I think about markets a lot, often focusing more on market failures than on market successes. I think our country generally views markets as infallible, and that drives me (in a somewhat contrarian strain) to look at spaces where markets don’t work. I also started my career in healthcare and have some relatively expensive healthcare concerns of my own, which also drives me to look at market failures with more energy than market successes. While there are many positive aspects of markets (they certainly do create a good level of efficiency and innovation and may also be generally pacifying across the globe), I think it is important to continue to highlight irrational market cycles, tragedy of the commons type situations, and areas where a market simply can’t be established because goods are nonrivalrous and nonexcludable. This post will specifically highlight an irrational market cycle, by which I mean a cycle of irrationality supported by market forces.
One of the strongest points of markets is that they help to weed out poor performers and eliminate waste. Someone selling a product that doesn’t provide value shouldn’t be able to find any customers. They might dupe a few people into buying their product, but overtime, we expect the market to marginalize the seller and for his business to eventually go bust. But this market efficiency mechanism only works if people are rational, and irrationality can be manipulated and exploited in a market, creating irrational market cycles. Cass Sunstein and Richard Thaler use extended warranties (not the spam ones you get calls about for your car but real ones offered when you buy a fridge) in their book Nudge to describe irrational market cycles. They write:
“If consumers have a less than fully rational belief, firms often have more incentive to cater to that belief than to eradicate it.”
There are products that don’t make sense. Sometimes they pop up as a fad, sometimes they are deliberate scams, and sometimes they are a new gadget that is attached to a new technology as an additional aid, but are in reality effectively useless. People can get sucked into purchasing these items, and they can be marketed as effective and must-have items, only to be irrational junk. The people selling the junk don’t have an incentive to help us think clearly about the product, they have an incentive to hide the truth and make their product appear more attractive by playing into and reinforcing irrational behaviors.
Using the extended warranty example Sunstein and Thaler continue, “If Humans realized that they were paying twenty dollars for two dollars’ worth of insurance, they would not buy the insurance. But if they do not realize this, markets cannot and will not unravel the situation. Competition will not drive the price down.”
An irrational market cycle can arise when incentives exist to encourage people to participate in irrational markets. People’s fear, lack of information, and cognitive biases can be leveraged by market actors to further irrational spending. A market on its own cannot correct this issue as Sunstein and Thaler show. Nudges can be helpful in diverting people out of the market, but it is worth recognizing that there is a role for outside forces to shape markets that fall into these irrational cycles.
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