I don’t think he would be very happy with my use of the assumption above.

The first thing he does is outline where in the then existing literature on general equilibrium theory there is use of the perfect foresight assumption.

However, he then proceeds to (attempt to, in my view) demolish the need for the assumption.

He discusses various paradoxes which he says the assumption gives rise to. However, I think he misses the point of foresight being perfect.

He goes on to argue that economic agents would have to have a perfect understanding of economic theory. I would argue that is not necessary. Economic agents do what they do, their behaviour given by the assumptions not by understanding economic theory (unlike in the case of the rational expectations model, where agents would require a perfect understanding of the economic model).

He introduces expectations – again he misses the point of perfect knowledge.

He introduces monopoly behaviour – he is way off beam here having departed from the theory of perfect competition, to where the assumption solely applies.

He raises Walrasian tatonnement. Again the perfect foresight assumption is not meant to apply.

Towards the end of the paper he says, (pulling the rug entirely from underneath his own argument):

“If, however, it is meant that the theory of equilibrium describes only an absolutely static situation, then, one can, of course, establish perfect foresight, for nothing can be changed ex definitione, since everything is given as static and unchangeable.”

Precisely, that is what the pure theory of perfect competition says. Most of his paper has him wandering off into the real world.

And I would argue that any excursion from the state of perfect competition lands you in a Keynesian world, i.e., the REAL world.

]]>Think what it would mean to have perfect knowledge – the present, past and future would known as one. That is why perfect knowledge is the same as perfect foresight. There would be no need for futures markets. Futures market arise because of uncertainty. With perfect knowledge there would be no uncertainty. Each good, asset would be priced on the basis of no uncertainty. Equilibrium would be fixed, stable and immutable. Isn’t that what pure classical theory says? In this pure, perfect world expectations are not necessary – everything there is to know is known.

Relax any of the assumptions and you step out of a classical world into a Keynesian world. (You’ll cane me on that one for sure. 🙂 )

” If expectations were not mentioned when you were taught micro 40 years, that was a significant gap in your education. ”

In macro yes, micro no.

“They did not claim that the existence of an equilibrium meant that the economy would actually attain that equilibrium.”

I’m pretty much gobsmacked at this statement. So what is the point of GE theory? Equilibrium is central to GE theory. There is no path to equilibrium. It is instantaneous. It is given by the assumptions of the theory.

]]>Since I don’t know what “perfect knowledge” means I am not going to argue that it is not equivalent to knowing all prices at which transactions could be made. However, when I referred to knowing all prices at which transactions could be made I meant only prices for current transactions not future transactions when there is not a full array of current markets for all future exchanges. So perfect knowledge cannot be the same thing as perfect foresight. If expectations were not mentioned when you were taught micro 40 years, that was a significant gap in your education. You are free to characterize the “classical model” however you wish to, but expectations have been part of economic theorizing for a very long time. Assuming perfect knowledge does solve a lot of problems, but the principle of Occam’s Razor encourages us to be parsimonious in our assumptions, and perfect knowledge — whatever you may want it to mean — seems like a rather extravagant assumption. All that Arrow and Debreu proved — and they never claimed to have proved anything more — is that an economy satisfying certain assumptions about individual preferences and production technology would have at least one — and possibly more than one — set of equilibrium prices with the property that, if all agents were given the opportunity to trade at those prices, all trades would be executed as planned and all agents would be optimizing given their wealth and knowledge endowments, and skills. They did not claim that the existence of an equilibrium meant that the economy would actually attain that equilibrium.

]]>I would say these two statements are compatible and effectively equivalent.

When I was taught micro over 40 years ago, there was no mention of expectations. It was perfect foresight/knowledge. As far as I am concerned, expectations don’t appear in the classical model’s specifications, they are not necessary if there is perfect knowledge. In the neoclassical model, perfect knowledge was replaced by tatonnement – an auctioneer was required to settle equilibrium prices. (So I should not have included neoclassical theory in my explanation above.)

“What do you find problematic about it?”

It weakens the foundation on which REH is constructed, particularly as I would argue and you disagree with, that if there was no assumption to that affect, the hypothesis would be reduced to a circular argument .

]]>Henry, Agents are assumed to have a complete and consistent preference ordering over all possible choices. I don’t know what the adjective “perfect” means in that context. I don’t know what “perfect knowledge” means. Agents are assumed to know all prices at which they could make transactions. There is no assumption of perfect foresight, though this is sometimes inaccurately asserted. Your expectations of the future can be correct without having the give of prophecy. These assumptions, by the way, are not sufficient to establish that markets will clear. They will only clear in the event that expectations are correct. Clearing markets and correct expectations by all agents are essentially synonymous. Everyone acknowledges that the assumptions are unrealistic, but unrealistic assumptions may not render a model empirically useless. Whether it is empirically useless will depend on how skillful the theorist/practitioner is in knowing or guessing how to relax the assumptions in a theoretically and empirically fruitful way. You said:

“But now equilibrium cannot be said to be determinate as a logical consequence of the starting premises of the revised model, it has to be assumed.”

That’s exactly right. And Hayek said precisely that in his 1937 paper “Economics and Knowledge.” It’s a pity Lucas either never read it or never understood it. But you state the conclusion as if it were somehow problematic. What do you find problematic about it?

]]>‘exit” in the sentence should be “exist”.

]]>In pure classical/neoclassical theory, three assumptions, among others are made:

1. agents have perfect rationality (essentially more is preferred to less).

2. agents have perfect knowledge.

3. agents have perfect foresight (could probably include this one in two).

From these assumptions, it can be logically concluded that markets will clear and that there will be a determinate equilibrium point. The equilibrium point does not exit by assumption but because of assumptions.

Now of course, these assumptions suffer from the criticism that they are totally unrealistic and hence that the classical/neoclassical model is totally unrealistic.

Along comes Robert Lucas and in an attempt to make the classical/neoclassical model more realistic he dispenses with the above three assumptions and replaces them with “rational expectations”.

But now equilibrium cannot be said to be determinate as a logical consequence of the starting premises of the revised model, it has to be assumed.

]]>There’s the rub..”if”.

This rests on an assumption.

The New Classical revolution was essentially foundered on this assumption along with arguing that the macromodels of the 1960s were ineffective (using as evidence the stagflation of the early 1970s – which can be explained in other ways I would argue – macromodels weren’t running policy, politics was).

“And if they aren’t wrong…”

Arrow Debreu GE theory was considered unassailable until the 1970s at which time the uniqueness of the equilibrium point was questioned.

“The assumption of equilibrium is not arbitrary it is extremely demanding and restrictive…”

It may be extremely demanding and restrictive but it is arbitrary, is it not, as probably most assumptions are?

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