Rethinking Economics Based on
Complexity Theory
Dirk Helbing (ETH Zurich)
„The Economy Is an Equilibrium System“
Going beyond Equilibrium Economics
As Coupling Gets Stronger, System Behavior Can Become Unstable: Crowd Disasters
At low densities: self-organized lane formation, like Adam Smith’s invisible hand At large densities: coordination breaks down
Love Parade Disaster in Duisburg, 2010
As Coupling Gets Stronger, System Behavior Can Become Unstable: Traffic Breakdowns
Thanks to Yuki Sugiyama
At high densities, free traffic flow is unstable: Despite best efforts, drivers fail to maintain speed
Capacity drop, when capacity
is most needed!
John D. Sterman’s Beer Game
Perturbations in demand amplify
Network structure
Commodity flow (average of FRA, GER, JAP, UK, USA)
D. H., U. Witt, S. Lämmer, T. Brenner, Physical Review E 70, 056118 (2004).
Supply Network of Economic Sectors
Business cycles because of the structure of production networks?
Input output matrix Related delivery network
Resulting oscillations in the gross domestic product
Investigation of the effect of network structure:
§ Positive and negative feedbacks in production processes
§ Time lags in the information flow and adaptation process
Business Cycles as Result of Network Flows
„More Liquidity is Better“
The Need for Bubble Control Mode of heat transfer depends on energy input: 1. diffusion 2. convection rolls 3. bubbles
Does liquidity play a similar role?
„(Financial) Markets Are Efficient“
Going Beyond the Efficient Market Paradigm
The Flash Crash on May 6, 2010
The flash crash turned solid assets into penny stocks within minutes. Was an interaction effect, no criminal act, ‘fat finger’, or error.
600 billion dollars evaporated in 20 minutes
Google Data Reveal Stock Market Inefficiency
Time, t [Years]2004 2005 2006 2007 2008 2009 2010 2011
A
B
Cum
ulativ
e Re
turn
, R [%
]
!40!20
0204060
1616’culture’
0100200300
Buy and Hold StrategyGoogle Trends Strategy! + ", !, ! # " of Random Strategy
312
16
’debt’
US Search Volume Data
ACumulative Return, R [%]
’housing’’derivatives’’leverage’’credit’’investment’’marriage’’hedge’’nyse’’religion’’dow jones’’house’’color’’revenue’’consumption’’present’’trader’’office’’default’’unemployment’’stock market’’forex’’bubble’’car’’invest’’chance’’movie’’food’’return’’gains’’tourism’’lifestyle’’short selling’’gold’’metals’BUY AND HOLD’buy’’politics’’garden’’dividend’’rare earths’’water’’short sell’’economy’’home’’world’’conflict’’oil’’transaction’’labor’’ring’
!50 0 50 100 150 200 250
’happy’’stocks’
’profit’’cancer’’society’
’portfolio’’markets’’money’’bonds’’greed’
’holiday’’success’
’economics’’banking’
’fine’’restaurant’
’war’’crisis’
’inflation’’risk’
’nasdaq’’opportunity’
’returns’’financial markets’
’crash’’growth’
’sell’’consume’
’finance’’cash’
’health’’kitchen’
’travel’DOW JONES
’headlines’’gain’
’culture’’loss’
’earnings’’fun’
’freedom’’fed’
’train’’arts’’rich’
’energy’’fond’
’environment’’ore’
’debt’
Entire
Tim
e Per
iod!"#
of Ra
ndom
Stra
tegy
!+#
of Ra
ndom
Stra
tegy
!+2#
!+3#
!+4#
Rand
om T
ime P
eriod
s
Cumulative Return, R [%]
’debt’’housing’’stocks’’credit’’markets’’portfolio’’cancer’’opportunity’’religion’’investment’’present’’revenue’’success’’house’’consumption’’returns’’holiday’’greed’’office’’movie’’return’’financial markets’’crisis’’finance’’trader’’chance’’invest’’cash’’food’’culture’’restaurant’’politics’’gains’’fun’DOW JONES’dividend’’sell’’buy’’travel’’loss’’health’’water’’short sell’’conflict’’energy’’fond’’arts’’rich’’environment’’labor’’ring’
!20 0 20 40 60
’happy’’derivatives’
’marriage’’profit’
’leverage’’society’
’nyse’’bonds’
’banking’’hedge’
’war’’stock market’
’dow jones’’color’
’risk’’money’
’economics’’nasdaq’
’unemployment’’’growth’’forex’
’inflation’’crash’
’bubble’’metals’
’fine’’lifestyle’’default’
’short selling’’gold’
’headlines’’gain’’car’
’earnings’’consume’
’kitchen’BUY AND HOLD
’rare earths’’tourism’
’fed’’economy’
’train’’freedom’
’garden’’home’
’oil’’world’
’transaction’’ore’
!"#
of Ra
ndom
Stra
tegy
!+#
of Ra
ndom
Stra
tegy
B
!+2#
It would have been possible to make >300% profit during the financial crisis
Joint work with Tobias Preis, Suzy Moat, and H. Eugene Stanley
Is all relevant information in the price?
„Selfish Behavior Optimizes the Systemic Outcome“
When Does Adam Smith‘s Principle of the Invisible Hand Work?
Self-Organized Traffic Light Control
Measurement input
Inspiration: Self-organized oscillations at bottlenecks
Optimal compromise between coordination and local flexibility
Published in JSTAT (2008)
Local Travel Time Minimization Does Not Optimize Traffic Flows
With constant arrival rates:
The switching sequence adapts to the arrival patterns." We observe a flexible switching regime with maximum red-times.
„Individuals and Companies Decide Rationally“
Going Beyond the Rational Agent Paradigm
Experimental Ultimatum Game with Power: Proposals Offered and Accepted hyperfair proposal fair proposal rational proposal
Rational responder always rejects
Fairness-oriented responder accepts
Rational responder
always accepts
Fairness-oriented responder rejects
Rational responder accepts
Fairness-oriented responder accepts
Rational responder
rejects Fairness-oriented responder rejects
16% rejections 37% rejections 27% rejections
Fairness-oriented responder rejects
Fairness-oriented responder accepts
Consensus and Overconfidence Undermine the Wisdom of Crowds
„The Mean Behavior Is Representative“
„Agents Can be Treated as if Acting Identically“
Something has changed…
People are linked and influence each other…
How Second-Order Free-Riders Are Eliminated+Punishment Spreads
D = Defectors (Free-Riders), M = Moralists, I=Immoralists C = Non-punishing Cooperators (Second-Order Free-Riders)
Overcoming the Tragedy of the Commons by Spatial Interactions
„Competition Eliminates Non-Selfish Behavior“
The Evolution of Moral Behavior
Evolution of Other-Regarding Preferences by Biological Selection
R. Murphy et al.:"There is a broad spectrum of non-selfish behavior
Joint work with Thomas Grund
„More Networking is Good and Reduces Risks“
Different recipes, new solutions, and a paradigm shift in our understanding of the world are needed.
Too Much Networking Can Cause Self-Destabilization: Breakdown of Cooperation
How the Banking Network Changed
From: Haldane
Bankruptcy Cascades of Banks
400 600 800 1000 1200 1400 1600 1800 2000time
1010
1012
1014
1016
1018
log
of th
e ag
greg
ate
outp
ut
Cascade size
Nu
mb
er
of
occu
ran
ce
s
x=1 x=5
x=10 x=49
0 1 2 5 10 49 50interbank linkages
0
10
20
30
40
50
aver
age
num
ber o
f sur
vivi
ng b
anks
Cascade size increases with interbank linkages
Joint work with G. Tedeschi, A. Mazloumian, and M. Gallegati
Cascading Effects During Financial Crises
Video by Frank Schweitzer, Stefano Battiston, et al.
„Regulation Can Fix the Imperfections of Economy“
Limits of Predictability
§ Large number of non-linearly interacting system components leads to complex dynamics
§ Example: Weather forecast
§ Chaotic dynamics/butterfly effect/
sensitivity: Small initial differences can cause very different behavior
Source: J. D. Murray
§ Big changes may have small, no, adverse or unexpected effects
§ Irreducible randomness: A degree of uncertainty and perturbation that cannot be eliminated
§ Principle of Le Chatelier/Goodhart’s law: A system tends to counteract external control attempts
§ Delays may cause instabilities
§ Regime shifts („phase transitions“,
catastrophes): Sometimes small
changes have a big impact
§ Unknown unknowns, structural instability
„Cusp catastrophe“
The Illusion of Control
34
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The Lotka-Volterra equations are used to describe, for example, interactions in ecological systems "
x1: number of species 1"x2: number of species 2"x0
1,2: attraction point"k1,2, c1,2, λ1,2: parameters
The Challenge to Manage Complex Systems
Centralized Control and Its Limits
• Advantage of centralized control is large-scale coordination
• Disadvantages are due to
– vulnerability of the network
– information overload
– wrong selection of control parameters
– delays in adaptive feedback control
• Decentralized control can perform better in complex systems with heterogeneous elements, large degree of fluctuations, and short-term predictability, because of greater flexibility to local conditions and greater robustness to perturbations
Logi
stic
targ
et
ach
ieve
men
t
Level of autonomy of control
(Windt, Böse, Philipp, 2006)
Managing Complexity: Modifying Interactions Allows to Promote Favorable Self-Organization
Some Grand Challenges (‚Hilbert Problems‘)
DH (2012) Accelerating scientific discovery by formulating grand scientific challenges
1. Socio-Economic and Real-World Challenges 2. Measurement and Methodological Issues 3. Understanding Underlying Principles 4. Modeling of Complex Adaptive Agents 5. Interactions, Networks, and Systemic
Interdependencies 6. Dynamics and Change 7. Self-Organization, Collective Behavior, Co-
Evolution and Emergence 8. Risks, Systemic Instability, and Resilience 9. Markets, Transaction and Exchange Systems 10. Institutions and Integrative Systems Design 11. Management of Complexity and Sustainability 12. Information, Innovation, and Knowledge 13. Social and Economic Capital 14. Values, Responsibility, and Ethics
„The Price is the Quantity that Matches Supply and Demand“
Price of hotel rooms as a function of room availability
Joint work with Aki-Hiro Sato
Note that there is no equilibrium price, when herding sets in
Atypical price formation
Price increases with demand, decreases with availability
Coordination Game with Network Interactions and Transaction Costs"
Cla
ssic
al c
oord
inat
ion
gam
e
Coordination failures are likely, but preserve diversity. However, diversity is more vulnerable than the representative agent approach suggests.
Emergence of Social Norms: Theoretical Results
Population 1 sets the norm
Population 2 sets the norm
Everyone tends to do what he/she likes (anomie)
Str
engt
h of
pop
ulat
ion
1
Reward of showing preferred behavior / Reward of conforming
Computer simulations: Red = individuals preferring behavior 1 Yellow = individuals adjusting to behavior 1 Blue = individuals preferring behavior 2 Green = individuals adjusting to behavior 2
Local cultures
Superexponential Bubbles or Crashes Instead of Stable Growth
Black Monday in 1987 was a 35 sigma event!)
Credits to Didier Sornette
Further Reading
Thanks to all supporters!