Adaptive Expectations, Rational Expectations, or Irrational Exuberance
by Professor Douglas Reynolds in Energy Politics, historical archives Fall 2005
What is important is to analyze the world’s energy situation from the perspective of rational as opposed to adaptive expectations. In economic theory, adaptive expectations are simply formed by an adaptive error correction adjustment to past changes. If changes form a twenty year trend, adaptive expectations assumes the trend will continue. Rational expectations are a more robust analysis where we apply all pertinent information to predict the future.
For example, while many analysts assumed the stock market would increase without bound in the 1990’s, The Economist explained well before the collapse how the dot.com bubble was parallel to other past technological eras where over investment in the new technology of the day such as railroads in the 1800s and radio technology in the 1920s also caused stock market bubbles that collapsed. The book Irrational Exuberance by Robert Shiller (2005) brought home the strength of using rational expectations analysis in such cases.
To apply this same rational expectations analysis to energy markets, we need to take all pertinent information into account. A starting point is M. King Hubbert’s (1962) life cycle production curve for nonrenewable resources. Hubbert’s analysis uses rational expectations by looking at similar resource production cycles of the past and then applying them to our current situation…
Where to now?
If, “the Stone Age did not end for lack of stone, and the oil age will end long before the world runs out of oil,” does that imply that Stone Age men had stone shocks similar to our oil shocks in the 1970s? The analogy is erroneous and misleading since there is no evidence of stone shortages. Thus today’s energy transition will be more like the transition we saw from oil to oil shale in the 1970s, not the transition from stone to bronze. What we saw in the 1970s was that as the price of oil went up, the cost of shale oil went up even faster.
About the Author:
Dr. Doug Reynolds is an associate professor of oil and energy economics at the University of Alaska Fairbanks, and author of Scarcity and Growth Considering Oil and Energy, and Alaska and North Slope Natural Gas. He can be contacted at ffdbr@uaf.edu.
