Irrational Market Cycles - Joe Abittan

Irrational Market Cycles

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.

Chaos and Innovation

The last few weeks I have been thinking quite a bit about chain restaurants. At some point in the recent past, I started to really dislike your typical chain restaurant. Perhaps my wife and I were gifted too many gift cards to Darden Restaurants, but I find myself feeling slightly disdainful toward chains and longing for the uniqueness of small locally owned restaurants. I’ve had trouble keeping chain restaurants off my mind, and I have been asking why they become so popular, why people get so excited when they spread, and why they have such staying power.


In his book The Complacent Class, George Mason economist Tyler Cowen offers an answer. He describes chains as being popular because they make the choices easier for the consumer. They standardize their products and environments, making decisions for consumers easy and automatic. They are also easily recognizable and expensive chains can be a simple way to signal wealth. Their products and services in general probably won’t blow anyone away, but things will always be predictably decent.


Cowen offers this as an explanation for why chains dominate markets, but also cautions against this market domination. He writes:


“As chain stores rise, there is also a loss of dynamism, competition, and market entry for new ideas and products. Keep in mind that today’s major chain was once a small individual store on a street somewhere. A bit more economic chaos, even if it is inconvenient in the short run, actually tends to be correlated with higher rates of innovation.”


When you go to a chain restaurant, you can be pretty confident that you will get a decent meal. You can be sure that the menu won’t have anything too strange on it, so you can almost throw a dart and select something generally in line with your usual tastes.


Go to a street corner food vendor, a locally owned ethnic restaurant, or that fusion joint that recently popped up, and the guarantee that you will know what you want to order is gone. Ordering is more difficult and you won’t have the certainty that you will enjoy whatever you order. This is great if you want something unique and new, but if you don’t feel like making more tough choices at the end of the day, this is another obstacle to a full belly.


The problem, however, with chain restaurants is that once they become dominant, and once they have a menu where everything generally appeals to the median customer’s pallet, there is little incentive for new innovations in the food space. Marginal gains won’t be found in new menu items and unique flavors, but rather in smaller portions and new ways of cutting costs or managing the supply chain. We might get some efficiency gains in this model, but the innovation has nothing to do with the product or service we receive, it is entirely focused on further back-end standardization.


We may all be happy and get what we want from this type of model, but we might also be foregoing greater gains from new innovations to the actual products and services themselves. More competition between restaurants might lead to even more new fusion joints, and we might get to experience new irresistible flavors that far surpass the standardized food options at chain restaurants.  It may be chaotic and hard to sort through at times, but settling for easy products and services might make us worse off in the end than if we made more of an effort to find something interesting and excellent.