When the Market Misleads: Stock Prices, Firm Behavior, and Industry Evolution

Abstract

This paper augments learning and institutional theories of firm behavior with an explicit focus on the idiosyncratic characteristics of learning from financial markets. Various streams of literature implicitly assume that financial markets influence firm strategies, yet the specifics of these interactions are not well specified. Motivated by a case study of the retail brokerage industry, this study proposes three particular characteristics of learning from financial markets. First, there is vicarious learning from outcomes (e.g., stock valuations), yet this has characteristics that are more similar to institutional forms of mimetic isomorphism. Second, the forward-looking and complex nature of financial valuations incites a paradoxically simplified type of crude heuristic learning. Third, there is a mutual and simultaneous learning process in that firms learn from financial markets, which in turn are themselves in a process of social construction. This combination of special characteristics suggests a number of learning pathologies that center around an increasing likelihood (compared with other types of learning and adaptation) of falling prey to misleading signals. A computer simulation, based on a model in which Cournot duopolists play a multistage game involving investment and cost reduction, explores the implications of these characteristics and pathologies in a systematic way.