hypothesis of aggregated expectations, in economics

7270 Technological Forecasting – General Hypothesis of Aggregated Expectations

The Aggregated Expectations Hypothesis, described here in full for the first time, offers a new way of examining likely future outcomes, based upon the most important contributor - expectations - to the individual decisions which aggregate to create these final macro-outcomes. It also offers the more powerful actors, especially governments, a new tool for influencing some of those future outcomes.

The future outcome of an issue - economic or political - will be largely determined by the expectations of those, in the population affected, whose aggregated individual decisions will shape that outcome.

The author is a senior lecturer in the Centre for Strategy and Policy, at the Open University Business School, of which he was the first Head. In addition to being the author of a number of books, including the MBA text-book 'Marketing' (in its second edition in Europe, and a newly-launched first edition in the US launched), he is in charge of the university’s Millennium Project and has been advisor on long-range planning to a number of organisations and governments.

A prime objective of strategy is, having predicted the future outcomes which are likely to occur without any intervention, to influence these outcomes by adopting the optimal pattern of intervention. Managers of organisations which are able to control the key variables in their micro-environment - most typically smaller organisations operating in niche markets - may be able, in this way, to achieve successful outcomes; though, due to ignorance of what they can achieve, they may still not choose to do so. On the other hand, in recent years, managers of organisations dependent upon the macro-environment - larger organisations and, most notably, national governments - have been largely unsuccessful in their endeavours. One major reason for this lack of success has been the increasing uncertainty which has pervaded the macro-environment, resulting in their inability to predict the likely outcomes; with the consequence that intervention has been poorly executed. Indeed, as a matter of principle, they have increasingly avoided such intervention.

This article, however, describes a viable hypothesis which allows such managers to make meaningful predictions, even in an otherwise uncertain macro-environment, and hence to permit the possibility of successful intervention. It is based upon observations made, as part of the Open University’s ‘Millennium Project’, working with more than a thousand large organisations and government departments. The ‘Millennium Project[1]’, overall, attempts to improve the accuracy of long-range forecasting using research techniques [1, 2, 3] derived from a combination of scenario-planning and focus-groups; described elsewhere in this issue.

A number of existing hypotheses refer to ‘expectations’ of future outcomes. Perhaps the most important of these, and the most directly related to the new hypothesis in the specific field of macro-economics, has been adopted by a number of economists as rational expectations. This was typically adopted by those graduating from monetarist theory, in order to explain why simple monetarist theories do not accurately predict real-life outcomes. By that time, its predecessor, adaptive expectations [4], had failed to explain the accelerating inflation experienced in the 1970s. Although the rational expectations hypothesis also deals with aggregated expectations, it is a more specific hypothesis, which is normally described in terms of the (economic) actors in the 'market' (usually a financial market) immediately recognising, and discounting, the expected effects of any outside intervention in that market; so that - apart from a role for short-run stabilisation policies [5] - any such intervention, by government in particular, is bound to be ineffective. As such, it also has political overtones, in terms of the debate between those who are committed to market economics and those who advocate more direct intervention.

It is quite specific, since in the Rational Expectations Hypothesis the emphasis has most often been placed on the first and last words; with expectations accordingly used in a tightly defined context. The key assumption, as in much of recent economics, is that the actor/agent (usually in a financial market, but almost always influential in macro-economic outcomes [6]) is rational. Further, development of the hypothesis is (mathematically) rigorous, and the outcomes are determined by the exact form of the equations chosen for the model. Indeed, based upon Lucas’s [7] original work, which took Muth’s [8] work in a single market and extended it to macro-economic models, the many subsequent developments have typically revolved around the details of the mathematics involved[2].

The ‘general hypothesis of aggregated expectations’ reported here, however, does not assume a rational actor; and, whilst it might be possible to argue that rational expectations is a special case of this more general hypothesis, the evidence would suggest that the latter is rarely applicable to the wider, real-life situations which this new generalised hypothesis is intended to cover. Moreover, rational expectations is based upon the actions of the informed actors (who are usually quite limited in number) most directly influencing macro-economic outcomes, where the new hypothesis typically looks to the very much larger number of uninformed, though not necessarily irrational, participants throughout the whole population.

In economic theory, the problem of limited information - which is seen by some economists as a limitation on rational behaviour - has been most directly addressed by the body of work which has developed - especially under the theories of transaction costs - from Simon’s [9] original suggestion that (economic) decisions might be based upon ‘bounded rationality’. Recently, this concept has also been applied (for instance by Sargent [10]) to rational expectations hypothesis; to allow for multiplicity of equilibria in a dynamic environment (especially where there are regime changes). Even so, some critics have protested that the hypothesis breaks down under the complexities and uncertainties imposed by real world economics [11] and research results indicate that managers, for instance, fail even the weakest possible tests of rationality [12].

Management practice, on the other hand, has taken a more pragmatic approach, looking to alternative forecasts, typically using the scenario planning processes; which derive from ‘soft’ practical judgements about the future (usually on the basis of experience) rather than the ‘hard’ theoretical equations favoured by many economists. Scenario planning techniques have been most extensively developed by Shell Oil [13, 14, 15]) with whom we worked - to develop the basic research techniques[3] which now support this present work.

For the record, at the other extreme, the personal expectations of individuals have been examined by a number of behaviouralists working in a range of disciplines. In sociology, for example, this has been in terms of individual’s expectations of their own (personal) future circumstances - as, for instance, recorded by Andrews and Withey [16] - and especially in the context of personal motivation (such as Homans [17]), or that of societal expectations - the (control) demands made by society on their personal behaviour. In the field of marketing this work has focused on consumer satisfaction. Thus, for instance, Maister [18] summarises the theory, as the ‘first law of service’, that “Satisfaction equals perception minus expectations”. Deming [19] also makes a similar observation in his latest book, about quality in general. Some sociologists (for instance Taylor [20]) have, though, disputed the validity of such theory in their own fields.

This work on personal expectations can provide indirect insights into how individuals may contribute to aggregated expectations. In particular, the ‘first law of service’ indicates why electorates are currently showing such obvious signs of frustration with their governments, when the actions of these governments result in outcomes which are perceived to fall short of those expected. It should be noted, however, that in general these theories of personal expectations are about individual outcomes; and, as they are not usually aggregated, do not directly relate to the generalised hypothesis (depicting aggregated outcomes) described here.

The future outcome of a (macro) issue - economic or political - will be largely determined by the expectations of those, in the population affected, whose aggregated individual decisions will shape that outcome.

The corollary is that changing the expectations of this population will change the (macro) outcome.

The outcome will be decided by many individual decisions[4], such that no one such single decision will unduly affect the overall aggregate[5] decision.

The outcome will not be unduly constrained by any resource scarcity, or bottle-neck.

The separate individual decisions, and hence the overall aggregated outcome, will on average be swayed by the individual expectations[6] of this population, as well as specifically by individual needs and/or wants; and the latter can be assumed to be random in nature, cancelling out when aggregated[7].

The hypothesis is best introduced in terms of a simple example, which parallels some of the earliest work on rational expectations but comes to a rather different conclusion:

Let us take the example of one individual who is asked to contract for the supply of a repeat purchase good at some time in the future. This example is chosen since it offers a more realistic example of price-setting than market-clearing by some form of auction (to an informed public) which is the starting point for much of neo-classical economics. Here, there is no direct balance of supply against demand, and bounded rationality is implicit in the process[8].

There have been many mechanisms suggested by marketing academics to describe how this is achieved in practice; ranging from historical, through cost-plus, to competitive pricing. Even so, it is arguable that the analogue of a 'market price' still enters into the equation in the shape of the expectations of the supplier, and of the purchaser, as to what will be - on the date of future supply - the generally prevailing price which they will be required to meet. As this is a repeat-purchased good, as indeed are most consumer goods, the price can be assumed to be based upon the currently applying price modified by an allowance for the expected inflation over the period in question.

Where P_f= Future Price, P_c = Current Price, I_e = Average Expected Inflation, and

The last term allows for the fact that the individual’s information is bounded, and their interpretation of it may not be as rational as many economists’ would wish. If, however, we aggregate a sufficient number of such individual decisions the resulting new aggregate price is:

As suggested earlier, it may then be reasonably assumed that the individual deviations are effectively random and will sum to zero - indeed that is, by definition, the case for the average price[4]. The resulting new ‘market price’ average (Pa) therefore will be:

It is, thus, possible to focus on the overall, average, expectations (of the total population) as to what inflation will be - and this becomes a self-fulfilling (prophetic) expectation.

Unfortunately, real life is normally not quite so simple. Even in the case of the Special Hypothesis some individual inputs can distort the overall aggregate. In particular, governments - at the national level - can intervene to influence this process[11]. Indeed, despite economists’ rational expectations, this is arguably the one area where they have learned to intervene in order to manipulate expectations (as the hypothesis allows); most notably, in recent years, by using interest rates as a signal.

Beyond this, most issues are significantly more complex - and are linked in complex ways to other issues. In addition, the population's reaction to them is dynamic; changing over time. This dynamic complexity defeats simple analysis; as it has defeated the simple rational expectations hypothesis. In particular, it defeats most attempts at building mathematical models to predict the future; and, in any case, these are typically are based only upon macro factors. Any form of regression analysis, which is typically used to determine the exact relationships in the creation of such models, is defeated on both counts.

It may be possible, however, to adopt at least some of the concepts now employed in marketing practice to benefit from the Aggregated Expectations Hypothesis. Most notably, it is possible to adopt the marketing research philosophy that, if you cannot realistically model individuals' behaviour from first principles, you can 'ask' them what their expectations are - on any given issue. In particular, the critical ‘dimensions’ of the key issues (as seen by the population as a whole) can be derived, and subsequently quantified, by the new research techniques we have developed [25, 26 27] and, by use of repeat surveys, changes in these can be tracked over time. The latest position on this work is described in the separate paper in this issue.

The evidence is that the assumptions underlying the hypothesis are met in many circumstances:

It is only in the past half century that this assumption could said to be generally true - but, in Galbraith's [28] memorable phrase, which was already coming true several decades ago when he coined it, we - in the West - now live in an affluent society. As yet, it is true only in the developed countries; though the very rapid growth of the Far Eastern economies (and especially important, in view of its population size, that of China) suggests that it may soon be much more widely applicable. Further, even now, bottlenecks and in particular uneven distribution of these resources mean that not all issues in developed countries are susceptible to this form of resolution. Never-the-less, for the majority of issues across the spectrum - not least those applying globally - real resource constraints, as opposed to perceived constraints (which affect expectations), can no longer be seen as the major factor determining overall outcomes. This is especially true where developed economies are rapidly moving from a predominance of physical goods to one of intangible services which make relatively fewer demands on resources.

In addition, few issues are now decided by just a few individuals. Over recent years it has become apparent that even national governments cannot control many of the events within their boundaries. Thus, true democracy is gradually coming about not because the individual is the focus of politicians' activities, but because in almost all fields the important trends are now set by the aggregate of individual actions - from brand shares through to inflationary pressures.

Even so, the one factor which sways the overall 'votes' is not individuals’ wishes but their expectations. As we have seen, it can be assumed that, to a degree, individual wishes cancel each other out. More important, individuals - who are more capable and better informed than many politicians would allow for - recognise that the world will not necessarily change to give them just what they want. They do, however, assume that it will change, in line with their expectations. It is for this reason that their expectations are such a powerful predictor of the future.

In a number of fields, most notably in that of economics, frequent attempts have been made to model behaviour of key variables. Indeed, it has even been claimed that the individual economic agent must possess a formal model in order to generate his or her expectations [29]. In view of the prevailing uncertainty, it is not surprising that many of these models, especially econometric attempts to model the macro-economy but even the less complex ones which are used in rational expectations work, have been doomed to ultimate failure. Even reference to elements of chaos theory, for example by Dopfer [30], is unlikely to unlock the solution to this problem. In the context of expectations theory, this failure should primarily be seen as that of trying to accurately predict (mathematically) the dynamic outcomes of essentially non-rational processes, which are based on the aggregation of individual decisions, by the use of (typically static) rational models ,which are based upon discrete macro-variables.

The Aggregated Expectations Hypothesis would posit, however, that these models do still have an important, albeit different, role - as potentially powerful elements of the communication process. Some models, in this context, can offer a very potent means of influencing expectations; as is now recognised by those governments which use interest rates to communicate (signal) their own expectations of future changes in inflation. Paradoxically, one of the best examples was to be seen in the influence of the Chicago School of economists in general, and of Friedmann [31] in particular; arising from their promotion of the simple model(s) behind monetarism. Their theories were eventually accepted by the majority of decision-makers; and built into their own expectations - in the terminology of our hypothesis - of future developments. Under those circumstances, monetarist theory was able to predict outcomes, for the relatively short time that these expectations were shared by the wider world, and enabled governments to influence those outcomes.

The nature of the model, as a communication device, becomes most apparent when we compare the success of this (monetarist) model with the equal success of that of the previous period - covering several decades - when the very different theories previously put forward by Keynes [32] were just as well accepted. In their time, they as powerfully influenced expectations, with an even better track record in terms of predictability and of government use.

The change from Keynesianism to Monetarism also illustrated another feature applying to the hypothesis of aggregated expectations:

When there is a general shift in expectations from a basis in one model to that in another - paralleling Kuhn's[33] paradigm shift - relative stability (in terms of predictability, at least) is replaced by a period of uncertainty; as the proportion of the population supporting the two competing models progressively shifts from one to the other (and the strength of their individual belief in the new model grows, as that of the old one wanes).

This may, thus, be seen as one contributor to the uncertainty which has been a characteristic of the macro-environment in recent decades. It has been compounded by the need for 'monetarists' to regularly modify their earlier, over-simplistic, theories to allow for discrepancies in the observed outcomes. The shifting nature of this recent (‘monetarist’) theory has possibly been one contributor to the on-going dissonance. In the context of stable, and predictable, expectations it is even arguable that it is better for a government to be consistently wrong - as in retrospect the Thatcher governments were - than to be inconsistently right - as John Major's governments have sometimes been subsequently.

This (expectations) communications aspect of modelling imposes rather different requirements. Previously, models were deemed most academically worthwhile - and supposedly more effectively productive - if they were reducible to exact mathematical equations[12] - as, for the benefit of my fellow academics, my own work at the beginning of this paper has been. Indeed, they were sometimes thought to be even more worthwhile if such equations were so complex ('mirroring the complexity of nature') that only the most erudite elite could understand them.

In the new context, of communicating expectations, such mathematical complexity should be seen to work against many models - not least those developed by econometricians. Instead, in line with the parallel requirements in the commercial sector for 'conviction marketing'[34], the key parameters for a persuasive model - one which most effectively influences expectations - are:

simplicity and clarity - the concepts have to be easily grasped by the population at large. The very simple message of monetarism, that of the devaluation caused by governments 'printing money', was easy to understand at a superficial level - even if it did not attempt to fully describe the complex issues involved.

distinctive, rich identity - the ideas have to be clearly differentiated from competitive offerings, as was monetarism, but ideally should also tap into a much richer 'value system', as was monetarism supported by the panoply of the (Chicago School) free-market debate.

believability, especially of the champions - the model must ultimately be believed by the majority of the population. This typically occurs because the promoter is believable, as was Friedmann on behalf of monetarism - where his 'opponent', Keynes, was dead.

strength of opponents - indeed, the comparison with the old paradigm, and especially with its supporters, is a key element in the battle for hearts and minds. The Keynesians were handicapped not just by the fact that their leader was no longer there to defend his theories, but - even worse - by the fact that they had foolishly also espoused the Phillips J Curve as a core element of their expanded theory (even though Keynes himself had written his theories, and died, before Phillips had propounded his). They were, therefore, highly vulnerable when Friedmann proved this particular theory to be false!

match to 'consumer' needs - finally, the concept(s) have to resonate with the population on which they are targeted. The main target of monetarism was the business community, and the economists who aspired to mediate between it and government, both of whom found the notion of the free-market emotionally, and practically, satisfying at a time when it was increasingly claimed that there was too much government intervention.

In addition, if such a model is to survive the ravages of time, it needs to incorporate:

ambiguity - such that it can be progressively reinterpreted to meet changing circumstances. This has happened to an extent with monetarist theory - and rational expectations itself can be viewed as one such reinterpretation. Most notably, though, it has also happened to the longest lived models of all; religious texts - such as the bible - which have been interpreted very differently by different sects at different times in history.

How, then, may the hypothesis of aggregated expectations be put into practical use? In essence, the process involves three stages:

1. observation/measurement of existing expectations - the starting point must be an understanding of what the population's existing expectations are; and, hence, what will happen if no intervention occurs. Without knowing where you are, and in what direction you are currently going, it is impossible to steer a course to the destination you want. The new research techniques, now being developed and reported elsewhere in this issue, allow this information to be obtained[13].

2. decision on the possibility of intervention - the next, key, step is to decide whether any intervention - to change the outcomes - might be feasible. This formalises the recent recognition that governments are not all powerful, but may only be successful in certain classes of action. This basic decision, whether or not to act, leads naturally to two types of subsequent activity. At one extreme, therefore, the expectations may be so firmly held, or the tools for changing them so weak, that it would be unrealistic to expect the outcomes to change. In this case the third step, where intervention simply is not possible, becomes:

3a actions to ameliorate the outcomes - actions are then taken not to change the outcomes, but to alleviate - or intensify (if positive) - the symptoms arising from the inevitable outcomes. Damage limitation may then offer the most practical route.

On the other hand, if it appears possible to modify the expectations, such that more beneficial outcomes will be achieved:

3b modification of expectations - the various tools, including those of marketing but also those of persuasive modelling, can then be deployed to steer expectations in the desired direction. Conviction marketing techniques [35] are then likely to become the methods of choice.

The Aggregated Expectations Hypothesis offers a new way of examining likely future outcomes, based upon observations of the most important contributor - expectations - to the individual decisions which aggregate to create the final macro-outcomes. It also offers the more powerful actors, especially governments, a new tool for influencing some of those future outcomes.

3. Mercer, D., A New Qualitative Technique for Exploring the Future, Marketing Education Group (MEG), Warwick (August, 1996)

4. Cagan, P., The Monetary Dynamics of Hyperinflation, in Studies in Quantity Theory of Money. M. Friedman, University of Chicago Press, Chicago, 1956,

5. Friedmann, M., The Role of Monetary Policy, American Economic Review, 58, 23-41 (1968)

6. Svensson, Lars E.O., Scientific Contributions of Robert E. Lucas, Jr., Scandinavian Journal of Economics, 98(1), 1-10 (1996)

7. Lucas, R.E., Some International Evidence on Output-Inflation Trade-Off, American Economic Review, 63, 326-334 (1973)

8. Muth, J. F., Rational Expectations and the Theory of Price Movements, Econometrica, 29, 315-335 (1961)

10. Sargent, Thomas J., Bounded Rationality in Macroecomics, Oxford University Press, Oxford, 1995

11. Shaw, G. K., Rational Expectations, Bulletin of Economic Research, 39(3), 187-209 (1987)

12. Anderson, M. A. and Godsmith, A. H., Rationality in the Mind’s Eye: An Alternative Test of Rational Expectations Using Subjective Forecast and Evaluation Data”, Journal of Economic Psychology, 15, 379-403 (1994)

13. Wack, Pierre, Scenarios: Uncharted Waters Ahead, Harvard Business Review, 1985(Sep/Oct), 139-150 (1985)

14. Wack, Pierre, Scenarios: Shooting the Rapids”, Harvard Business Review, 1985(Nov/Dec), 139-150 (1985)

16. Andrews, Frank M. and Withey, Stephen B., Social Indicators of Well-Being: American’s Perceptions of Life Quality, Plenum Press, 1976

17. Homans, George, Social Behaviour: Its Elementary Forms, Harcourt Brace, San Diego, 1961

18. Maister, D. H, The Psychology of Waiting Lines, Managing Services: Marketing, Operations and Human Resources, Prentice-Hall, Englewood Cliffs N. J., 1988

19. Deming, W. Edwards, The New Economics for Industry, Government, Educations, Massachusetts Institute of Technology Centre for Advanced Engineering Study, Cambridge Mass., 1993

20. Taylor, Marylee C., Improved Conditions, Rising Expectations and Dissatisfaction: A Test of the Past/Present Relative Deprivation Hypothesis, Social Psychology Quarterly, Vol 45, (1982)

21. Gerrard, Bill, Beyond Rational Expectations: A Constructive Interpretation of Keynes’s Analysis of Behaviour Under Uncertainty, The Economic Journal, 4 (March), 327-337 (1994)

22. Galbraith, J. K., The Affluent Society, Hamish Hamilton, Harmondsworth England, 1958

23. Hahn, F., Money and Inflation, Mitsui Lectures in Economics, Blackwell, Oxford, 1973

24. Dopfer, K., The Complexity of Economic Phenomena, Journal of Economic Issues, 25 (March), (1991)

25. Keynes, John Maynard, The General Theory of Employment, Interest and Money, Macmillan, London, 1936

26. Kuhn, Thomas S., The Structure of Scientific Revolutions. 2nd ed., University of Chicago Press, Chicago, 1970

[1] Now also the UK focus of the United Nations University American Committee’s (UNUAC) Millennium Project.

[2] Thus, one key difference between the rational expectations hypothesis and the hypothesis described in this paper is that the outcomes are theoretically ‘predicted’ in the case of the former, on the basis of mathematical models, but are practically derived from actual observations in the case of the latter.

[3] Described in the separate paper also published in this issue.

[4] Made by the whole population involved, not just by the key economic actors involved in the rational expectations hypothesis.

[5] Not the personal outcomes typically explored by behaviouralists.

[6] Usually observed by practical marketing research techniques, not predicted by theoretical models.

[7] This is similar to the forecast errors typically allowed for in rational expectations work, which are also essentially random with a mean value of zero [22]. It is the reason this generalised theory is not applicable to individuals’ own circumstances.

[8] Hence, one key reason for the divergence from classic rational expectations, even if wage or price stickiness is allowed for.

[9] This compares, for instance, with the rather more complex form of even the ‘simple’ representation of the rational expectations hypothesis given by Gerrard [23]:

_t-1 X^e_t=E(X_t|Ω_t-1)

where _t-1 X^e_tis the rational expectation formed in period t-1 of the variable, X, in period t and E(X_t|Ω_t-1) is the mathematical expectation of X_t conditional on the information set Ω_t-1 available in period t-1 (where the whole is characterised by unbiasedness and orthogonality)

[10] This is a key feature of the generalised hypothesis, as it is for the rational expectations hypothesis, hence the emphasis on aggregation

[11] In contrast with rational expectations theory, which typically only allows for short-run stabilisation policies to succeed [24]

[12] As, indeed, has been the case with rational expectations

[13] The emphasis upon observing (measuring) the population’s expectations - rather than predicting them from mathematical models - is central to the practical use of the hypothesis.