The Other Invisible Hand: How Markets Can Propagate Errors

Abstract

Markets, the arenas where many strategies are enacted, are ubiquitous in modern society. This status is often justified by their presumed ability to aggregate bits of information into a single unbiased estimate of value. While acknowledging their unique role, we suggest that markets can also propagate individual valuation errors, agglomerating them into price bubbles. We offer a more sociological interpretation of such collective errors by advancing the notion that the very ubiquity of markets can cause participants to overweight market signals, thereby undermining the accuracy of individual decision-making. To identify causality, we study behavior and outcomes in laboratory markets resembling highly competitive strategic markets. Consistent with a perspective that theorizes markets as institutionalized practices, we find that even when participants possess and comprehend the information needed to price assets accurately, they are overly attentive to market signals (i.e., others’ valuation). Thus, they are likely to mimic others’ valuations — even when these reflect a distortion of an asset’s true value. We further predict and find that such overattention is also sensitive to differences in levels of ambiguity, as institutional theory predicts. We conclude by highlighting the relevance of our micro-institutionalization perspective, empirical approach, and supportive findings for research on valuation errors, market dynamics, micro-institutional processes, and behavioral strategy.