Daily Archives: June 4, 2007

Market Design as Applied Hayekian Insight

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Michael Giberson

[PREAMBLE: This post is a follow-up to Lynne’s recent post, “Reconciling A Hayekian/Organic Approach With ‘Designing’ Markets.” If you haven’t already read it, I recommend reading it first. Otherwise, when I get to the part of my post where I say, “I liked D. F. Linton's question and I liked Lynne's answer, too,” you won’t know what I am talking about. So read it first.

Also, this post is probably only interesting to you if you think “Knowledge Problem” is a fine name for an economics blog.]

I liked D. F. Linton’s question and I liked Lynne’s answer, too. But in trying to answer the question, I took a somewhat different approach than Lynne.

At first glance, market design proposals may sound a bit un-Hayekian. Hayek was obviously a critic of “rationalist” approaches to social phenomena, and markets are clearly social phenomena, and design sounds like a rationalist effort. Hayek advocated a “spontaneous order” concept of human institutions, endorsing and often quoting Adam Ferguson’s view of social institutions as “the result of human action, but not of human design.” So how does one invoke Hayek while talking of market design?

Financial markets offer a good example. The NYSE began with an agreement among stockbrokers and merchants in 1792. These brokers and merchants didn’t invent the joint stock company or the idea of organized exchange. They certainly didn’t sit down in 1792 and sketch out anything like the NYSE of 2007. Somehow, however, the institution started one place and ended another place. The steps along the way – the “human action” in Ferguson’s description – are the product of design efforts.

I think of “market design,” as a field in economics – what Vernon Smith would call “economic systems design” or Al Roth would call “economic engineering” – as an effort to understand how markets work on a micro-level, and the testing of that understanding in practice. The questions are very practical: Why are some markets “posted price,” while others are auction based? Why are stock markets usually organized as continuous double auctions (i.e., the NYSE), and not periodic call auctions (i.e., the now defunct Arizona Stock Exchange)? Will financial markets work better with “circuit breakers,” or worse? Market design at this level has very Hayekian themes, it is all about incentives and the coordination of dispersed knowledge.

The design efforts Lynne discussed, the emissions markets and carbon futures market that caught the reader’s eye, are a bit grander than these market micro-structure issues. But emissions markets, too, seem to be Hayekian in fundamental ways. In the first case, emission markets were proposed as a response to “command and control” approaches to environmental regulation. I suggest that “command and control” is straight out of the constructivist/rationalist impulse that Hayek argued against, and that emission markets are Hayekian: Economists observed the emission markets would align incentives better than technology-based regulation, and especially would promote better coordination of dispersed knowledge (who has the cheapest method to reduce or avoid polluting? what alternative products can be substituted? how to integrate new technologies for pollution control into the market?)

In “The Errors of Constructivism,” Hayek wrote:

None of our ancestors could have known that the protection of property and contracts would lead to an extensive division of labour, specialisation and the establishment of markets….

All that a man could do was to try to improve bit by bit on a process of mutually adjusting individual activities, by reducing conflicts through modifications to some of the inherited rules. All that he could deliberately design, he could and did create only within a system of rules, which he had not invented …. In his efforts to improve the existing order, he was therefore never free arbitrarily to lay down any new rule he liked, but had always a definite problem to solve, raised by an imperfection of the existing order….

Hayek-aware market design acknowledges the existing system of rules within which the designer works, and acknowledges that we may not understand all the reasons why the existing system of rules works as well as it does. Hayek is absolutely clear that the market designer is “never free arbitrarily to lay down any new rule he liked,” but Hayek is just as clear that a market designer with “a definite problem to solve, raised by an imperfection of the existing order” can “try to improve bit by bit” the existing order.

I liked Linton’s question, but a better one might be, “How can one speak of ‘designing’ a market in one breath, and not speak of Hayek in the next?” Market design is fundamentally Hayekian.

More Exercise: Udder Century Bike Ride

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Lynne Kiesling

Then on Sunday the KP Spouse and I did the McHenry County Bicycle Club’s Udder Century Invitational with a friend of ours. We did the metric century, 62 miles, which was plenty after my triathlon exertions on the previous day.

McHenry County has lots of lovely, rolling countryside, and great biking roads. The weather was glorious until about mile 50, when the rain started. We had a deluge for about a mile or so, and rain for about 7 miles total, but it was OK. I think we are going to spend a lot more time riding out there!

Race Report: Tri-Shark

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Lynne Kiesling

We had a sporty weekend here in KP land … on Saturday I participated in the Tri-Shark sprint triathlon outside of Bloomington, Illinois. Here’s an action shot:

trishark07run

The race is well-organized and the course is beautiful; Dawson Lake in Moraine View State Park is great for swimming, the bike course has some lovely rolling hills, and the run is similarly lovely. What interested me compared to the other sprint tris I’ve done is that the participants here are more experienced and more competitive than I’m used to (although everyone was nice and friendly). This is a high-demand event, with registration usually closing within a few days.

More comments on the race below the cut …

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Reconciling A Hayekian/Organic Approach With “Designing” Markets

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Lynne Kiesling

In the comments to my carbon market post from Friday, D. F. Linton asks this very good question:

How does one invoke Hayek in one breath and the speak of “designing” a market in the next while keeping a straight face?

Good question, and one I struggle with every day as an economist who works on regulation in retail markets and comes from a very organic/complexity/ dynamism perspective. D. F. Linton’s question lurks in my mind constantly. At a practical level, I reconcile them by acknowledging that when we are dealing with markets or industries that have historically had a significant amount of regulation and government control and involvement, the movement from heavily regulated to thriving market processes is very unlikely to be organic. It’s also unlikely to be a healthy transition, because embedded regulation creates embedded special interests who would like to see the regulation persist and will resist change, so if the transition process is too “laissez-faire”, the embedded special interests are likely to succeed at manipulating the transition to their advantage. For evidence on this point I give you post-Soviet Russia.

So in regulated industries like electricity, I think that’s one of the big challenges: how do you get to the situation in which market processes are organic, given that you are not starting from an atomistic, almost-clean-slate beginning? How do you get to the organic market processes when you are starting with historic incumbents (and regulators) that are themselves creatures of the regulatory process? Coming up with market rules that do not favor those incumbents over potential entrants is what I mean by “designing markets” as alluded to above.

The carbon situation is a bit different, because it’s an introduction of regulation, not a removal of regulation in response to dynamic technological and economic change. Here my inner Hayekian teams up with my inner Demsetzian, if you will, to ask “compared to what?”: if such regulation is going to be implemented, and if we can do it in a way that increases total surplus by defining property rights and allowing private parties to trade those rights, how does that arrangement perform relative to other realistic, feasible alternatives to such a policy? That’s the spirit in which I intended the initial post.

But the truly Hayekian sense in which I can reconcile the organic/complexity approach with “designing markets” is the sense in which Hayek writes in Law, Legislation, and Liberty. Market processes for the mutually beneficial, voluntary exchange of rights always occur within a context of law, of legal institutions, whether formal or informal or a combination of both. Many of what we think of as the most free and most capitalist of our market institutions, such as financial exchanges, involve elaborate contracts and laws enforcing those contracts. This legal context determines the rules by which we exchange; the context and the rules form the market institution. The quality of that institution and its variation across places or across time can affect how much exchange actually occurs, and how much net benefit is created through exchange. Even in free markets, the market institution is carefully designed, although in most organic markets the design process is a very distributed one, building upon centuries of legal precedent and experience, so it doesn’t look like it’s highly designed or deliberate.

The problem is that in markets coming out of regulation or in markets that have never existed before, the market institution has to be designed in less-than-organic circumstances. That’s the hard part, because it introduces a political dimension to the design of market institutions that is not present in more organic situations, because there are special interests in the status quo and special interests in the future setup, all trying to influence the design of the rules in the market institution.

I hope that clarifies how I can reconcile them. Another lens through which you can think about it is imperfection. In a perfect world there should be no need to reconcile Hayekian and organic perspectives with deliberate design, because there would be no transaction costs and everything would be fluid and self-organizing. Reality is not so perfect, so I think we have to be willing to recognize the situations in which some deliberate organization is necessary to get us to a point where we have institutions that can support self-organization.

Markets for Kidney Transplants

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Michael Giberson

Last week, a Dutch “reality” show was announced in which three patients in need of a kidney transplant would compete to acquire a kidney to be given by a living donor. The proposal generated a storm of commentary, for and against, only to be revealed as a hoax of sorts, a publicity stunt intended to generate attention to the issue of organ donations.

Tim Worstall had some of the best comments. News reports indicated that many in the Dutch government saw the proposed program as unethical. Worstall responded:

What is unethical are the current arrangements for organizing (sorry) the whole process of garnering kidneys for transplant. You see, under the guise of “ethics”, many thousands of people are condemned to lengthy and painful dialysis treatment, many of whom die before they receive a new kidney. And yet we know how to solve this….

He then cited an Economist story about Iran, which permits a payment of $2,000 to $4,000 to kidney donors and no longer has a waiting list. Worstall again:

What’s worse is that this is not news to those who decide our policies on such matters. But they condemn those thousands to death rather than allowing icky things like markets to solve the problem.

But of course there is a market in kidney transplants. As I read Worstall’s blog post, I couldn’t help but notice the contextually-cued “Ads by Google.” One said “Kidney Transplant at Penn: Among the Top 10 Programs in the US, High Volumes, Experienced Surgeons.” Another: “Learn about our active programs at New York-Presbyterian Hospital.”

In the kidney transplant business in the United States, the hospital can get paid. Apparently the business is profitable because otherwise it wouldn’t pay to advertise.

And, by the way, the doctors can get paid and the nurses can get paid and the orderlies can get paid and the medical supply companies that supply the bandages can get paid and the food service personnel that work in the hospital kitchen can get paid … everyone involved can be paid for their time and trouble except the person giving up a kidney.

NOTES: The publicity stunt worked: In addition to Tim Worstall’s posting there was an Associated Press story in the Washington Post. Blogging at: Dynamist (and again), Marginal Revolution, Division of Labour, among others.