Why Markets Make Mistakes

Henry Birdseye Weil

Massachusetts Institute of Technology (MIT) - Sloan School of Management

August 10, 2009

MIT Sloan Research Paper No. 4745-09

Many models of markets are based on assumptions of rationality, transparency, efficiency, and homogeneity in various combinations. They 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. Are these models acceptable simplifications, or can they be seriously misleading? The research described in this article explains why markets routinely and repeatedly make 'mistakes' that are inconsistent with the simplifying assumptions. 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. The undesirable outcomes could 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. The article illuminates the effects of bounded rationality, imperfect information, and fragmentation of decision making. Decision makers 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. Examples are drawn from airlines, telecommunications, IT, aerospace, energy, and media. The key conclusions in this article are about the critical roles of behavioral factors in the evolution of markets.

Number of Pages in PDF File: 24

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Date posted: August 12, 2009  

Suggested Citation

Weil, Henry Birdseye, Why Markets Make Mistakes (August 10, 2009). MIT Sloan Research Paper No. 4745-09. Available at SSRN: http://ssrn.com/abstract=1446802 or http://dx.doi.org/10.2139/ssrn.1446802

Contact Information

Henry Birdseye Weil (Contact Author)
Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )
Cambridge, MA 02142
United States
617-258-6101 (Phone)
617-253-2660 (Fax)
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