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# 1 Econophysics: the physics of money and the market

Physics Department, Panskura Banamali College, Panskura, East Midnapore, W.B., Pin Code: 721152

-Abhijit Kar Gupta (kg.abhi@gmail.com)

Econophysics is the physics of economy – in short. Economics is a social science where importance is, in general, given to the social difference, the agent behaviors and the pattern coming out of that. Physics, on the other hand, has a tendency of looking for some generalities. The idea of econophysics comes from the fact that economics and physics (particularly statistical physics) both deal with system of many interacting components that obey specific rules. In statistical physics, the behaviour of bulk matter comes from the forces acting between molecules and atoms. In economic studies, it is the interaction between economic agents (traders, businessmen or common people). The Trends: • Ideas of thermodynamics and statistical physics directly applying to economic problems. Formulation of the key questions in terms of the laws of thermodynamics and statistical mechanics for better understanding. • Challenging the ideas of neoclassical theory of economics where it is assumed that the agents act perfectly rationally based upon complete information and the equilibrium is quickly attained. • Econophysics focus attention on the financial markets as it offers a lot of good quality data which may serve the purpose of understanding similar complex events in physical world like earthquake and avalanches. • Human society is a network; network of people of common interests. Study of the properties of network reveals new ideas. Multi agent modeling, agent based computer simulations, incorporating the tools of equilibrium statistical physics and thermodynamics, Nonlinear dynamics, Evolutionary games to study out of equilibrium economics. The economic world is full of patterns. One of the most interesting and controversial one is the wealth distribution. Few people are very rich, few more have less and the most of us have far less. There are inequalities that exist everywhere, in every society, within a nation. The inequality in the wealth or asset or income distribution has an interesting universal character. More than a century ago, around the time of Boltzmann, an Italian engineer Vilfredo Pareto discovered this universal pattern in the distribution of wealth. The basic mathematical form of wealth distribution has always been the same irrespective of politics, culture and time, across the boundaries of the world. Even if we start with same wealth, some people will always tend to accumulate more wealth. The distribution turns to be a fat tailed distribution, a power law towards the high end. This is known as Pareto’s law. Each time the amount of wealth is multiplied by a factor, the number of people falls by a constant factor. But the pattern (the distribution law) remains basically the same. A connected law is Zipf’s law: P (> r ) ~ r −1 where r is the rank determined by the descending order of the frequency of occurrence of the event. The observation was initially made for the occurrence of English

2 words in the literature. Later it was found to be in various fields, the population in cities, citations of scientific papers, magnitude of earthquakes, diameter of moon craters, copies of books sold, intensity of solar flares, web hits, wealth of the richest people etc. What causes the pattern? At the heart of the distributions of wealth is exchange. There are essential exchanges every now and then among the people, among the traders. The other thing is the rise and fall of the asset values, the stocks. It thus may be assumed that the stationary distributions of wealth or money emerge from exchanges. The intermediate processes or the details of personal interactions may be ignored or the purpose of seeking an overall behaviour. Models are made on the basis of kinetic theory of ideal gas in statistical physics. Two randomly selected agents with money mi and m j interact in such a way that there is some exchange of money between them.

mi/ = mi − ∆m

m /j = m j + ∆m

Let us consider that the total money in the economy is conserved (Individual people do not create money). The money or wealth of two people after the interaction can be connected by a 2 × 2 transfer matrix T : mi/ m / = T i . m m j j The choice of the exchange amount ∆m gives rise to a wide variety of distributions from Boltzmann-Gibbs type exponential distribution [ P (m) ~ e − m / m ] to Gamma type distributions [ P (m) ~ m β e − m / m ] to Pareto distribution with power law tail [

**P( m) ~ m − (1+α ) ]. Instead of random interaction, if selective interaction is considered,
**

distributions with power laws of different exponents emerge. Works in this direction are mainly based on mean field type analysis and computer simulations. Besides, simple mathematical analysis involving the transfer matrix T can help understanding some basic properties. In a different kind of work, the economy is considered as a network of interacting people and it is looked at how wealth diffuses through the network. Two findings from the models: (i) greater the flow of wealth, the greater will be the economic activities, i.e., trading and the less will be the inequality. (ii) On the other and, the more volatile the investment returns, the greater becomes the inequality. Example - Russia after the collapse of USSR. Their works are based on the computer modeling. The claim is that the positive returns build a person’s wealth not merely by addition but by multiplication. Another area of interest is the study of financial time series – the fluctuations in financial markets, correlations and finding patterns out of it (prediction of collapse?). The works involve data analysis and modeling; modeling of efficient markets (like ideal physical systems). Financial markets exhibit several of the properties that characterize complex

3 systems. The human society is an open system where many subunits interact nonlinearly in the presence of feedback. One new interesting area is modeling through evolutionary games like Minority game (MG). or popularly known as El Farol Bar Problem in the literature. El Farol bar is a Spanish restaurant/ bar at Santa Fe in USA where local people assemble to enjoy their weekends. However, as the seats are limited, it is often disappointing if one goes there and does not get a seat. It is thus often wiser to remain at home rather than going to the crowded bar. But if everyone thinks so then the bar will be empty. People come to a natural conclusion of whether to go or not go by examining the history of the last weekends and without consulting each other. This is an interesting non-equilibrium problem which can mimic a social situation where the agents individually have incomplete information or capabilities for solving the problem but can reach a solution by interacting among them. In this new kind of mathematical game it is assumed rightly that the people have bounded rationality and have finite number of strategies. So this is case of adaptation or inductive reasoning (as compared to deductive reasoning as assumed in conventional neoclassical economics). The model is now being applied to the real markets of buyers or sellers. Mathematical calculations and involved computer simulations are used to obtain interesting results. An yet another attempt is to construct the thermodynamic formulation of economics (exactly δQ that in physics). Consider entropy, dS = . First law of thermodynamics essentially tells us T that the differential form δQ is generally not exact. The second law is prescription of how to make the non-exact differential form into an exact one with the help of the integrating factor 1 . Here in terms of economic parameters one may think Q to be the profit, S to be the T production function and T the market index or standard of living etc. Probability distributions are obtained through maximizing the Lagrange’s function 1 L = S − E , where E can be thought of cost of production like energy. Next, the growth and T wealth are conceived by Carnot cycle hypothesis. Every company, Bank or every person is acting as a Carnot engine. Labour is converted into capital. Banks collect money from poor people and give it to the rich investors etc. In all, econophysics is a newly conceived interdisciplinary area where the concepts and techniques (both analytical and computational) are borrowed mostly from statistical physics (equilibrium and non-equilibrium) and competitive evolutionary games are designed to understand some social and economic problems.

References:

1. An Introduction to Econophysics: Correlations and complexity in Finance – Rosario N. Mantegna, H. Eugene Stanley (Cambridge Univ. Press) 2. Econophysics of Wealth Distributions – eds. A. Chatterjee, S. Yarlagadda, B.K. Chakrabarti (Springer) 3. Econophysics and Sociophysics: Trends and Perspectives – eds. B.K. Chakrabarti, A. Chakrabarti, A. Chatterjee (Wiley-VCH)

4 4. www.unifr.ch/econophysics (website dedicated to Econophysics and Sociophysics)