Practical analysis for investment professionals
24 July 2017

Where Markets Fail: Visible Hands

Markets are less perfect than commonly assumed.

I have discussed their inability to price unknowns; the blindness of the assumptions that underlie market activity; that the implicit presumption that market fungibility bears consequences; and that markets are not systemic.

How else do markets fail? They have visible hands, not invisible ones. Markets rely on symmetries between sellers and buyers, but due to these interventions — visible hands — those symmetries do not exist.

Market information is asymmetric.

Tobacco companies hid evidence of the cancerous nature of their products because they knew disclosure would forever shift the demand curve left. General Electric (GE) delayed its massive clean-up of the Hudson River for similar reasons. When you buy something from a secondary market — including eBay or antique stores — you seek to benefit from knowing more about the product than the seller. In our own industry, hucksters often obfuscate the costs of financial products.

These examples demonstrate an asymmetry of information between buyers and sellers. Which is ironic because markets are supposed to be about more than just the exchange of goods and services. Aren’t they also about information discovery? Specifically, the invisible hand that is price discovery? In fact, hiding information from one or both parties is a way to facilitate market transactions. That is, it is doubtful that both sellers and buyers are transacting exactly where marginal benefits equal marginal costs. Both likely perceive marginal benefits that are greater than or equal to marginal costs and some degree of economic surplus in the transaction.

Sellers think they are selling at maximum marginal profitability and buyers think they are buying marginal utility, right? If you think about it, this requires that some information be hidden from both parties. Sellers know exactly how much it costs them to manufacture or inventory an item as well as their required or even actual profit margins. Buyers know their true income, their ability to pay for a good, and just how much they want that good. In general, this mechanism — markets — facilitates beneficial economic activity. Yet the price changes if either party gets wind of the position of the other.

Thus, contrary to their general perception, markets have incentives to hide rather than to reveal information. These incentives, which spur actions, are visible hands.

Benefits are asymmetric.

Another asymmetry represents the tug-of-war between buyers and sellers: The different benefits of engaging in a transaction. On one side, most goods and services have tremendous consumer surplus embedded within the market clearing price.

What is consumer surplus? Imagine you don’t own any shoes and have to rent a pair each day before heading out the door. How much money would you pay to wear shoes today? Most people say something like £5, $10, or ¥2,000.

Yet, if you multiply that by the number of days each year you want to wear shoes, say 300, you get a price of approximately $3,000 per pair. Clearly, most consumers do not pay anywhere near that figure. The consumer surplus represents the difference between what you would pay and what you do pay.

Conversely, supplier surplus occurs when you pay £10 to see a movie and wish you hadn’t. Bundling is another form of supplier surplus. iTunes eclipsed compact discs (CDs) in part because most people only wanted one or two songs from an album, but record companies made you buy the whole CD. If you wanted to read the sports section, you had to buy the entire newspaper. Few people read the whole paper, but that’s what they paid for.

Markets are not systemic either, and often their real costs are not reflected in their prices. Supplier surplus accrues here as well. For example, human capital is not capitalized, yet the returns on people are booked as operating income. Practically speaking, if a grocery store has 1% operating margins, but the wear and tear on its people are not capitalized and expensed, then in all likelihood, the store is operating at a loss. The difference is an asymmetry that is not priced in and represents a conscious, visible hand interfering in markets.

You may think this is no big deal, but markets are supposed to deliver accurate pricing so that resources are allocated efficiently on the front end.

Timing is frequently asymmetric.

Timing is an obvious and critical asymmetry. Think, “Act now, while supplies last!” or “Special one-time offer!” You may believe these pitches, which everyone receives at one time or another, are just capitalist treacle. But such techniques work. How do I know? Because they are still used. Sellers and buyers both may have all the time in the world, but sellers show the visible hand by creating the perception of rapidly increasing scarcity in the face of your demand. Still, this is harmless . . . right?

When I was an investment manager during the dot-com era, new multi-billion dollar securities issues were scheduled to come to market in less than a day. A red herring would be emailed out about an hour before the close of the market. If you were lucky, there would be a conference call with management or a sell-side analyst just after the close. You then had to place your bid on the offering. “Act now, while supplies last!” These timing games mean that capital is allocated inefficiently and represent another visible hand in markets.

More Visible Hands

  • Regulations
  • Lobbying (in markets as well as in politics)
  • Anything meant to obscure the true nature of a transaction, including bribery, graft, nepotism, etc.
  • Monopoly, monopsony, and oligopoly
  • Explicit or implicit price fixing

Possible Remedies

  • Ask what information the counterparty may have in a prospective transaction that you don’t. Management may know the cost of its incentives programs relative to all other shareholders. Are you blindly voting the proxy not knowing this information? Management is counting on it.
  • Before transacting, are you sure you understand the value of a good or service to you? What information is out there to which you don’t have access? Are labor-intensive and low-margin businesses you invest in actually earning returns on capital?
  • What are the unspoken components — the elephants in the room — that overshadow or underlie a transaction?
  • Do you have enough time to render impartial, independent, and full judgment? If not, insist upon it, or else pass on the transaction.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/erhui1979

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, is a content director at CFA Institute, where he tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor. Jason also ran a successful blog titled What My Intuition Tells Me Now. Previously, Voss was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund. He holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason.voss@cfainstitute.org

13 thoughts on “Where Markets Fail: Visible Hands”

  1. Skot Kortje says:

    Thanks for the article, Jason. However, if you would grant that cultural factors are also an example of a visible hand – Christmas retail comes to mind – then your premise that markets are somehow failing because of these visible hands seems weak. I mean, how could markets not fail under this rubric? I think markets succeed despite the factors you identify. That is the magic – that through a complex myriad of obstacles and inefficiencies, the market still presents the best, and most efficient outcome. That’s just my initial response to reading your piece. Perhaps the silent, innumerable workings of the invisible hand eclipse the clumsy enumeration of all the visible hands – hands down!

    1. Hello Skot,

      Thanks for your thoughtful comments. I love the engagement with the piece.

      I do not think that markets fail generally, I think they fail specifically; which is what this series is about. There are many die hard mercantilists that worship markets as a messiah born to solve all problems. They ascribe special, magical properties to them, and wax poetic about them, too. Lovely, but let’s not forget about their limitations. I refuse to engage in fantastical thinking.

      Another example of their failure is that they are poor at evaluating potential partners/spouses. In other words, I think markets ARE the right tool for the job – which most of the objections to this series have been about. [But the underlying assumption is: context] Left unresolved is, yes, right tool, but for which jobs? Put another way, the conscientious objectors have sourced their comments, complaints, and responses in subconscious contexts, one in which markets are above reproach. Bust out the mind from those spaces, and you see them for what they are: potent tools for specific jobs. Yea!

      Yours, in service,

      Jason

      1. Skot Kortje says:

        Hi Jason.

        I do understand you contention. However, I cannot see markets as a tool, anymore than I could ascribe any natural system as a tool. My opinion is obviously framed by the understandings I have of gifted writers like Hayek who have formulated clear thoughts about this, and I would even go so far as to challenge your assertion about the way principles of markets are evident in successful matchmaking in our social lives. I guess we have a different opinion of the evolutionary aspect of markets. You believe, I think, that it is a man-made convention that can be cut to order. I understand it as a natural system that did not result from human design, but rather evolved spontaneously, as Hayek proposed. With that understanding, it’s impossible, futile, and counter-productive to intercede by tailoring it to specific jobs.

        Nevertheless, I enjoy the series, and certainly have appreciated your many great articles about quant finance.

        Thanks.

        Cheers!

        Skot

        1. Hello Skot,

          Thank you again for thoughtful comments. I know that markets are a person-made construct. If it were not then animals would also be transacting, and they do not. If markets were ‘natural’ then in a situation in which an airplane crashes into an icy winter river, and as survivors emerge from the plane, there would be people standing on the shore bartering with the people in need of rescue over the correct price of their lives. The survivor who bid highest for services would be rescued first. That would then be the market clearing price. And then the auction would start again for the next survivor. And so on.

          This very situation happened with a plane crash in Washington, D.C. in the early 1980s. Markets did not spontaneously arise. Instead, people, in total defiance of rational expectations jumped into the river to rescue people with no possibility of reward. Not all of these people were paid professionals whose jobs asked of them to make such a sacrifice. Some of the erstwhile rescuers died. Some did not. When the surviving rescuers were asked why they did what they did they did not bring up market clearing prices. Now, if markets are natural, why didn’t they arise in this critical economic exchange? Why in all such situations do they not arise? The reason is that these are contexts for which markets are not designed. And as soon as we use that word context then we have the critical intellectual separation from the subject that allows us to recognize that they are tools for a job. The question is: for what jobs are they tools. That is what the series has been about.

          Next point, if, at any time, we as people can only imagine one singular possibility it is a sure sign of a behavioral bias. I would argue that Hayek and socialists, both ( they are lumped together by me in this instance) are quite guilty of confirmation bias.

          Final point. The meaning of the word ‘absolute’ is similar to the word ‘infinity.’ By definition, anything less than infinity, has a defined context – only infinity includes all contexts, including non-contexts. Are you saying markets are infinite? Probably not. And if you are, then I would love to hear your market-based, capitalist-based model of explaining the strong nuclear force. Chances are you agree that this is not an appropriate context for markets. I agree. I also think that within economics – simply the exchange of resources – markets are not always the best solution. Again, see the rescue situation above. My series has featured multiple examples of contexts in which markets fail. I believe the most powerful example I provided was that of sea level rises. Here I am not making a claim as to the causality of sea level rises. But they are measurably higher. The current trend, with little deviation, is for them to continue to rise. From the perspective of the sea wall construction company’s investors this is a wonderful outcome. But from the perspective of the entire economy it is a disaster because such an investment diverts capital to an unproductive use. This isn’t an externality, it is just that individual markets form around individual products (e.g. sea walls) without relating themselves to other contexts. Ouch!

          Markets are wonderful for allocating resources in some contexts, but not in all. That is my only point.

          Again, thank you for your comments and discussion.

          Jason

  2. Skot Kortje says:

    Hi Jason,

    I guess we agree to disagree. I think your main point is sufficiently addressed by Adam Smith’s most important work, The Theory of Moral Sentiment, which in the words of scholar Vernon Smith present “one behavioral axiom, ‘the propensity to truck, barter, and exchange one thing for another,’ where the objects of trade I will interpret to include not only goods, but also gifts, assistance, and favors out of sympathy … whether it is goods or favors that are exchanged, they bestow gains from trade that humans seek relentlessly in all social transactions. Thus, Adam Smith’s single axiom, broadly interpreted … is sufficient to characterize a major portion of the human social and cultural enterprise. It explains why human nature appears to be simultaneously self-regarding and other-regarding.”

    It’s a big topic you present, and an important one in the field of economic theory. I don’t think we could possibly debate it completely. But, it’s been thought provoking.

    Cheers!

    Skot

    1. Hello Skot,

      Thank you for your comment and sorry for my delayed response, I was traveling last week. Adam Smith is actually where I borrowed the idea of information asymmetry from, and that served as one of the points I made in this article. I did not mention Adam Smith because I am loathe to mention any philosopher whose ideas are 250+ years old. In some cases, a commenter is discussing something perennial. But in most cases I am a believer in the powers of human ingenuity, and neural plasticity. That is, that which we call ‘hard wired’ and ‘human nature’ often are not. Instead, they are cultural phenomena that are inculcated through socialization, and hence are frequently confused for ‘hard wiring.’ That is one of the reasons I feel it is okay to criticize markets. It isn’t that I think we should abandon them, it is that I think we might be able to improve upon them.

      Yours, in service,

      Jason

      1. Skot Kortje says:

        Hi Jason,

        It’s pretty clear that we are on opposite sides of a divide. There is a pantheon of economic thought flanking my perception that markets are something you think they are not, and that barriers to efficiency only sculpt the market’s path like the water on its way to lower ground. You’re talking about building dikes and canals, I’m talking about a force of nature – something mankind can only harness, not improve or tailor. If I’ve interpreted your reasoning properly, you might also be one of those misguided souls who think there is a spectrum of genders? Yes, there are obstacles to efficiency, but these are not failures of the market, in my humble opinion.

        Cheers!

        Skot

        p.s. You can’t out-polite a Canadian. 😉

        1. Hi Skot,

          Forces of nature? So is murder, and there is a market for that, too. If we knew where that market convened we could hire a contract killer at a market clearing price. That something exists in nature does not make it either moral, right, or correct for every situation. What makes us human is that we have the ability to overcome instinct to create a different decision set.

          Yours, in service,

          Jason

          1. Skot Kortje says:

            Hi Jason,

            If this were a tavern debate, we’d certainly be on our fourth pint. It won’t end til last call!

            I think you’ve suitably exposed, at the very least, a Keynesian bloodline, and as such, perhaps you’ve have never gotten over the fact that Bambi dies. There is no morality in nature. For those that want to impose one, we may all ask: whose morality? This is the problem with statist intervention in nature. China is a fine empirical example of how that works – cookie-cutting nature. Watch that experiment blow up, as it should.

            You touch on big subjects and I commend you for that. I’m a lowly stock-picker – a forager in the forest – but I take great interest in topics about how mankind can best harness and reap benefits from the laws of nature. Data science is bringing us ever closer to understanding the true nature of the system that guides us. Behavior, behavioral science, will soon enough be relegated to market astrology – an engaging emotional anchor, but more pawn than king.

            Your worries about mankind’s base nature ignores the higher purpose of self-interest, and the moral exchanges in the market that Smith fully expounded. You call this a blind faith in the market. I call it the truth.

            Cheers!

            Skot

          2. Hi Skot,

            I am agnostic about economic philosophy. My own is to see reality for what it is, and not for what I might prefer it to be. So when the tool of markets seems appropriate relative to my values, then I apply market philosophy. Sometimes I am an intransigent and irascible mercantilist, and at other times a soft socialist. Depends on what the moment calls for.

            I find an inherent paradox in your logic. Nature is not moral. By definition then, people stand outside of nature, because there is strong evidence that people have spent thousands of years trying to construct legal and moral systems, including markets. After all, the argument against socialism is that it is amoral. If you believe that people are separate from nature that then also means that they do not need to use nature as a mental model. So what people think, believe, and create is valid. Witness: language, philosophy, and religions, including scientism. That you refer to people’s ‘base’ nature also implies this same divide and paradox in your thinking. Namely, that people have a base and not-base nature. This again results in the same paradox described in the preceding. Me? I think that people are just as much a part of nature as gnats. After many decades of contemplation I believe that what sets people apart from other animals is our ability to overcome instinct through deliberation. If you believe that is true, then it means that ‘nature’ becomes less absolute as a model. It means that the concerns of people, such as morality, are an issue to be considered when evaluating the quality of a mental model. Interestingly, this also restores the preeminence of responsibility and choice to people, and it becomes another moral expectation. I note with great interest that you are a ‘lowly stock picker.’ Ergo, you believe in the power of choice. In the pure instinct nature you describe why is choice, and its twin, responsibility a concern? All there is action flowing from instinct.

            Yours, in service,

            Jason

  3. Brad Case says:

    Jason, I know you don’t like anybody to suggest there’s anything wrong with the articles you write, but it seems as though the only argument you’re capable of making goes like this: (1) comically overstate a position, (2) show that position is wrong, (3) voila!
    I don’t know of anybody who thinks that markets are perfect. Anybody who has taken an Economics 101 course in college has been taught that markets are typically not perfect. Some markets are generally more perfect than others, but no economist assumes that any market is perfect. The “perfect market” is like a Platonic ideal: it’s a definition, not a description of anything that actually exists in the real world.
    On the other hand, you continue to make it sound as though you believe that a better solution can be fashioned. Why?

    1. Hi Brad,

      Far from it. I have always responded to your comments, and everybody else’s, too. That we disagree okay by me. Thanks for taking the time to share your thoughts.

      Regarding a more perfect solution…I am so glad that you dangled this. The more perfect solution is to see the world for what it is, and not what one would prefer it to be. In other words, I call out blind faith and distortion where I see it. A part of this is to recognize imperfections. As for the no one thinking that markets are perfect. Hmmmm. In my experience I have seen markets defended as a kind of messianic force on many occasions. Also, some of the complaints I raised I have not seen other commentators discuss. Last on this point, at no point have I called for an abandonment of markets or market thinking. To criticize something that you care about is to attempt to: a) spark useful dialogue about how to improve something; b) barring that, highlight gaps; and I do not feel obliged to have to have all of the answers; and c) point out the limitations of things so that people can be smart about their usage. Interestingly, you level a criticism of me that I don’t like anybody to suggest there’s anything wrong with the articles I write. Here I think you are suggesting an emotional shortcoming. And yet, that is the very thing I am pointing out with people’s blind faith in markets. So, once again, you have made my point for me.

      Yours, in service,

      Jason

      Yours, in service,

      Jason

      1. Brad Case, PhD, CFA, CAIA says:

        Perfectly fair, Jason. I’m good with that.
        I guess I just haven’t had much contact with people who express a belief that markets are perfect.

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