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Friday, November 02, 2007

Market Design

The term market failure is often used when we don't like the market outcome. Markets are dependent on the rules and constraints in place. Incentives, transaction costs, information and regulation all matter in producing particular outcomes. Sometimes we know enough to improve the rules and sometimes we don't. One section of this Arnold Kling column, So You Want to be a Masonomist deals with the matter:

At the University of Chicago, economists lean to the right of the economics profession. They are known for saying, in effect, "Markets work well. Use the market."

At MIT and other bastions of mainstream economics, most economists are to the left of center but to the right of the academic community as a whole. These economists are known for saying, in effect, "Markets fail. Use government."

Masonomics says, "Markets fail. Use markets."

Somewhere along the way, mainstream economics became hung up on the concept of a perfect market and an optimal allocation of resources. The conditions necessary for a perfect market are absurdly demanding. Everything in the economy must be transparent. Managers must have perfect information about worker productivity and consumers must have perfect information about product quality. There can be nothing that gives an advantage to a firm with a large market share. There cannot be any benefits or costs of any market activity that spill over beyond that market.

The argument between Chicago and MIT seems to be over whether perfect markets are a "good approximation" or a "bad approximation" to reality. Masonomics goes along with the MIT view that perfect markets are a bad approximation to reality. But we do not look to government as a "solution" to imperfect markets.

Masonomics sees market failure as a motivation for entrepreneurship. As an example of market failure, let us use a classic case described by a Nobel Laureate, which is that the seller of a used car knows more about the condition of the car than the buyer. Masonomics predicts that entrepreneurs will try to address this problem. In fact, there are a number of entrepreneurial solutions. Buyers can obtain vehicle history reports. Sellers can offer warranties. Firms such as Carmax undertake professional inspections and stake their reputation on the quality of the cars that they sell.

Masonomics worries much more about government failure than market failure. Governments do not face competitive pressure. They are immune from the "creative destruction" of entrepreneurial innovation. In the market, ineffective firms go out of business. In government, ineffective programs develop powerful constituent groups with a stake in their perpetuation.

I was thinking about the relevance of this because recent winners of the Nobel Prize in Economics focused on Mechanism Design. Economist Peter Boettke give us these posts,
Explaining Mechanism Design Theory and here

Leonid Hurwicz (along with Roger Myerson and Eric Maskin) have been named the 2007 Nobel Prize winners in economics for their foundational work in mechanism design theory.

Mechanism design theory ---- which seeks to find rules of the game so that the institutional structure operating under those rules will produce social optimum ---- was a by-product of Hayek's informational and incentive challenge to socialism and market socialism in the 1930s and 1940s. Mathematical economists who took Hayek's challenge seriously set off on the path to provide the appropriate mechanism design that would meet Hayek's challenge.

Surely mechanism design theory has its problems --- don't all intellectual efforts? --- but its original motivation (to answer Hayek's challenge), and its subsequent development (focus on rules, incentives and information) is very useful for studying firms, markets, politics, and ultimately economic systems.
Alex Tabarrock explains further:

Mechanism design is a very general way of thinking about institutions. An institution or mechanism takes as input "messages" or "signals" from agents and it responds with an outcome. The idea of mechanism design is to create institutions that produce a desirable outcome while respecting the fact that agents have private information and are self-interested. It turns out that designing mechanisms that work well while respecting information and self-interest constraints is very difficult.

Ironically, the market, an undesigned mechanism, is the best example of a powerful incentive-compatible mechanism. Thus, in their explanation for the prize the Nobel committee wrote:

"These results support Friedrich Hayek's (1945) argument that markets efficiently aggregate relevant private information."

Mechanism design, however, is not simply a mathematical apparatus justifying the insights of Hayek. Leonid Hurwicz, the godfather of the field who is now in his nineties, was influenced by Hayek and by his opponent Oscar Lange. One can think of Hurwicz as trying to prove when the goals of Lange could work even taking into account the objections of Hayek.

It's long been known that markets are challenged by externalities, public goods, asymmetric information and so forth. Standard public finance theory says "thus government"—a clear example of the nirvana fallacy.

Mechanism design theorists at least take their challenge seriously, and thus try to design institutions that work under the same constraints as the market—i.e. institutions that respect information and self-interest constraints. The results have been mixed.

More realistically, I see mechanism design as a tool to make markets more powerful. In some situations, for example, mechanism design shows that public goods can be voluntarily provided. In other situations, mechanism design can make government more effective, but it will do so by making government more "market-like."

Overall, mechanism design increases our appreciation of markets, if only by showing how difficult it is to produce good outcomes while respecting the constraints that markets must satisfy. In a sense, mechanism design is to markets what genetic algorithms are to life. Theorists may one day design a better market mechanism or a better genetic code but for now the gains will come from using our deeper understanding to gently improve something that's already pretty marvelous.

This paper by Al Roth, a colleague of Greg Mankiw, offers some general ideas on market design as well as some specific cases he has dealt with in the fields of education and in organ transplant exchanges:
To work well, marketplaces have to provide thickness, i.e. they need to attract a large enough proportion of the potential participants in the market; they have to overcome the congestion that thickness can bring, by making it possible to consider enough alternative transactions to arrive at good ones; and they need to make it safe and sufficiently simple to participate in the market, as opposed to transacting outside of the market, or having to engage in costly and risky strategic behavior.
Here is a video covering the same material.

Hey, if instances in which markets have problems can really be improved upon... then again I'm reminded of a Hayek statement, "the curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."


Bret said...

University of Chicago: Markets work well. Use the market.

MIT: Markets fail. Use government.

GMU: Markets fail. Use markets.

Modern Marxist: Markets work well. Use government. :-)

That way we have all four possibilities!

erp said...

Gee, I always did think economists were thick, but didn't know it was proven until now.