Al Roth’s new book on matchmaking and market design

Alex Tabarrok reviews Al Roth‘s new book, Who Gets What — and Why: The New Economics of Matchmaking and Market Design, in the Wall Street Journal. An excerpt:

Most economic theory focuses on commodity markets, in which anyone willing to pay the price gets the good and anyone not willing to pay the price doesn’t. In matching markets, price isn’t the only determinant of who gets what. Willingness to pay the price is one determinant of who gets into Harvard but not the only one. Willingness to accept a certain wage is one part of who gets a job but not the only one. In some cases, such as assigning kidneys to dialysis patients, price isn’t part of the equation at all—at least in the United States.

Mr. Roth’s work has been to discover the most efficient and equitable methods of matching and implement them in the world. He writes with verve and style, describing many market malfunctions—from aboriginal tribes in Australia arranging marriages for children not yet born to judges bending every rule in the book to hire law clerks years before they have graduated from law school—and how we ought to think about them.

Mr. Roth’s approach contrasts with standard debates over free markets versus government regulation. We want markets to be thick, quick, timely and trustworthy, but without careful design markets can become thin, slow, ill-timed and dangerous for the honest. The solution to these problems is unlikely to be regulation legislated from on high. Instead what Mr. Roth practices is nuanced market design created mostly by market participants.

We have discussed Roth’s work and market design topics many times here at Knowledge Problem (link to links). Tabarrok mentions the review at Marginal Revolution. Al Roth’s Market Design blog is here.

NOTE: If the WSJ link does not work for you, here is a link to review on the Mercatus website.

Technology market experimentation in regulated industries: Are administrative pilot projects bad for retail markets?

Since 2008, multiple smart grid pilot projects have been occurring in the US, funded jointly through regulated utility investments and taxpayer-funded Department of Energy cost sharing. In this bureaucratic market environment, market experimentation takes the form of the large-scale, multi-year pilot project. The regulated utility (after approval from the state public utility commission) publishes a request for proposals from smart grid technology vendors to sell devices and systems that provide a pre-determined range of services specified in the RFP. The regulated utility, not the end user, is thus the vendor’s primary customer.

When regulated incumbent distribution monopolists provide in-home technology to residential customers in states where retail markets are nominally competitive but the incumbent is the default service provider, does that involvement of the regulated incumbent have an anti-competitive effect? Does it reduce experimentation and innovation?

In markets with low entry and exit barriers, entrepreneurship drives new product creation and product differentiation. Market experimentation reveals whether or not consumers value such innovations. In regulated markets like electricity, however, this experimentation occurs in a top-down, procurement-oriented manner, without the organic evolution of market boundaries as entrants generate new products and services. Innovations do not succeed or fail based on their ability to attract end-use customers, but rather on their ability to persuade the regulated monopolist that the product is cost-reducing to the firm rather than value-creating for the consumer (and, similarly, their ability to persuade regulators).

The stated goal of many projects is installing digital technologies that increase performance and reliability of the basic provision of basic wires distribution service. For that reason, the projects emphasize technologies in the distribution wires network (distribution automation) and the digital meter at each home. The digital meter is the edge of the wires network, from the regulated utility’s perspective, and in restructured states it is the edge of its business, the edge of the regulated footprint. A secondary goal is to explore how some customers actually use technology to control and manage their own energy use; a longer-run consequence of this exploration may be consumer learning with respect to their electricity consumption, now that digital technology exists that can enable them to reduce consumption and save money by automating their actions.

In these cases, consumer technology choices are being made at the firm level by the regulated monopolist, not at the consumer level by consumers. This narrowed path to market for in-home technology changes the nature of the market experimentation – on one hand, the larger-volume purchases by regulated utilities may attract vendors and investors and increase rivalry and experimentation, but on the other hand, the margin at which the technology rivalry occurs is not at the end-user as decision-maker, but instead at the regulated utility. The objective functions of the utility and their heterogeneous residential customers differ substantially, and this more bureaucratic, narrowed experimentation path reduces the role of the different preferences and knowledge of those heterogeneous consumers. In that sense, the in-home technology choice being in the hands of the regulated utility stifles market experimentation with respect to the preferences of the heterogeneous consumers, although it increases experimentation with respect to the features that the regulated monopolist thinks that its customers want.

Focusing any burgeoning consumer demand on a specific technology, specific vendor, and specific firm, while creating critical mass for some technology entrepreneurs, rigidifies and channels experimentation into vendors and technologies chosen by the regulated monopolist, not by end-use consumers. Ask yourself this counterfactual: would the innovation and increase in features and value of mobile technologies have been this high if instead of competing for the end user’s business, Apple and Google had to pitch their offerings to a large, regulated utility?

These regulated incumbent technology choices may have anti-competitive downstream effects. They reduce the set of experimentation and commercialization opportunities available to retail entrants to provide product differentiation, product bundling, or other innovative value propositions beyond the scope of those being tested by the incumbent monopolist. Bundling and product differentiation are the dominant forms that dynamic competition take, and in this industry such retail bundling and product differentiation would probably include in-home devices. The regulated incumbent providing in-home technology to default customers participating in pilot projects reduces the scope for competing retail providers to engage in either product differentiation or bundling. That limitation undercuts their business models and is potentially anti-competitive.

The regulated incumbent’s default service provision and designation of in-home technology reduces a motive for consumers to search for other providers and other competing products and services. While they may argue that they are providing a convenience to their customers, they are substituting their judgment of what they think their customers want for the individual judgments of their customers.

By offering a competing regulated retail service and leveraging it into the provision of in-home devices for pilot projects, the incumbent reduces the set of feasible potentially valuable profit opportunities facing the potential retail competitors, thus reducing entry. They have to be that much more innovative to get a foothold in this market against the incumbent, in the face of consumer switching costs and inertia, when incumbent provision of in-home devices reduces potential demand facing potential entrants. Even if the customer pays for and owns the device, the anti-competitive effect can arise from the monopolist offering the device as a complement to their regulated default service product.

Leaving in-home technology choice to retailers and consumers contributes to healthy retail competition. Allowing the upstream regulated incumbent to provide in-home technology hampers it, to the detriment of both entrepreneurs and the residential customers who would have gotten more value out of a different device than the one provided by the regulated incumbent. By increasing the number of default service customers with in-home smart grid devices, these projects decrease the potential demand facing these independent retailers by removing or diluting one of the service dimensions on which they could compete. Their forays into in-home technology may not have anti-competitive intent, but they still may have anti-competitive consequences.

Al Roth, Matchmaker

Michael Giberson

Stanford’s alumni association magazine has a good article on recent economics Nobelist Al Roth. Several things about the article will trigger resistance among some free market readers, beginning with the title (“The Visible Hand”) and the subhead (A new breed of economist, Alvin Roth brings an engineering sensibility to fixing markets.). Deep into the article, this too: “Thanks to guys like Al Roth and powerful software … we were able to put all our incompatible pairs in there and just hit a button and the computer would spit out the answer.”

In fact just this morning I was just re-reading James Buchanan’s remarks about differences between economics as a science of allocation versus economics as a science of exchange – Buchanan was definitely in the exchange camp – and perhaps Buchanan would wonder whether or not these game-theoretic algorithms constituted a kind of applied economics or perhaps were something more akin to mere logistics tools. But in that article (“General Implications of Subjectivism in Economics”) Buchanan does suggest that game theory, in that it can frame situations from the point of view of economic agents, might constitute a valuable tool for understanding economics as a science of exchange.

But it is clear enough from the Stanford Magazine article that more than logistics is going on in Roth’s efforts. In all of the matching schemes Roth has helped develop, the incentives created for participants are a key constraint. It isn’t a mere matter of minimizing fuels costs for a delivery fleet, Roth is using economics to meddle with the rules of particular kinds of economic systems in order to bring about better arrangements as valued by the participants themselves. These efforts are not about imposing allocations, they are about enabling better exchanges in complex environments.

[HT to Daniel Cole, who draws attention to the dwarf-tossing issues raised at the end of the article.]


Game-industry market design job openings for economists

Michael Giberson

Buzzfeed columnist Russell Brandom explains, “Economists Are Taking Over the Game Industry: The game industry is hiring a new class of central bankers — but not in time to save Diablo III.” The post links to my earlier post on Diablo’s auction market design.

Perhaps in support of Brandom’s title, the current (June 2012) Job Openings for Economists, published by the American Economics Association, contains an advertisement from fiveoneninegames seeking a “Director of Monetization” to help the game company “develop and refine in-game economies” and “[help] decide how the virtual economies are structured and optimized in every mobile and web social game.”

Poor market design causing high prices in Diablo III auction house?

Michael Giberson 

I don’t play Diablo III, but I do follow price gouging discussions online, which led me to this post on the Diablo III discussion forum: “Auction House and Price Gouging.”

The initial complaint comes from a player trying to equip a new character through purchases in the Auction House, an in-game player-to-player trading mechanism, and finding prices were much higher than just a few weeks earlier.

WTF is going on? When I first got this game (release), I thought (despite all the issues) that the Auction House was a wonderful implementation …

I was able to gear up my Monk even at lower levels for fairly cheap. You have to remember that it was my first character and gold was scarce/difficult to come by, but still.. items in the AH were affordable. This includes +dex rares, IAS blues, +vit rares, etc.

3 weeks later and I finally roll another toon, only to find out that low level items (even in the 5-10 lvl range) are BEYOND inflated. I couldn’t even find blue +movement speed boots for my new DH without dropping 3-5k gold…

It seems like people price their gear (even low level gear) depending on what other people price their gear, so it almost feels like the sense of community (it’s difficult to explain, but I felt it in the beginning) has been replaced by $$$ signs, lol.

Price gouging leading to a loss of the sense of community? Sounds like someone has been reading his Michael Sandel.

Diablo III auction house screen shot from MMO News

A few economic explanations are offered in the replies, ranging from the basic microeconomics (“supply and demand”) to intermediate macroeconomics level (gold farmers are bringing too much money into the game, causing inflation).

The advanced economics explanations focuses on market design choices made by the game designers. Each player can only offer up to ten items at a time, and once offered the item cannot be replaced by another offer for 36 hours.

When the game was first released, many players were low level, no one had a lot of gold, and low-powered items were placed into the market as characters advanced and obtained better quality items. As characters became even more advanced, continuing to accumulate a mix of low-, medium-, and high-quality items, the 10-item limit becomes binding.

Now, to sell a low-quality item of the sort a beginning character could use, the player has to forego the opportunity to sell medium- or high-quality items at higher prices.

The opportunity cost of selling low-level items has risen, and the price follows.

NOTE: Diablo III will soon feature a real money Auction House.

NEWER, RELATED: Game-industry market design job openings for economists.

Market design helps people attain goals effectively

Michael Giberson

Harvard economic systems designer Al Roth is profiled in the Boston Globe:

Academically speaking, Roth is a pioneer of so-called market design: finding situations where a market is failing — often, a place that most people wouldn’t even recognize as a market — and making it work better. Roth has influenced a cadre of young, energetic market designers, many of whom have taken up prominent positions at top universities. Inspired by Roth’s work, these rising economists are also setting their sights on real-world problems. Some are looking at dating websites; others are interested in how universities could do better at scheduling their students’ classes. Like Roth, all of them envision a world in which economists, as unlikely as it may seem, are recognized as society’s mechanics.

Some market-oriented people will react negatively to the idea of “economists … as society’s mechanics,” but the negative reaction is based on a misunderstanding. Roth is no central planner. The point is to rework organizations so that participants in those organizations can more effectively achieve their goals.

When most people think of economics, they think of money — the study of how much things cost and why. Roth distinguishes himself by being more interested in situations where money plays little or no role — for instance, the process that determines who among the thousands of patients awaiting kidney transplants nationwide should receive the small number of organs that are available. As a society, we’ve decided we’re not comfortable with people selling their organs, so some other system — some other kind of market — is required. And a market, in Roth’s view, does not necessarily come down to prices, nor is it always ruled by simple principles like supply and demand: As long as people are competing with each other to get what they want, then resources are being allocated, and that means economists should be thinking about it.

One response to the lack of markets for transplantable kidneys is to agitate for change, to advocate lifting the regulations that prevent it. (Same for bone marrow.) These are good ideas. While we wait for society to get over its squeamishness at allowing compensation to donors, Roth’s kidney exchange is enabling more people to obtain transplants now. And Roth’s work on repugnance in markets is helping probe the reasons many people are reluctant to let markets work in this realm, so useful to advocates for change.

A by-product of working in areas where money plays little or no role is becoming sensitized to the role that money plays when it is allowed:

The trouble is that when you can’t rely on prices to stand in for value, things get complicated. In typical markets, “Money finds the matches,” said Utku Ünver, an associate professor of economics at Boston College who has collaborated with Roth on projects. “But when there’s no money, there’s lots of friction, and there are lots of things that may cause these markets to fail and not function efficiently.”

When you can’t use prices to express how much something’s worth, in other words, figuring out who should get what becomes a complicated business. “That’ll kill your economics 101 market real quick,” said [MIT economist Robert] Gibbons. “Al comes along to help you with situations where you’re not allowed to use the price mechanism.”


Rob Harmon at TEDxRanier: How the market can keep streams flowing

Michael Giberson

Rob Harmon gave a TEDx talk last fall in Seattle on a market mechanism that links willing buyers and willing sellers in a way that protects in-stream water flows and helps restore stream ecosystems. Harmon was formerly with the Bonneville Environmental Foundation (BEF) in Portland, Oregon, where he was a developer of the Water Restoration Certificates program.

The TED talk was just posted on the TED website, but a little searching around reveals that the smart water/markets/environment people were already aware. TEDx had the video up on youtube a few months ago, as Shawn Regan of PERC noticed in December.

In December 2009, David Zetland interviewed Rob Harmon about the program. [Zetland comments at Aguanomics; Link to MP3 audio.]

Here is bit from the Zetland interview beginning just after the 9:00 minute mark, where Harmon describes his visit to a stream that would have been dry in August but for the water restoration certificate program:

So, I decided this is a nice view from the bridge – you get the long view, you can see for a ways, you get the beaver dam.

But let’s go down and look right at the water. I walk down and I brought my camera with me and I looked in the water and I saw movement. And a stared and I stared and I stared, and I suddenly focused at the right depth and there were hundreds of baby steelheads. […]

Ordinarily, for the last ten, twenty, fifty years there would be no water for them to hatch into, they’d just die. […]

So, basically, here is habitat for all of these fish that ordinarily would not have habitat. It was a very sort of , it was a very sort of rubber meets the road sort of experience for me, sort of fish meet the water.

It went from the process, for me, of writing the contract, putting a business plan together, figuring out the website and the water calculator there on the website, and all of the things you do to make a business like this work, to actually seeing the results right before my eyes. That was very fulfilling, really nice to see actual ecological benefits right in front of me. (Unofficial transcript, parts edited out, use at your own risk.)

See also Harmon’s blog post about his trip to this site.

An interesting element here is that no laws needed to be changed to allow the program to work. The program works with the existing water laws in Oregon, Washington, and Montana. But for decades that law had led to regulation, extensive litigation, and dry stream beds because owners of water rights had to use their water rights in order to preserve them, and using involved withdrawing the water from the stream.

Until this program came along, there was no mechanism to allow water rights holders to use their rights to preserve in-stream flows. BEF does the necessary legwork: identifying streams at risk, tracking water flows, issuing certificates, and so on all the way up to bringing together willing buyers and willing sellers.

ASIDE: Next time a misguided free-market economist tells me markets can’t be designed, they can only emerge spontaneously, I am going to point to this example.