The Other Invisible Hand: How Markets Can Propagate Valuation Errors

Abstract

Markets are ubiquitous in modern society, a status often justified by their presumed ability to aggregate bits of incomplete information from many actors into a single, unbiased estimate of value. While acknowledging markets’ unique role, we suggest that they can also be potent in spreading individual valuation errors, thus inflating collective mistakes — price bubbles. We offer a more sociological interpretation of bubbles by advancing the notion that the very ubiquity of markets can cause traders to overweight market signals in a manner that weakens the quality of individual decision-making. We examine this process empirically in laboratory studies of asset trading in experimental markets. We find that even when traders possess and comprehend the information needed to price assets accurately, they remain overly attentive to market signals (i.e., others’ pricing). Thus, they are likely to mimic other traders’ valuations — even if at odds with the asset’s true value. We further predict and find that such overattention is also sensitive to differences in levels of ambiguity, as predicted by a perspective that theorizes markets as institutionalized practices. We conclude by highlighting the relevance of our perspective, empirical approach, and supportive findings for future research on valuation errors, price bubbles, market dynamics, and micro-institutional processes.