[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.