A general Economic Value Theory

This section introduces a rather bold line of reasoning. We extend the theories of macroscopic thermodynamics to functions of state termed potential value, or in shorthand value, and economic value respectively. These are the counterparts of energy, potential value, and free energy, economic value, as these feature in classical thermodynamics (Chapter 3). In this book, we use the term economic value instead of free value, a term we use in earlier work (Roels (2010)). The definitions are straightforward if we assume equivalency between economic work and thermodynamic work. In that case, potential value becomes the potential capacity to generate economic value. It is the analogue of internal energy in thermodynamics.

Economic value is the analogue of free energy. Economic value is potential value corrected for the statistical entropy of the macroscopic picture of reality that we adopt in view of the overwhelming complexity of the system at the microscopic level. Economic value is the actually available capacity to do economically relevant work based on our reduced information picture. Thus, we obtain complete symmetry between thermodynamics and our general theory of economic value, EVT. We propose a macroscopic theory of economic value; we do not consider the microscopic complexity. The symbol W indicates potential value. It is the counterpart of the concept of energy in thermodynamics. For economic value, we use the symbol G to remind us of the thermodynamic counterpart free energy. We assume that we have an objective unit of value, just as in thermodynamics where we use gravitational work, i.e. the movement of a mass in the gravitational field, to define the units and the equivalence of different forms of work.

We straightforwardly proceed with the formulation of the first law of EVT. It defines the

44

conservation of potential value. Its production or destruction in processes in a system in an economy is zero. Henceforth, following terms used in economic reality, we use the term transactions for all economically relevant processes. We introduce the following expression for the first law of EVT for a system part of the economic reality:

dt W

dW ) (5.1)

Although the notation is perhaps already familiar, we reiterate that the term at the left hand side stands for the rate of change of the amount of value, the term at the right hand side is the increase of value due to exchange with the environment. At the right hand side, no contribution due to transactions in the system appears by virtue of the conservation of value.

Considering potential value conserved may be confusing as it implies that its creation or destruction does not take place economic transactions. This may conflict with the illusion that we create value in our economy. Explaining this feature involves returning to energy and thermodynamics. In addition, we move to some 13.5 billion years ago when, according to the Big-Bang theory of its creation, the universe instantaneously appears with all the energy that it has today. By virtue of the first law the universe’s internal energy today cannot be anything else than equal to that when the universe emerges. The first law does not allow a change as the universe is an isolated system. The energy in the universe fueled the emergence of the socioeconomic system, as we argue later, and the potential value that exists in the universe is constant and equal to the amount of energy present in the universe when it emerges. Earth with is socioeconomic system is an example of an open system and the solar radiation is to a good approximation the only source of resources on earth. The solar radiation is the product of the minute part of the energy present in the universe that constitutes the sun. If we think that we observe the creation of value, we see transformation of potential value into economic value that is available to perform economic work. We see the creation of economic value out of the potential value that emerges with the creation of the universe.

We can complete the conservation equation according to the first law of EVT if we formulate an expression for the exchange of value with the environment. It turns out that we have three types of contributions to the exchange of value:

2 The first term at the right hand side is the equivalent of heat in thermodynamics; in EVT, it represents a flow of information (in fact information that is lacking in the macroscopic description). In doing this we follow the formalism of statistical thermodynamics introduced in Chapter 4 where we revealed the informational nature of heat. The second flow represents the equivalent of work in thermodynamics. In EVT, we can think of liquid capital and other assets of which we know the economic value with certainty. The third part represents the sum of the values of the assets of which we only know the expected value subject to uncertainty that is reflected in the EVT equivalent of entropy, i.e. the information that is lacking to complete specify the value microstate the asset is in. These assets can be stocks and bonds or industrial and consumer products that we sell or buy. We again limit the number of such assets to two as this serves to illustrate the properties of more complex situations in which many assets appear.

A new feature in EVT is economic work to complement the purely physical sources of work such as mechanical, electrical and chemical work. It is worthwhile to explore the nature of economic work somewhat further. My thoughts on this subject are still incomplete so part of the remarks made here are speculative in nature. The present view of this author is that at least

45 an important contribution to economic work is information work. It reflects the ability to gather information and hence increase the economic value of a given amount of potential value. We return to this concept in Chapter 7 when discussing the nature of the firm.

Taking the next step in the development of EVT involves introducing the second law of EVT.

It will not come as a surprise that this law states that every economic transaction results in the destruction of information reflected by production of the EVT equivalent of entropy. The information that is lacking to specify the exact value microstate of everything in our system can only increase. This leads to the following macroscopic balance equation for that lacking information:

The term at the left hand side stands for the rate of change of the amount of lacking information. The first term at the right hand side of eqn. 5.3 stands for the creation of uncertainty or the destruction if information that must be positive due to the second law. The second term at the right hand side is the equivalent of the contribution of heat in thermodynamics. We stressed that temperature in thermodynamics is of an informational nature, the product of Boltzmann’s constant and temperature stands for the minimum of the energy cost for obtaining one unit of information about the microstate of the system beyond the information contained in the macroscopic description (Chapter 4). The symbol C_I is the EVT equivalent of the product of the Boltzmann constant and temperature; it represents the cost of additional information about the value microstate of the system.

The economic value follows, in analogy with free energy in thermodynamics, as:

I C W

G _I (5.4) The interpretation of eqn. 5.4 runs as follows. Any economic asset has a macroscopic potential value or in shorthand a macroscopic value. That value is conserved in every possible transaction. We only know the expected macroscopic value and the asset can exist in many value microstates. To specify the exact value microstate in view of the uncertainty contained in our macroscopic picture, we need information beyond that contained in that macroscopic picture, its amount is I. That information is not a free commodity it comes at a cost of C_I units of value per unit of information. Hence, the economic value is obtained if the product of that cost and the amount of lacking information is subtracted from the expected macroscopic value. In fact, that cost is a minimum. In general, the value expenditure to obtain the information is higher.

By reasoning analogous to the thermodynamic discussion in Section 3.4, we arrive at the general restriction due to the EVT formalism:

In any economic system, the net effect of a pattern of transactions can only be the destruction of economic value.

In addition with perfect generality:

In an economic system, there are no restrictions to the direction of individual transactions.

Activities in which information increases, i.e. against the natural direction set by the second law, are perfectly possible if transactions in the natural direction of sufficient magnitude support these. All we can say is that at least one transaction must proceed in the natural

46

direction and that the overall effect of all the transactions in the system must be a decrease in information.

We termed this coupling in the thermodynamic treatment. Coupling shows of crucial importance to the understanding of evolutionary phenomena in any system, including the socioeconomic system.

The restrictions apply to any system be it isolated or open. Hence, it also applies to the universe; the direction of its evolution involves an irreversible destruction of economic value that also sets the time arrow of evolution of the universe and the socioeconomic system.

For a system in steady state, we can formulate a restriction that does not depend on the complexity of the transactions in the system. Just as in thermodynamics, we can analyze the constraint based on a black box approach. We can police the boundaries of the system and simply apply economic value accounting to the flows going in and out. This leads to a vast reduction of the complexity of the analysis.

For a system in a steady state outside equilibrium, the perfectly general conclusion is that the net effect of the exchange flows with the environment must be transport of economic value to the system.

This completes the development of the EVT formalism. We apply it to the analysis of economic transactions later in this work. This formalism also allows us the derive the force that drives evolution in socioeconomic systems just as the thermodynamic forces that drive evolution in physical system, such as in the example of heat transfer that we discussed earlier.