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Is There a Physics of Society? January 10-12, 2008, Santa Fe NM
Saturday, January 12, 2008
2:20 - 3:00 Doyne Farmer (homepage)
Structure and strategy in financial markets: What can we understand without making detailed models of human behavior?
Over the last fifty years economics has increasingly become the study of strategic interactions in economic settings, with rational expectations as its principle tool. There are some successes with this approach, but there are also increasing reactions against it, leading to programs of research such as behavioral economics. While very much a supporter of behavioral economics, understanding how real people make decisions is a big problem that will probably take centuries to sort out. How much we can understand using very simple models? I will argue that in many cases the culprit is not so much rationality itself, but rather the neglect of important structural properties. By structure I mean aspects of a problem such as the institutions that shape behavior or the emergent properties of humans interacting with each other and with these institutions.
To illustrate this I will discuss one of the most classic problems in economics, supply and demand. Because supply and demand are unobservable, a better target for research is the closely related concept of market impact (A.K.A price elasticity). We will see that we can understand a great deal about the surprising functional form of market impact using models based on a mixture of different ideas, emphasizing structure or emphasizing strategy as needed.