Economics:
A New Foundation and a New Scientific Revolution
Many people have recognized
fundamental flaws in neoclassical economics and have called for a new
foundation for economic theory. In this newsletter, we will present such a new
foundation.
All systems, living or not, follow
physical laws. Any living system has to satisfy an additional economic
principle: For an organism or organization to be viable, its cost in extracting
resources from the environment, which it needs to maintain itself, has to be
lower than the value of the resources obtained. From physical laws and economic
principle, we derive a mathematical theory on the behavior of social and
biological systems. It provides a simpler and more consistent description of
the world than established theories. The theory was systematically presented in
my 2005 book, The Physical Foundation
of Economics: An Analytical Thermodynamic Theory.
Conceptually, this new economic
theory is a dynamic non-equilibrium theory, while the theoretical foundation of
neoclassical economics is the general equilibrium theory. It has been
recognized for a long time that the general equilibrium theory does not
describe reality accurately and hence is a temporary solution before a dynamic
non-equilibrium theory could be developed. More than half century ago, Joseph
Schumpeter made the following comments about the general equilibrium theory and
predicted the emergence of a dynamic economic theory in the future:
So a dynamic non-equilibrium theory
is a natural continuation of the general equilibrium theory. The mathematical
techniques for a non-equilibrium theory have been available for a long time.
But the development of a new foundation of economic theory could have been
delayed by many concerns, which may be grouped into three categories. First,
human beings have free will. Ideas keep changing. We are emotional and
irrational. So it is unlikely that human behaviors can be described by a simple
mathematical theory even though the general equilibrium theory is seriously
flawed. Second, economic values are determined by marginal utility. But
utilities are highly subjective. So a quantitative theory of value is unlikely
to develop. Third, the world is complex and imperfect. It seems impossible to
develop a simple and universal theory about social and biological systems. To
answer these questions, we have developed a theory of mind, a theory of value
and a theory of production. In this issue we will briefly introduce each part
of the theory and provide some references with more detailed discussions.
To extract resources from the
environment, organisms must be able to first identify those resources. While
the forms of resources are diverse, most resources can be understood from a
unifying principle. A system has a tendency to move from a less probable state
to a more probable state. This tendency of directional movement is what drives,
among other things, living organisms.
Intuitively, resources are something that is of low probability, or
scarce. The measure of probability of a system is called entropy in physics. In
a formal language, systems move from low entropy state to high entropy state.
This is the second law of thermodynamics. The second law is often understood
from an equilibrium perspective, rendering entropy an image of waste and death.
However, from the non-equilibrium perspective, the entropy flow, which is
manifested as heat flow, light flow, electricity flow, water flow and many
other forms, is the fountain of life. Since all living organisms need to tap
into the entropy flow from the environment for survival, it is inevitable that
the mind, including the human mind, is evolved to identify entropy as the most
important concept. This is why information, which we collect for our survival,
is represented mathematically by the entropy function.
To identify
resources, the human mind must be able to receive external signals and
interpret them properly. In other words, the mind is a communication system
with its coding system shaped by the need to recognize resource at low cost.
With this basic understanding, many concrete results about the state of the
human mind can be derived as natural extensions of standard results from
information theory and statistical mechanics. From the information theory, the ability
to receive information depends on the correlation between the source of
information and the receiver. To better receive information, our mind is
evolved to store data and preferences so we can receive relevant information at
low cost. At the same time, the stored data and preferences also generate bias
in information processing.
A detailed discussion of the theory of mind can be
found in Chapter One of my book.
A more recent update on part of the theory can be found at The Physical Foundation of
the Mind.
This new and
integrated theory of information and mind provides a unified understanding of
many psychological patterns documented in literature. This theory is especially
helpful in providing a simple and coherent understanding of many of the
difficult problems in the field of behavioral finance. A detailed discussion on the application of the
theory of information to understand the main patterns in security markets and
the trading behaviors of the market participants can be found at The
Informational Theory of Investment: A Comparison with Behavioral Theories.
Human beings,
as individuals, require mostly physical assets. We eat bread, live in a house,
drive a car. But our social interactions are chiefly regulated by economic
values instead of the physical values of different commodities. How are
economic values related to physical values? Currently, there are two theories
of value in mainstream economics. The first is the scarcity theory of value.
This theory is taught in most economics courses. But it is not a mathematical theory. The
second is the marginal utility theory of value. This is a mathematical theory
used in most research papers. But it does not provide a measurable quantity for
value. From the scarcity theory of value, we derive that the only mathematical
formula to represent value, as a function of scarcity, is the entropy function.
This is parallel to the case where the only mathematical formula to represent
information, as a function of probability, is the entropy function. The entropy theory of
value offers a unified
understanding of physical resources, information and economic value. It provides a quantitative
measure of value that is highly consistent with our intuitive
understanding. The theory of value, as a non-equilibrium theory, provides a
simple mathematical theory to describe the dynamics of competition and product
life cycles. Just like the entropy theory of information provided a clear
understanding of the fundamental problems in communication theory, the entropy
theory of value provides clear understanding of the fundamental problems in social
activities. While this quantitative theory of value is a formalization of
scarcity theory of value, it does not suggest that the marginal utility theory
is wrong. In recent years, there has been active research about human
preferences and utilities from an evolutionary perspective, which indicates
that human preferences are far from arbitrary. It is likely that the same
quantitative theory of value can be derived from a refined utility theory of
value.
The idea of
an entropy theory of value, or information theory of value, had been explored
and abandoned by many researchers. In my book, we discussed many of the
conceptual difficulties and how they are resolved. Here, we will give only one
example. In an often cited passage, Kenneth Arrow wrote, “the well-known
A
detailed discussion of the theory of value can be found in Chapter Two of my book.
For a business to be viable, its
revenue has to be higher than its cost. For a species to be viable, on average
each member of that species has to bring up more than one member of the next
generation to maturity. While
the principle is very simple, business and evolutionary strategies can be very
complex. Some animals are large; others are small. Some live a long life;
others have a very short lifespan. Some thrive in volatile environments; others
dominate in stable environments. Some give birth to many offspring and most do
not make it to maturity, thus displaying a high discount rate; others give
birth to very few offspring and take good care of them, thereby displaying a
low discount rate. Ecologists and economists have done a lot of research to
uncover some general patterns from seemingly infinitely complex evolutionary
and business strategies. Can we derive these patterns from a mathematical
theory?
To develop
the production theory, we will ask ourselves two simple questions. What are the
most fundamental properties of organisms and organizations and how can we
represent them mathematically? First, organisms and organizations need to
obtain resources from the environment to compensate for the continuous
diffusion of resources required to maintain various functions. This can be
represented mathematically by lognormal processes, which contain both a growth
term and a dissipation term.
Second, to obtain resources, organisms and organizations have to have
special structures that incur fixed cost. For example, to transform energy from
water flow into electric energy, we have to build a dam; to transform solar
energy to chemical energy, plants have evolved elaborate photosynthesis systems
that are coded into their genes. Not only do organisms and organizations incur
fixed costs in extracting external resources, they also experience variable
costs. For a system to be viable, the total cost of extracting resources has to
be less than the value of resources extracted, or the total cost of operation
has to be less than the total revenue.
Lowering variable cost generally requires higher fixed cost. Fixed cost
is largely determined by the structure of an organism or an organization.
Variable cost is a function of the fixed cost, product value and other
parameters, such as the lifespan of the organisms or the duration of projects
uncertainty about external and internal environments and discount rates for an
animal, a human, or for an organization.
From the above considerations, we
derive the thermodynamic equation that variable cost of a production system
should satisfy. We set the initial condition of the equation so that total cost
is equal to the amount of resource extracted or revenue generated. Since an
organism or a project has a finite life span, we integrate the equation over
the duration of the project to obtain a formula of variable cost as a
mathematical function of product value, fixed cost, uncertainty, discount rate
and project duration. From this formula of variable cost, together with fixed
cost and volume of output, we can compute and analyze the returns and profits
of different production systems under various kinds of environment in a simple
and systematic way. The
results are highly consistent with the empirical evidences obtained from the
vast amount of literature in economics and biology. Furthermore, by putting
major factors of production into a compact mathematical model, the theory
provides precise insights about the tradeoffs and constraints of various
business or evolutionary strategies that are often lost in intuitive thinking.
A
detailed discussion of the theory of production can be found at The Economy of Social
and Biological Systems: A Physical Theory.
The same theory, written from the finance perspective, can be found at An Analytical
Theory of Project Investment: A Comparison with Real Option Theory.
Our theory provides a unified description of
social and biological systems from the same economic principle. Many people
observe striking parallels between social and biological systems. Yet it is
often assumed that there is a fundamental difference between the two: genetic
mutations are considered random while human behaviors are considered
purposeful. This assumed chasm between social and biological systems limited
the knowledge flow between social and biological sciences. However, the
argument that genetic mutations are random while human behaviors are purposeful confuses activities at different
levels. Many animal behaviors are purpose driven and human biological evolutions
are largely determined by genetic mutations as well. Furthermore, more precise observation shows that genetic mutations are not
completely random. When, where and how fast genes mutate depends on many
environmental factors. The regulation in genetic and epigenetic changes in
organisms is highly directed to enhance their survival under different kinds of
environments. Since a directed and informed change provides a higher rate of
return than a complete random one, purposeful changes evolve both in social and
biological systems. Therefore there is no reason to segregate the study of
social systems from the rest of biological systems.
There are
many advantages for such an integrated approach. Biological studies cover many
more species over a much longer time period than social studies. Therefore
principles derived from biological studies tend to be more general and more
robust than those from social studies. For example, in a recent paper, Kenneth
Arrow and others concluded from an empirical investigation that “genuine
investment was positive in all the rich nations of the world and in many of the
poorer nations as well”. This means that the current level of living standard
in rich countries is sustainable. However, in most rich nations of the world
and in some of the poorer nations as well, fertility rates have dropped far
below the replacement rate for a prolonged period of time. From the biological
theory, it is a clear indication that the current living standard at rich
countries cannot be sustained by the amount of available resources. However, there is a time lag between the drop in fertility rate below the
replacement level and the drop in economic output. The initial drop in
fertility rate reduces the number of dependant children. Many more adults become
available as labor forces. As a result, countries in demographic transition
often enjoy a high level of growth in economic output. Since most economic
observers focused on economic output alone, information implicit in demographic
transitions is often ignored.
A
detailed discussion about the relations among resources, technology and human
societies can be found in Chapter
Four of my book.
Government
agencies often try to adjust one or several factors in economic activities,
such as discount rate, to influence other factors in economic activities.
However, the precise relations among different factors are not well understood
in established economic theories. This is why the consequences of financial policies
often surprise policy makers. In particular, government policies that are
mainly beneficial when the costs of resource extraction are low may have the
opposite effect when the costs of resource extraction become high and is
increasing. Our analytical theory provides a more precise understanding of the
relations of major factors in economic activities and the impacts of government
policies. During most of the past several centuries, the costs of resource
extraction remained low and the consumption of resources increased more or less
unabated. However, many signs indicate that the age of cheap abundant resources
is at its peak.
An
intuitive explanation of the impacts of monetary and fiscal policies, is
provided in Cycles,
Trends and Financial Crisis: Understanding the Impacts of Monetary Policies. Discount rate is at the center of many policy issues. The Nature of
Discounting was written to provide a more detailed understanding of the
relations between discount rate and other factors in economic activities.
This economic theory is derived from physical
laws. At the same time, the concept of physical laws may be examined profitably
from economic principles. Physical laws, which reflect our understanding of
nature, are the products of the human mind. Mind, as a product of biological evolution, is subject to the
economic principle that its cost must be lower than its benefit. This helps
explain many things about our understanding of the world. We sometimes marvel
at the generality of physical laws and "The Unreasonable Effectiveness of
Mathematics". The physical world may contain many less general activities.
But it would be uneconomical for the mind to develop capacities to detect
isolated events. Indeed, human beings have only limited capacities to detect
many frequently occurring events. Our eyes can detect only very narrow ranges
of electromagnetic waves. We don’t have sense organs to detect electric fields,
while some fish do. Our sense of smell is highly degenerated. Since it is
costly to develop and maintain information processing capacity, only the most
frequently occurring physical events that are most relevant to our survival
will be detected by the human mind. Physical laws are so general because only
the most general will be detected by our minds. Similarly, mathematics is so
effective because only very general patterns in nature are summarized into
mathematical structures by our mind. Otherwise, the cost of maintaining
mathematical capacity would be greater than the benefits.
Some of the most fascinating and
general physical laws, such as the least action principle, the maximum entropy
principle and the conservation laws, are expressed as economic principles.
Physics is sometimes called the economy of nature. This economic theory also
provides a new way to understand physical phenomena. For example, physicists
are often puzzled by the apparent tendency for biological systems to form
complex structures, which seems to contradict the second law of thermodynamics.
However, once we realize that systems of higher fixed cost provide higher
returns in resource rich environments, this problem in non-equilibrium
thermodynamics becomes easy to understand.
There has been a long tradition of
exchange of ideas between economics and the natural sciences. Both Wallace and
Darwin were influenced by Malthus’s population theory in formulating the theory
of natural selection. Both Jevons and Walras, the main founders of neoclassical
economics, were trained in science. “Jevons did so many things it is difficult
to classify him by occupation… from examination of his other works we are
inclined to list him as a physicist who wrote extensively on economics,” said
Edwin Jaynes. More recently, Fischer Black made fundamental contributions to
many areas of economics. Jack Treynor, who introduced the world of finance to
Black, observed:
Fischer never
took a course in either economics or finance, so he never learned the way you
were supposed to do things. But that lack of training proved to be an advantage
… since the traditional methods in those fields were better at producing
academic careers than new knowledge. Fischer’s intellectual formation was
instead in physics and mathematics, and his success in finance came from
applying the methods of astrophysics. Lacking the ability to run controlled
experiments on the stars, the astrophysist relies on careful observation and
then imagination to find the simplicity underlying apparent complexity. In
Fischer’s hands, the same habits of research turned out to be effective for
producing new knowledge in finance.
Treynor’s observation illustrates the
problem and promise in economic and finance research. The problem is that “the
traditional methods in those fields were better at producing academic careers
than new knowledge.” The promise is that the methods of physics “turned out to
be effective for producing new knowledge in finance.” Our works show that through
the lens of physical laws and economic principle, we can “find the simplicity
underlying apparent complexity” in whole social systems. Richard West, a former
student of mine, summarized the essence of the theory succinctly:
This book presents a
theory that bridges the well ordered world of physics and the chaotic world of
economics. It goes a long way in explaining why the world of human structures
and systems are the way they are and suggests that, perhaps, the world is not
as unpredictable, chaotic or complex as the dismal science would have us
believe. This book contains a fundamental idea that leaves readers thinking,
"that's so simple and obvious, I could of thought of that".
From this
theory, social systems and biological systems are understood from the same
economic principle; mind and matter are understood from the same physical laws;
economy of human society is imbedded into the economy of nature. Behind all
these integrations is a dynamic non-equilibrium theory that provides simple
analytical results for many of the most important problems in our society. In
other words, this is a very economical economic theory. However, we are only at
the dawn of a new scientific
revolution. Once the high walls
of disciplinary compartmentalization are torn down, we all will be freed from
the tiny cells that have imprisoned our mind for so long.
It has been
almost ten years since the theory started circulating on the internet. My
working papers on SSRN, most of which are about various applications of the
theory, generated over twelve thousand download. People from all walks of life
wrote to me about their enthusiasm to the new theory. Some took extra effort to write reviews for my works. Editors from
some new and open minded journals wrote to advise me to submit my works in
their journals. I am very grateful for their kind help. However, despite the
popularity of my works in the informal channels, the direction of research in
economics, as well as in other academic fields, is governed through the formal
channels, which are rarely open to revolutionary ideas, especially revolutionary
ideas developed by the outsiders.
In How the
Economists Got It Wrong, James Galbraith explained the working of the
economics profession:
Leading active members of today's economics profession … have joined
together into a kind of politburo for correct economic thinking. As a general
rule--as one might expect from a gentleman's club--this has placed them on the
wrong side of every important policy issue, and not just recently but for
decades. They predict disaster where none occurs. They deny the possibility of
events that then happen. …They are always surprised when something untoward
(like a recession) actually occurs.
And when finally they
sense that some position cannot be sustained, they do not re-examine their
ideas. Instead, they simply change the subject. No one loses face, in this
club, for having been wrong. No one is disinvited from presenting papers at
later annual meetings. And still less is anyone from the outside invited in.
Only the occasional top-insider-turned-dissident … can reliably count on
getting a hearing. …
But self-absorption and
consistent policy error are just two of the endemic problems of the leading
American economists, and not even the most serious among them. The deeper
problem is the nearly complete collapse of the prevailing economic theory--of
the structure of thought that supports their policy ideas. It is a collapse so
complete, so pervasive, that the profession can only deny it by refusing to
discuss theoretical questions in the first place.
So I decide
to write this newsletter to reach individuals directly. By doing so, we may
work together to generate a public discussion about the foundation of economic
theory at this critical moment of human history. I will continue to discuss
various aspects of this theory in greater detail in later issues of this
newsletter and will be very happy to discuss any specific questions you may
have. I plan to combine the various issues of the newsletter into a book. Your
advices on the writings are greatly appreciated. If you find the theory
interesting, please pass the message to your colleagues, friends, students and
family members.
Thanks for
your kind attention.
Jing Chen
This document
can be found at
http://web.unbc.ca/~chenj/NL/1.htm
Acknowledgement:
We thank Peter Ostrowski and Richard West for helpful revision and comments.