Classical thermodynamics and economic general equilibrium theory

Eric Smith Duncan K. Foley SFI New School for Social Research

SFI Complex Systems Summer School SF 2007

Outline
History and some conventions Modern neoclassical economics Structure of thermodynamics The right connection An example

A (very) little history

Parallel goals of natural and social physics circa 1900

Dene and characterize equilibria
Points of rest Equations of state Work, heat ow Best resource allocations Discovery of price systems Trade, allocation processes

Describe transformations

The Walrasian Analogy

Leon Walras (1909) 6 6 & &

Equilibrium as force Equilibrium as

balance in mechanics

X 5 5

balance of marginal utility in exchange

X X demands

Analogies from mechanics

Position (x) Potential Energy (V) Force (F) Holdings (x) Utility (U) Prices (p)

F = V

p = U
(Utility is implicitly measurable)

Ball settles in the bottom of the bowl to minimize energy

Gibbs and thermodynamics

Entropy is maximized in a Helmholtz Free Energy is
equivalently minimized
Distinction between particle and system

closed system at equilibrium For open subsystem, excess entropy is maximized

S (U ) S (U ) U
Senv 1 = Uenv T

A = U TS

Ball settles in the bottom of the bowl to maximize excess entropy (by losing energy)

And yet Fisher...

A particle Space (x? V?) Energy (U?, E?,V?) Force (F)

Irving Fisher (1926)

An individual Commodities (x) Utility (U) Marginal utility (p)

Particles and individuals are unpredictable State variables are only properties of
thermodynamic systems at equilibrium

Fisher mixes metaphors from

thermodynamics and statistical mechanics

Analogy and confusion

J. H. C. Lisman (1949)
A quasi-eq. system Entropy pV (ideal gas) An individual Utility (analogon) px (value)

J. Bryant (1982)
pV = NT

px = NT (productive content)

Disgust
The formal mathematical analogy between classical thermodynamics and mathematic economic systems has now been explored. This does not warrant the commonly met attempt to nd more exact analogies of physical magnitudes -such as entropy or energy -- in the economic realm. Why should there be laws like the rst or second laws of thermodynamics holding in the economic realm? Why should ``utility'' be literally identied with entropy, energy, or anything else? Why should a failure to make such a successful identication lead anyone to overlook or deny the mathematical isomorphism that does exist between minimum systems that arise in different disciplines?

Samuelson 1960

But duality survived

Extensive quantities
Energy, volume Goods

Intensive quantities
Temperature, pressure Prices

The marginalist revolution and modern Neoclassical mathematical economic theory

Indifference and utility

Suppose more than one good

P1P U
x2

x = (x0 , x1 , . . . , xn )
notion of indifference

Only try to capture the Relative prices = marginal

u(x) = U
rates of substitution of goods
x1

Absolute price undened

Utility is now explicitly only ordinal

u/ xi = pi /pj u/ xi

The separating hyperplane

(Tj. Koopmans, 1957)

Edgeworth-Bowley box:
Conserve endowments:
(allocation of resources under conditions of scarcity)
P1P
x2 
P.S.

Prices separate agent

(trade and production)

decisions from each other



Pareto Optimum denes

equilibrium as no-trade be irreversible

Trade to equilibrium must

No trade any agent can propose from an equilibrium will be voluntarily accepted by any other agent

x1

Duality: prices and demands

P1P U

x = (x0 , x1 , . . . , xn ) u(x) = U u pi Offer prices xi

x2

x1

e (p, U ) min [p x | u [x] U ]

x

Expenditure function

x e = p x + p U U p

e pi

= xi
U

Exchange economies and the Walrasian equilibrium

x = (x0 , x1 , . . . , xn ) p = ( p0 , p 1 , . . . , pn )
Maximize:
P1P
x2 
P.S.

eq 0
0
 x1

L = u(x) p x x

Wealth preservation hoped to extract a single equilibrium from the Pareto set

Trading paths to equilibrium really arent determined

The equilibrium price is a
terminal property of real trade paths of trading
x2 
P.S.

Need not restrict prior The equilibrium price can

be quite unrelated to the Walrasian price
 x1

F. Hahn and T. Negishi (1962)

and you may ask yourself how did I get here?

The mathematical structure of thermodynamics

State relations
General statistical systems
have E, S, not predictable systems is E also a constraint U
S = S(V,E) U
Closed-system, irreversible

Only for equilibrium

V
Open-system, reversible

S(V,U) = max(S)|

denes the surface of state

V,U

Equation of state is not

E U

dependent on the path by which a point is reached

Reversible and irreversible transformations result in the same nal state relation

Duality and Gibbs potential

State:
S (U, V )
V

S V
S

1 p dS dU + dV T T 1 p U + V S T T

p = T

1 =U T (G/T ) (p/T )

p +V T G = p =V
T

G U + pV T S = T T

1/T

Connecting thermodynamics to mechanics

V F = p*area

S (U, V ) 1 p dS dU + dV T T S V p = T

A(T, V ) = U T S dA = pdV SdT A V =p

T

Reversible transformations and work

reservoir (T)

A V W = =

=p
T

p1
piston

p2 V2 Load

V1

p p
1

dV

6

dA + dA

$A

Helmholtz free energy

= A

 3

Analogies suggested by duality

Surface of state Indifference surface Increase of utility Offer prices

S (V, U ) = max(S )|V,U

Increase of entropy

u(x) = U U 0

Intensive state variables

S 0

S V

Gibbs potential

p = T

u pi xi
Expenditure function
x

G = U + pV T S e (p, U ) min [p x | u [x] U ]

Problems (1): counting

Different numbers of intensive and extensive
state variables (incomplete duality)

(U, V ) 1 p , T T G(p, T ) S 0

x = (x0 , x1 , . . . , xn ) p (p0 , p1 , . . . , pn ) /p0 e(p, U )

Entropy is measurable, utility is not Total entropy increases; individual utility does
U 0

Problems (II): meaning

T

pdV = dW = dU T dS
6 

p
x2 
P.S.

$A

 3

 x1

Essence of the mismatch

In physics, duality of state constrains transformations
The price of this power is that we must limit ourselves to reversible transformations, and cannot conserve all extensive state variable quantities

In economics, conservation of endowments forces

irreversible transformations
The result is that dual properties of state become irrelevant to analysis of transformations

Finding the right correspondence

Three laws in both systems

The state of a thermodynamic system at equilibrium is completely determined by a set of pairs of dual state variables

Encapsulation

Economic agents are characterized by their holdings of commodity bundles and dual offer price systems to each bundle

Constraint
Energy is conserved under arbitrary transformations of a closed system Commodities are neither created nor destroyed by the process of exchange

Preference

A partial order on states is dened by the entropy; transformations that decrease the entropy of a closed system do not occur

A partial order on commodity bundles is dened by utility; agents never voluntarily accept utilitydecreasing trades

The construction
Relate the surface of state to indifference
surfaces correctly transformations analogy

Study economics of reversible Associate quantities by homology, not by

Quasilinear economies: introduce an irrelevant good

Indifference surfaces are translations of a single surface in x0 (hence so are all equilibria of an economy) are equal

u(x) = x0 + u ( x)
X 

x (x0 , x )

All prices on the Pareto Set Differences among equilibria

have no consequences for future trading behavior

03

 X

Duality on equivalence classes

u pi = xi p0 i > 0
Independent of distribution of x0 among agents Equivalence class of expenditures corresponds to Gibbs

eQL (p, U ) = p0 [U u ( x)] + p x eQL p0 U G = T S + (U + pV )

p0 T

Resulting economic entropy gradient is normalized prices

SQL = u ( x)

dSQL

p = dx p0

Reversible trading in a closed economy

Ext. speculators prot =
x 2

1 p0 dx0

2 dx0

p 1 p 2 dx 1
1 SQL

S
P.S.

= p0

2 SQL

1 x0

But SQL is a state variable! Same for rev. and irrev. trade

Money-metric value of trade is the amount agents could keep an external speculator from extracting

Prot extraction potentials in partially open systems

x (x0 , x1 , x )
e p0 U p x p0 = x1 + u (x1 , x ) p1 p1 p1
~ x 2

Economic Helmholtz potential

p0 AQL = x1 u (x1 , x ) p1 p dAQL = dx p1

A
P.S.

1 x1+(p0/p1)x0
reservoir (T)

A V

=p
T

p1
piston

p2 V2 Load

V1

Aggregatability and social welfare functions

QL economies are the most general
aggregatable economies independent of composition or endowments (Obvious reason: dual offer prices are now meaningful constraints on trading behavior)

For these, a social welfare function is the

sum of economic entropies

Such economies are mathematically identical

to classical thermodynamic systems

A small worked example

The dividend-discount model of nance

1 M = pN N + D r t N d 2 U Nd 1 2 (x0 , x1 , x2 ) (D, M, N )
Contract Energy Conservation

U = p V + Q

Constant Absolute Risk Aversion (CARA) utility model

D + (M )

(p0 , p1 , p2 ) (1/r t, 1, pN )

think

(T, 1, p)

The state-variable description

Economic entropy and basis for the social welfare function
N d 1 S U + D = Nd 2 2 + (M )
d S r t = = dM M
N

Economic Gibbs part of the expenditure function

1 G = M + pN N S r t 1 A=M S r t

G pN A N

=N
rt

Economic Helmholtz potential for trade at xed interest

rt

= pN

Summary comments
Irreversible transformations are not generally
predictable in either physics or economics by theories of equilibrium

They require a theory of dynamics The domain in which equilibrium theory has
consequences is the domain of reversible transformations neoclassical prices may be different

In this domain the natural interpretation of

Further reading
P. Mirowski, More Heat than Light, (Cambridge U. Press, Cambridge, 1989) L. Walras, Economique et Mecanique, Bulletin de la Societe Vaudoise de Science Naturelle 45:313-325 (1909) I. Fisher, Mathematical Investigations in the Theory of Value and Prices (doctoral thesis) Transactions of the Connecticut Academy Vol.IX, July 1892 F. Hahn and T. Negishi, A Theorem on Nontatonnement Stability, Econometrica 30:463-469 (1962) P. A. Samuelson, Structure of a Minimum Equilibrium System, (R.W. Pfouts ed. Essays in Economics and Econometrics: A Volume in Honor of Harold Hotelling. U. North Carolina Press, 1960), reprinted in J. E. Stiglitz ed. The Collected Scientic Papers of Paul A. Samuelson, (MIT Press, Cambridge, Mass, 1966) J. H. C. Lisman, Econometrics, Statistics and Thermodynamics, The Netherlands Postal and Telecommunications Services, The Hague, Holland, 1949, Ch.IV. J. A. Bryant, A thermodynamic approach to economics, 36-50, Butterworth and Co. (1982) Tj. Koopmans, Three Essays on the State of Economic Science (McGraw Hill, New York, 1957) G. Debrue, Theory of Value (Yale U. Press, New Haven, CT, 1987) H. R.Varian, Microeconomic Analysis (Norton, New York, 1992) 3rd ed., ch.7 and ch.10