Wednesday, January 2, 2013

The Economic Theory of Chaos: Controlling the Uncontrollable

Chaos is a natural part of our lives and is prevalent in anything from weather patterns to economics. In order to understand the unpredictable nature of life and fluctuations in normal development through time Chaos Theory came into being. "Discoveries in quantum physics, biology, and chaos theory enable us to deal successfully with change and uncertainty in our organizations and our lives....the new science radically alters our understanding of the world, and it can teach us to live and work well together in these chaotic times" (Wheatley, 2009). Originally used in weather patterns and physics the theory has been applied to understanding and minimizing economic crisis.

Before understanding the theory it is important to first have a grasp of the field of economics. "Economics, if it is to be a science at all, must be a mathematical science … mechanics of utility and self-interest"(Jevons, 1924). The very purpose of economic models is to predict, explain and potentially forecast economic conditions. As a science it is subject to the same scrutiny of validity, relevance, and significance as other fields of study. Economics is used to explain everything from individual transactions to the cost of your student loans.

In most economic theories the individual agent is the central component. The economy can be seen as an analysis of how these agents influence each other through evaluations of worth.  When the agents continually evaluate each other they create what is called "the market". Analysis often focuses on the similarities and patterns of society as they relate to the price of commodities and goods. The French mathematician Henri PoincarĂ© believed that people do not act alone but constantly watch each other to make decisions (Colander, 2011).

Economics is also often seen in terms of equilibrium in efficiency of functioning. “A characteristic feature that distinguishes economics from other scientific fields is that, for us, the equations of equilibrium constitute the center of our discipline. Other sciences, such as physics or even ecology, put comparatively more emphasis on the determination of dynamic laws of change” (Mas-Colell, Whinston & Green, 1995). Equilibrium can be seen as homeostasis where prices, supply, demand, activity, unemployment and other factors are accurate and on autopilot. This is where the market can self-regulate and the forces are in balance. Yet such equilibrium doesn't necessarily indicate stability of a system so Chaos Theory can help further explanations of systematic behavior.

When the system is out of balance a concept called Chaos Theory may be more accurate in predicting and controlling the outcome. According to Faggini and Parziale (2011) Chaos Theory represents, "a shift in thinking about methods to study economic activity and in the explanation of economic phenomena such as fluctuations, instability, crisis, and depressions."  The theory attempts to explain and understand market fluctuations ranging from hiccups to depressions in order to lessen their impact.

Through Chaos Theory it has been postulated by Ott, Grebogi and Yorke that small adjustments in the market can change the course of a natural economic system without having to change the fundamental principles (1990). In essence, as fluctuations occur it takes much less effort to adjust the system than attempting to control the whole system throughout its movement. Think of how thrusters on a spaceship can adjust the path of the flight with minimal energy by doing so when the ship first moves off course. Thus controlling chaotic fluctuations within the economic system relies in part on a number of principles (Faggini & Parziale, 2011):

1.) The fluctuations in chaos can be exploited for greater growth that would not be possible in less chaotic systems.

2.) Control based upon the sensitivities of initial conditions can create higher levels of efficiency.

3.) The amount of government adjustment in policy would be lessor than under traditional models that require an abundance of resources.

Chaos Theory includes the concept that pure control of an economic system is difficult, unrealistic, or impossible. Thus trying to obtain a perfectly controlled outcome would be costly and expensive in the long run. Under this theory it is wiser for a government to make small and incremental changes during times of fluctuation and chaos that help use attraction to obtain desired outcomes versus more common highly engaged adjustments.

One of the most difficult aspects of predicting and adjusting the economy is that such systems are large and complex. They are not rational human beings even if rational human beings are behind its face plate. Furthermore, in order to determine when a system is going into chaos it is necessary to have a reasonable benchmark of its homeostatic course of development. This can be difficult due to inadequate tools used to measure current economic systems full of fluctuating noise.

Colander, D. (2011). The economics profession, the financial crisis, and method. Journal of Economic Methodology, 17 (4).

Faggini, M. & Parziale, A. (2012). The failure of economic theory. Lessons from chaos theory. Modern Economy, 3

Jevons, W. (1924). The theory of political economy. London Journal, 57 (2).

Mas-Colell, M., Whinston, M. & Green. Microeconomic Theory. Oxford University Press; Oxford

Ott, E., Grebogi, C. & Yorke, J. (1990). "Controlling Chaos," physical review letters, 64 (11).

Wheatley, M. (2009). Leadership and the new science: discovering order in a chaotic world (Third Edition). San Francisco: Berrett-Koehler Publishers.

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