How Hidden Markets Give Some People an Advantage You Don’t See - Tom Wheelwright and Judd B. Kessler

Key Concepts

• Hidden Markets: Markets where price does not adjust to determine allocation, leading to excess demand and the need for alternative allocation rules.
• Excess Demand: A situation where the quantity of a good or service demanded exceeds the quantity supplied at the prevailing price.
• Market Rules: The underlying dynamics and mechanisms that govern how scarce resources are allocated in a market.
• Allocation Mechanism: The process or system used to distribute scarce resources among those who want them.
• Hidden Costs: Costs associated with participating in hidden markets that are not immediately apparent, such as time spent waiting or researching.
• Three E's of Allocation: Equity, Efficiency, and Ease, which are criteria for evaluating the effectiveness of market allocation mechanisms.
• Costly Signals: Actions or behaviors that are expensive and time-consuming to produce, making them credible indicators of genuine interest or commitment.
• AI and Hidden Markets: The impact of artificial intelligence, particularly large language models, on the dynamics and credibility of signals in hidden markets.

Hidden Economy Within Your Business and Investing

This discussion, featuring Professor Jud Kesler from the Wharton School of Business and author of "Lucky by Design," delves into the concept of "hidden markets" and their implications for entrepreneurs and investors. The core argument is that beyond traditional revenue and expense tracking, a deeper understanding of the underlying economics of how scarce resources are allocated is crucial for success.

Understanding Hidden Markets

1. Definition and Core Principle: Hidden markets arise when the price mechanism fails to clear the market, resulting in excess demand. Instead of price adjusting to balance supply and demand, other rules dictate who gets access to the scarce resource. Professor Kesler emphasizes that while standard economics often focuses on supply equaling demand through price adjustments, this is not universally true, especially in many important markets individuals and businesses engage in daily.

2. Examples of Hidden Markets:

• Live Events: Tickets for popular artists like Taylor Swift are often sold below the market-clearing price, leading to more demand than supply.
• Hot Restaurants: Difficulty in securing reservations at popular establishments signifies excess demand.
• Fad Products: Items like Laboos, Beanie Babies, or Cabbage Patch dolls experience high demand with limited supply.
• Educational Institutions: Gaining admission to desirable elementary schools or colleges.
• Dating Market: Finding a suitable partner.
• Labor Market: Hiring the best talent for a firm.
• Healthcare: Accessing appointments with desired doctors or life-saving organ transplants.
• Personal Time and Attention: Entrepreneurs' time is a scarce resource that many people vie for.

3. The Role of Market Rules: In hidden markets, success hinges on understanding the specific rules governing allocation and developing appropriate strategies. These rules are not always obvious and can vary significantly.

Navigating Hidden Markets: Examples and Strategies

1. The Taylor Swift Concert Ticket Market:

• Historical Allocation (40 years ago): First-come, first-served lines outside box offices. The strategic game involved managing the "hidden cost" of time spent waiting, deciding when to arrive, and mitigating discomfort (e.g., bringing a friend, warm clothes).
• Evolution with Technology:
  • Pre-Internet: Phone-in orders (e.g., Ticketmaster) became a race to get through.
  • Internet Era: Online sales where speed is paramount. This has led to sophisticated strategies involving high-speed internet and awareness of release times.
  • Bots and Brokers: Ticket brokers use automated bots and fake accounts to acquire tickets, further complicating the market for individual consumers.
• Emergence of Secondary Markets: Resale markets for tickets at inflated prices.
• Lottery Systems: Rush lotteries or last-minute ticket releases are implemented to expand access.
• Key Takeaway: Market rules evolve with technology, requiring adaptive strategies. Understanding these evolving rules is critical.

2. Identifying Hidden Markets: The key is to identify the specific rules that determine allocation. This involves moving beyond assumptions and asking critical questions.

3. The Doctor's Appointment Example:

• Questioning the Waiting List: How does the doctor's office manage its waiting list? Is it a one-by-one offer, or a first-come, first-served race via email or phone?
• Strategic Advantage: Those who understand the rules (e.g., responding immediately to an email for a first-come, first-served race) gain an advantage.
• Disadvantage of Ignorance: Failing to understand these rules puts individuals at a disadvantage against those who have thought them through.

4. Healthcare as a Hidden Market: Professor Kesler acknowledges that healthcare can feel like a "game" where understanding the rules is paramount for fair access.

Strategies for Understanding and Navigating Hidden Markets

1. Hiring Experts:

• CPA Example: CPAs understand complex tax rules, a hidden market for many, and are hired to navigate them.
• High-Stakes Markets: For markets with very high stakes (e.g., private elementary school admissions in NYC), hiring consultants with repeated interactions and established reputations can provide not only advice but also credibility. A consultant's reputation is on the line if their client breaks promises, making their advice more trustworthy to admissions committees.

2. Empowering Yourself Through Inquiry:

• Asking Questions: Even without hiring an expert, individuals can ask clarifying questions:
  • "Am I allowed to enter this lottery multiple times?"
  • "If my friend enters with me, can we both win?"
  • "What time do people normally show up to get a table at 6 PM if there's a line?"
• Research: Conducting necessary research to understand the rules and devise the right strategy.

3. The Hidden Cost of Time and Research:

• Investment: Learning the rules and researching requires time and effort, which is itself a hidden cost.
• Balancing Professional Help vs. Self-Research: The decision depends on the stakes, the complexity of the market, and the individual's capacity.

4. The Role of AI:

• Uncertainty: Current AI capabilities are not always aligned with our predictions. Trusting AI for high-stakes tasks like navigating an IRS audit is not yet advisable without independent verification.
• Asking Better Questions: The quality of AI output depends on the quality of the input questions. Most people struggle to formulate the right questions to uncover hidden market dynamics.
• AI's Impact on Labor Markets: AI has dramatically reduced the cost of producing signals like cover letters, making it harder to discern genuine interest from AI-generated content. This necessitates relying on other, more costly signals.

5. Designing Your Own Hidden Markets:

• Personal Time and Attention: Entrepreneurs are designers of their own hidden markets for their time and attention. They control the rules of access.
• Intentionality: Instead of haphazard allocation, being intentional about setting rules for how time and attention are distributed is crucial.
• Colorado River Water Allocation Example: The "first in time, first in right" system, where early diversions get priority even during droughts, is presented as an inefficient and inequitable allocation mechanism. This contrasts with how individuals might manage their own schedules, inadvertently using similar inefficient rules.

The Three E's of Allocation: Equity, Efficiency, and Ease

Professor Kesler proposes three criteria for evaluating good allocation mechanisms:

• Efficiency: Scarce resources are used for their highest value. For example, an entrepreneur's time is spent on the most important meetings.
• Equity: People are treated fairly. This could mean spending a consistent amount of time with all employees or customers.
• Ease: The allocation mechanism is easy for market participants. This minimizes hidden costs like extensive research, waiting, or complex strategizing.

1. Overlooking "Ease": Market designers often overlook "ease" because they are not the ones experiencing the difficulty. They are the ones in their office, not waiting in line.

2. Reducing Friction (JSX Airline Example): JSX, an airline that operates as a private charter despite flying scheduled routes, reduces friction by allowing passengers to bypass TSA security. This is contrasted with traditional airports that might offer amenities like nice restaurants to mitigate the difficulty of their processes.

3. Rewarding Resource Abundance (TSA Pre-Check and Organ Donation):

• TSA Pre-Check: Participants who invest in the upfront process (fingerprinting, background checks) are rewarded with faster passage through security. This also makes the overall process more efficient for everyone by reducing the burden on TSA agents.
• Organ Donation: Countries like Israel, Singapore, and China have implemented policies where individuals who agree to be organ donors are prioritized if they later need a transplant. This incentivizes organ donation, making the resource more abundant and benefiting the entire system. Data from Israel showed substantial increases in organ donor sign-ups after implementing such a rule.

Applying Hidden Market Principles to Business

1. Identifying and Reducing Friction in a Tax Return Business:

• Friction Point: Gathering necessary information from clients is a significant bottleneck.
• Suggested Steps:
  • Prioritize and Reward Timeliness: Design rules that prioritize clients who provide essential information by a specific deadline. This creates a reward system, similar to TSA Pre-Check, where clients are incentivized to help eliminate bottlenecks.
  • Non-Financial Incentives: The reward doesn't have to be financial. Moving clients to the top of the queue for tax return processing can be a highly valued incentive, especially as filing deadlines approach.
  • Control Scarce Resources: Entrepreneurs control scarce resources like their time and the order of processing. These can be used as incentives to encourage desired client behavior.

2. AI's Impact on Labor Markets:

• The Challenge of Hiring: Identifying candidates who are both qualified and committed to staying with the firm is difficult. Historically, detailed cover letters served as costly signals of interest.
• AI's Disruption: Large language models (LLMs) like ChatGPT have drastically reduced the cost of producing such signals, making it harder to discern genuine interest.
• New Strategies: Businesses need to rely on other, less replicable signals:
  • In-person or direct LinkedIn networking.
  • Attendance at industry events.
  • Referrals.
  • These "costly signals" are becoming more important as AI makes other signals less credible.

Conclusion and Further Resources

Professor Kesler's work emphasizes that by understanding and intentionally designing the rules of hidden markets, individuals and businesses can gain more agency, achieve better outcomes, and create more efficient, equitable, and easier-to-navigate systems.

• Website: judkesler.com
• LinkedIn: Jud Kesler

The discussion concludes with the idea that mastering hidden economics is key to reducing business friction, improving customer experience, increasing revenue, and potentially reducing taxes.