Thursday, June 2, 2016

Who gets what and why – How market design makes us happier and richer

Alvin E. Roth has written a great book about market design. Here is why I recommend reading it.

“As an economist approaching a new market, I am something of a generalist, sort of like an experienced mountain climber approaching a new mountain.”

Market design and matching

First a definition: What is market design? It actually refers to setting the rules of how a market operates.

Second, why does this matter? The reason is that markets help matching offer and demand. In the words of the author, it determines “how we get the many things we choose in life that also must choose us”. The consequence then is that this matching process is one of the most important elements which influences on our life.

Matching is a pretty simple process only where the price is the only parameter deciding who gets what. Standardized commodity markets can serve as an example here. However, only very few markets work like this. Usually, a market involves other parameters, in addition to pricing: timing, availability, personal preferences, technical or biological compatibility, etc. This is usually where design problems kick in.

Market efficiency criteria

Before a market actually needs some form of design, you first need to know whether it is actually an efficient market or not. In his book, the author discusses the following criteria:

A market is thick when there are a lot of participants. Oftentimes, this is not an absolute question but depends on timing. In other words, you need lots of buyers at the same time when there are lots of sellers. Another aspect of market thickness is that it is self-reinforcing: As the Amazon marketplace shows, more buyers attract more sellers and vice versa.

Congestion means that there are too many participants. Alvin E. Roth has a nice formula here: It's the economic equivalent of traffic jam. The opposite of congestion is speed. But sometimes, markets can also become too fast to be efficient. The author gives the example of financial markets where market makers are driven out of the market by high frequency traders. The faster the market is the less have market makers the possibility to make money on a bid-ask spread. This makes market makers disappear. Thus, there will be less bid/ask offers in total on the market.

Market safety has three principal enemies:

  • Obviously, an illegal market (for example drugs or prostitution) cannot be safe as you cannot enforce a transaction in case your counter party defaults.
  • A related execution problem might even come up in legal markets: In the early days of the Internet, people were reluctant to buy on line because it was often unclear whether you would ever receive the ordered goods.
  • The market might be legal but dangerous (for example taxi drivers at night) and, thus, hamper people to participate in it.

The author sums market safety up in the statement that “participants on both sides of a transaction must be able to rely on each other and on the technology”.

Market simplicity is mainly about the way people communicate with each other. The easier it is for people to exchange offers and responses, the simpler a market will become. Recent digital technology has naturally helped a lot here. However, despite technology, confidentiality about people's wants and needs often complicates a market. Indeed, buyers can be reluctant revealing their true needs and preferences because they fear that sellers would then sell them a less desirable product only because they are willing to accept it.

A market is reliable when buyers are not only sure to get the ordered goods but also any additional service that they have agreed upon. This also applies to any information / customer experience about the product.

A repugnant market is the younger brother of the illegal market: Although no-one prevents people from transacting, public opinion simply finds a transaction inappropriate. These can have three main roots:

  • Objectification is the fear that the act of putting a price on something moves the object into the class of impersonal objects. This is the risk of something loosing its moral value.
  • Coercion = Substantial monetary payments might prove coercive, i.e. provide an offer that one cannot refuse. This can make people open to exploitation from which they deserve protection.
  • Allowing a transaction may not be criticizable as such. However, it may lead to a future development that we could regret. The author's example here is buying and selling kidneys.

Let's finish with market trustworthiness which is simply the sum of market safety and market reliability.

Market failures and design solutions:

“The “magic” of the market doesn't happen by magic: Many marketplaces fail to work well because of poor design.”

Once a market has failed, market design actually uses any tool that can enhance the above described efficiency criteria.

Solutions to market failure are sometimes invented, sometimes discovered, and often a bit of both. In addition, designs of markets usually evolve through trial and error.

Some of the tools that Professor Roth describes are:

  • Commoditizing a market enhances market efficiency in that sellers can sell to the whole market and buyers know exactly what they get.
  • Product differentiation is the opposite: It helps buyers to find the precise product they want but usually increases their dependency on a specific seller.
  • A clearinghouse makes it safe for people to state their preferences honestly: The clearinghouse only registers the preferences and tries to match them without communicating the positions to both parties.

The frustrating (or interesting – It depends how you see it.) feature of market design is that it will always be temporary. Markets actually evolve, fail, get fixed again and again...

Let me finish with a short quotation:

“I hope, [this book] will give you a new way to see the world and to understand who gets what – and why.”

In my view, this is a bit too ambitious. But the book is definitely worth reading.


Alvin E. Roth – Who gets what and why – 2015