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

TL;DR

This paper demonstrates how the maximum relative entropy method, originating from physics, can be applied to economic problems by incorporating data and constraints, with detailed examples illustrating its advantages over traditional approaches.

Contribution

It introduces the application of maximum relative entropy to econometrics, providing detailed examples and comparisons to traditional methods, showcasing its practical utility.

Findings

Maximum relative entropy effectively incorporates data and constraints in economic modeling.

The method offers advantages over large deviation solutions in certain econometric problems.

Detailed templates for real-world applications are provided.

Abstract

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.