Why markets make mistakes

Henry Birdseye Weil (MIT Sloan School of Management, Cambridge, Massachusetts, USA)

Kybernetes

ISSN: 0368-492X

Publication date: 19 October 2010

Abstract

Purpose

Many models of markets are based on assumptions of rationality, transparency, efficiency, and homogeneity in various combinations. This paper aims to explain why markets routinely and repeatedly make “mistakes” that are inconsistent with these simplifying assumptions.

Design/methodology/approach

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. Examples are drawn from airlines, telecommunications, IT, aerospace, energy, and media.

Findings

The undesirable outcomes can 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. Differentiating transient phenomena from the longer term trends, movement away from vertically integrated business models, and effective use of early warning signs avoid these mistakes, or at least limit the damage that they cause.

Practical implications

Decision makers tend to 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. Behavioural factors that play critical roles in the evolution of markets often are misunderstood or ignored.

Originality/value

The paper illuminates the effects of bounded rationality, imperfect information, and fragmentation of decision making on the behavior of markets. Models which 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 can be dangerous simplifications and seriously misleading.

Keywords

Citation

Birdseye Weil, H. (2010), "Why markets make mistakes", Kybernetes, Vol. 39 No. 9/10, pp. 1429-1451. https://doi.org/10.1108/03684921011081114

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Publisher

:

Emerald Group Publishing Limited

Copyright © 2010, Emerald Group Publishing Limited

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