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Thermodynamic analogies in economics and finance: instability of markets

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  • McCauley, Joseph l.

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 no-arbitrage 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.

Suggested Citation

  • McCauley, Joseph l., 2004. "Thermodynamic analogies in economics and finance: instability of markets," MPRA Paper 2159, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:2159
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    File URL: https://mpra.ub.uni-muenchen.de/2159/1/MPRA_paper_2159.pdf
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    References listed on IDEAS

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    1. J.L. McCauley & G.h. Gunaratne, 2002. "An empirical model of volatility of returns and option pricing," Computing in Economics and Finance 2002 186, Society for Computational Economics.
    2. J. Doyne Farmer, 2002. "Market force, ecology and evolution," Industrial and Corporate Change, Oxford University Press, vol. 11(5), pages 895-953, November.
    3. Mirowski,Philip, 2002. "Machine Dreams," Cambridge Books, Cambridge University Press, number 9780521772839, March.
    4. Mirowski,Philip, 2002. "Machine Dreams," Cambridge Books, Cambridge University Press, number 9780521775267, March.
    5. Leonard I. Nakamura, 2000. "Economics and the new economy: the invisible hand meets creative destruction," Business Review, Federal Reserve Bank of Philadelphia, issue Jul, pages 15-30.
    6. Per Bak & Simon F. Norrelykke & Martin Shubik, 1998. "The Dynamics of Money," Research in Economics 98-11-102e, Santa Fe Institute.
    7. Gemunu H. Gunaratne & Joseph L. McCauley, 2002. "A theory for Fluctuations in Stock Prices and Valuation of their Options," Papers cond-mat/0209475, arXiv.org.
    8. McCauley, Joseph L. & Gunaratne, Gemunu H., 2003. "An empirical model of volatility of returns and option pricing," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 329(1), pages 178-198.
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    Cited by:

    1. Wayne, James J., 2014. "Generalized Second Law of Thermodynamics and Its Applications in Social Science," MPRA Paper 59734, University Library of Munich, Germany.
    2. Wayne, James J., 2013. "Fundamental Equation of Economics," MPRA Paper 59574, University Library of Munich, Germany.
    3. Josip Stepanic, 2004. "Social Equivalent of Free Energy," Interdisciplinary Description of Complex Systems - scientific journal, Croatian Interdisciplinary Society Provider Homepage: http://indecs.eu, vol. 2(1), pages 53-60.
    4. Pichl, Lukáš & Kaizoji, Taisei & Yamano, Takuya, 2007. "Stylized facts in internal rates of return on stock index and its derivative transactions," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 382(1), pages 219-227.
    5. Bucsa, G. & Jovanovic, F. & Schinckus, C., 2011. "A unified model for price return distributions used in econophysics," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 390(20), pages 3435-3443.
    6. Jovanovic, Franck & Schinckus, Christophe, 2017. "Econophysics and Financial Economics: An Emerging Dialogue," OUP Catalogue, Oxford University Press, number 9780190205034.
    7. Schinckus, Christophe, 2008. "The financial simulacrum: The consequences of the symbolization and the computerization of the financial market," Journal of Behavioral and Experimental Economics (formerly The Journal of Socio-Economics), Elsevier, vol. 37(3), pages 1076-1089, June.

    More about this item

    Keywords

    Economics; utility; entropy and disorder; thermodynamics; financial markets; stochastic processes;

    JEL classification:

    • D5 - Microeconomics - - General Equilibrium and Disequilibrium
    • A2 - General Economics and Teaching - - Economic Education and Teaching of Economics

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