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The futility of utility: how market dynamics marginalize Adam Smith

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  • McCauley, Joseph L.

Abstract

Economic theorizing is based on the postulated, nonempiric notion of utility. Economists assume that prices, dynamics, and market equilibria are supposed to be derived from utility. The results are supposed to represent mathematically the stabilizing action of Adam Smith's invisible hand. In deterministic excess demand dynamics I show the following. A utility function generally does not exist mathematically due to nonintegrable dynamics when production/investment are accounted for, resolving Mirowski's thesis. Price as a function of demand does not exist mathematically either. All equilibria are unstable. I then explain how deterministic chaos can be distinguished from random noise at short times. In the generalization to liquid markets and finance theory described by stochastic excess demand dynamics, I also show the following. Market price distributions cannot be rescaled to describe price movements as ‘equilibrium’ fluctuations about a systematic drift in price. Utility maximization does not describe equilibrium. Maximization of the Gibbs entropy of the observed price distribution of an asset would describe equilibrium, if equilibrium could be achieved, but equilibrium does not describe real, liquid markets (stocks, bonds, foreign exchange). There are three inconsistent definitions of equilibrium used in economics and finance, only one of which is correct. Prices in unregulated free markets are unstable against both noise and rising or falling expectations: Adam Smith's stabilizing invisible hand does not exist, either in mathematical models of liquid market data, or in real market data.

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  • McCauley, Joseph L., 2000. "The futility of utility: how market dynamics marginalize Adam Smith," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 285(3), pages 506-538.
    • Handle: RePEc:eee:phsmap:v:285:y:2000:i:3:p:506-538
    DOI: 10.1016/S0378-4371(00)00296-X
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    References listed on IDEAS

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    1. Per Bak & Simon F. Norrelykke & Martin Shubik, 1998. "The Dynamics of Money," Research in Economics 98-11-102e, Santa Fe Institute.
    2. Yi-Cheng Zhang, 1999. "Toward a Theory of Marginally Efficient Markets," Papers cond-mat/9901243, arXiv.org.
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    Cited by:

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    4. McCauley, Joseph L, 2002. "Adam Smith's invisible hand is unstable: physics and dynamics reasoning applied to economic theorizing," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 314(1), pages 722-727.
    5. Small Michael & Tse Chi K., 2003. "Determinism in Financial Time Series," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 7(3), pages 1-31, October.

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