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Expectations

Beliefs or states of mind about the nature of future events. Expectations are often crucial in determining economic behaviour. A firm will select a price, a leve! of output or some other policy variable in the light of its expectations about the future. Similarly, a consumer may base his current purchases on his expectations of what the price will be over the next month. A difficulty this presents for economics is that though expectations may determine current behaviour they cannot be directly observed, and this then makes it difficult to test the validity of hypotheses. For example, we may hypothesize that a rise in price causes a fall in quantity demanded. Yet we may observe a rise in price of, say, a company stock to be followed by an increase in the quantity demanded. We may then argue that our theory of demand is not refuted, because the buyers’ expectations were of a further rise in price, after which they could sel! at a profit. But unless we can find some way of finding out what buyers’ expectations really are we cannot firmly answer the question. One possible solution is to attempt to explain how expectations are formed, e.g. by hypothesizing that they are some function of the current and past values of the relevant vari­ables. Another is to attempt to find, by questionnaire, what the expec­tations of a particular group of decision-takers are, and then to try to find what determines the changes in expectations over time.

Reference: The Penguin Dictionary of Economics, 3rd edt.