Designing markets

One of the (many) things I like about market design is the name. It’s a reminder that markets are social institutions too, and that there is a wide spectrum of ways of organising the allocation of resources. So often only the two extremes are discussed: ‘free’ markets (dependent only on property law and contract enforcement – oh, and social norms and culture, and infrastructure, and standards and…. but I digress); and ‘the state’ (with its benign and omniscient ability to analyse market failures and tell people what to do so they are fixed…. oh, wait).

Al Roth’s new book describing his career’s worth of market design, culminating in his Nobel prize with Lloyd Shapley, is a truly excellent overview of the subject. [amazon_link id=”000752076X” target=”_blank” ]Who Gets What and Why: the hidden world of matchmaking and market design[/amazon_link] is a very clear and non-technical description of what can cause markets to malfunction, and how to make them do a better job of matching up supply and demand. It includes the work for which he is most famous, on designing an exchange¬† to enable the matching of kidney donors and recipients, where no money changes hands in the market-like process.

[amazon_image id=”000752076X” link=”true” target=”_blank” size=”medium” ]Who Gets What – And Why: The Hidden World of Matchmaking and Market Design[/amazon_image]

The first section is a warm-up describing the pervasiveness and importance of markets, and some of the problems market design addresses. The second and third sections are the meat in the sandwich. Roth first of all explains why some markets will collapse, with many examples. The fundamental need is for a ‘thick’ market with plenty of buyers and sellers, in which people have enough time to make their decision, but neither the need nor the opportunity to act strategically. The problems are therefore: incentives to jump the gun ahead of most people in the market – which causes everyone to try & do so once somebody does; trades that occur too fast so people on the slower side of the market cannot make good decisions; rules that cause people to have to devise strategies other than expressing their true preferences; and ‘goldilocks’ communications between participants, not too fast/frequent and not too slow. The following section sets out market design solutions to each kind of problem.

For example, the ‘too soon’ problem featured in the market for first jobs for junior doctors in the US, as 2nd tier hospitals would make earlier and earlier binding and exploding offers to medical students – exploding meaning the candidate had as little as half an hour to say yes before the offer expired. They wanted to make sure they had the best students, but the good students faced the dilemma of a sure job versus the chance of a job at a competitive but better hospital. Attempts to reform the system always foundered on a lack of trust between hospitals. The solution was the famous ‘deferred acceptance’ algorithm run by a central clearing house: it ensures offers can be held until it is clear each student will not get a better one. Every hospital and every student gets their best possible match given everyone’s preferences.

The ‘too fast’ example is high frequency trading, where the millisecond speed means the market is actually thin at each moment. The proposed solution – not yet adopted by regulators – is to insist that all trades occur together once every second.

Matching students to schools is the example of a system that forced strategic behaviour under the old rules in New York and Boston, where Roth’s solutions have been implemented. Parents had to decide disguise their real preferences to reflect the fact that certain schools would only take pupils who had put them as first choice, and that some were so popular that the 2nd or 3rd choice had to reflect a realistic ‘insurance’ option. The deferred acceptance algorithm, with adjustments to reflect policies such as a sibling rule, was again the solution, making it safe to express true preferences.

The later chapters of the book cover other issues, among them signalling, and repugnant markets. Roth also emphasises two important factors: the role of culture in shaping how markets work (gastroenterologists vs orthopedic surgeons have sufficiently different professional cultures that their matching markets needed to be set up differently); and the need to work alongside politicians who might not take every bit of the economists’ advice. The context changes too, calling for redesigns – for example, the medical student matching market needed to be updated when more couples started looking for jobs in the same city.

[amazon_link id=”000752076X” target=”_blank” ]Who Gets What and Why[/amazon_link] has jumped to near the top of my list of books to recommend to students and non-economists to help explain (a) what a lot of economists actually do when they get involved in public policy and (b) why the standard political debate about ‘free markets versus government intervention’ is so utterly inadequate and misleading. Highly recommended.

3 thoughts on “Designing markets

  1. Pingback: Designing markets | Homines Economici

  2. Market design is a nice name, but presumably it is only in rare cases where markets are designed in the manner of a car.

    Most markets have emerged as an interplay of buyers and sellers, and the culture and institutions they find themselves in; not as a result of intentional design.

    That’s not to downplay its importance. I think I’ll come along to the Festival of Ideas. I’d quite like to hear Prof Shiller. Some of his most interesting ideas are creating macro markets in financial securities that will allow people to insure against the big economic risks in their lives; recessions, viability of careers etc. I expect that for such markets to take off a lot of design will have to go into them.

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