Rational Expectations?

Feb 22, 2016
IanRunge
0

Economists use the term a lot – economist Robert Lucas won the Nobel Prize in 1995 largely because of his work in this field. But the term doesn’t make the mainstream business vernacular very often. Maybe it should.

“Rational Expectations” is the fancy name to describe the many economic situations in which the outcome depends partly upon what people expect to happen. The price of corn, for example, depends on how many acres that farmers choose to plant, which in turn depends on the price that they expect to realize when they sell their crops. And of course, if one farmer arrives at one conclusion as to what this price will be, rationally he must assume that other farmers will arrive at a similar conclusion and that they will pursue their choices similarly. If the process is repeated year-in-year-out some consistency can result – you get a sense of the likely actions and reactions of the other participants.

But for one-off choices, like most capital investment choices, the process will have far less consistency.

Such is the situation with the commodities markets right now. The best way for commodity prices to improve is for all producers to decrease production. For some commodities – oil, for instance – a small (less than 10%) reduction in supply could easily result in a doubling of the price. The return associated with the lower output will be more than compensated for by the higher price. Every producer benefits if everyone participates. But is it rational to expect other producers to reduce their production if you take the lead and reduce yours? Or would you merely be opening the door for a competitor to step into the market taking up the supply gap that your reduced production opened up.

There is a lot to be learned in the mining industry from some of the arcane economics studies that have taken place in this field over the last 30 years.

(Similar article originally published in the Capital Strategy Newsletter #1999/02. Click here for a PDF Version of the Newsletter (4 pages))