Roger Martin – who is the former dean of the Rotman School of Management and one of my favorite business thinkers – recently published a post on the Harvard Business Review blog called: The Dark Side of Efficient Markets.

In it, he makes an interesting distinction between what he calls use-driven markets and expectations-driven markets, the latter of which is assumed to be the more efficient one:

In the natural evolution of markets, as markets become more efficient, they turn from being use-driven to expectations-driven — like equities, real estate, or derivatives based on both.

The example he starts off with is that of corn. In its simplest form, this market is about farmers growing corn, taking it to a local market, and then selling it to real humans who will then go home and eat it for dinner. Simple. And this is what he means by a use-driven market.

But as markets grow and evolve, you have middle agents or market makers that insert themselves between buyers and sellers, suppliers and consumers. They help create greater marketplace liquidity and generally help buyers and sellers find each other and transact.

However, as this happens, Roger argues that the game eventually shifts from being use-driven to expectations-driven. Now people buy, not necessarily to consume, but to invest, resell, and generally speculate on future values. In other words, they stop buying the corn to eat it. And instead buy it (or sell it) because of what they think it might be worth at some point in the future.

Now, his argument is that even though this latter stage is considered to be more “efficient”, there’s a dark side to it: increased price volatility. When people are buying, not because they need something, but because of future expectations, it can lead to big price swings. And that’s because the market is now being driven by fear and greed, as opposed to utility. Interesting. 

But I want to talk about something a bit different today. I agree with him, but I want to look at it from a different angle.

What I’m instead curious about after reading his article are the following:

• Are these non-use-driven markets really that “efficient”?

• Is this a natural market evolution only because we had no other choice and no other distribution options?

• And how does the internet change this natural evolution?

Efficient markets are supposed to be based on perfect information. Buyers and sellers know the same things, prices accurately reflect intrinsic value, and all that other good stuff. But while this may be more true in some markets – such as perhaps the stock market – I would argue that it’s far from the truth in others.

The real estate market in my view is actually an imperfect market. There’s lots of missing information and there’s overall poor transparency. And I’m sure this also leads to big distortions in the market. So I find it difficult to classify the real estate market as an efficient one – though it may still have a dark side.

I also don’t think you can talk about markets, today, without talking about the internet. One of the most interesting things for me is how it’s completely rewriting distribution between buyers and sellers, producers and consumer.

In the old days, we needed middle actors because it wasn’t cost effective to distribute on your own. If I wanted to write about cities every day, I would have had to get picked up by some newspaper or publication. But today (for better or for worse), I and anybody else can self-publish for basically no cost. The same goes for videos on YouTube, short-term spaces on Airbnb, and so on.

Now, I’m not exactly sure how the changes taking place in marketplaces will ultimately play out in the financial markets, but I do think there’s room for our markets – the simple act of people buying and selling stuff – to get a lot more “efficient”. And as that happens, maybe the dark side won’t be as dark anymore.

Image: Flickr

Roger Martin – who is the former dean of the Rotman School of Management and one of my favorite business thinkers – recently published a post on the Harvard Business Review blog called: The Dark Side of Efficient Markets.

In it, he makes an interesting distinction between what he calls use-driven markets and expectations-driven markets, the latter of which is assumed to be the more efficient one:

In the natural evolution of markets, as markets become more efficient, they turn from being use-driven to expectations-driven — like equities, real estate, or derivatives based on both.

The example he starts off with is that of corn. In its simplest form, this market is about farmers growing corn, taking it to a local market, and then selling it to real humans who will then go home and eat it for dinner. Simple. And this is what he means by a use-driven market.

But as markets grow and evolve, you have middle agents or market makers that insert themselves between buyers and sellers, suppliers and consumers. They help create greater marketplace liquidity and generally help buyers and sellers find each other and transact.

However, as this happens, Roger argues that the game eventually shifts from being use-driven to expectations-driven. Now people buy, not necessarily to consume, but to invest, resell, and generally speculate on future values. In other words, they stop buying the corn to eat it. And instead buy it (or sell it) because of what they think it might be worth at some point in the future.

Now, his argument is that even though this latter stage is considered to be more “efficient”, there’s a dark side to it: increased price volatility. When people are buying, not because they need something, but because of future expectations, it can lead to big price swings. And that’s because the market is now being driven by fear and greed, as opposed to utility. Interesting. 

But I want to talk about something a bit different today. I agree with him, but I want to look at it from a different angle.

What I’m instead curious about after reading his article are the following:

• Are these non-use-driven markets really that “efficient”?

• Is this a natural market evolution only because we had no other choice and no other distribution options?

• And how does the internet change this natural evolution?

Efficient markets are supposed to be based on perfect information. Buyers and sellers know the same things, prices accurately reflect intrinsic value, and all that other good stuff. But while this may be more true in some markets – such as perhaps the stock market – I would argue that it’s far from the truth in others.

The real estate market in my view is actually an imperfect market. There’s lots of missing information and there’s overall poor transparency. And I’m sure this also leads to big distortions in the market. So I find it difficult to classify the real estate market as an efficient one – though it may still have a dark side.

I also don’t think you can talk about markets, today, without talking about the internet. One of the most interesting things for me is how it’s completely rewriting distribution between buyers and sellers, producers and consumer.

In the old days, we needed middle actors because it wasn’t cost effective to distribute on your own. If I wanted to write about cities every day, I would have had to get picked up by some newspaper or publication. But today (for better or for worse), I and anybody else can self-publish for basically no cost. The same goes for videos on YouTube, short-term spaces on Airbnb, and so on.

Now, I’m not exactly sure how the changes taking place in marketplaces will ultimately play out in the financial markets, but I do think there’s room for our markets – the simple act of people buying and selling stuff – to get a lot more “efficient”. And as that happens, maybe the dark side won’t be as dark anymore.

Image: Flickr