Saturday, March 19, 2011

Intro to Economics for Physicists: Part 1

“For meaningless is exactly what you have to flirt with when you are in between social, and in particular linguistic practices—unwilling to take part in an old one but not yet having succeeded in creating a new one.” R. Rorty, Philosophy and the Mirror of Nature

In this post, I'd like to give a general overview of economics and how it relates to physics. At first, it might seem that there is no connection between economics and physics, but both are part of the same underlying study of how the universe operates. By "economics," I mean the study of how humans make decisions related to food, shelter, clothing, entertainment, etc. By "physics," I mean the movement of particles, atoms, or molecules according to the fundamental forces of nature. Generally, we don't use the term "physics" to describe the evolution of biological species or the evolution of human financial markets because we lack the fundamental understanding of how the laws of physics can be used to describe, let alone, predict the evolution of species or financial markets.

While we lack a full understanding of systems far-from-equilibrium, we can at least recognize that biological species and their financial markets are both part of an overall system that is far-from-equilibrium, and that system is the Earth. Not only are they initially far-from-equilibrium, but they manage to stay far-from-equilibrium via the continuous input of exergy. (The definition of exergy is the capability to do work.) Sources of exergy include sunlight, fossil fuels, nuclear potential energy, wind motion, and underground thermal reservoirs with temperatures above room temperature. (Some forms of energy have no exergy, such as thermal energy at the same temperature as the environment.)

What I'd like to cover here is the difference between "economics" in the sense of "how humans make decisions related to food, shelter, clothing, entertainment, etc." and "economics" in the sense of "neo-classical equilibrium theory" or  "free-market capitalism."

Here are some definitions that will be useful for any physicist hoping to communicate with economists:

'ceteris paribus' =   Holding all other things constant, such as in the sentence: "the price of oil will increase if there are major supply disruptions, ceteris paribus."

Demand = the desire and capability of buyers to purchase  goods within a given period of time [Units of demand in an electricity-backed currency are Energy/time (Work/time), such as kW-hr/week]

Supply  =  the desire and capability of sellers to produce and offer to sell goods with a given period of time. [Units of supply in an electricity-backed currency are also Energy/time (Work/time), such as kW-hr/week]

Money = any object that is widely accepted as a means of exchange and/or repayment of debts  [Units of money in an electricity-backed currency are Energy (Work), such as kW-hr]

price = the actual amount of money exchanged in a financial transaction [Units of price in an electricity-backed currency are also Energy (Work), such as kW-hr]   The inverse relationship between price and demand for most items is due to the fact that increasing the price of an object forces those people who can't make a positive return on the investment under the higher price to not buy the product. As the price increases, demand decreases because less people can achieve a positive return on investment.

[For more details on the supply, demand & price, check out: Comparison between supply&demand curves]

Gross Domestic Product (GDP) = the total market value of all final goods and services produced annually within the country's borders. Calculating the GDP of country is very difficult because it's hard to avoid double counting because almost every 'final product' can be considered to be an  'intermediate product' in some larger system. Also, there are issues with failing to include black market transactions and barter transactions.
   Note that one can also calculate the GDP by summing up all of the work (force times distance definition of work) that is generated in a country in a given year. As in the other way of calculating GDP, it's important not to double count the work produced (such as counting the electricity produced at plant and then recounting it after a voltage let-down station.) [Either way, the units of GDP in an electricity-backed currency are Energy/time (Work/time), such as kW-hr/year.]
Positive economics = attempts to determine what is   (positive economics is much like the study of science, which asks questions about how the world is)
Normative economics = addresses what should be   (Normative economics is much like politics, which asks questions like how should the world be)

The laws of physics have a lot to say about both positive and normative economics. One of the main laws of physics is that the entropy of the universe is increasing with time. This is a statement of how the world is (not a statement about how the world should be.) One of the laws of non-equilibrium physics states that there is no way to prove which is the fastest way to increase the entropy of the universe. This means that there is no right way or best way to bring the universe into equilibrium. For this reason, we need to have normative economics. We need to have discussions and debates about how best to maximize the rate of production of entropy. So, the reason why we need to have normative economics rests on the fact that there is no way to prove definitely what is the best way to maximize the rate of production of entropy. Some physicists might initially have problems leaving the field of 'positive science' (i.e. studying how the universe is) and entering the field of 'normative science' (i.e. how to bring the universe into equilibrium at the fastest route possible). But I think that more physicists would be interested in 'normative science' if we can ground 'normative economics' in terms that have physical relevance.

What I've been arguing for throughout my recent blogs is that we need to ground the study of economics with our understanding of the laws of physics. To do this, we have to eliminate the concept of 'utility' from the field of economics. Utility is typically defined as desire or want. Utility can not be directly measured. (So, we can see why many physicists tend not to study economics. If an entire field of study were based on a notion that can not be quantified or measured, then there's a good reason to be skeptical of learning the subject as it's currently taught.) Utility is a term that originally came the utilitarian philosophy of trying to maximize the greatest good for the greatest number of people, but it has never been grounded in anything real, so we should be skeptical of any field of study with utility as its underlying foundation.

Utility is a human-centric notion that needs to be removed from all discussions of economics. Many environmentalists have a problem with our current theories of economics because they are human-centric. Most economists try to maximize human happiness, regardless of the effect that the actions taken to maximize human happiness have on the environment. These economists value human utility, even if the actions to maximize utility cause the destruction of forests or pollution of the oceans.

In order to ground economics in physical (reality), we need to de-humanize the field of economics. This means that we need to have a measurable quantity that includes the production capability of all life-forms and that is quantifiable, not subjective. I believe that this quantity is the rate of production of entropy. This is a non-human-centric quantity that can be measured and quantified.

This means that the goal of life should not be to maximize human happiness. Instead, the goal of life should be to maximize the rate of production of entropy.

In all different types of economics, 'price' is the rationing device that is required for us to make decisions between our competing needs and desires. All economists agree that 'price' is required because there are more needs & desires than there are objects to meet those needs & desires, i.e. there is scarcity and there is competition for limited resources.

What economists disagree about is how to best satisfy the needs of the global population. Most economists agree that the goal is to maximize the happiness (utility) of as many people as possible. However, economists can't agree on the definition of utility (let alone how to maximize it.) This means that the study of economics is like a castle built on sand. There is currently no foundation for economics, and this is a major problem. And because there is no foundation to economics, this means that we are living in a society that make decisions based on a theory that is not grounded in reality. This disconnect is readily apparent in the fact that the "laws" of economics have never been experimentally proved. There are some "laws" of economics, but these "laws" lack the power of the laws of physics listed above because these "laws" of economics are often violated. Laws of Economics

Unlike economics, there are three main laws of physics in which there has been no experimental evidence disproving these laws:
1) Conservation of energy
2) Non-decrease of the entropy of the universe  (i.e. non-conservation of entropy and exergy)
3) Conservation of momentum

While these three laws of physics may not have any direct relevance to the study of economics, it's important to remember that an economy runs on exergy, and because of this, an economy can't grow unless we expand the consumption of exergy. For example, conserving "energy" is only a good thing if conserving energy (exergy) eventually leads to more productive consumption of energy (exergy) elsewhere. (Remember Jevons Paradox) Overall, we need to be increasing our consumption of energy (exergy).

This is the first of a couple of posts on economics for physicists (and hopefully for non-physicists who would like to make the field of economics more grounded in the laws of physics.) In future posts, I've cover topics like: what does physics say about neo-classical equilibrium theory and about neo-Keysenians theories? And what is the connection between rate of return on investment and risk?