Professor of Strategy and Entrepreneurship
London Business School

Should we stop saying that the market is efficient?

No, we should not stop saying that the market is efficient. We should stop saying that, because the market is efficient, the most efficient firms prevail. Because they do not. And that is because there are always multiple markets going on at the same time.

Take a firm in any market of your choice, and then consider this firm’s internal labor market. It often is a very competitive race who is going to be the CEO of the company. Yet, the characteristics that make a person more likely to win this race do not necessarily make him or her a good person to lead the company. Let me explain.

An interesting line of research in social anthropology analyzed what type of person is more likely to rise through the ranks to become the headman of a tribe. Often, this would be the most fierce, ambitious and aggressive warrior, who would be willing to take on all his opponents in the quest for leadership. Yet, interestingly, although characteristics such as fierceness and ambition would be helpful in becoming tribe leader, these characteristics were not necessarily positive for the future of the settlement, since these type of leaders were prone to take the tribe to war. This would ultimately take its toll on the size, strength and survival chances of the tribe. Thus, the same characteristics that would make people more likely to become the headman were likely to get the tribe in to trouble.

CEOs might not be all that different. Those people who are ambitious, risk-seeking and aggressive enough to be able to rise to the ultimate spot of CEO, just might be the same people who, once they’re there, take their firm on a conquest. Take acquisitions. They often offer the thrill of the chase. You select a target, mobilize resources and lead the attack. Sometimes there are others eyeing your prey but skilful maneuvering and a fierce battle will make you come out victorious again. And another victory means pictures in the newspapers, popping champagne, and a larger tribe to rule and command.

Yet, we have seen many firms going on an acquisition spree, inspired by their ambitious new CEO, who not for long went down in a blaze without much glory. The aggressiveness, boldness, and risk-taking behavior of the person at the helm had brought him or her to that position, but it didn’t translate well into a sensible corporate strategy.

Markets are in some form or another efficient, whether they are internal labor markets or markets for corporate control. But they may not be aligned, and victory in one may very well lead to defeat in another.

7 Comments for “Should we stop saying that the market is efficient?”

  • vlade says:

    Ultimately, we're a society, and a company is only other social organization. We all have an agenda and pursue it, and as often as not it's not really aligned with the organization's one.

    That's one of the reasons why I believe that management should be the owners or at least majority owners, as otherwise the "shareholder value alignement" just cannot exist.
    Assuming that humans will behave the way that someone thinks they should is I think the most common failing. The first rule of making rules should be "people will find their way around this rule" :)

  • John says:

    I share the same views. Liked your blog very much.

  • M A J Jeyaseelan says:

    Business cycles that haunt economies around the world every now and then are clear proofs of the inadequacy of the market mechanism. ( I am not using the word 'inefficient' deliberately.) Frequent corrections in the stock markets indicate the same. What economists forget is that market is a tool that is supposed to serve the society. It is in this context markets fail. First of all market is not an inclusive societal mechanism. There is an entry barrier everywhere in terms of purchasing power, education, social networks, political affiliations, corporate patronage, etc. The list is endless. The second most inadequacy of the market is its inability to deal with societal values as opposed to prices. There is still no way of putting a correct price on a genuine smile, loyalty, compassion, and even on qualities like risk taking. By equating everything to money, markets have managed to produce money hungry monsters. I can go on and on. My simple point is that it is important for all intelligent people to acknowledge the inadequacies of the market and make it more and more humane. It would be foolhardy to rely only on the market mechanism to deliver societal prosperity. While a market correction could bring about equilibration in stock prices, it has noway of taking care of the losses that an individual might have incurred during correction. Such losses at times can be devastating for the individual or their dependents.

  • vlade says:

    I beg to differ from the last poster.

    Markets provide exactly what they are supposed to provide (assuming we let them), which is price discovery and transparency.

    Note that I use "price" – that's because more or less we can put a price everything by comparing it with something else. Is a genuine smile worth enough to you to sell your house? No? Then we have an upper monetary limit on how much the smile is worth to you – it's not worth more than your house, which is worth to you X.
    If it is, then I'm still sure I can find something with monetary value which would be more worth to you (say a cancer treatment for someone in your family, if I were to pick a drastic example).
    We all have values, we all make choices based on those values, and most of them happens in real world where we transact.
    Again, market is just a mechanism to make those values obvious and transparent.

    The problem is, that once we get the transparency, as often as not we don't like what it exposes – such as that quite a lot of people values cheap flights over future of their children.

    I'd also like to point out that more of societal prosperity has been delivered by markets than by any other mechanism we have invented so far in our few thousands years of history.

  • M A J Jeyaseelan says:

    If markets are truly efficient then we should not be having such devastating business cycles in the first place. Secondly, there are no transparent markets. There are intermediaries that manipulate it willfully or distort it like what most governments do deliberately. Perfect demand supply equilibration might have been possible if all markets were auction oriented where the highest bidder always gets the goods. Nothing could be more wishful than to dream of transparent markets.

    What I would like to say in summary is that the failure of communism alone is no guarantee for the success of capitalism. If left to the markets entirely capitalist economies would plunge themselves in to deeper recession. Why are not all those who believe the efficiency of markets opposing government bail outs using tax money. Real markets are multidimensional and involve many more parameters than just the price. It is a pity that economists still want to view markets within the limited perspective two dimensional x,y graphs

  • vlade says:

    I have never claimed that markets are perfectly efficient. The strongest claim I'd make is that where real competition can exists, markets are more efficient in price discovery and transparency than any other mechanism we invented so far.
    This of course can be disrupted in a number of ways – from "natural" (such as insider information in health insurance, the fact that short-sellers int he markets don't have access to infinite money supply so irrational markets can kill them off more easily than bubble-riders etc. etc.), to crooking the markets intentionaly by special interest groups.

    The former can be dealt with, the latter is much bigger problem, because when we tie it together with democracy as practiced now, it is not that hard for special interest groups (be they left or right or whatever) to gain disproportionate power and as a result distort the playing field. IMO, effectively the only way to dislodge a well entrenched SIG is some sort of revolution – not necessarily political and violent, but technological, social etc. (fortunately for us, the more entrenched a SIG is, the less flexible it becomes. Although Chinese communist party is experimenting in that direction too :) ).

    That is why I agree that "free market" as such is a nonsense, and we have never had it – there must be some laws and regulations (at the very minimum personal property must be legaly defensible and contracts enforceable). Of course, the problem with it is what ones, and there I personally would go for laws which restrict the ability to create mono/oligopolies. If we had (a global) regulation that no bank can have assets (off or on balance sheet) of more than say 50bn dollars, growing with GDP deflator, I dare to say that the financial crisis we had wouldn't have been that severe.

    It's getting a bit off topic, but IMO large complicated systems work better if made up of a large number of simple relatively idependent parts than few very complicated ones with high degree of interdependency. And that is I believe situation when the markets work best too.
    Unfortunately, this is directly against interest of just about any SIG in existence.

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