{"id":5485,"date":"2017-02-08T10:33:46","date_gmt":"2017-02-08T15:33:46","guid":{"rendered":"http:\/\/www.jasonapollovoss.local\/?p=5485"},"modified":"2018-09-21T02:03:29","modified_gmt":"2018-09-21T06:03:29","slug":"where-markets-fail-markets-assume-a-context","status":"publish","type":"post","link":"https:\/\/jasonapollovoss.com\/web\/2017\/02\/08\/where-markets-fail-markets-assume-a-context\/","title":{"rendered":"Where Markets Fail: Markets Assume a Context"},"content":{"rendered":"

\"Where<\/span><\/p>\n

In the premiere edition<\/a>\u00a0of the Where Markets Fail series<\/a>, I pointed out that markets are imperfect discounting mechanisms. In this installment, I demonstrate that markets assume a context entirely out of view of their participants, which can have deleterious effects for\u00a0both suppliers and demanders.<\/span><\/p>\n

Let me lead with an example: In 1994 there was a price for camera film as well as a price for developing that film into photographs. These markets functioned exceptionally well and many companies made money producing film, especially Kodak and Fuji. Many local shops, in turn,\u00a0made money in film development by creating photographic images.<\/span><\/p>\n

Yet these two markets had suppliers that assumed incorrect contexts, specifically film and processing. The true context was photographic images \u2014 the ends \u2014 and not film and processing \u2014 the means.<\/span><\/p>\n

Even on the demand side, consumers did not understand their market either. They thought they were consumers of film and processing. Only when digital cameras overtook the market for the creation of photographic images did the old implicit assumption look strange and backward.<\/span><\/p>\n

You may believe this is simply the destructive end\u00a0of Joseph Schumpeter\u2019s famous “creative destruction,” but something more important is hidden here. By taking a context for granted, markets do something else: They presuppose their own legitimacy and, therefore, only discount affirmations of that legitimacy.<\/span><\/p>\n

The film and processing markets developed\u00a0when products were offered up for sale to consumers back in the 1800’s. Thereafter, every transaction involving those products qualified as a tacit \u201cyes\u201d vote for those markets. So long as demand is strong enough for a good or service to generate profits, that market’s underlying premise is that \u201cyes\u201d rules the day.<\/span><\/p>\n

But what about all of the \u201cno\u201d votes for that good or service? How does the market register them? Only on the margin. That is, only if enough participants exit the market and marginal profits dip below marginal costs are the \u201cno\u201d votes counted.<\/span><\/p>\n

This can take a very long time. Yet, the underlying assumption is that the market is viable and that it is manifest destiny to seek out additional \u201cyes\u201d votes, to expand, and search for growth opportunities.<\/span><\/p>\n

Again, you may think this is benign. But because markets assume a context \u2014\u00a0usually that the market is legitimate and that \u201cyes\u201d votes are what matters \u2014 systemic outcomes can result \u2014 securities market bubbles, for example. Here the assumed premise is that a market\u2019s activity is legitimate just because there are participants in that market. \u201cYes\u201d votes (bidders) are happily filled by suppliers (askers). Both bidders and suppliers believe prices are legitimate simply because bids and asks lead to clearance.<\/span><\/p>\n

In the market for mortgage-backed securities circa 2004, bidders and suppliers took for granted\u00a0that prices for the bundling of subprime mortgages into supposedly risk-reducing portfolios were fair. But this was the incorrect context and incorrect assumption, and the market had no way of explicitly recognizing \u201cno\u201d votes (except for shorting) so long as marginal supply and marginal demand met.<\/span><\/p>\n

This demonstrates another problem created because markets presuppose\u00a0a context. If a market forms and persists, if marginal revenues exceed marginal costs and generate profits, then its activity is implicitly accepted as legitimate. But is it? After all, there are markets for many illegal and unethical activities, from drug dealing to murder.<\/span><\/p>\n

Put another way, markets are not meant to be ethical. Instead, they are mechanisms for establishing clearing prices that match supply and demand.<\/span><\/p>\n

But in the modern world, where capitalism is triumphant in so many spectacular ways, we have come to believe markets can improve behavior and ethics. After all, when outcomes and ethics in our culture are seen as wayward, we frequently default to discussions about “incentives” as the missing ingredient<\/a>.<\/span><\/p>\n

What do we mean by this? That if we alter the underlying economics of \u201ca market,\u201d we can drive behaviors.<\/span><\/p>\n

This infatuation with the resource allocation benefits of capitalism is a misguided conflation of these conversations that have nothing to do with markets. Why? Because if something can be priced, we assume that it is a legitimate activity.<\/span><\/p>\n

How is this made manifest? One example is how we seek to price externalities, such as polluting the air or water, as a way of driving change and behavioral outcomes. The implicit assumption is that polluting the air or water are legitimate activities, if only to the degree that marginal benefits still exceed marginal costs. Lost in that assumed context is how to log the \u201cno\u201d votes.<\/span><\/p>\n

Yes, license terms on the part of market makers are designed to reduce volumes of externalities to “acceptable” levels. But what happens when our future discounting abilities are faulty? We end up legitimizing activities \u2014 pollution and weapons manufacturing, for example \u2014 that can potentially\u00a0undermine all other markets.<\/span><\/p>\n

In finance, many practitioners bristle at industry regulations. I am no apologist for overregulation \u2014 though I was quite happy under Glass-Steagall. But perhaps we arch-capitalists in finance should see the regulation now in place in our industry as the \u201cno\u201d votes registered \u2014 you guessed it \u2014 out of context.<\/span><\/p>\n

Why? Because our assumed context is that our activities are legitimate, but the public and their elected officials may not necessarily agree.<\/span><\/p>\n

Possible Remedies<\/strong><\/span><\/p>\n