Econophysics

Everyone knows physicists are the smartest of them all. Thus, prefixing your field’s name onto the word “physics” provides automatic doubleplusgoodness. At least it means you can publish economics in physics journals. Example:

Rising cost of oil ‘due to speculation’ – [E]conophysicists Didier Sornette of ETH Zurich, Switzerland, and Wei-Xing Zhou of the East China University of Science and Technology, together with Ryan Woodard of ETH Zurich, claim that speculation must have driven some of the escalation in oil prices. They have found evidence for a “bubble” — an indicator of speculation — in prices since 2003, when the cost of an oil barrel was four times lower than it is today.

Bubbles are a controversial topic in academic finance because there is no clear way to define them. However, Sornette’s group says it can pin them down by examining the precise rate of growth in prices.

In an economy without speculation, the price of commodities tends to grow by a fixed percentage every year; this is an exponential rate of growth. But when an economy is influenced by speculation, the percentage increase can grow too. This gives rise to a power-law growth or, as the researchers call it, a “super-exponential growth”.

Sornette’s group has looked at three different models to see if oil prices exhibit super-exponential growth…The researchers found that all three models fitted the oil-price data well, implying that the growth has indeed been a bubble (Physica A submitted; preprint at arXiv:0806.1170v2).

Could it be that there is no financial speculation, but that the demand for oil from China and India is growing super-exponentially, like a bubble? Sornette’s group cites figures on world oil supply and demand from the International Energy Agency that suggest this cannot be the case. Sornette told physicsworld.com that he is “99% certain” speculation is influencing current oil prices.

Sornette group first came up with his theory of super-exponential growth as a symptom of economic bubbles in 1996. In 2005, they used it to predict the burst of the US housing bubble.

Basically, prices have been going up really fast and the authors have noticed this pattern in prices is associated with speculative bubbles when supply and demand aren’t changing much. To say oil prices have gone up due to speculation, they have to rule out large shifts in supply and demand.

The authors make the decent assumption that supply — by which, I think they mean oil coming out of the ground — doesn’t change that fast. Their job, they say, is to show demand didn’t change that much. Given small changes in demand and small changes in supply, the price increases must be due to speculation. They use demand and supply data from some non-publicly available source to assess the speed of demand shifts. Its not clear what these data are, but, charitably, they must be quantity data where the difference in supply in demand is the change in inventories. So they’re using quantity data to assess demand shifts. They don’t find big changes in quantity, so they assume small shifts in demand.

In other words, they ignore elasticities. Apparently, its ok to ignore behavioral responses in econophysics. I guess this is understandable given physicists don’t have to worry much about they budget constrained, preference maximizing behavior of quarks.

The problem is if supply (or demand) for oil is inelastic, even small changes in demand (or supply) will induce large changes in price and the authors method for determining the existence of speculation goes out the window. I’m guessing both demand and supply for oil are inelastic so it could be both demand shifts caused by China and supply shifts caused by speculators inducing the large price increases. Given the huge rise in demand and the fact that inventories are finite (thus limiting the effect of speculators), it seems more likely the price changes are due to the former rather than the latter.

UPDATE: Rapture is near… I’m really liking the bloggy version of Paul Krugman.

4 thoughts on “Econophysics”

  1. Are you saying that there’s some “tipping point” where demand starts to catch up with supply, causing prices to spike well before actual shortages?

  2. I’m saying its possible to see small changes in quantity supplied (the amount of stuff you see bought and sold on the market) after large shifts in demand. The thing that changes a lot if quantity doesn’t change, is price. This would happen, for example, when its technically hard to increase supply of the commodity even wen there’s large price increases.

    The technology involved in supplying the good is important. If demand for pizzas doubles, its pretty easy for Round Table to increase the number of pizza cooks it has working for it and to keep its ovens on longer (or get more ovens). In this case, supply is really responsive to a demand shift and quantity is what changes most. BTW, if Round Table doesn’t react to the increase in demand, prices will increase at first, but because its easy for someone else to start making more pizzas price will soon go down (and quantities up).

    In the oil example, its harder for suppliers to react to demand shifts. There’s only so much oil in the fields they’re extracting from. They have to explore for new deposits, they might have to invent new technology to extract lower quality raw oil, etc. Because supply can’t react well to demand, prices are what adjust. The higher prices make it so only those that really value oil will buy it. Given, the huge start-up costs of oil extraction its hard for potential competitors to react to the increase in demand as well. They might worry, for example, the oil price is just a spike and that they sunk all this start-up cost into an ultimately unprofitable oil field.

    In any case, if its possible to observe small changes in quantities supplied even with substantial changes increases in demand, then the “econophysicists” method goes out the window. With high supply elasticities (like we’d expect with oil), super-exponential price increases can result from normal demand shifts, i.e. there’s no reason to suspect we’re seeing a speculative bubble.

  3. The issue is very simple: The authors think that a certain speed of price change is incompatible with supply and demand for real goods. That´s okay if you have a theory for that- but physicists are not really used to bringing that much empathy to their objects of research, so they cannot provide the theory. It´s measurement without theory.

  4. True. Except, like hundreds of labor economics studies I’ve seen, there’s an implicit theory with implicit assumptions (that might turn out to imply other things that aren’t true). This would have been measurement without theory if they reported whatever line they fitted to the data and didn’t conclude “with 99% certainty” the cause of the price changes. Causes aren’t observed; they require theories.

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