Thursday, July 8, 2010

A new dimension in Economics - Econophysics

Econophysics is an interdisciplinary research field, applying theories and methods originally developed by physicists in order to solve problems in economics, usually those including uncertainty or stochastic processes and nonlinear dynamics. Its application to the study of financial markets has also been termed statistical finance referring to its roots in statistical physics. Physicists’ interest in the social sciences is not new; Daniel Bernoulli, as an example, was the originator of utility-based preferences. One of the founders ofneoclassical economic theory, former Yale University Professor of Economics Irving Fisher, was originally trained under the renowned Yale physicist, Josiah Willard Gibbs.

Econophysics was started in the mid 1990s by several physicists working in the subfield of statistical mechanics. They decided to tackle the complex problems posed by economics, especially by financial markets. Unsatisfied with the traditional explanations of economists, they applied tools and methods from physics - first to try to match financial data sets, and then to explain more general economic phenomena.

One driving force behind econophysics arising at this time was the availability of huge amounts of financial data, starting in the 1980s. It became apparent that traditional methods of analysis were insufficient - standard economic methods dealt with homogeneous agents and equilibrium, while many of the more interesting phenomena in financial markets fundamentally depended on heterogeneous agents and far-from-equilibrium situations.

The term “econophysics” was coined by H. Eugene Stanley in the mid 1990s, to describe the large number of papers written by physicists in the problems of (stock and other) markets, and first appeared in a conference on statistical physics in Calcutta in 1995 and its following publications. The inaugural meeting on Econophysics was organised 1998 in Budapest byJanos Kertesz and Imre Kondor.

Currently, the almost regular meeting series on the topic include: Econophysics Colloquium, ESHIA/ WEHIA, ECONOPHYS-KOLKATA, APFA

If "econophysics" is taken to denote the principle of applying statistical mechanics to economic analysis, as opposed to a particular literature or network, priority of innovation is probably due to Farjoun and Machover (1983). Their book Laws of Chaos: A Probabilistic Approach to Political Economy proposes dissolving (their words) the transformation problem in Marx's political economy by re-conceptualising the relevant quantities as random variables.

If, on the other side, "econophysics" is taken to denote the application of physics to economics, one can already consider the works of Léon Walras and Vilfredo Pareto as part of it. Indeed, as shown by Ingrao and Israel, general equilibrium theory in economics is just based on the physical concept of mechanical equilibrium.

It should be noted that econophysics has nothing to do with the "physical quantities approach" to economics, advocated by Ian Steedman and others associated with Neo-Ricardianism.

Basic tools of econophysics are probabilistic and statistical methods often taken from statistical physics.

Physics models that have been applied in economics include percolation models, chaotic models developed to study cardiac arrest, and models with self-organizing criticality as well as other models developed for earthquake prediction. Moreover, there have been attempts to use the mathematical theory of complexity and information theory, as developed by many scientists among whom are Murray Gell-Mann and Claude E. Shannon, respectively.

Since economic phenomena are the result of the interaction among many heterogeneous agents, there is an analogy with statistical mechanics, where many particles interact; but it must be taken into account that the properties of human beings and particles significantly differ.

There are, however, various other tools from physics that have so far been used with mixed success, such as fluid dynamics, classical mechanics and quantum mechanics (including so-called classical economy and quantum economy), and the path integral formulation of statistical mechanics.

There are also analogies between finance theory and diffusion theory. For instance, the Black-Scholes equation for option pricing is a diffusion-advection equation.

Papers on econophysics have been published primarily in journals devoted to physics and statistical mechanics, rather than in leading economics journals. Mainstream economists have generally been unimpressed by this work. Some Heterodox economists, including Mauro Gallegati, Steve Keen and Paul Ormerod, have shown more interest, but also criticized trends in econophysics.

In contrast, econophysics is having some impact on the more applied field of quantitative finance, whose scope and aims significantly differ from those of economic theory. Various econophysicists have introduced models for price fluctuations in financial markets or original points of view on established models.

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