Ben Southwood recently directed me to an interesting post by Sam Atis:
In the post, Sam Atis suggested that the basic idea behind the Efficient Markets Hypothesis could also be applied to other areas of life. Here’s one of his examples:
Thinking about which charities to donate to is long and difficult, and I’m probably not smart enough to do it properly anyway. But GiveWell does a load of research, so I should just donate to whatever charities they recommend as the most effective.
I find that the more efficient the market, the less time I need to spend on annoying tasks like information gathering. For instance, while the grocery store market is not perfectly competitive, it is efficient enough that I don’t bother doing price comparisons. I rush through the store grabbing what looks good, assuming that if the price of an item were wildly out of line then the store would not find willing consumers for the good. In a sense, I free ride off the people that do check prices more carefully. Every so often I get “ripped off”, but I’m willing to pay that price in order to save valuable time.
Cyber Monday provides another good example. When I don’t know much about a product that I’m purchasing online, I often opt for the most popular version. The fact that one company’s product greatly outsells its competitors does not necessarily mean it’s better, but popularity is certainly one valuable piece of information, especially when combined with the online ratings.
The development of the internet hasn’t just provided consumer ratings, it has also improved the quality of consumer goods. Some small towns that are outside of major metro areas have high quality restaurants that would not be able to survive without the internet. In the past, on road trips we used to stop at the least bad chain restaurant near a freeway exit. Now we search the internet for the highly rated Vietnamese place that might be a few blocks further from the highway. Producing high quality is expensive, and firms can only recoup the costs of doing so if consumers have the information necessary to make informed choices.
Even in cases where market efficiency falls short of the theoretical ideal, a market may be efficient enough to offer major benefits to consumers that wish to avoid time intensive search costs. The EMH has never been literally true; it has always been an approximation of reality. Over time, however, more and more product markets are becoming increasingly like the relatively efficient financial markets.
READER COMMENTS
Spencer
Dec 4 2022 at 1:30pm
“The most important assumption underlying the efficient market hypothesis is that all information relevant to stock prices is freely available and shared with all market participants.”
…You mean like crypto and tulip bulbs? Or: buy the rumor sell the news?
…No, it’s more like “Caveat emptor”
…The board of directors of an REIT can suspend the redemption policy…
…Supply and demand, clip some coupons.
Mark Brophy
Dec 6 2022 at 10:03am
It’s not only tulip bulbs and crypto, it’s a big company, Cisco, covered by many analysts, too, that was wildly overpriced 22 years ago. A year ago, if you had thought that the market for Facebook and Amazon stock was efficient, you’d have lost big even if you had hedged it with an inverse S&P ETF. People invest in ETFs because they know that the market for any big company could be wildly inefficient.
john hare
Dec 4 2022 at 1:33pm
I have had my mobile service with AT&T for over 30 years. I am well aware of better prices with other servers, but as long as they keep my provider in line, it’s not worth my time to constantly shop the product.
Jon Murphy
Dec 4 2022 at 1:43pm
And even to the extent one gets “ripped off,” the ripping is fairly minor. To stick with grocery stores, I shop at Trader Joes. For much of what I buy, TJ’s is cheaper than Ingles, the other local grocery store. However, TJ’s is more expensive when it comes to dairy and meat. While more expensive, the difference is measured in cents (a gallon of milk at my TJ’s goes for $3.60 while it’s about $3.10 at Ingles). Is TJ’s engaging in some monopoly pricing? Yes. But it’s such a small difference.
David Seltzer
Dec 5 2022 at 5:35pm
“Every so often I get “ripped off”, but I’m willing to pay that price in order to save valuable time.” How can one be “ripped off” if they are are informed as to alternatives and the proceed to engage in voluntary exchange? As I understand the phrase, being ripped off is the result of asymmetric information and little or no alternative.
Jon Murphy
Dec 7 2022 at 7:35am
I agree. I’m using the term in response to Scott. And the way I read him using the term is to mean generally some sort of monopoly pricing power. I see him as using the term colloquially rather than precisely.
David Seltzer
Dec 7 2022 at 11:42am
Jon, good point. My wife often suggests I’m a bit more pedantic than is necessary. LOL
nobody.really
Dec 4 2022 at 8:45pm
Two thoughts on efficient market signals–but not the EMH specifically.
1: Regarding the internet–I’m old enough to remember when Amazon.com was a bookstore–and one of it’s first competitive consequences was to kill off a lot of independent bookstores. Many decried this fact, emphasizing the importance of literature and reading, etc. Or something. Honestly, it’s a bit hard to discern what the problem was. Because the truth was that Amazon made VASTLY more books available to people, and made it pretty darn easy to search for them. Like the horse & buggy, book stores seem like quaint, beloved, inefficient vestiges of the past that will endure largely on the power of nostalgia (not that there’s anything wrong with that.)
2: Regarding restaurants and road trips–I’m old enough to remember a popular strategy of free-riding on the “revealed preference” of experts: If you observe a lot of truckers at a place, it must be a pretty good, right? I subsequently revised this theory: If you observe a lot of truckers at a place, it probably has lots of a) showers, b) drugs, and c) prostitutes. That is, the presents of truckers DOES signal quality–just a different quality than I was looking for.
Scott Sumner
Dec 4 2022 at 11:29pm
Jon, John and Nobody, Good comments.
Michael Sandifer
Dec 4 2022 at 11:52pm
Yes, the internet has made price comparisons so easy, that price matching has become much more common. Also, obviously websites like Zillow have made the real estate market more efficient, as many internet innovations and falling commissions have made the stock market more efficient.
Jose Pablo
Dec 5 2022 at 2:32pm
On the other hand this has made pricing more complicated, in an effort by companies to make prices more difficult to compare.
Airlines are a particularly annoying example.
BC
Dec 5 2022 at 6:01am
Yes, we rely on market quasi-efficiency all the time without necessarily realizing it. No one can research everything. However, quasi-efficiency in consumer markets is different from financial markets due to differences in consumers’ tastes and preferences. A remarkable feature of financial market efficiency — at least the CAPM version — is that one’s risk preferences shouldn’t affect one’s valuation of a security. Risk preferences affect only how much of the market portfolio (index fund) one should want to hold. So, a risk averse investor doesn’t have to buy a different risky portfolio than a risk tolerant investor; the risk averse investor would just hold less of the market portfolio. In contrast, differences in consumer preferences lead to differences in what consumers would be willing to pay for various goods.
For example, I notice that the CVS near my downtown apartment charges significantly higher prices for the same good than does a suburban supermarket a few miles away. The price differences are probably “efficient” in the sense that they reflect higher real estate costs for the CVS store. However, that doesn’t mean that a typical suburban resident should be willing to pay the same prices as a downtown dweller or office worker if that suburban resident doesn’t value the location premium embedded in CVS prices.
I similarly notice that Amazon tends to charge equal or lower prices for the same good than other retailers (online and bricks-and-mortar), and Xfinity Mobile is cheaper than Verizon Wireless even though both use Verizon’s network and, thus, offer the same coverage (except perhaps during high congestion periods when Verizon may favor its own customers). Price differences may be efficient. Amazon may have lower costs due to logistical efficiency. Xfinity Mobile may have lower marketing costs because they can only offer the service to their existing home internet customers. Some consumers may be willing to pay more to shop at Amazon’s competitors for personal convenience or for Verizon’s service due to the risk that Verizon will favor its own users over Xfinity’s during high congestion periods. Also, they may not want to buy Xfinity’s home internet service. But, a consumer without those same preferences would probably not want to pay the price premiums.
Finally, warranties and insurance sold at point-of-sale, e.g., warranties on electronics and travel insurance sold when someone books a ticket, are notoriously “overpriced”. One might be able to tell an “efficiency” story around convenience. However, I think the high prices mostly reflect uncompetitive markets: competing insurers can’t offer their products to the consumer at point of sale, so competition doesn’t drive prices down towards actuarial value.
Scott Sumner
Dec 5 2022 at 12:04pm
I think those overpriced warranties are a form of price discrimination.
Rajat
Dec 5 2022 at 6:56am
I’m wondering whether an implication of what you’re saying is that markets for many goods and services have become more competitive: offerings have become more uniform across price-quality space and quality has increased. But could the offerings have become uniformly more expensive?
Lots of recent research has indicated that US product markets have become more concentrated and exhibit higher profit margins. What do you make of this? It could be increasing returns to scale and network effects leading to lower prices and higher margins. But that should mean less homogeneity among offerings, not more.
Scott Sumner
Dec 5 2022 at 12:03pm
Is it possible that companies like Amazon have both higher profit margins and lower prices than traditional retailers?
Rajat
Dec 5 2022 at 3:20pm
Yes, it could be. But the empirical phenomenon is wider than big tech. My point was that if scale efficiencies were responsible for higher margins, you would expect ‘winner’ firms to dominate and choices to be limited to one or two. But what you’re describing seems to be more competition in a structural sense of more higher-quality options to choose between, such that it almost doesn’t matter which one you pick. So instead of chain fast-food stores making high profits due to their perceived reliability, good restaurants across a wider geography can prosper, That should lead to lower margins I would have thought?
Incidentally, things like Cyber Monday don’t seem to square with the EMH. Why should firms offer big sales a month before Xmas on items that have nothing to do with Thanksgiving – unlike say, selling Xmas decorations or seasonal clothes after Xmas when they need to be stored for a year?
MarkW
Dec 5 2022 at 7:38am
I’ve long been both an index investor and Givewell donor, so this seems right on point.
Producing high quality is expensive, and firms can only recoup the costs of doing so if consumers have the information necessary to make informed choices.
It doesn’t have to be greatly expensive, just marginally. In former times, hotels and restaurants catering to tourists (therefore one-time customers) could get away lousy service even if it saved them only a little money. But review sites thankfully make this much more difficult (or on the positive side, properly direct rewards to the more honest, skilled, conscientious sellers who do a better job).
As for getting the best deals, I have a friend who has a buddy ‘Ed’ who’s always deal hunting. Ed is always telling him about his latest bargain. My friend told Ed, “I don’t have to waste my time bargain hunting — I have a service that costs me $500 a year and always gets me the best deals on everything!” Ed was very interested until my friend told him, he didn’t even need to sign up to use the service since it was an imaginary, virtual service. Just stop bargain hunting and pay the extra $500!
That said, I’m a bit of a bargain hunter myself and think that $500 is a serious underestimate of how much you can not spend if you focus on the right high-leverage situations — houses, cars, flights, dining out, contractors, appliances, electronics and a few other categories. There are plenty of products and services where a 2x or more (sometimes much more) increase in price yields only a very marginal improvement in utility — unless you’re one of those folks who derives enormous utility from status goods. Sometimes when the status value goes up, other utility decreases (as with some fancy and complex but therefore more fragile and unreliable luxury goods).
Knut P. Heen
Dec 5 2022 at 8:02am
The EMH applies to stocks and bonds because money mostly has a common value component (today there may be a taste for green investments). The EMH does not apply to goods with a mostly private value component. The fact that someone is willing to pay a lot for frogs or snails, does not imply that frogs or snails are food for me.
David Seltzer
Dec 5 2022 at 5:59pm
Knut, good point. When one considers the Joint Hypothesis the EMH, by itself, is not a well-defined and empirically refutable hypothesis. Individual investors’ preferences and aversion to risk which varies over time must be known. To your point, frogs and snails are not food for me either. Nor am I a vegan.
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