Perfect Foresight

Abstract

Perfect foresight is an occasionally convenient theoretical assumption whose total lack of realism is undisputed, and perhaps unrivalled. There are two elements to perfect foresight; firstly that people have definite point expectations, allowing no uncertainty, of future variables, and secondly that these expectations are correct. In practice, as these fortunate perfectly foresightful individuals generally inhabit models with instantaneously clearing perfectly competitive markets, they only need to forecast prices. The pioneering work by Hicks (1939) on intertemporal general equilibrium theory provides a framework in which the issues associated with perfect foresight can be explored. Writing prior to the development of the expected utility theory of choice under uncertainty (von Neumann and Morgenstern 1944), Hicks had no alternative to a deterministic model in his discussion. He acknowledges the existence and importance of uncertainty in expectation formation, but argues in a somewhat unsatisfactory fashion that point predictions can be interpreted as risk-adjusted summaries of underlying probability distributions. Hicks divides time into weeks. Trade takes place weekly. Supply and demand in each week depend upon decisions made in the past, expectations of spot prices in future weeks, and current spot prices. In temporary equilibrium these spot prices adjust to clear markets, but expectations may be wrong. In the situation which Hicks terms ‘Equilibrium over Time’, markets clear at each date, and, crucially, everyone has perfect foresight; price expectations are fulfilled.