Academic journal article Economic Inquiry

The Bias towards Zero in Aggregate Perceptions: An Explanation Based on Rationally Calculating Individuals

Academic journal article Economic Inquiry

The Bias towards Zero in Aggregate Perceptions: An Explanation Based on Rationally Calculating Individuals

Article excerpt

I. INTRODUCTION

A central theme in the study of economic behavior is individual rationality, or utility maximizing behavior. Contrary to the accusations of many outside critics, the economics assumption of rationality neither denies that information is costly nor implies that decisions are error free. Rational expectations allows for ignorance, but insists on the absence of systematic errors in the aggregate. Even if some individuals make large underestimates, their errors are offset by large overestimates made by others. Alternatively, even if people on average underestimate the effect of some variable during one period, they may overestimate its effect at a later date. These assumptions form the basis for the standard conclusion that the government cannot systematically "outsmart" the public.

The theory and application of rational expectations has generated a vast literature over the last couple of decades. It is now well known that the application of rational expectations theory to actual cases may, for instance, be unsuitable when there are systematic errors in the observed variables, when loss functions are not quadratic, or when variables are constrained to take only positive values. While such limitations may well be problematic, these objections have, in our view, not been very damaging in the sense that rational expectations still provides a natural starting point for much economic analysis.

Like rational expectations, this paper takes individual rationality as its central theme. Yet, we reach a radically different conclusion from rational expectations regarding aggregate behavior. We demonstrate that individual errors in identifying the relationships among variables cause a downward bias in the aggregate that would be equivalent to the public underestimating the strengths of the true relationships. Rational expectations has considered the "misestimation" type of error, which can "cancel out" in the aggregate, but with errors in identifying relationships, there exists no similar cancelling out effect; and thus the public appears to ("irrationally") underestimate the strengths of relationships.

The paper is organized as follows. First we set up a simple formal model to examine the "misestimation problem," and then contrast it to the "identification problem." Section III explains why the identification problem can be so important even when a relatively small number of variables are involved. Section IV reviews empirical evidence of bias in the expectations formation literature. As shown in section V, our hypothesis can be used to explain political business cycles in a standard aggregate supply and demand framework.

II. THEORY

In our model individuals acquire knowledge in two steps: they first identify the causal relationship between two (or more) variables and then estimate the strength of that relationship. As with Herbert A. Simon's "satisficing" approach [1959; 1979] and the analysis in Ronald A. Heiner [1988], we assume finite intellectual capabilities. However, our model neither assumes nor implies anything about Simon's "satisficing" approach and the often related concept of bounded rationality. Instead, our inquiry is strictly limited to the consequences of omitting variables and will not address the more ambitious question of what strategies individuals might adopt to improve learning.

Like Heiner we distinguish between the reliability of making decisions and the issue of obtaining information. Heiner shows that while decision making itself might be flawless when individuals face only a very limited amount of information, it is optimal for them to choose a larger information set and enter into "the imperfect decision zone." He provides several different reasons ("finite channel capacity," "information complexity," and "nonlocal information") for why the advantage of having much information also translates into more decision error. While Heiner's model deals with individuals making correct or incorrect decisions, his underlying reasoning could equally well be used to motivate our analysis of why a portion of the population fails to appreciate certain economic relationships. …

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