How mechanism and market design play an important role in contemporary global business

nHow mechanism and market design play an important role in global business and our society at large

What connects Google, Microsoft, Uber, Airbnb and Amazon? They understand economics and they understand the strand of economics known as mechanism and market design.

A core question in economics is how to allocate scarce goods and resources among a group of people. Sometimes these decisions are made in markets with prices and consumers who decide what to purchase, at other times we decide collectively in a group, for example, the decision on the construction of a new metro line in Delhi.

The methods used to reach a decision on allocating goods and resources varies greatly in different contexts. Mechanism design provides a toolbox and a language to analyze the benefits and disadvantages of different rules and institutional settings. The theory goes further than analyzing current practices by also producing and implementing new methods in solving allocation problems.

After the end of the Second World War there was a debate among economists on the best way to allocate goods, services and resources in an economy. The two systems in focus were a centralized and planned economy versus that of a market system. Economics had focused on analyzing the market system but there was not a way of comparing the two systems. The economist Leonid Hurwicz developed new tools and models to formally compare and study different systems of allocating goods and resources in a society. The work of Hurwiczs in the 1960s laid the foundations of mechanism design. He used the new tools produced in game theory and economic theory at large and realized that a particular system such as a market economy can be analyzed formally. The key insight was to translate a given institutional context for allocating goods and resources in a group into a set of rules that determines allocation outcomes as a function of the behaviour of the people involved in the group. Other important contributions were made by Eric Maskin and Roger Myerson whom together with Leonid Hurwicz shared the 2007 Prize in Economic Sciences in Memory of Alfred Nobel. They received it “for having laid the foundations of mechanism design theory”.

Using insights and tools from the theory of mechanism design economists have engineered mechanisms for many realworld allocation problems. For example, due to the huge importance of mobile services around the world there is fierce competition between companies to secure spectrum licences for cellular data and in a number of countries they are sold by governments using auctions. A common objective in selling spectrum rights is to maximize the expected revenue for the government. Such auctions have successfully been devised by economists using the concepts and tools invented in mechanism design. A recent example is the auction for the re-allocation of spectrum that took place in the US in 2017. The auction yielded a revenue of $19.8 billion to the US government, similar and equally successful auctions have been designed in the UK, India, Germany and many other countries raising significant revenues to the governments.

A different set of applications of mechanism design and market design is matching employers to employees in entry level labour markets such as doctors, psychologists, teachers and other professions.

Consider the case of doctors looking for their first jobs at a hospital. The key objective is to match doctors to hospitals in a systematic manner so that once a doctor is assigned to a hospital the doctor cannot find another hospital that would prefer to hire this doctor more than one of the proposed doctors for that hospital. If this is true for all pairs of doctors and hospitals it is said that the matching is ‘stable’ as there is no doctor-hospital pair that wishes to break up the match and form a new pair. It turns out, somewhat surprisingly, that for all instances of these doctor-hospital problems a stable matching can be achieved using a centralized matching algorithm invented by David Gale and Lloyd Shapley. This was part of the reason for awarding the 2012 Prize in Economic Sciences in Memory of Alfred Nobel to Shapley and Alvin E. Roth (Gale had sadly passed away already in 2008). The prize was given to them “for the theory of stable allocations and the practice of market design”. There is a now long standing centralized matching market for medical doctors in the US. Currently the matching program receives each year more than 40.000 applications from doctors and has more than 30.000 open positions at various hospitals across the country.

These two examples illustrate how economic theory and in particular mechanism design and market design can be applied to engineer solutions to real-life allocation problems. I have only mentioned two examples, but the list of applications and designed markets are much longer ranging from the design of kidney exchange programs to assigning pupils to public schools, and the list is growing. I think there will be new applications down the line which in turn requires new research to tackle new questions. The field has been growing and I expect this trend to continue especially with the work done in other disciplines than economics.

The importance and use of mechanism and market design is not limited to the public sector. During the last 20 years many large and innovative technological companies such as Google, Microsoft, Uber, Airbnb, Amazon have hired economists with background in mechanism and market design.

A majority of these firms also have a chief economist employed as an in-house market designer, in Microsoft there is a whole team of people working in a group led by the Chief Economist Michael Schwarz. The question of how to design pricing policies and rules for companies like Airbnb requires careful thinking and modelling of the market and the consequences of the rules chosen. Having a training in economics and in particular mechanism design provides an excellent background to tackle questions along this line either as an employer in a firm, as a regulator in a governmental agency or as researcher in academia. The author is Lecturer, University of

Essex