Rational expectations

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Rational expectations

The idea that people rationally anticipate the future and respond today to what they see ahead. This concept was pioneered by Nobel Laureate, Robert E. Lucas, Jr.
Copyright © 2012, Campbell R. Harvey. All Rights Reserved.

Rational Expectations Theory

In economics, a theory stating that economic actors make decisions based on their expectations for the future, which are based on their observations and past experiences. A basic example of rational expectations theory is a situation in which a consumer delays buying a certain good because, based on his/her observations and experiences, he/she believes that the price will be less expensive in a month. If enough consumers believe that, demand eases and the good is likely to actually be less expensive next month. Thus, the consumer waits a month before buying the good. Rational expectations theory states that current expectations strongly influence future performance. Economists disagree about how well the rational expectations theory works in the real world.
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References in periodicals archive ?
In their book The Misinformation Age: How False Beliefs Spread, a pair of professors of logic and philosophy of science from University of California Irvine, Cailin O'Connor and James Owen Weatherall, use computer models to explain how judgments about things, such as the causes or best cures for certain illnesses, spread through scientific networks--and how that spread can cause false beliefs to dominate a community even if each of the participants is individually rational.
That's individually rational, but collectively suboptimal.
(3) Quantity inefficiency occurs because the median price is set below some winning bidders' costs and thus the median-price auction is not ex post Individually Rational, leading some demand to go unfulfilled.
His case studies are social dilemmas, that is, social situations in which individually rational behavior can lead to sub-optimal results at the collective level.
In common with many aspects underlying the financial crisis, individually rational actions of agents such as hedging by exporters and asset managers (importers typically do not hedge) can contribute to systemic instability in the counterpart banking sector that sell the hedges.
So, what is individually rational is collectively irrational.
In his book Capitalism and Freedom (1962), he wrote: "There is one and only one social responsibility of business--to use its resources and engage in activities designed to increase its profits...." This attitude could lead executives to conclude they need to be loyal only to their shareholders, regardless of whether their individually rational desires (a quick return on investments) lead collectively to a "damn the torpedoes, full-speed ahead" pursuit of profit at any and all cost.
Individually rational choices were giving rise to collectively irrational results.
The individually rational outcome of (confess, confess) is Pareto-dominated by (not confess, not confess).
In addition to that tendency of investors to take the behavioral aspects of other market players, an important role in determining the individually rational behavior is the market constraints.
For some, such as Greenspan, it is individual decision making that was "irrational." For others, such as Joseph Heath in his September essay for this publication, it is individually rational, self-interested decisions that resulted in collectively poor outcomes.
This paper also involves behavioral industrial organization--it notes that one way to make the add-on pricing individually rational rather than just collectively rational for the firms is to add a small population of irrational consumers who buy add-ons only when the high add-on prices are not advertised.

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