We have often pointed out that economics does not apply scientific principles. An article in the "New Scientist" looks at a scientific approach being taken in the USA. The California Institute of Technology in Pasadena has an experimental economics lab. It is intended as a place where the economic behaviour of real people can be studied. (None of this 'assume ...' here).

The article says that economics might be able to escape being marooned in the 18th century and become something of a truly experimental science. The CALTECH economist involved in this work says: "For decades, economists worked almost exclusively on very rational models of human behaviour just because those models lend themselves to neat mathematical analysis".

In Newsletter No 3 we looked at the assumptions made when asserting that the "free market" is the "best" allocator of resources and will lead to a "Pareto optimum" where everyone is so well off that nobody can be made better off without reducing the lot of somebody else. Implicit in this is the assumption that people behave "rationally".

In this theoretical world, people facing economic choices collect all relevant information, (access to all relevant information is another assumption) analyse alternatives, and develop complex, sophisticated strategies that they can adapt to unexpected twists of fate. They constantly analyse potential returns and calculate probabilities to wring the maximum value from their money - an idea known as expected utility theory.

Richard Thaler, an economist at Chicago University, produced an influential paper in 1985 which demonstrated mathematically that erratic financial behaviour is neither fatal nor immediately self defeating and that non-rational spenders have a continual effect that cannot be ignored. That, Thaler believes, is a fundamental reason why standard economics fails. He says: "Standard theory doesn't just miss by a smidgen, its often embarrassingly false." and "... people's actual behaviour differs from rational choice in systematic ways".

Hence the laboratory attempt to measure such sub-rational behaviour and use this to "tweak standard economic equations". Apparently, a lot of people tend to place too much value on what they have now and too little on what they could have tomorrow.

In a study of New York taxi drivers, it was found that income varied day by day depending on the number of fares carried. The taxi drivers consistently quit earlier on good days and worked longer when fares were scarce. In a "rational" approach they would maximise earnings while minimising the hours worked and do this by working longer when busy and quit early when fares were scarce. The drivers could increase their earnings by 8% by working the same number of hours every day, and by 15% if they worked longer on good days. But while that may be "rational", they did not exploit the good days but only worked to a day by day target.

Economists in the past have assumed that people take the long view by "exponentially discounting" the future. However people's real behaviour is sub-rational and not like that. The way people actually trade off the present against the future is a very important consideration in economics and has great implications for spending versus savings, for investment planning, and a range of similar decisions. Don Brash for one, is frustrated that people do not behave according to theory. They are not saving enough and are putting too much of their savings into having their own home.

Thaler says: "Economists should allow for the possibility that people are human." Now there is a novel thought!

QUANTUM THEORY?

Science writer, Nicholas Dunbar, in an article in "New Scientist" no 2128 (4th April 1998), looks at the application of quantum theory to "market forces" because they are "both crazy, wild and unpredictable".

Using something called gauge theory, two Russian physicists, Kirill Illinski and Gleb Kalinin created a theory that is said to reproduce the complex rules used by traders to work the markets using equations that resemble those of the quantum theory of electrons and photons.

Electric charge becomes money, account surplus analogous to positive charge while debt is negative charge. Choice of currency becomes choice of phase in the electron's wave function. Exchange variations set up a "arbitrage" field which produces a force between trading accounts.

The New Scientist of 18th August 2000 has another look at economics from a scientific point of view with an article entitled "That's the way the money goes.".

The article looks at the distribution of wealth. Vilfredo Pareto analysed the distribution of wealth and found a consistent relationship with just a few very wealthy and a lot of people poor. The number of people in a category was proportional to wealth raised to a negative power (-2 to -3). This is now well known in business circles with what is known as the 80/20 rule. 80% of the business is done by 20% of the customers; 80% of the stock turnover takes place in 20% of the stock, etc. So the inference is that the mal-distribution is a fact of nature.

Two Frenchmen, Bouchard and Mezard, have looked at simple model of trading behaviour without the usual economists assumptions. The large collection of equations seem useless but they found they were analogous to equations relating to "condensed matter" in physics. (Physica A, vol 282, p536; xxx.lanl.govt/abs/cond-mat/0002374). They concluded that under normal conditions, their economy follows Pareto's law. Because the returns on investment are proportional to the amount invested, rich people tend to win or lose larger amounts than poorer. over time, even if all the changes are random, wealth ends up following Pareto's law with an exponent between -2 and -3.

To me it is a simple result of positive feedback - disposable wealth enabling the accumulation of more wealth.

The author, Mark Buchanan, says the model offers what might be the "first lesson of economics to be founded in mathematics: that the way to distribute wealth more fairly is to encourage its movement." ... and: "Having illuminated Pareto's law of wealth Bouchard and Mezard's approach is pointing towards a deeper theoretical perspective on economics. They hope to build more realistic models by moving away from the assumptions of complete randomness; and that every economic agent is identical."

Oh dear ... more unrealistic assumptions!

Nobel Prize winning physicist Richard Feynman gave his children a scientist's sense of wonderment to his children and taught them to both question and observe. He also taught them what he considered the basics of economics: that when prices go up, people buy less; manufacturers set prices to maximise profits; that economist know very little.

COMPLEXITY.

The book "Complexity: The emerging Science at the edge of Order & Chaos" by M Mitchell Waldrop (Touchstone Books 1992) looks at an academic, Brian Arthur, who came up with some heretical ideas which owed something to modern physics. After considering atoms, molecules, cells in physics and biology he was interested in the way that simple "particles" obeying simple rules will sometimes engage in the most astonishing, unpredictable behaviour. And why is that simple particles will spontaneously organise themselves into complex structures like stars, galaxies, snowflakes, and hurricanes - almost as if they were obeying a hidden yearning for organisation and order?

Somehow a new unified science was out there waiting to be born. It would be a rigorous science, just as "hard" as physics ever was, and just as thoroughly grounded in natural law. But instead of being a quest for the ultimate particles, it would be about flux, change, and the forming and dissolving of patterns. Instead of ignoring anything that wasn't uniform and predictable, it would have a place for individuality and the accidents of history. instead of being about simplicity, it would be about - well complexity.

Theoretical economists endlessly talked about the stability of the marketplace, and the balance of supply and demand. They transcribed the concept into mathematical equations and proved theorems about it. They accepted the gospel according to Adam Smith as the foundation for a kind of state religion. But when it came to instability and change in the economy - well, they seemed to find the very idea disturbing, something they'd just as soon not talk about.

But Arthur embraced instability. Look out the window, he'd told his colleagues. Like it or not, the marketplace isn't stable. The world isn't stable. Its full of evolution, upheaval, and surprise. Economics has to take this ferment into account. Arthur's heresy was to consider the principle of "increasing returns". In seminars, some of the audience reacted with outrage: how dare he suggest the economy was not in equilibrium! Journal editors told him that his increasing returns stuff "wasn't economics." The American Journal "The American Economic Review" over two and a half years demanded that he re-write a paper on his ideas. After some fourteen re-writes his paper was finally accepted by "The Economic Journal" in March 1989.

He read an article by someone who suggested that the economy is a self-organising system, in which market structures are spontaneously organised by such things as the demand for labour and the demand for goods and services. Just like a hurricane is a self organising system powered by the sun's energy. Just like a living cell which survives by taking in energy in the form of food. The principle of self-organisation depends on self-reinforcement; a tendency for small effects to be magnified when the conditions are right, instead of dying away. To control engineers, it is positive feedback.

Neoclassical economic theory assumes that the economy is entirely dominated by negative feedback: the tendency of small effects to die away under the influence of the system's properties. The dying away tendency is implicit in the economic doctrine of "diminishing returns." Neoclassical theory would have us believe that a free market will always winnow out the best and most efficient technologies from the inferior. But how do you explain the continued existence of the QWERTY keyboard which was designed to be inefficient by Christopher Scholes in 1873 (to slow typists down to avoid key-clash)? The Dvorak keyboard was designed a half century later to be efficient and proved itself in typing speed tests. You can get Dvorak keyboards for computers if you search hard for them but the dreadful QWERTY keyboard still reigns supreme. The inferior VHS videotaping system beat out the Beta system.

These properties of increasing returns, lock-in, and unpredictability have immense consequences and are analogous to nonlinear physics and the whole chaos theory. Arthur's critics got riled by ideas about the economy locking itself in to an unpredictable outcome. Economists wanted their field to be "scientific" as physics, meaning that everything had to be mathematically predictable. They could not accept that economics was more like biology and the best they could expect was an explanation.

He even found that a member of the Supreme Soviet thought his ideas only applied to Western economics and would not happen in perfect socialist planning.

Waldrop's book "Complexity" describes a economics workshop in Santa Fe in 1987 which included physicists. Arthur gave the first presentation "Self-Reinforcing Mechanisms in Economics". The economists had difficulty with ideas of non-linearity, mixtures of negative and positive feedback, etc. The physicists could understand what he was on about and became interested in economics. But the physicists were awestruck and appalled at the axioms, theories and proofs that the economists elaborated to them. They were casual with their maths but were obsessive about founding their assumptions and their theories on empirical fact. Physicists were disconcerted at how seldom the economists seemed to pay attention to the empirical data which did exist.

While the particles in physics obey "universal laws", the agents in economics (banks, firms, consumers, governments) act on the basis of expectation and strategies. Real human beings are neither perfectly rational nor perfectly predictable. As chaos theory tells us, the slightest uncertainty in your knowledge of the initial conditions will grow inexorably. After a while your predictions are nonsense.

The book goes on to look at another paper: "The Global Economy as an Adaptive Process" by John J Holland. Holland's paper considered the economy as an example of "complex adaptive systems". These are for example brains, immune systems, ecologies, cells, developing embryos, and ant colonies.

The properties of these systems are first: each system is a network of many "agents" working in parallel and furthermore the control of each system tends to be highly dispersed. No agent is the master.

Second: the system has many levels of organisation, with agents at any one level serving as the building blocks for agents at a higher level and these building blocks are constantly revising and rearranging their building blocks as they gain experience. All these processes of learning, evolution, and adaption are the same.

Third: all complex adaptive systems anticipate the future, and finally: these systems have many niches, each one of which can be exploited by an agent adapted to fill that niche. The filling of one niche can open up a role for more.

The consequence is that it is essentially meaningless to talk of a complex adaptive system being in equilibrium; the system can never get there. It is always unfolding, always in transition. If the system ever does reach equilibrium, it is dead rather than stable.

This exposition lead Arthur to see that this flux corresponded to his understanding of increasing-returns economics. A whole new vocabulary of complexity was opening up: adaption, emergence, collective behaviour, and spontaneous organisation. Biology and economics could meet. A whole new metaphor for economics could be examined.