Knowledge that Transforms

T his paper analyzes optimal formation of rational expectations where information is costly to obtain to utilize. Under these conditions, expectations normally formed by an estimator will be intermediate between those based on all available information and those which are optimal extrapolative predictors. 1 Since the costs of information are likely to vary less than the value of information, this model can explain systematic differences in expectations in markets, such as, labor, for which the value of accuracy of expectations differs between or among buyers and sellers. Similarly, expectations about the same variable may differ between markets where arbitrage is also costly. Section I extends a model due to Theil toanalyzetheeffectsofcostlyinformation. Illustrative applications are discussed in Section II .

In economics, the word interest refers to the cost of using capital. The definition of interest in financial accounting differs from its economics definition in two fundamental respects. First, in financial accounting, interest refers only to the charge for using debt capital; accountants do not record a charge for the use of equity capital. Second, in financial accounting, interest is not ordinarily treated as an element of cost in the sense that labour and material are so treated; rather, interest on debt capital is regarded as an expense that is deducted in full from the revenues of the period in which the interest is incurred.