Conventions as a basis for forming expectations, Microeconomics

Conventions as a Basis for Forming Expectations:

Since there is little objective basis for probability distributions about future yields, decision-makers have to act on the basis of subjective judgments. It means there must be some element of arbitrariness involved in the formation of expectations and therefore, in the decisions taken on the basis of those expectations. In such situations individual decision-makers, in forming their expectations, usually tend to fall back on practical norms or conventions generally prevailing in society. 

For example, one convention for estimating the expected rate of return on an investment project may be as follows: Assume that an objective probability distribution for future returns on an investment project can be determined from quantitative historical data. Hence, estimate regression equations which have the rate of return on such projects as the dependent variable and particular subsets of a set of variables as independent variables. Then, on the basis of some given statistical criterion (convention) choose the 'best' estimated regression equation. Use this, given values of the independent variables, to obtain an estimated probability distribution for the rate of return on the investment project. 

The tendency to rely on conventional wisdom might be due to a variety of reasons. Individuals might feel that conventions reflect the collective wisdom of others who have been in similar positions and therefore would be less arbitrary as a guide to decision-making. Besides, individual decision-makers can justify their decisions as being of the same variety as that taken by many others placed in similar position. In this, case it appears less the outcome of individual whim or sentiment or prejudice.

Moreover, in following conventions, particularly in relation to the valuation of investments or assets, the individual entrepreneur might be minimising risks. If a majority of investors follow the same conventions in calculating values then the individual entrepreneur would have a good idea about the market value of his investment over the short tern. Once the investment has been made on the basis of such valuation, the entrepreneur will be exposed to the risk of a significant loss. Since individuals have relatively greater certainty about the near future, the chance of increasing losses over a short time period is small.

Posted Date: 11/19/2012 7:42:51 AM | Location : United States

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