You know that moment you stare at a guy or a girl…. the person is cute and start to day dream about the future with him? How you go on dates, how you get married and have babies and stuff?? This has happened to me once or twice maybe but when the guy opens his mouth or starts texting the guy seems to be a real douche or pretty darn stupid. Yeah, the bubble bursts suddenly. Also I have been having these dreams where I wake up early, jog a bit and socialize with friends and maybe have fun and at the end of the day you realize what you have really accomplished is socializing with books and making a bit of sweat at the library because you don’t understand what the book says?? This is the point where you get disappointed.
As humans, the fact that we are natural problem solvers, try to avoid future problems and sometimes solve anticipated ones by planning ahead. You see, we inadvertently create models for things and people. At least some of us…For example, planning your day, estimating how long it takes for you to get to your workplace/ institute or perhaps university, allocating extra hours for possible traffic to get to the destination. This interpretation can be applied to the classical economics where the models have been created assuming that markets are perfect. The economists and we forecast that nothing could go wrong counting possible exogenous factors in the example like traffic. When we deviate from our perfect model, for instance if there are unanticipated incidents like accidents and strikes which could affect your model time for the destination, you get pissed off and your plans go bonkers. In real life great depression, financial crisis in 2007/2008 happens.
After the great depression, theoretical background of classical economics was questioned. The expectations were introduced to economic theories which is the basis of us day dreaming and disappointment.
Economic theory has been introduced with three main types of expectations. Adaptive expectations, bounded rationality and rational expectations. Let’s take an example and further clarify these concepts.
Suppose you have a paper coming up. What my friends do is they go through the past papers and forecast. I should tell you; they are getting pretty good at it. This is what they consider.
- The lessons that have repeatedly mentioned in the questions are given a higher weight, say 3/5. This could be the “core” of a certain model. So they thoroughly go through the unit.
- Lessons that have “not” been given on the paper and based on intuition they predict these lessons might come. So these lessons are given a weight of let’s say 2/5.
So this is the main basis of their forecast or rather their expectations are based on past information and analyzing according to a certain trend. This method is very effective. Suppose my friend’s department is International Bluffing (IB) department; this is very effective assuming their syllabuses have not changed. They analyze the past questions and come to a conclusion that there’s a higher probability that these questions could come. This is adaptive expectations; analyzing past data to forecast what could be expected today or tomorrow. We come into conclusions according to adaptive expectations in our day to day lives. Suppose you need to throw a surprise birthday party and assume your friend’s schedule on the day is same as it used to and plan it. What could go wrong right?
Well, this is where disappointment happens. What if, your department has revised the syllabus and has actually included new topics. You wouldn’t be able to forecast the questions because the very core of the course unit has been changed; unless you are very lucky. So a sensible student would actually go through the syllabus, identify the main units as well as past paper questions to prepare the exam. This is rational expectations. You consider all the available data where marginal benefit equals marginal costs and come to a conclusion. Bounded rationality is when there are certain boundaries such as restrictions of time or information to make a decision. Suppose there are no past papers for the module you are taking, you are to choose 4 questions out of 5 to answer during a limited amount of time or you are restricted by time to go through the past papers; bounded rationality is the type of expectation which is used in this context.
Why do we form expectations in the first place and what is the best type or rather the most practical type of expectation which could be and which is used in real world situations? Expectations make our hectic life more orderly as we face many constraints everyday. This is mostly due to scarcity of resources, it can either be time, lack of information, mismatch of communication etc. For instance, we go through the past papers and create a model and predict questions due to time constraints we face while preparing for the exam. But it is important always to keep an open mind(this is the point where my friend would roll her eyes at me if she were sitting next to me 🙂 ) to know that expectations are just expectations; not the reality and work towards it.
The role of expectations in economics is not discussed due to the lengthy content of today’s blog. Stay tuned!!! Thanks for reading…..