Rational expectations — sheer nonsense

8 Mar, 2017 at 19:41 | Posted in Economics | 2 Comments

56238100Expectations, 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. 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 …

cn_image.size.kahneman 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.

Daniel Kahneman

2 Comments

  1. To falsify an all-time true economic hypothesis such as ∀ t REH(t), etc, we only need to find one time period t such that ∃ 𝑡 ~ REH(t).
    .
    Economic theory is a collection of temporal logic assertions about the actual economy with time-series data. Economic data and accounting identities are valid-time temporal logic assertions with time quantifier ∀ about the actual economy.
    .
    Scientific methodology is based on a form of non-monotonic logic to gain new knowledge.

    Hypothesize X unless ~ X and nonexistence of X cannot be proved
    .
    This defeasible assumption X must be retracted or modified once X is inconsistent with indefeasible facts or “unless” condition: ~ X or nonexistence of X can be proved from new evidence.
    .

    Current economic hypotheses, behavioral assumptions, or equilibrium equations, regression equations are just defeasible assumptions from a scientific methodology viewpoint. Often, “unless” condition can be proved. Thus, in fact, most theoretical economic models are inconsistent systems by using these types of math equations and they are useless for temporal assertions about actual economy.

    Comment by Peiya Liu— 9 Mar, 2017 #

    • My mistake: a typo in quote.

      Hypothesize X unless ~ X “or” nonexistence of X “can” be proved.

      Note, abduction is also a form of non-monotonic logic. It is critical to add the unless condition for defeasible inferences.

      P -> Q
      Q
      ———-
      Assume P unless ~ P can be proved.

      Comment by Peiya Liu— 9 Mar, 2017 #


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