Bizsim The World of Business - in A Box: Santa Fe Institute, 1399 Hyde Park Road, Santa Fe, NM 87501, New Mexico, Usa

Volume 08
http://www.csu.edu.au/ci/
BizSim
The World of Business – in a Box
John L. Casti
Santa Fe Institute, 1399 Hyde Park Road,

Santa Fe, NM 87501, New Mexico, USA
Email: [email protected]
1. The Computer as a Laboratory

The central process distinguishing science from its competitors – religion, music, literature,
mysticism – in the reality-generation business is the so-called scientific method. An integral
part of this method by which we arrive at scientific “truth,” is the ability to do controlled,
repeatable laboratory experiments by which hypotheses about the phenomenon under
investigation can be tested. It is just such experiments that on a good day lead to the theories
and paradigms constituting today’s “scientific” world view. And, more than anything else, it is
the inability to perform experiments of this type that separate the natural sciences from the
worlds of social and behavioural phenomena. In the latter, we have no way of doing the
experiments necessary to create a bona fide scientific theory of processes like stock market
dynamics, road-traffic flow, and organizational restructuring.
In an earlier, less discerning era, it was often claimed that the realm of human social
behavior was beyond the bounds of scientific analysis, simply because human beings are
“complex”, “unpredictable”, “display free will”, “act randomly”, and so on and so forth. It’s
hard to believe that any modern system theorist would do anything but laugh at such childish
and naïve attitudes to the creation of workable and worthwhile scientific theories of social and
behavioural phenomena. The major barrier to bringing the social beneath the umbrella of
science is not the non-explanations just given in quotes, but the fact that until now we have
had no way to test hypotheses and, therefore, make use of the scientific method in the creation
of theories of social behavior. Now we do. And that laboratory in which we do our
experiments is the digital computer. Let me illustrate with an example from the world of
finance.
Received: 15 Jul 2000 © Copyright 2001

Accepted: 01 Nov 2000 –1– http://www.csu.edu.au/ci/vol08/casti01/
Complexity International Volume 08
2. Booms and Busts, Bubbles and Crashes

In the fall of 1987, W. Brian Arthur, an economist from Stanford, and John Holland, a
computer scientist from the University of Michigan, were sharing a house in Santa Fe while
both were visiting the Santa Fe Institute. During endless hours of evening conversations over
numerous beers, Arthur and Holland hit upon the idea of creating an artificial stock market
inside a computer, one that could be used to answer a number of questions that people in
finance had wondered and worried about for decades. Among those questions were
• Does the average price of a stock settle down to its so-called fundamental value – the value
determined by the discounted stream of dividends that one can expect to receive by holding
the stock indefinitely?
• Is it possible to concoct technical trading schemes that systematically turn a profit greater
than a simple buy-and-hold strategy?
• Does the market eventually settle into a fixed pattern of buying and selling? In other words,
does it “stationarity”?
• Alternately, does a rich “ecology” of trading rules and price movements emerge in the
market?
Arthur and Holland knew that the conventional wisdom of finance argued that today’s
price of stock is simply the discounted expectation of tomorrow’s price plus the dividend,
given the information available about the stock today. This theoretical price-setting procedure
is based on the assumption that there is an objective way to use today’s information to form
this expectation. But the information available typically consists of past prices, trading
volumes, economic indications, and the like. So there may be many perfectly defensible ways
based on many different assumptions to statistically process this information in order to
forecast tomorrow’s price. For example, we could say that tomorrow’s price will equal today’s
price. Or we might predict that the new price will be today’s price divided by the dividend
rate. And so on and so forth.
The simple observation that there is no single, best way to process information led Arthur
and Holland to the not-very-surprising conclusion that deductive methods for forecasting
prices are, at best, an academic fiction. As soon as you admit the possibility that not all traders
in the market arrive at their forecasts in the same way, the deductive approach of classical
finance theory, which relies upon following a fixed set of rules to determine tomorrow’s price,
begins to break down. So a trader must make assumptions about how other investors form
expectations and how they behave. He or she must try to psyche out the market. But this leads
to a world of subjective beliefs and to beliefs about those beliefs. In short, it leads to a world
of induction in which we generalize rules from specific observations rather than one of
deduction.
In order to address these kinds of questions, Arthur, Holland and their colleagues
constructed an electronic stock market, in which they could manipulate trader’s strategies,
market parameters, and all the other things that cannot be done with real exchanges. The
traders in this market are assumed to each summarize recent market activity by a collection of
descriptors, which involve verbal characterization like “the price has gone up every day for
the past week,” or “the price is higher than the fundamental value,” or “the trading volume is
high.” Let us label these descriptors A, B, C, and so on. In terms of the descriptors, the traders
decide whether to buy or sell by rules of the form: “If the market fulfills conditions A, B and
C, then buy, but if conditions D, G, S, and K are fulfilled, then hold.” Each trader has a
casti01 –2– © Copyright 2001

collection of such rules, and acts in accordance with only one rule at any given time period.
This rule is the one that the trader views as his or her currently most accurate rule.
As buying and selling goes on in the market, the traders can reevaluate their different rules
by assigning a higher probability of triggering a given rule that has proved profitable in the
past, and/or by recombining successful rules to form new ones that can then be tested in the
market. This latter process is carried out by use of what is called a genetic algorithm, which
mimics the way nature combines the genetic pattern of males and females of a species to form
a new genome that is a combination of those from the two parents.
A run of such a simulation involves initially assigning sets of predictors to the traders at
random, and then beginning the simulation with a particular history of stock prices, interest
rates, and dividends. The traders then randomly choose one of the rules and use it to start the
buying-and-selling process. As a result of what happens on the first round of trading, the
traders modify their estimate of the goodness of their collection of rules, generate new rules
(possibly), and then choose the best rule for the next round of trading. And so the process
goes, period after period, buying, selling, placing money in bonds, modifying and generating
rules, estimating how good the rules are, and, in general, acting in the same way that traders
act in real financial markets.
A typical frozen moment in this artificial market is displayed in Figure 1. Moving
clockwise from the upper left, the first window shows the time history of the stock price and
dividend, where the current price of the stock is the black line and the top of the grey region is
the current fundamental value. The region where the black line is much greater than the height
of the grey region represents a price bubble, whereas the market has crashed in the region
where the black line sinks far below the grey. The upper right window is the current relative
wealth of the various traders, and the lower right window displays their current level of stock
holdings. The lower left window shows the trading volume, where grey is the number of
shares offered for sale and black is the number of shares that traders have offered to buy. The
total number of trades possible is then the smaller of these two quantities, because for every
share purchased these must be one share available for sale.
After many time periods of trading and modification of the traders’ decision rules, what
emerges is a kind of ecology of predictors, with different traders employing different rules to
make their decisions. Furthermore, it is observed that the stock price always settles down to a
random fluctuation about its fundamental value. However, within these fluctuations a very
rich behavior is seen: price bubbles and crashes, market moods, over-reactions to price
movements, and all the other things associated with speculative markets in the real world.
The agents in the stock market simulation are individual traders. A quite different type of
business simulation emerges when we want to look at an entire industry, in which case the
agents become the individual firms constituting that industry. The world’s catastrophe
insurance industry served as the focus for just such a simulation exercise called Insurance
World, carried out by the author and colleagues at the Santa Fe Institute and Intelligize, Inc.
over the past couple of years.

3. Insurance World
As a crude, first-cut, the insurance industry can be regarded as an interplay among three
components: firms, which offer insurance, clients, who buy it, and events, which determine the
outcomes of the “bets” that have been placed between the insurers and their clients. In
Insurance World, the agents consist of primary casualty insurers and the reinsurers, the firms
that insure the insurers, as well as various external factors like government regulators and the
global capital markets.
Figure 1. A frozen moment in the surrogate stock market.
Insurance World is a laboratory for studying questions of the following sort:

• Optimal uncertainty: While insurers and reinsurers talk about getting a better handle on
uncertainty so as to more accurately assess their risk and more profitably price their product,
it’s self-evident that perfect foreknowledge of natural hazards would spell the end of the
insurance industry. On the other hand, complete ignorance of hazards is also pretty bad news,
since it means there is no way to weight the bets the firms make and price their product. This
simple observation suggests that there is some optimal level of uncertainty at which the
insurance firms – but perhaps not their clients – can operate in the most profitable and
efficient fashion. What is that level? Does is vary across firms? Does
• Industry Structure: In terms of the standard metaphors used to characterize organizations –
a machine, a brain, an organism, a culture, a political system, a psychic prison – which type(s)
most accurately represents the insurance industry? And how is this picture of the organization
shaped by the specific “routines” used by the decisionmakers in the various components
making up the organization?
The simulator calls for the management of each firm to set a variety of parameters having
to do with their desired market share in certain regions for different types of hazards and level
of risk they want to take on, as well as to provide a picture of the external economic climate
(interest rates, likelihood of hurricanes/earthquakes, inflation rates and so forth). The
simulation then runs for 10 years in steps of one quarter, at which time a variety of outputs can

be examined. For instance, Figure 2 shows that market share for Gulf Coast hurricane
insurance of the five primary insurers in the toy world, under the assumption that the initial
market shares were almost identical – but not quite. In this experiment, firm 2 has a little
larger initial market share than any of the other firms, a differential advantage that it then uses
to squeeze out all the other firms at the end of the ten-year period. This is due to the “brand
effect,” in which buyers tend to purchase insurance from companies that they know about.
As a final example of what simulation and business have to say to each other, consider the
movement of shoppers in a typical supermarket. This world is dubbed SimStore by Ugur Bilge
of SimWorld, Ltd. and Mark Venables at J. Sainsbury in London, who collaborated with the
author on its creation.
Figure 2. Market share distribution for five primary insurers.
4. SimStore
The starting point for SimStore is a real supermarket in the Sainsbury chain, one located in the
London region of South Ruislip. The agents are individual shoppers who frequent this store.
These electronic shoppers are dropped into the store, and then make their way to the various
locations in the store by rules such as “wherever you are now, go to the location of the nearest
item on your shopping list,” so as to gather all the items they want to purchase.
As an example of the types of outputs generated by SimStore, customer checkout data are
used to calculate customer densities at each location. Color codes are with descending order:
blue, red, purple, orange, pink, green, cyan, grey and nothing. Using the Manhattan metric
pattern of movement, in which a customer can only move along the aisles of the store, all
locations above 30 percent of customer densities have been linked to form a most popular
customer path. Once this path is formed a genetic algorithm will minimize (or maximize!) the
length of the overall shopping path.
In the same store, this time each individual customer path has been internally calculated
using the simple “nearest neighbor” rule noted above. All customer paths have been summed
for each aisle, in order to calculate the customer path densities. These densities are displayed
in Figure 3 as a relative density map using the same color code just mentioned.

Figure 3. Customer densities along each aisle in the simulated store.
5. Simulation is Good for Business

Large-scale, agent-based simulations of the type discussed here are in their infancy. But even
the preliminary exercises outlined here show the promise of using modern computing
technology to provide the basis for doing experiments that have never been possible before.
Even better, these experiments are exactly the sort called for by the scientific method –
controlled and repeatable – so that for the first time in history we have the opportunity to
actually create a science of human affairs. If I were placing bets on the matter, I’d guess that
the world of business and commerce will lead the charge into this new science that will form
during the 21st century.
References
Casti, J. (1997), Would-Be Worlds. New York: Wiley.

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Volume 08

Santa Fe Institute, 1399 Hyde Park Road,

1. The Computer as a Laboratory

Received: 15 Jul 2000 © Copyright 2001

2. Booms and Busts, Bubbles and Crashes

casti01 –2– © Copyright 2001

casti01 –3– © Copyright 2001

Figure 1. A frozen moment in the surrogate stock market.

Insurance World is a laboratory for studying questions of the following sort:

casti01 –4– © Copyright 2001

Figure 2. Market share distribution for five primary insurers.

casti01 –5– © Copyright 2001

Figure 3. Customer densities along each aisle in the simulated store.

5. Simulation is Good for Business

casti01 –6– © Copyright 2001

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