A general hypothesis of aggregated expectations

NORTH-HOLlAND

A General Hypothesis of Aggregated Expectations

D A V I D M E R C E R

ABSTRACT

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 more powerful actors, especially governments, a new tool for influencing some of those future outcomes. The core concept is that 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. © 1997 Elsevier Sci- ence Inc.

Introduction 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 organizations that are able to control the key variables in their micro-environment--most typically smaller organizations operating in niche markets- -may be able, in this way, to achieve successful outcomes; although, because of ignorance of what they can achieve, they may still not choose to do so. In recent years, however, managers of organizations dependent upon the macro- environment--larger organizations and, most notably, national governments--have been largely unsuccessful in their endeavors. One major reason for this lack of success has been the increasing uncertainty which has pervaded the macro-environment, resulting in managers' inability to predict the likely outcomes, with the consequence that intervention has been poorly executed. 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 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

DAVID MERCER is a senior lecturer in the Centre for Strategy and Policy, at the Open University Business School in Milton Keynes, United Kingdom.

Address correspondence to David Mercer, Open University Business School, Walton Hall, Milton Keynes, MK7 6AA, UK.

Technological Forecasting and Social Change 55, 145-154 (1997) © 1997 Elsevier Science Inc. 655 Avenue of the Americas, New York, NY 10010

0040-1625/97/$17.00 PII S0040-1625 (96)00176-X

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thousand large organizations and government departments. The Millennium Project, ~ overall, attempts to improve the accuracy of long-range forecasting using research techniques [1-3] derived from a combination of scenario-planning and focus groups described elsewhere in this issue.

Existing Hypotheses Relating to Expectations A number of existing hypotheses refer to "expectations" of future outcomes. Per-

haps 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 recognizing, and discounting, the expected effects of any outside intervention in that market, so that--apart from a role for short- run stabilization policies [5J--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, because 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, while 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 generalized 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. 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 behavior--has been most directly addressed by the body of work which has developed, especially under the theories of transaction

Now also the U.K. focus of the United Nations University American Commit tee ' s ( U N U A C ) Millen- nium Project.

2 One key difference between the rat ional expectations hypothesis and the hypothesis described in this article is that the outcomes are theoretically "predicted" in the case of the former, on the basis of mathemat ica l models, but are practically derived from actual observations in the case of the latter.

AGGREGATED EXPECTATIONS HYPOTHESIS 147

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 experi- ence) rather than the "hard" theoretical equations favored by many economists. Scenario planning techniques have been most extensively developed by Shell Oil [13-15] with whom we worked to develop the basic research techniques 3 which support this present work.

For the record, at the other extreme, the personal expectations of individuals have been examined by a number of behavioralists working in a range of disciplines. In sociology, for example, this has been in terms of individuals' 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 behavior. In the field of marketing this work has focused on consumer satisfaction. Thus, for instance, Maister [18] summarizes 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, however, 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 generalized hypothesis (depicting aggregated outcomes) described here.

General Hypothesis of Aggregated Expectations The core concept is that 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.

Underlying this statement are three major assumptions:

• 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.

3 Described in the separate article 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 behavioralists.

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• 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.

S P E C I A L H Y P O T H E S I S O F I N F L A T I O N A R Y E X P E C T A T I O N S

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 because 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 neoclassical economics. Here, there is no direct balance of supply against demand, and bounded rationality is implicit in the process, s

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 b e - - o n 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 current applying price modified by an allowance for the expected inflation over the period in question.

This can be simply represented by the equation

P f - - Pc(1 + Ie + I~)

where Pf = future price, Pc = current price, Is = average expected inflation, and I~ = individual deviation from the average (expected) inflation?

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

YPf = EPc(1 + Ie + I~).

As suggested earlier, it may then be reasonably assumed that the individual deviations

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 [11]. It is the reason this generalized 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 [21]: ~ ~X~: = E(XtF~ ,) where ~ ~X7 is the rational

expectation formed in period t - I of the variable, X, in period t and E(X, II)~_~) is the mathematical expectation of Xt conditional on the information set O~_a available in period t - 1 (where the whole is characterized by unbiasedness and orthogonality).

A G G R E G A T E D EXPECTATIONS HYPOTHESIS 149

are effectively random and will sum to zero--indeed that is, by definition, the case for the average price. 1° The resulting new market price average (P,) therefore will be

Pa = EPc(1 + Ie)/n (where the number in the population is n)

o r

Pa = Pc + EPcIe/n.

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.

LIMITATIONS OF THE SPECIAL HYPOTHESIS

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 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.

PRACTICAL APPROXIMATIONS TO THE G E N E R A L HYPOTHESIS

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' behavior 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 [1-3] 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 article in this issue.

Assumptions The evidence is that the assumptions underlying the hypothesis are met in many cir-

cumstances.

RESOURCE CONSTRAINTS

It is only in the past half century that this assumption could be said to be generally true but, in Galbraith's [22] 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, although the very rapid growth of the

10 This is a key feature of the generalized hypothesis, as it is for the rational expectations hypothesis, hence the emphasis on aggregation.

H In contrast with rational expectations theory, which typically only allows for short-run stabilization policies to succeed [5].

150 D. MERCER

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. Neverthe- less, for the majority of issues across the spect rum--not least those applying global ly-- 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.

AGGREGATION OF INDIVIDUAL DECISIONS 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 act ions--f rom brand shares through to inflationary pressures.

EXPECTATIONS NOT WISHES 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--recognize 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.

Model Frameworks In a number of fields, most notably in that of economics, frequent attempts have

been made to model behavior 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 [23]. 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 [24], 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 predict accurately (mathematically) the dynamic outcomes of essentially nonrational 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.

MODELS AS COMMUNICATION DEVICES 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 recognized 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 seen in the influence of the Chicago School of economists in general, and of Friedmann [5] in particular; arising

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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 expecta- t i ons - i n 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 [25] 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.

MODEL DISSONANCE When there is a general shift in expectations from a basis in one model to that in

another--paralleling Kuhn's [26] 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 be seen as one contributor to the uncertainty which has been a characteris- tic 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.

MODEL POWER This (expectations) communications aspect of modeling imposes rather different

requirements. Previously, models were deemed most academically worthwhile--and supposedly more effectively productive--if they were reducible to exact mathematical equationsJ~--as, for the benefit of my fellow academics, my own work at the beginning of this article 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 econometri- cians. Instead, in line with the parallel requirements in the commercial sector for "conviction marketing" [27], 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

~2 As, indeed, has been the case with rational expectations.

152 D. MERCER

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) flee-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: 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 flee-market emotionally, and practically, satisfying at a time when it was increasingly claimed that there was too much government intervention.

• Ambiguity: If such a model is to survive the ravages of time, it needs to incorporate ambiguity so 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.

Use of the Aggregated Expectations Hypothesis 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 formalizes the recent recognition that governments are not all powerful, but may only be successful in certain classes of action. This basic decision, whether

~3 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.

A G G R E G A T E D E X P E C T A T I O N S HYPOTHESIS 153

3a.

3b.

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: 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: Modification of expectations: The various tools, including those of marketing but also those of persuasive modeling, can then be deployed to steer expectations in the desired direction. Conviction marketing techniques [27] are then likely to become the methods of choice.

Conclusion 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.

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(MEG), Warwick (August, 1996). 4. Cagan, P.: The Monetary Dynamics of Hyperinflation, in Studies in Quantity Theory of Money. M. Friedman,

ed., University of Chicago Press, Chicago, 1956. 5. Friedmann, M.: The Role of Monetary Policy, American Economic Review 58, 23-41 (1968). 6. Svensson, L. E. O.: Scientific Contributions of Robert E. Lucas, Jr., Scandinavian Journal o f Economics

98(1), 1-10 (1996). 7. Lucas, R. E.: Some International Evidence on Output-Inflation Trade-Off, American Economic Review

63, 32(~334 (1973). 8. Muth, J. F.: Rational Expectations and the Theory of Price Movements, Econometrica 29, 315-335 (1961). 9. Simon, H.: Models o f Man: Social and Rational. Wiley, New York, 1957.

10. Sargent, T. J.: Bounded Rationality in Macroeconomics. Oxf~d University Press. Oxford, 1995. 11. Shaw, G. K.: Rational Expectations, Bulletin o f Economic Research 39(3), 187-209 (1987). 12. Anderson, M. A., and Goldsmith, 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, P.: Scenarios: Uncharted Waters Ahead, Harvard Business Review (September October) 139-150 (1985).

14. Wack, P.: Scenarios:Shooting the Rapids, Harvard Business Review (November-December), 139-150 (1985).

15. Schwartz, P.: The Art o f the Long View, Doubleday, London, 1991. 16. Andrews, F. M., and Withey, S. B.: Social Indicators o f Well-Being: American's Perceptions of Life Quality.

Plenum Press, New York, 1976. 17. Homans, G.: Social Behaviour: Its Elementary Forms. Harcourt Brace, San Diego, 1961. 18. Maister, D. H.: The Psychology ~2f Waiting Lines, Managing Services: Marketing, Operatio:~, and Human

Resources. Prentice-Hall, Englewood Cliffs, N.J., 1988. 19. Deming, W. E.: The New Economics for Industry, Government, Educations. Massachusetts Institute of

Technology Centre for Advanced Engineering Study, Cambridge, MA, 1993.

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

21. Gerrard, B.: Beyond Rational Expectations: A Constructive Interpretation of Keynes's Analysis of Behav- iour 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. glackwell, Oxford, 1973. 24. Dopfer, K.: The Complexity of Economic Phenomena, Journal of Economic Issues 25 (March), (I991). 25. Keynes, J. M.: The General Theory of Employment, Interest and Money. Macmillan, London, 1936. 26. Kuhn, T. S.: The Structure of Scientific Revolutions. 2nd ed., University of Chicago Press, Chicago, 1970. 27. Mercer, D.: Marketing. 2nd. ed., Blackwell, Oxford, 1996.

Received 19 July 1996; accepted 23 October 1996

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A general hypothesis of aggregated expectations