The state of confidence in conventional judgements, Microeconomics

The State of Confidence in Conventional Judgements:

While individuals fall back on conventions to guide their behaviour in the face of uncertainty, they are also aware that these conventions might prove to be misleading guides to the future, because the future might well be very different from the past. Consequently, individual decision-makers depending on their level of confidence decide whether or not to act on the basis of these conventions in the face of such uncertainty.

Thus, while a particular convention or norm for estimating the future returns on an 'investment project might suggest that investment projects should be carried out in two, different instances, the actual investment may be carried out in only one, if the state of confidence is high in one and low in the other. In the latter case, the same predictions about future yields using prevailing conventions would as it were be discounted by a factor reflecting the decision-maker's confidence about whether the prediction would actually be correct.

Thus, it is not only various 'objective' factors in the economy, which through prevailing norms for forming long-term expectations, determine the volume of investment in the economy. The same set of values for the 'fundamental factors' (according to prevailing conventions) can influence investment decisions in either direction, the relation of these 'fundamentals' to expectations about the future being governed by the prevailing psychological state of businessmen and entrepreneurs. Thus, according to Keynes (1936, p. 161), a certain degree of optimism, "of animal spirits - of a spontaneous urge to action rather than inaction," is necessary for enterprise and investment.

The preceding discussion assumes that the 'marginal efficiency of capital', which is relevant to the decision to invest, is derived from the expectations of the professional entrepreneur or businessman who actually undertakes the investment. However, Keynes believed that the rate of investment was significantly influenced by movements in the share market values of existing enterprises. According to him (Keynes, 1936, p. 15 1): 1 "... there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; while there is an inducement to spend on a new project what may seem an extravagant sum if it can be floated on the Stock Exchange at an immediate profit." Thus, it is the marginal efficiency of capital Rational Expectations and corresponding to the "average expectation of those who deal on the Stock Exchange Economic Theory as revealed in the price of shares" which is actually relevant in many cases.

In this case, the role played by psychological factors represented in the state of confidence, increases with the share of total equity capital held by market investors who (compared with professional entrepreneurs or businessmen) are relatively uninformed. Since the factual basis underlying the expectations of the relatively uninformed investor is smaller, the level of confidence in these expectations is also subject to greater instability. The volatility of expectations (and of investment) arises because the state of confidence of investors is subject to waves of optimism and pessimism, sensitive to the extent to which even single small events seem to confirm or refute currently held expectations based on existing conventions. According to Keynes (1936, pp.153-4): "Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market."

Also, major events, which take place in the present and whose impact on future events cannot be gauged to any adequate degree, increase the extent of uncertainty and make the state of confidence even more sensitive to the single small events. "In abnormal times in particular: when the hypothesis of indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation." (Keynes, 1936, p.154)

Nowadays, there is often reference in the media to the 'feel good' factor, whereby a set of unrelated but favourable events taking place elsewhere in society might induce a high degree of confidence in positive judgments. Similarly a sequence of unrelated but unfavourable events might induce pessimism about positive judgments. In the words of Keynes (1936, p.162): ". . . economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average businessman. If the fear of a Labour Government [a government favouring greater state intervention in the economy and greater support for organised labour or a New Deal [a policy programme involving increased public intervention and expenditure] depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with a political intent - it is the mere consequence of upsetting the delicate balance of spontaneous optimism." 

Posted Date: 11/19/2012 8:24:36 AM | Location : United States

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