The Virtues and Vices of Equilibrium and the Future of Financial Economics

69 Pages Posted: 24 Mar 2008

See all articles by J. Doyne Farmer

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; Santa Fe Institute

John Geanakoplos

Yale University - Cowles Foundation

Date Written: March 2008

Abstract

The use of equilibrium models in economics springs from the desire for parsimonious models of economic phenomena that take human reasoning into account. This approach has been the cornerstone of modern economic theory. We explain why this is so, extolling the virtues of equilibrium theory; then we present a critique and describe why this approach is inherently limited, and why economics needs to move in new directions if it is to continue to make progress. We stress that this shouldn't be a question of dogma, but should be resolved empirically. There are situations where equilibrium models provide useful predictions and there are situations where they can never provide useful predictions. There are also many situations where the jury is still out, i.e., where so far they fail to provide a good description of the world, but where proper extensions might change this. Our goal is to convince the skeptics that equilibrium models can be useful, but also to make traditional economists more aware of the limitations of equilibrium models. We sketch some alternative approaches and discuss why they should play an important role in future research in economics.

Keywords: Equilibrium, Rational expectations, Efficiency, Arbitrage, Bounded rationality, Power laws, Disequilibrium, Zero intelligence, Market ecology, Agent based modeling

JEL Classification: A10, A12, B0, B40, B50, C69, C9, D5, D1, G1, G10

Suggested Citation

Farmer, J. Doyne and Geanakoplos, John D, The Virtues and Vices of Equilibrium and the Future of Financial Economics (March 2008). Cowles Foundation Discussion Paper No. 1647. Available at SSRN: https://ssrn.com/abstract=1112664

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

HOME PAGE: http://www.inet.ox.ac.uk/people/view/4

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States
505-984-8800 (Phone)
505-982-0565 (Fax)

HOME PAGE: http://www.santafe.edu/~jdf/

John D Geanakoplos (Contact Author)

Yale University - Cowles Foundation ( email )

Box 208281
New Haven, CT 06520-8281
United States
203-432-3397 (Phone)
203-432-6167 (Fax)

HOME PAGE: http://cowles.econ.yale.edu/P/au/d_gean.htm

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