RATIONAL EXPECTATIONS UNDER CONDITIONS OF COSTLY INFORMATION

Abstract

This paper analyzesoptimal formation of rational expectations where information is costly to obtain to utilize. Under these conditions, expectations normally formed by an estimator will be intermediate between those based on all available information and those which are optimal extrapolative predictors.1Since the costs of information are likely to vary less than the value of information, this model can explain systematic differences in expectations in markets, such as, labor, for which the value of accuracy of expectations differs between or among buyers and sellers. Similarly, expectations about the same variable may differ between markets where arbitrage is also costly. Section Iextends a model due to Theil toanalyzetheeffectsofcostlyinformation. Illustrative applications are discussed inSection II.