by Rational expectations — sheer nonsense Expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory. At the risk of confusing this purely descriptive hypothesis with a pronouncement as to what firms ought to do, we call such expectations “rational.” It is sometimes argued that the assumption of rationality in economics leads to theories inconsistent with, or inadequate to explain, observed phenomena, especially changes over time … Our hypothesis is based on exactly the opposite point of view: that dynamic economic models do not assume enough rationality. John Muth Rational expectations is today standard procedure in mainstream economic models. It basically says that people on the average hold expectations that will be fulfilled.
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Rational expectations — sheer nonsense
Expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory. At the risk of confusing this purely descriptive hypothesis with a pronouncement as to what firms ought to do, we call such expectations “rational.” It is sometimes argued that the assumption of rationality in economics leads to theories inconsistent with, or inadequate to explain, observed phenomena, especially changes over time … Our hypothesis is based on exactly the opposite point of view: that dynamic economic models do not assume enough rationality.
Rational expectations is today standard procedure in mainstream economic models. It basically says that people on the average hold expectations that will be fulfilled. This certainly simplifies the economist’s analysis enormously — but is it really proper to assume that people have these kind of expectations? Maybe the following quote may give a hint …
Jumping to conclusions on the basis of limited evidence is so important to an understanding of intuitive thinking … that I will use a cumbersome abbreviation for it: WYSIATI, which stands for what you see is all there is …
I have had several occasions to ask founders and participants in innovative start-ups a question: To what extent will the outcome of your effort depend on what you do in your firm? This is evidently an easy question; the answer comes quickly and in my small sample it has never been less than 80% … They are surely wrong: the outcome of a start-up depends as much on the achievements of its competitors and on changes in the markets as on its own efforts …
The familiar processes of WYSIATI and substitution produce both competition neglect and the above-average effect. The consequence of competition neglect is excess entry: more competitors enter the market than the market can profitably sustain, so their average outcome is a loss.