Expectations are crucial elements of everyday life. We form expectations in many situations: we decide which queue to stand in based on our expectations of their speed. We gamble over lottery numbers. A common property of these examples is that our expectations do not influence the outcome: the queue won’t be quicker just because we stand there. There is no higher chance of specific numbers on the lottery just because some people have chosen them. Tomorrow’s weather forecast does not influence today’s weather.
On the other hand, there are many economic situations where our expectations do have an impact on the realization. In the stock market if many people expect a high price, and based on these expectations, they buy a lot of stocks, the price will indeed be higher (based on the law of supply and demand). However, this might drive the economy in a stage where stock prices are very high, whereas the expected return on the stocks is rather low. This leads to a bubble in the stock-market followed by a crash when prices return to a lower level. Similar bubbles and crashes have occurred in the housing markets in many countries.
Another example is from the commodity markets of non-durable, non-storable goods. Producers form expectations about future prices, and based on these prices, they decide on the quantity to produce. The higher the price expectations are, the more they produce. However, the higher the supply on the market is, the lower the price on the market is.
These two examples highlight a very important difference in market dynamics: the expectation feedback type. In both examples there is a given price level in which the economy is in equilibrium, meaning that the expectations are correct. However, whether the economy is able to reach this point depends on the nature of the problem. In case of the asset market, we deal with a positive feedback situation: the higher the expectations are, the higher the realized price is. In this case it is much more difficult for forecasters to learn the equilibrium price level, and bubbles and crashes can be observed in the market. However, in case of an above-mentioned commodity market, where the economy has a negative feedback, forecasters can more easily learn the environment, and the equilibrium price.
Social experiments with human subjects showed the above-mentioned relationship between expectation types and learning. Comparing stable situations, that is, where under rationality the price should always end up at the equilibrium level, with the only difference of the negative vs. positive feedback, we find that it is indeed more difficult to learn the equilibrium price level under the positive feedback. Prices are more volatile in a positive feedback environment, such as stock or housing markets, than in case of negative feedback.
Since expectation formation plays a prominent role in different markets, it is important to understand how people form their expectations. What are the factors that distinguish between situations, what drives the dynamics in different markets? This question also belongs to the research areas of IBSEN and will be addressed in large groups of interacting individuals.