THEODORE KOUKOVISTAS

ECONOMICS & PHYSICS

Economics and Thermodynamics*

Economists always tried to analyze the economic system with terms and concepts borrowed from Physics. The edifice of Classical Economics was built, partly, in proportion to Classical Mechanics and in particular the concept of mechanical equilibrium. But as Physics faced a temporary impasse at the end of the 19th century (which led to Relativity and Quantum Mechanics), Economics is heading to (or already is in) the same situation. Mainstream theories (Keynesian, Neoclassical) cannot describe reality in accurate manner, that is to say they cannot give adequate answers for the very big (the economic system and its interaction with the environment) 1, 2 and the very small (consumer behavior, forecast of a stock price etc.) The cause for a different approach was an article from John von Neumann 3, in which he tried to analyze the economic system in terms of Classical Thermodynamics (flows) instead of Classical Mechanics (displacements). During the last 50-60 years many economists and physicists, mainstream or less conventional, are seeking analogies between Thermodynamics and Economics. Thermodynamics (Th.) began as an empirical field, about the same period Economics was founded. The purpose was to construct and analyze machines that transform heat into power (see the work of Carnot on steam engine). The analysis was based on two empirically determined quantities: energy and entropy 4. Today Th. is separated into two large fields: Classical (Phenomenological) Th. which is concerned with bodies or systems with internal structure and Statistical Th. which is concerned with the properties of the individual (microscopic) parts of the system and uses these (statistical) properties to estimate the general (macroscopic) properties of the system 5. Thus, as very broad (crude) analogies with Economics, we can say that a stock market is a system and the stocks its constitutive parts, a multinational corporation is a system and the employees and machineries its constitutive parts, a University is a system and the professors with the students (and the cleaners) its constitutive parts etc 6. Of course things are not that straightforward. The second "law" of Th. (entropy) stipulates that it is impossible to have 100% efficiency for irreversible processes (in Economics most of the processes are irreversible except from theoretical cases). An issue arises since in everyday life the output always has to be greater than the inputs. Thus we must have >100% efficiency 7. Let's see at another problem. When we analyze the macroeconomic system we cannot make accurate forecasts when a recession (or boom) will occur, how long is going to last, the impact on society etc. It seems like something is missing from the equations, which will explain and predict behaviors and decisions; a variable equivalent to thermodynamic entropy. Even if we manage to define such variable, this does not imply that we can secure the growth and general equilibrium of the system. The main concern is the time interval between an economic action 8 (analogous to chemical mixing) and equilibrium and how long this equilibrium will last. In Economics the time interval is very short compared to chemical reactions, thus it would be more appropriate to turn our sight to disequilibrium Th. 9. That is to say, economists approach equilibrium, so far, as an effort to put an elephant on top of a pin head. In theory there would be a price (equilibrium point) where the pin will hold. In practice this can happen only transitory. In the case of disequilibrium Th. we can approach economic system as a self-organizational mechanism 10. But it is very difficult to correspond between economic system and any other inorganic or biological system. Arbitrarily, we can make a classification and rank the economic system as a fourth order system. The first order is inorganic matter; the second order is simple biological systems (monads); the third order is complex biological systems and the fourth order is

the economic (or any other social) system which is the development of the most complex biological system in the known world. So far we have analyzed first order systems in depth and efforts are under way to analyze second order systems. That means we have a long way to go in order to analyze social systems and even if we go this far we're going to need the assistance of other disciplines as Artificial Intelligence and Neurology 11.

End Notes *This article was published in a local newspaper ("Thessaly", March 2004). The translation is mine. 1. The terms Economics and economic system are reference to free market. Thus with the term environment is not implied only the natural environment but systems outside free market as the public sector, political parties, NGO's etc. 2. For instance mainstream theories cannot make reliable predictions about the economic cycle (growth, recession). 3. V. Neumann built a general equilibrium model; by general equilibrium we mean that in every market demand equals supply and postulated that in order to have maximum growth we must have minimum profits. 4. Based on energy and entropy three "laws" of Th. were formulated: conservation of energy, increase of entropy for irreversible processes and the impossibility to reach absolute zero. 5. Classical Th. was constructed with the use of mathematical (deterministic) relations and Statistical Th. with the use of statistical (probabilistic) relations. 6. A subtler analogy is the statistical connection (distribution) between the fluctuations of a stock price and the collision of particles in boson gases. They both have exponential power law distribution. 7. Even if we accept that humans are smarter than Nature, which generally holds; then why have we pollution? We need a more advanced structure, which means humans must outsmart themselves. 8. As the exports of a company, the mergers of banks, the levy of a tax etc. 9. In disequilibrium Th. there isn't a global equilibrium point; the equilibrium is transient. 10. A self-organization mechanism is characterized by irreversibility, exchange of energy and matter (and entropy) with the environment and has certain boundaries. 11. This does not imply that we erase everything mainstream theories have achieved until now. But as Newtonian Physics explains up to a point the natural world so neoclassical and Keynesian schools explain the economic world partially.

Selected Bibliography

Economics and Thermodynamics. New perspectives on Economic Analysis. Kluwer Academic Publishers, 1994. An introduction to Econophysics, Correlations and Complexity in Finance. Cambridge University Press, 2000. J. Von Neumann, "A Model of General Economic Equilibrium", Review of Economic Studies, 13, p. 1-9, 1945-46.