Role of Economic Expectations in our everyday life
Let me ask you an interesting question today. Why did you spend that extra hour today preparing for your dream company that comes tomorrow? Or why do you think people spend thousands or lakhs of rupees to get knowledge out of prestigious institutions? Do you think, it has something to do with the expectation that this might bring fruits later?
I feel the keyword here is expectations. We human beings set a lot of expectations, be it waking up early tomorrow, or cracking our dream entrance, or simply reading up this article to know more. Well, economic agents also do form expectations. These aren’t the typical everyday expectations I wrote above, but are on general economic activities. For example: How much a farmer should expect the price of a crop would be 3 months down the line? Or, how much an economic agent should expect the inflation level in an economy to be next year.
Today we cover the different kinds of expectations that economists modeled in our article today. Don’t worry I am not going to bore you with textbook formulas or terminology. So, let us get started by knowing different kinds of economic expectations.
The Cob-Web Model
Imagine you are a farmer selling wheat in the X region of Punjab. Say due to a bad policy in Y region all the wheat crops in that region got destroyed. Now, you go to the market to sell wheat. Since the market has a lower supply of wheat you get really good money for your wheat. What would you do expect next season? You along with the people around you expect that growing wheat is really profitable. You all double your produce, guess what happens? The market now has an excess supply and you really don’t get good money for your produce. What do you do next season? Your region does not grow a lot of wheat, and the cycle continues.
Thus, you are trapped in a sort of a Cobb-Web. The theory argues that one season there would be a boom, the other would be bust. Now, you may have already noticed that this theory is full of flaws. The biggest one is that why don’t farmers question the low production in the first year itself. Yet, despite its flaws, this theory does have some empirical backing in the short run and it did turn out to be a starting point for a lot of theories that followed.
Now imagine, you are a farmer again. Before growing your crop, you would look at a lot of factors. Majorly these would be associated with the cost and revenues of your business. One such cost is of purchasing pesticides say 1 month down the line. What would you expect the price to be? Remembers farmers are not economists or industry experts (at least I haven’t met one), and thus they won’t analyse the entire pesticide industry. What would you do then? The simplest answer is that you would look at the price that was prevalent last year.
If you do just that you are in Cobb-Web World. So, you go a step forward and look at the prices that were prevalent last year and also look at the price increase that happened last year. A simple formula using these two parameters would decide your expectations regarding the pesticide prices.
The above theory was simple and obviously an extension of the first model, but it wasn’t very close to how we as humans form expectations. We understand about last year’s price bit, but the theory could not find practical backing behind the price increase part. Like do you really look at price changes between 2018 and 2019 to predict the price in 2020?
Thus, the next model came up with something closer to reality. Well, this is a pretty popular one too. The essence of this model in a layman’s language is that by how much we have missed our target last year. So, you still look at last year’s price, but now you also look at how much you expected the price to be last year. I’ll give you some numbers. For instance, you expected the rate of inflation last year to be 2% but it turned out to be 3%. Now, you know you missed your mark by 1%. You keep this missed mark in your mind when you make your final expectation. The mathematical model is a little tricky, but this is what the theory behind it looks like.
This theory was extensively used by a lot of economists particularly in explaining how Policy Shocks could be fruitful for the economy. We will get into the details someday later.
Well, this theory is like the perfect kid your parents expected from you. It’s good in theory but it is simply not practical. The Rational Expectation Model expects that every agent in the economy takes all the information into account while expecting something. In the first example above, the Rational Expectation model says that the farmer knows perfectly before every season what the price is going to be because he modeled the rainfall, government policies, past prices, or basically everything to come at his decision.
You know this just isn’t practical in the real physical world. But, it still has real-life applications, like the Stock Market. No doubt shares are undervalued or overvalued but eventually, they come at their true valuation because the market does take all the available information in mind. At least that is what the Efficient Market Hypothesis said.
I hope you now understand what are the different models that are present in the world which explain what are market expectations all about. I agree that these aren’t all very real but remember economics is a social science, not an exact one.
Written By – Aditya Jain