George Akerlof’s seminal contribution to economic theory is in the area of information imperfection and how it affects markets. His paper, “The Market for Lemons”, is brilliant and an easy read. Information asymmetry between the buyers and sellers of used cars (very poor quality used cars are the lemons that Akerlof talks about) leads to that specific market failure. The role of expectations is critical in that specific case. In fact, I am persuaded that expectations play a very important role in how human systems behave dynamically.
The most important advance in the economics toolkit in the past century is undeniably game theory. Game theory informs economics because economics studies what happens when economic agents behave strategically. That is, the result of the “game” of human activity is not chosen by any economic agent. Like in those activities that are games (sports such as football, or board games such as chess and checkers), formal games model how the outcome emerges from the interaction of the choices that individuals make motivated by their own self-interest. The strategic part lies in how a player chooses to do something that is based on his expectation of how the others players will respond to his move.
Once you start thinking about expectations, it is surprising how pervasive the role of expectations in outcomes is. There is a definite and positive link between expectations and results. Personal anecdotal evidence is persuasive. I have noticed that I generally aim to achieve that is expected of me. Some of my mentors cleverly used that tendency. Whenever I am expected to be good at something, I try hard to be good at it; if I am expected to be lazy and unproductive, I usually am.
In the US, I noticed that Americans of African descent do much worse than Americans of Jewish descent in most spheres. Jews are expected to be good at whatever they do, whether scholarship or the arts, while blacks are expected to generally drop out of school, engage in crime and end up in jail. I believe (and this is a conjecture only) that from early childhood, people understand what is expected of them and they do as the script dictates. We are prisoners of our own expectations, expectations that get communicated to us by our families and by the environment that we are immersed in.
We behave to a large extent on how others expect us to behave.
It is interesting to understand how expectations are formed. Within a closed system, expectations are endogenous (i.e., caused by factors from within the system) by definition. In open systems, at least part of the expectations must be exogenous (i.e., caused by factors that lie outside the system.) Since individuals are not closed systems – that is, they are influenced by events and things outside of themselves – there is a role for others to influence the expectations that individuals have. For now, I will not go into how expectations are formed. I am only asking how the aggregation of individual behavior influenced by expectations gives rise to macro phenomenon.
People expect trash on the streets in India. That is, they expect others to throw trash. That expectation allows them to feel free to add their own (small amount of) trash. Aggregated over many people over an extended period of time, the trash accumulates as the expectation itself gets reinforced.
Differing expectations lead to different outcomes. Thus emerge Singapores and Mumbais.
People expect the politicians to be crooks. Their expectation of a lower moral standard allows the politicians to be immoral scum. The immorality of politicians is widely known. The pile of immoral acts grows and with it, the average level of depravity. The next politician seeing the huge pile, feels free to add to the heap and indeed goes a little deeper in the depravity department. The average climbs and people adjust their expectations appropriately and the vicious cycle continues.
Take a publication such as a newspaper or magazine, such as The Time of India. There is an average quality of the articles. Then it accepts a very low quality article. This brings down the average very slightly in the short run but can have a large negative effect in the long run through the mechanism of expectations.
Assume that in general, writing article that are above the average at any particular time is more costly than writing below average articles. The publication of a very poor quality article expands the range of articles that are accepted for publication. So the average creeps downwards as more below the current average articles are submitted. The submission is based on the expectation that it will be accepted as was demonstrated by the very poor quality article. As the average creeps downwards, the quality of the readership changes to reflect the poor quality of the publication, and the good writers move on.
I believe that revolutionary change at its core is the raising of expectations of the people far above the prevalent average. It takes leadership, courage, vision, and heaps of chutzpah. Which, in our case, we do not have. But imagine if we did. Imagine that somehow our expectations were raised sufficiently that we would not tolerate crooks and criminals in high office. Imagine that there would be revolt in the streets when we find that the highest political offices are held by murders and embezzlers. Would not that change the political climate, would that not allow the good guys to hold office in India?
[Links: The wikipedia on The Market for Lemons.]