Designing a Better Market

In 2012 Edvard Munch's "The Scream" was auctioned by Sotheby's for a record price of nearly 120 million dollars. The painting was sold using the English auction format, meaning the auction started with a low minimum bid and ended when no one was willing to bid more. This auction format raises interesting questions, however: Was the buyer of "The Scream" potentially willing to pay more? More specifically: Could the painting have been sold for an even higher price given a different set of auction rules? "Market design" is a new economic subfield that seeks to answer questions such as these.

The objective of market design consists not only in analysing individual markets, but also in actively designing them. To this end, researchers in that field avail themselves of economic techniques such as game theory and behavioural economics. Yet as real markets are highly complex, market design is inherently interdisciplinary in nature, and has crossover to other fields, such as psychology and computer science.

As a subfield, market design has a great deal of practical potential. Clearly, the state takes a direct hand in shaping market conditions in a wide variety of domains, whether this involves the allocation of cellular frequencies, the contracting of public works, the running of emissions trading, or the promotion of renewable energy. Yet market design is also useful as an analytic tool in areas that are not traditionally considered markets, because no money changes hands. Examples include the assignment of students to schools or the allocation of donor organs. Market design can help to optimise transactions in such "matching markets". Thanks to progress in market design, for example, one donor kidney can now save several lives, instead of just one: this occurs when a donor kidney is a missing link in a chain of incompatible donor-spender pairs.

Market design involves a change of perspective in the field of economics, as details and frictions in real markets are no longer ignored. On the contrary, market design realises that it is essential to understand the idiosyncrasies of a real market in order to create rules that are optimally attuned to it.

The benefits of market design research can be illustrated by returning to the auction mentioned at the outset. As a thought experiment, let us imagine that the buyer had been willing to pay 160 million dollars. Furthermore, imagine that the auctioneer had not started with a low price, but rather with a high price that was gradually reduced. In this type of auction, the first bidder to accept the current price wins the auction. Known as a Dutch auction, this auction format is used for selling various commodities, such as flowers. Would the bidder, who was willing to pay 160 million dollars, have waited until the price fell to 120 million dollars? Or, for fear of losing, would he have bid earlier, perhaps at 150 million dollars? In this way, we see the risk aversion of the bidder is one key factor.

We should expand our use of market design as a tool for determining the optimal design of real markets in Germany. Many markets that depend on an exchange of money could benefit from the adoption of market-design instruments. Public procurement or government bond auctions are just two possible examples. Enormous potential is also available in "matching markets". The complaints raised by students each year in Germany after they are assigned a place in university as well as the desperate efforts of parents to find a spot in preschool are both connected to allocation problems that could be considerably alleviated through improved market design.

This article is an English translation of a piece that appeared in more lengthy form in the 5 September 2016 issue of the newspaper "Frankfurter Allgemeine Zeitung".