Understanding the formation of individual expectations and the roles of information and knowledge in economic decisions has long been one of the most difficult and important problems in economics. Until the recent rational expectations movement, it was widely thought that expectations behavior contained psychological and sociological elements and hence could not be modeled with only the tools of individualistic optimization calculus and statistical decision theory.

Modern thought on expectations modeling

Knight, in his classic book, introduced the distinction between measurable uncertainty – which he called “risk” – and “true uncertainty,” which cannot “by any method be reduced to an objective, quantitatively determined probability” (Knight, 1921, p. 321). For Knight, the uncertainty of events arises from their uniqueness:

But there is some regularity in economic life. Although Knight's insistence on the unique aspects of each situation cannot be neglected, economics must also recognize the recurring elements. It must do so if it is to aspire to any explanatory power.

Keynes, too, spoke of uncertainty. Unique developments over the future – parameter shifts, in modern terms – make it impossible to assign an objective probability distribution to distant future states. In fact, Keynes noted that “[not] all probabilities are measurable” (Keynes, 1921, p. 34), because it is not generally possible to enumerate all possible states of the world (thus foreshadowing a problem for contract theory!).