A more generalized market transaction

Fig. 5.4 represents a more involved market transaction. An investor, characterized by a value and statistical entropy and a cost of information acquires one unit of a risk bearing asset. The value per unit is W₁ and the statistical entropy per unitI₁ . The investor pays a price P per unit in risk free value. The cost of information of the seller and the buyer is equal and we use its familiar notation. However, the probability distributions of value of the buyer and the seller are different as their states of information differ. The seller’s statistical entropy is different from that of the buyer. Information exchanges with the environment. Application of the first and second laws of EVT and realizing that the economic value, and hence, the expected price, to the seller is

I2

C

W _I leads, for a situation in which the statistical entropy of the buyer does not change, to the conclusion that the gain of value by the investor is:

1 1,I W

,I2

P

I I,C )

Investor, W, I.

Fig 5.4. A generalized market transaction.

57 We see that contrary to the situation in the previous section a positive increase of the value for the investor is possible if the right hand side of eqn. 5.12 is positive. This applies if the statistical entropy of the picture of reality of the seller is higher than that of the buyer. This applies if the buyer avails of superior information. In economic theory, this is termed a case in which asymmetries in information exist. The derivation of eqn. 5.12 follows in note 5.1; the reader can skip it if (s)he accepts that the equation is right.

Note 5.1.

With reference to Fig. 5.4, we write the first law of EVT as:

P I

dt W

dW 1 )

As we indicated, the seller accepts a price according to his perception of the economic value of the asset:

2

1 CI

W

P _I

If we substitute this in the first law equation, we get:

I II dt C

dW 2)

The second law of EVT reads:

I I

I I C

dt

dI 3 ₁)

If the entropy of the investor remains unchanged, the term at the left hand side of the equation above vanishes and it follows:

Substituting this in the last first law equation shows:

)

Eqn. 5.12 is the limiting case that we obtain if the production of statistical entropy is zero.

These asymmetries in information are the forces that drive transactions in a non-equilibrium situation where gradients in statistical entropy occur. In a practical situation of non-equilibrium in an economy, many forces as defined in eqn. 5.7 exist and these are the driver behind socioeconomic evolution. We discuss this more exhaustively in Chapters 6 and 7.

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5.10. Conclusion.

It is instructive to compare the result obtained in the preceding section with the classical microeconomic model of perfect competition. We include this model in our analysis of economic theories in Section 8.8. One assumption underlying the theory of perfect competition is that the market shows a large number of buyers and sellers. The entry and exit barriers facing suppliers are negligible. All producers and consumers avail of the same information and use that information in the most effective way. No inhomogeneities in product and production methods exist; the suppliers produce one product in a standardized way. Considering the situation in real life markets, these assumptions have a questionable degree of realism.

These assumptions lead to a market in which a balance between supply and demand exists. The sellers in the market earn only a “normal” return; probably this means that the players only earn the risk free return and hence there is no overall creation of economic value. Furthermore, the situation is at equilibrium socially optimal, it leads to an optimal allocation of resources in the economy. We show later that these conclusions generally do not apply to the harshness of economic reality.

The result concerning the absence of creation of economic value agrees with our discussion of an EVT equilibrium transaction as discussed in Section 5.8. In addition, EVT shows that this critically depends on the information of the various players. In case of asymmetries in information, over average returns are possible. Asymmetries in information do not exist in the perfect competition world.

Clearly, the perfect competition model as well as the EVT formalism applied to an equilibrium situation, lead to severe discrepancies between the theory and some observations regarding real life situations. It is difficult to find the rationale for the existence of firms as these offer no clear advantage over transactions completely based on market exchange. In addition, the fact that some firms earn over-average returns, prosper and grow, whilst others disappear, is problematic from the equilibrium perspective.

Perhaps the best reflection of the problems with efficient markets and equilibrium theory is the way in which Jensen (1972) defines an efficient market. A market is efficient with respect to a given set of information if none of the players can earn a profit if they optimally use the available information and have access to the same information. This agrees with the information based EVT approach. If the information set of all players is equal, no creation of economic value by transactions is possible. EVT, however, also shows that over-average returns are possible if asymmetries in information exist. In EVT, asymmetries in information follow from the nature of the probability distribution of value. The probability distribution relevant to an actor depends on his information about the state of the system. As this level of information may be different for suppliers and sellers, such differences are very likely to exist. In fact, in later chapters (e.g.

Chapter 6) we show that these are the very driver of evolution and constitute the substance that makes economies tick.

The EVT formalism has, in addition to the ability to tackle information asymmetries, a lot more to offer in removing the limitations of the perfect competition and the equilibrium approaches to markets. Clearly, an equilibrium approach is not adequate to describe situations in markets in which firms and other institutions appear. Such markets are definitively not in equilibrium and firms and other organizations are the product and the source of this disequilibrium. In a situation away from equilibrium, competition between firms creates, maintains and destroys gradients in information and costs of information. The underlying asymmetries in information lead to a situation in which over-average returns appear. In the general non-equilibrium case firms, markets and industries constantly evolve under the pressure of competition between the actors that contest the sources of economic value.

Based on our EVT approach we also identify the forces that drive market transactions and the

59 appearance of industries and markets. In analogy with thermodynamics, the force that drives transactions is a gradient in the ratio of the economic value to cost of information (eqn. 5.7). It leads to the interpretation of firms and other organization as dissipative structures that inevitably appear if forces exist that result in evolution beyond equilibrium.

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