August 29, 2015

Who gets what and why by Alvin E Roth

Who gets what and why by Alvin E Roth
(Nobel prize winner in economics)

Matching is economist-speak for how we get the many things we choose in life that also must choose us.  Until recently, economists often passed quickly over matching and focused primarily on commodity markets, in which prices alone determine who gets what. But, in matching markets, prices don’t work that way. For example, going to college can be costly and not everyone can afford it and even if it is affordable for some, the choice is not mainly with price alone.

Decisions that depend on what others are doing are called strategic decisions and are the concern of the branch of economics called game theory. Strategic decision making plays a big role in determining who does well or badly in many selection process. Often when we game theorists study a matching process, we learn how participants ‘game the system’ Well-designed matching process try to take into account the fact that participants are making strategic decisions.  A good marketplace makes participation safe and simple. .

Repugnant transactions - transaction that some people don’t want others to engage in- don’t have to involve money. But addition of money makes an otherwise acceptable transaction seem repugnant. Repugnance shows with particular clarity what all markets reveal: people’s values, desires and beliefs.

In the late 1800s, the economist William Stanley Jevons pointed out that the invention of money was a market design solution that overcame a major problem that severely limited barter, namely the need to find someone who both has what you want and wants what you have. Money eases the need to find this ‘double coincidence:’ with money in the market, it’s enough to find someone who has what you want. You can buy what you want from that person without having to find someone with whom you can trade goods.

In building up new markets, the entrepreneurs building them have had to figure out the following:

  1. How to make the market thick by attracting lots of buyers and sellers
  2. How to overcome the potential congestion that could result - that is, how to make the market quick even when it was thick:
  3. How to make the market safe and trustworthy

Making market safe is one of the oldest problems of market design, going back to well before the invention of agriculture, when hunters traded the ax heads and arrowheads that archaeologists today find thousands of miles from where they were made.

When participants in a market are reluctant to reveal crucial information, the market may run inefficiently. On eBay, concealing bid information from other bidders by sniping makes prices unpredictable and when there a lot of sniping, not every auction is won by the person who is willing to pay the most. Covisint was started in 2000 by a consortium of the biggest car companies. It was intended to be a transparent online marketplace for automobile makers and their suppliers. But it turned out that auto parts suppliers weren’t wild about making their prices public to auto companies and competitors. In 2004, the automakers threw in the towel and sold Covisint for a tiny fraction of what they’d invested in it.

Marketplaces as varied as eBay, FreeMarkets and the New York City Public school system reveal a challenge that must be faced by virtually all markets: how to manage the flow of information. No matter how well a market is otherwise designed, it will have trouble giving people what they want if it doesn’t make it safe for them to try to get what they want.

The solutions to problems in market design are sometime invented, sometimes discovered, and often a bit of both. The designs for many markets have evolved, usually through trial and error, over the long span of human history. So we can sometimes discover a solution to a new market failure in a design pioneered in another market.

Markets can be dramatically improved when their design encourages people to communicate essential information they might otherwise have kept to themselves. But sometimes markets suffer from too much communication. It is a paradox of market design that as communication gets easier and cheaper, it sometimes also gets less informative.

In a congested market - one in which it is impossible to explore every opportunity - it helps to be able to signal not only how desirable you are but also how interested. That is why, while many of us might wish to marry a movie star, we devote most of our efforts to finding and courting more realistic mates who might also like to marry us (Mutual interest is what separates courting couples from stalker and prey).

Asking a person out on a date in person offers lots of opportunities to send both kinds of signals. By comparison, arranging a date on the internet, which makes the dating market thicker by making initial contacts easier, also makes it harder to send credible signals to cut through the congestion.

When other signals may be cheap talks (sending e-greeting cards), these signals (posting a physical card, sending flowers on birthday, etc.) indicate that you are interested enough to use scarce resources that you can’t just send to everyone. So a scarce signal isn’t cheap talk; it comes with an opportunity cost - you could have sent that signal to someone else instead. In labor market, a cover letter in a job application can provide a powerful signal of interest, esp. if it shows that the candidate has spent time to learn about the job for which he or she is applying, or even that the applicant has spent time carefully crafting a letter addresses specifically to the job in question.

Near the beginning of his long essay ‘The Protestant Ethic and the spirit of Capitalism, Max Weber quotes Benjamin Franklin on the virtues of responsible lending and borrowing. Franklin’s view was the opposite of Polonius's: he felt that responsible borrowing and lending were Puritan virtues and he offered advice about how to use credit responsibly.

Economists have long been accustomed to the fact that cash payments can fill such gaps by providing incentives to increase supply: Adam Smith, in his book ‘An Inquiry into the Nature and Causes of the Wealth of Nations’, famously observed, “It is not from the benevolence of the butcher, the brewer, or the banker, that we respect our dinner, but from their regard to their own interest”.

The markets we try to ban, repugnant markets, are precisely that some people willingly take part in despite other’ opposition. People wanting to transact with one another is a powerful force. The same force that has made markets an ancient and pervasive human activity also leads to black markets springing up when legal ones are prevented. America's Prohibition period shows, sometimes banning a market leads to widespread lawbreaking. Let us consider one other example in which repugnant transactions are common: sex. People want to have sex with each other in circumstances that society disapproves of.Instead of a ban, we will more nearly achieve our goals if we try to channel behavior or offer alternatives (for this reason, we sometimes try to promote ‘safe sex’ rather than abstinence). In short, when we deal with sex, we need to recognize that we are dealing with powerful attractions. Markets are like that, too.

We encounter markets through marketplaces, just as we experience language through speeches, conversations, books, essays and tweets. And market are like languages. Both are ancient human inventions. Both are tools we use to organize ourselves, to cooperate and coordinate and compete with one another, and ultimately to figure out who gets what. These two fundamental human artifacts play a role in all the things we do and in everything we make (we cannot make love, let alone war, without them).

Markets, like languages, come in many varieties. Commodity markets are impersonal, but matching markets can be deeply personal, as personal as a job offer or a marriage proposal. And once you observe that matching is one of the major things that markets do, you realize that matching markets - markets in which prices don’t do all the work, and in which you care about whom you deal with - are everywhere and at many of the most important junctures of our lives.

As we start to understand better how markets and marketplaces work, we realize that we can intervene in them, redesign them, fix them when they are broker and start new ones where they will be useful. The growing ability in recent years of economists to be engineers is a bit like the epochal transformation that farming or medicine have experienced over the millennia. Markets are human artifacts, not natural phenomena. Markets design gives us a chance to maintain and improve some of humanity’s more ancient essential inventions.

No comments: