I knew I was going to enjoy The Inner Lives of Markets by Ray Fisman and Tim Sullivan when, early in the book, it mentions the use of Kakutani’s fixed point theorem in the proof of existence of general equilibrium. Not that this should put you off. All of the economics covered in this delightful book (shipping on 9 June in the UK, already shipping in the US) is described clearly and with a lovely lightness of touch.
As the book explains, “A market is just a technology, a mechanism where participants have the chance to directly affect resource allocation through an expression of their preferences.” They can be organised and run in many ways, and are varyingly effective at that principal task of allocating resources. The book begins (after an introduction featuring the famous Radford paper (pdf) on the economy of a WW2 prisoner of war camp) by explaining the elegant abstraction of general equilibrium theory and the welfare properties of markets. It goes on to the variety of ways in which the welfare properties do not hold, due to asymmetries of information, through the lens of a particular model or approach to modeling.
The first of these is Akerlof’s lemons model of second hand car sales – the adverse selection that can ultimately cause a market to collapse when sellers have more information about the product than buyers. Of course there are markets for second hand cars: devices such as warranties and nice showrooms help compensate for the information asymmetry. The book goes on to Spence’s introduction of signalling in labour and other markets.
There is a nice chapter covering auctions – including online auctions – and how these are evolving. The use of online auctions is decreasing over time; it seems the transactions costs are actually rather high, at least for most buyers. As the chapter observes, prices achieved in online auctions on sites like Ebay are about 10% lower than fixed prices for the same items, so this is rather a high transaction cost. The ‘auction discount’ across markets has grown over time from 3% in 2003 to 15% now. I liked this observation in the book about the scope for using auctions: “This lack of use [in practical applications] of the Vickrey [2nd price] auction was something of a puzzle to economists, who were captivated by the way that, in its elegant simplicity, the mechanism helped magically cure the bidders’ headaches over strategizing and over-paying.” It reminded me of a conversation with a friend who was helping test the auction one regulator had designed for a sale of spectrum licences; she said, “It was great fun. The economists assumed we wouldn’t talk to each other but of course we cheated like anything!”
The book proceeds on to digital platforms, and ends with Roth-style matching markets such as the kidney exchange – the latter a shorter version of Roth’s own excellent book, Who Gets What and Why.
One of the interesting threads through this new book is the strong defence it puts up of the integral role of maths in economics. Critics of economics often, of course, see the mathematization of the subject as one of its big flaws – how can you reduce the complexity of society to a few equations? Equally of course, this is nonsense (even though – as Paul Romer has explained – there is misuse of maths too): the humanities also use ‘models’, but with words rather than symbols – the causes of the First World War? Actor-network theory? And careful statistical inference cannot happen without representing the relationships being tested algebraically. The Inner Lives of Markets goes further, explaining that key insights in understanding and improving the way markets work came about because economists were using mathematics. Akerlof got his ‘lemons’ insight from attending a class on topology. Auction theory and market design similarly depend on sophisticated algorithms.
The book is an ideal read to introduce students to these areas of economics, and to describe to general readers the power and usefulness of a part of economics not very visible to the public but where substantial progress has occurred during the past 10 or 20 years. (The authors’ previous book, The Org, did the same for industrial organisation.) Digital platforms for example wouldn’t exist without digital technology, but equally wouldn’t exist without the economic technology. The Inner Lives of Markets is a very nice complement to and update of one of my favourite books, John McMillan’s Reinventing the Bazaar. It is clear and readable, with lots of examples of familiar, everyday contexts. It would be terrific if the message gets out that economics is about so much more than the ups and downs of the financial market and the arcana of macroeconomics.