Just based on a loose qualitative understanding of coherence arguments, one might think that the inexploitability (i.e. efficiency) of markets implies that they maximize a utility function.
This is probably a dumb beginner question indicative of not understanding the definition of key terms, but to reveal my ignorance anyway—isn’t any company that consistently makes a profit successfully exploiting the market? And if it is, why do we say that markets are inexploitable, if they’re built on the existence of countless actors exploiting them?
First, the standard economics answer: economic profit ≠ accounting profit. Economic profit is how much better a company does than their opportunity cost; accounting profit is revenue minus expenses. A trading firm packed with top-notch physicists, mathematicians, and programmers can make enormous accounting profit and yet still make zero economic profit, because the opportunity costs for such people are quite high. “Efficient markets” means zero economic profits, not zero accounting profits.
Second answer: as Zvi is fond of pointing out, the efficient market hypothesis is false (even after accounting for the distinction between economic and accounting profit). For instance, Renaissance—a real trading firm packed with top-notch physicists, mathematicians, and programmers—in fact makes far more money than the opportunity cost of its employees and capital. That said, market efficiency is still a very good approximation for a lot of purposes, and I’d be very curious to know whether selection pressures have already induced the trades which would make markets approximately aggregate into a utility maximizer.
This is probably a dumb beginner question indicative of not understanding the definition of key terms, but to reveal my ignorance anyway—isn’t any company that consistently makes a profit successfully exploiting the market? And if it is, why do we say that markets are inexploitable, if they’re built on the existence of countless actors exploiting them?
Two answers here.
First, the standard economics answer: economic profit ≠ accounting profit. Economic profit is how much better a company does than their opportunity cost; accounting profit is revenue minus expenses. A trading firm packed with top-notch physicists, mathematicians, and programmers can make enormous accounting profit and yet still make zero economic profit, because the opportunity costs for such people are quite high. “Efficient markets” means zero economic profits, not zero accounting profits.
Second answer: as Zvi is fond of pointing out, the efficient market hypothesis is false (even after accounting for the distinction between economic and accounting profit). For instance, Renaissance—a real trading firm packed with top-notch physicists, mathematicians, and programmers—in fact makes far more money than the opportunity cost of its employees and capital. That said, market efficiency is still a very good approximation for a lot of purposes, and I’d be very curious to know whether selection pressures have already induced the trades which would make markets approximately aggregate into a utility maximizer.