Irrational Expectations

There's nothing like the first game of the season: optimism everywhere. Even at Everton, after a pre-season to forget and serious concerns for the standard of the squad, you couldn't help but wonder if we could pull off a shock against the Champions. 90 minutes later, and an embarrasing lesson in fluid, pressing and inventive football we're back down to earth wondering how we could have even dreamt of a realistic chance. But that's what the first game of the season is all about: belief, fantasy, and "just maybe".

And it holds across the country - in each and every league, expectations are high.

Rational Expectations, a cornerstone of post 60s economics assumes that people, on average, are correct. Any discrepency between the expected, and actual, is therefore random. For every fan expecting to improve this season, there's a fan expecting to do worse. And yet even Evertonians were smiling on Sunday morning.

Just one of the things about Rational Expectations I struggle with is the impossibility of individuals to have RE if they belong to a group that does. The problem of aggregation has not been resolved: the assumption that individual agents hold RE therefore the group does, is false. The whole point is that because individuals are irrational, their irrationality cancels out. To then model based on invidual RE is nonsense.

Comments

[Mighty Mike]

Not sure if I follow, but it sounds like the ecological fallacy: making assumptions about individuals based on aggregate data. By that name it originates in geography, but the principle spans many disciplines. I suppose its genesis lies in logic

[The Butter]

"the assumption that individual agents hold RE therefore the group does, is false. The whole point is that because individuals are irrational, their irrationality cancels out."

No. RE states some individuals make mistakes in judgement, no individual is ever irrational. Mistakes cancel out, if they didn't individuals would be systematically making costly errors in judgement. But it depends on how personally costly these mistakes in judgement are (See B. Caplan).

[AJE]

I'm afraid my pea soup fog of ignorance remains...

With the example of pre-season expectations (not perfect, but topical), can individuals and the group be simultaneously rational?

For "football supporters" to hold RE, in this instance, surely the individuals must be "making costly errors in judgement". Therefore to model on the assumption of individual rationality seems internally inconsistant.

The observation that every first game of the season contains such optimism suggests that judgement is indeed systematic.

Also, I don't think "rational irrationality" is the best tool to help us. Grasping in the dark, but I suspect that hesitant research into betting markets can show that people lose money through this "irrationality".

I know the RE brigade have an answer for this, so please try to rephrase because I'm just not getting it...

[Nick]

Allow me to chime in with some comments here.

First, a couple general comments that seem relevant.

Just because a group's estimates are, on average, correct does not imply that any of them are rational. It is entirely possible that their irrationalities are cancelling out. When you average Republican and Democratic estimates on many issues, you may very well arrive at the truth. That doesn't mean neither group is biased.

Second, just because a group's estimates are, on average, different from the objective truth implies only that at least 1 person is irrational. It does not speak of "the group."

Of course, RE economists usually speak of rationality as belonging or not belonging to a group. This leads to a very curious result. One cannot decipher whether one person is "rational" or not by analyzing his responses or actions, but only by looking at the actions of everybody else in that "group."

For example, suppose that Republicans (R) and Democrats (D) each arrive at cost estimates for a particular government program. Each D says the program will cost $1 billion, and each R says $9 billion. The truth is $5 billion. If there are 4R and 4D in a room debating the issue, RE says they are being rational. Now, when another person walks through the door, they have all become irrational, regardless of whether the person walking through the door is R or D. Let's suppose the person is R. Now, if the next person to walk through the door is D, they can all breath a sigh of relief - they are again rational. If, however, it's R... you get the point.

That seems like a crazy result to me.

I agree with Caplan that there is something of a downward sloping demand curve for "irrationality," but for completely different reasons. Caplan basically attributes deviations from RE to motivational or emotional causes. People derive utility from irrationality, etc. In doing this, he's basically supporting the basic RE framework. Indeed, his paper assumes that people have RE about the "costs" of irrationality. Again, Caplan is working within the RE framework, but simply admitting 1 more good - irrationality. It's more of a "modified RE" than anything.

My objections to RE are basically cognitive. That is, there is no absolutely no reason to expect that people's beliefs are centered around the truth. People basically believe what seems prima facie true until taught otherwise. If what seems prima facie true and what are actually true differ, people's beliefs will be off-target, not because people derive "utility" from holding irrational beliefs, but because they have no motivation to change their prima facie beliefs.

Take poker as an example. Nearly all beginning poker players play far too many hands. For every beginning poker player that plays too few hands, there are 99 others who play too many. The reason is because it just doesn't "seem" right that you should fold a good hand, one that can beat 80% of the hands out there. No economist who plays poker would tell you that beginning poker players hold RE about the quality of hands in a game. And Caplan would be hard-pressed to argue that people derive "utility" from having mistaken beliefs about the game of poker. (Yes, you could argue that people want to believe their hands to be better than they actually are, but this wouldn't explain why these same people cry out in exasperation when they see the pros fold the same hands.)

The reason that people have these mistaken beliefs is because the odds in poker are not what one would prima facie expect them to be.

As I mentioned above, I agree with Caplan that there is a downward sloping demand for irrationality, but not because of emotional reasons, per se, but rather because people will take the time and energy to modify their prima facie beliefs when the costs of not doing so are high.

I apologize for the ridiculously long "comment," but Anthony knows I get on the rag about this RE garbage.

Replies wanted.

[AJE]

Thanks for taking the time to share your ever insightful views. Nick and I had a few minutes of ravishing RE discussion but now agree too much to really proceed. Can I echo the above, and say that the assumption of objective truth in economic policy is disturbing, and I am sure antagonistic to most types of Margerine. If it were to exist, I'm not at all sure the economics profession would be the ones to know it!