Rational Expectation: A Paradigm Shift

Owing to the limitation of adaptive expectation principle in modeling peoples’ expectation about the future economic conditions based on past experience, the assumption had been relaxed to accommodate the proposition that people form their expectations by making use of all the available information in the market in such interference on these economic conditions is drawn. The concept of rational expectations asserts that outcomes do not differ systematically (i.e., regularly or predictably) from what people expected them to be (the market equilibrium results). The concept is motivated by the same thinking that led Abraham Lincoln to assert, "You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time." It does not deny that people often make forecasting errors, but it does suggest that errors will not occur at random order. (Rational Expectations, Thomas J. Sargent)
In the rational expectation model, the actual price denotes as P is the equilibrium price in a simple market, determined by supply and demand. The actual price is equal to its rational expectation as shown as follows:

P = P* + e; e = 0
E(P) = P*

where P* is the rational expectation and e is the random error term, which has an expected value of zero, and is independent of P*. The rational expectation model suggests that the actual price (P) will only vary from the expectation if new set of information of unforeseen nature prevails in a simple market (e). The rational expectation hypothesis draws attention to the way people make decisions by taking all available information into consideration as it is also strongly purported in the efficient market hypothesis (efficient market theory). In a situation where the price of shares does not reflect all the information about it, then an arbitrage opportunity arises; people can buy (or sell) the security to make a profit, thus pushing the price towards equilibrium to the extent that the profit margin will be squeezed to zero. In this instance, all prices are accurately representative of the current market fundamentals (ie capital gains and dividend streams in the future) as they have reflected information about their true values.