From Physics to Economics: An Econometric Example Using Maximum Relative Entropy

Details From Physics to Economics: An Econometric Example Using Maximum Relative Entropy From Physics to Economics: An Econometric Example Using Maximum Relative Entropy

2009-01-04

arxiv.org/abs/0901.0401v1

Physica A 388 (2009), pp. 1610-1620

Economy

Quantitative Finance

Statistical Finance

This paper has been accepted in Physica A. 19 Pages, 3 Figures

Scientific paper

10.1016/j.physa.2008.12.066

Econophysics, is based on the premise that some ideas and methods from physics can be applied to economic situations. We intend to show in this paper how a physics concept such as entropy can be applied to an economic problem. In so doing, we demonstrate how information in the form of observable data and moment constraints are introduced into the method of Maximum relative Entropy (MrE). A general example of updating with data and moments is shown. Two specific econometric examples are solved in detail which can then be used as templates for real world problems. A numerical example is compared to a large deviation solution which illustrates some of the advantages of the MrE method.

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