behavior
G1 - Financial Economics - - General Financial Markets
G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies

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This page was last updated on 2008-7-18.

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