Market design “form follows function”

16 October 2012. Do you still remember how after you had completed your traineeship or your studies, you were looking for a job? You probably wrote a letter and sent it to potential employers. With such “spontaneous” organisation, much ultimately depends on sheer chance, which does not always guarantee efficiency. It is for this reason that in the past decades, an “engineering” school of economics has developed, which organises markets on the basis of scientific findings.

Early examples of this were markets for graduates in medicine and law in the US and in Canada. This year’s two Nobel prize winners Alvin E. Roth und Lloyd S. Shapley provided central impulses to the development of this engineering school of thought in economics.

Bringing together supply and demand
Such a configuration of market mechanisms, which is also called “market design”, deals with the rules which bring together supply and demand. Traditionally, such “allocation mechanisms” developed in an unplanned fashion and tended to be formed by processes of cultural evolution. It is a central advance in knowledge to be able to understand that markets cannot only be described and roughly structured by a legal framework in the spirit of classic economic policy but that their rules can also be shaped and that their detailed configuration has a significant impact of their efficiency. One of the crucial factors of this idea was not only this very general insight but also the possibilities and necessities which emerged through the spread of the PC and the internet. Internet trade as practised on eBay is inconceivable without a procedure, thought out in advance, which brings supply and demand together. It is not an exaggeration to describe eBay’s allocation mechanism, its specific market design, as one of its value creation elements.

The example of eBay also reveals the speed with which deliberately designed market and allocation mechanisms change our everyday lives: by now, labour markets, internet and other auctions, markets for environmental certificates and energy are all deliberately designed on the basis of economic findings.

Markets become products
In addition, important market mechanisms are protected by patents; markets become products. Economics Nobel prize winner Lloyd S. Shapley laid the mathematical foundations for the market design of labour markets very early on. Together with David Gale, he demonstrated as early as 1962 what a procedure must look like that brings supply and demand together in an efficient manner. The specific procedure is stable in the sense that no demand/supply pair can find each other that are able to improve through a deviation from the result of this procedure.

This property is important in practice since without it, such procedures are not accepted and people’s long-term voluntary participation in them cannot be ensured. This procedure is of an almost aesthetic simplicity and can also be reproduced by a computer algorithm without any problems. However, it only has its desirable properties under certain assumptions, and these assumptions are not always satisfied in reality.

Market design for a complex world
Thus it may be, for example, that you would prefer to work in St.Gallen rather than in Zurich – but only if your partner also has a job in St.Gallen. If he or she works in Zurich, your preference will change. The complexity of such and similar cases means that optimal market designs can no longer be defined in precise mathematical terms, and other, experimental procedures must be used to find reasonable market designs.

It is one of Nobel prize winner Alvin E. Roth’s main achievements to have picked up the thread right here and to have added other, complementary procedures which help to develop market designs for a more complex world. They include experiments, computer simulations and empirical analyses. Besides these highly practical results concerning good market design, it is one of Shapley and Roth’s central merits to have created an awareness of the fact that market rules can be shaped with precision.

This is an idea which has an impact on the area indicated above and whose potential has not been exploited by far.

Picture: Photocase / Anoehre