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Irrational and Rational Expectations

by Elaine Schwartz    •    Dec 12, 2011    •    292 Views

Sometimes, expectations can determine outcomes.

In articles on the placebo effect, Wired and the New Yorker tell us that people tend to believe that green pills are best at diminishing anxiety, brand names are better, and medication taken 4 times daily will generate more relief than a twice a day dose.

And then, because of the color, the name, or the dose, what we expect happens because we expect it.

In How We Decide, Jonah Lehrer describes what happens when we presume that a pricier product is better. For one experiment, researchers asked tasters to compare glasses of wine with price labels. Sipping while inside an MRI machine, taste-wise and neurologically, participants reacted more positively to the “expensive” wines–even though the glasses with $5 and $45 were from the same bottle.

The Economic Lesson

In economics, the study of the impact of people’s expectations on outcomes is called rational expectations theory. If a retailer says a sale will start next week, customers buy less now and create the retailer’s need for a sale. Anticipating inflation, workers seek higher wages and thereby create inflation.

Rational expectations theorists suggest that policy makers recognize that forecasts can become self-fulfilling prophecies.

An Economic Question: In your life, how has an expectation affected an outcome?

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