ON THE NATURE OF EXPECTATIONS

We review economic and psychological models of expectation formation. According to the rational model, expectations are optimal; according t o the adaptive model, they minimize previous error; according to the e xtrapolative model, they continue a trend. In an experiment, we asked subjects to make forecasts from previous data in the same series or fr om previous data in a different but related series. We also asked them to estimate the probability that their forecasts would be correct. Th e rational model failed because within-series forecasts were too poor, cross-series forecasts were biased, and probability estimates showed overconfidence. Regression analyses and a lack of performance improvem ent showed that the adaptive model was inappropriate. Instead, within- series forecasts were made by extrapolation and cross-series forecasts appeared to be based on a faulty conditional rule.