Why Markets Make Mistakes

Many models of markets are based on assumptions of rationality, transparency, efficiency, and homogeneity in various combinations. They assume, at least implicitly, that decision makers understand the structure of the market and how it produces the dynamics which can be observed or might potentially occur. Are these models acceptable simplifications, or can they be seriously misleading? The research described in this article explains why markets routinely and repeatedly make 'mistakes' that are inconsistent with the simplifying assumptions. System Dynamics models are used to show how misestimating demand growth, allowing financial discipline to lapse, unrealistic business planning, and misperception of technology trajectories can produce disastrously wrong business decisions. The undesirable outcomes could include vicious cycles of investment and profitability, market bubbles, accelerated commoditization, excessive investment in dead-end technologies, giving up on a product that becomes a huge success, waiting too long to reinvent legacy companies, and changes in market leadership. The article illuminates the effects of bounded rationality, imperfect information, and fragmentation of decision making. Decision makers rely on simple mental models which have serious limitations. They become increasingly deficient as problems grow more complex, as the environment changes more rapidly, and as the number of decision makers increases. The amplification and tipping dynamics typical of highly coupled systems, for example, bandwagon, network, and lemming effects, are not anticipated. Examples are drawn from airlines, telecommunications, IT, aerospace, energy, and media. The key conclusions in this article are about the critical roles of behavioral factors in the evolution of markets

The Behavioral Paradox: Why Investor Irrationality Calls for Lighter and Simpler Financial Regulation

It is widely believed that behavioral economics justifies more intrusive regulation of financial markets, because people are not fully rational and need to be protected from their quirks. This Article challenges that belief. Firstly, insofar as people can be helped to make better choices, that goal can usually be achieved through light-touch regulations. Secondly, faulty perceptions about markets seem to be best corrected through market-based solutions. Thirdly, increasing regulation does not seem to solve problems caused by lack of market discipline, pricing inefficiencies, and financial innovation; better results may be achieved with freer markets and simpler rules. Fourthly, regulatory rule makers are subject to imperfect rationality, which tends to reduce the quality of regulatory intervention. Finally, regulatory complexity exacerbates the harmful effects of bounded rationality, whereas simple and stable rules give rise to positive learning effects

Not a Defence of Organ Markets

Selgelid and Koplin’s article ‘Kidney Sales and the Burden of Proof’ (K&S 2019) presents a series of detailed and persuasive arguments, intended to demolish my own arguments against the prohibition of organ selling. And perhaps they might succeed, if the case described by the authors were anything like the one I actually make. However, notwithstanding the extensive quotations and the detailed explanations of the way I supposedly argue, this account of my position comprehensively mistakes both the conclusions I reach and the arguments I give for them. I know that there are around many misconceptions about my views on this subject, but I have always hoped they could not survive a reading of what I had actually written. I have just—after a gap of many years—looked again at the two most recent of the texts Koplin and Selgelid refer to, and it goes without saying that I can see various things I could now do better; but I do still find these misinterpretations hard to understand. And since anyone with nothing to go on but this article would reasonably conclude that the original texts were not worth reading, I am grateful to the editors for the opportunity to try to set the record straight. I presume not many readers would be interested in a detailed comparative commentary on the texts, showing where this account gets my intentions wrong. I shall try instead to explain how what I do mean—and what I think I say—diverges from what is said here, and then go on to a brief outline of what my arguments and conclusions really are. I hope this may also give some sense of why, for all the opposition I have encountered since I was first drawn into this debate, I persist in thinking that the work I have been doing is important not only for this topic but for analysis in practical ethics more generally

Complexity and Biases

We examine experimentally how complexity affects decision-making, when individuals choose among different products with varying benefits and costs. We find that complexity in costs leads to choosing a high-benefit product, with high costs and overall lower payoffs. In contrast, when complexity is in the benefits of the product, we cannot reject the hypothesis of random mistakes. We also examine the role of heterogeneous complexity. We find that individuals still (mistakenly) choose the high-benefit but costly product, even if cheaper and simple products are available. Our results suggest that salience is a main driver of choices under different forms of complexity

The price is right? : Has the financial crisis provided a fatal blow to the efficient market hypothesis?

Related link(s): http://www.richmondfed.org/publications/research/region_focus/2009/fall/feature_weblinks.cfmCapital market ; Financial crises ; Business cycles