How market design can help markets function effectively

How market design can help markets function effectively

Alex Teytelboym, Associate Professor of Economics at the University of Oxford, talks about what goes into designing fair and effective marketplaces.

Key Points

  • • From supermarkets to auction houses, market design is integral to ensuring systems of trade function to the benefit of their participants.
  • • Effective markets have several fundamental properties. Most importantly, markets should be fair, easy to use and efficient.
  • • When properly designed and implemented, markets are capable of supporting complex trades without the use of money. In the case of organ donors and recipients, this can save hundreds or even thousands of lives a year.

Market design matters

Photo by Sercan Erturk

Market design is the application of rigorous economic theory to redesigning real-world market institutions. When most people think about markets, they think about going to a supermarket to buy an apple. Yet, markets are often much more complicated. In particular, some markets don’t emerge organically but instead need a bit of engineering. Market designers try to create rules and infrastructure for markets to function effectively.

A simple example of a designed market is an auction. If you were to buy an expensive painting, you might find yourself in an auction house, and there are rules about how the auction works. For instance, the painting might go to the person who bids the highest amount. Indeed, this is a type of market, but it’s been carefully designed to fulfill the objectives of the person selling the painting or the auction house and its participants.

School selection

Markets sometimes function in unexpected places. Take, for example, the school choice setting. This market is two-sided. Students need to choose a school, and the school must agree to take the student. To be picked, the other side must consent.

Nevertheless, market designers have discovered that many of the systems that local governments have designed in the past create bad incentives for parents that result in bad outcomes for students. If you use improper rules in a system like this, it might give parents an incentive to lie about their school preferences to get their children into a better school. If parents strategise and lie about their preferences, it makes the whole system very messy. This system also disadvantages students whose parents are not quite as strategic. In a way, it misallocates children to schools.

Market designers have proposed algorithms or rules that allocate children to schools to remove parents’ incentive to lie. If you live in the UK, you can choose a school in virtually any local authority in the country. You should report your preferences honestly, and if you lie about your preferences, you can only receive a worse outcome than if you had been honest.

These are the kinds of properties of well-designed marketplaces. Overall, market designers hope to create markets that are simple, fair and efficient. They try to develop systems that work well for the participants that are a part of them.

Important market properties

When market designers create rules and infrastructure for marketplaces, they consider what benefits the market participants. This varies a lot from market to market. For instance, there is no money in the school choice system. One of the rules is you can’t use money, and it would be quite objectionable if you could.

Another property that often matters is fairness or at least the appearance of fairness. In many systems around the world, this is satisfied by prioritisation. If you miss out on a school placement, you can be assured that nobody with a lower priority was placed. That seems fair. While it also seems obvious, it requires a deliberate design to take place.

Another essential property associated with economics in general is efficiency. In allocating school placements, students shouldn’t swap or trade school places. The ability to trade might make students want to go out and look for opportunities to do so. Instead, it’s better if everyone understands there is no reason to look for these trades.

Maintaining fairness

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Feeding America, an NGO concerned with relieving hunger, created a marketplace to allocate donations it receives to various food banks. Its system allows food banks to use a scrip, a fake currency, to bid on different food trucks.

For example, if you are running a food bank, you might notice that you’re running out of pasta, and your clients have a high demand for pasta. You would then go to the auction and bid on a truck of pasta using the scrip. In this manner, the marketplace gathers everyone’s bids. Furthermore, it allows Feeding America to gather everyone’s preferences and efficiently allocate food.

But where does the fairness come in? Some food banks are relatively small, whereas other food banks serve big cities and are typically quite big. These larger food banks often end up with much more of that currency. As it were, they’re “richer” and essentially have more resources to acquire food trucks.

To maintain fairness, designers created a solution whereby those who win a truck of food have to pay their scrip for the food. Their currency, then, is redistributed to the losers who can use it later on.

Saving lives

One of the most unusual applications of market design that is truly life-saving and revolutionary is the idea of paired organ exchange. When people associate the word market with the word organ, their first reaction is probably, Oh! Gosh, this is something about organ trade and the exchange of organs for money. Paired organ exchange is not this at all. It does involve trade, but it involves no money whatsoever.

There are many people worldwide who suffer from kidney failure. These people often have loved ones who are keen to donate one of their kidneys because, you can survive only having one kidney. If a patient receives a donation from a loved one, they can live a happy and healthy life. However, without a kidney, they will have to stay on dialysis, which is extremely painful and costly, and has a real negative effect on quality of life.

Unfortunately, even though a patient’s family members are often willing to donate a kidney, they’re not compatible via blood type. Of course, everyone has one of four blood types, and not every person with a particular blood type can donate to another person with a different blood type.

Designing a solution

So, what has been the market designers’ suggestion for this market? Firstly, it’s crucial to recognise all the potential pairs of patients and donors. Let’s suppose there is a patient and donor pair, only the patient has blood type B and the donor has blood type A. Let’s say the exact opposite is happening in a situation between myself and my sister.

What is the possibility of a profitable trade here? A mutually beneficial situation arises when the other patient’s donors give her kidney to me, and my sister gives her kidney to the other patient. This is, of course, a type of trade. Overall, my sister ends up donating a kidney, except she doesn’t donate the kidney to me but to the patient whose donor helped me.

Sure enough, this type of marketplace is challenging to organise because the trade must happen simultaneously. In practice, four people receive operations, and these four operations occur at the same time.

Why is that? You can imagine that as soon as I receive a kidney from somebody else, my sister might become reluctant to give up her kidney to the other patient. Furthermore, laws prohibit us from writing a contract that forces her to give up her kidney later. For that reason, the other operations have to happen simultaneously to ensure a fair trade.

Creating complex trades

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It’s an extraordinary insight that you can create trades like this. In fact, you can make even more complicated trades. You can imagine cycles of trades where my sister gives a kidney to one patient, this patient’s donor gives a kidney to somebody else, and, finally, this person’s donor gives their kidney to me. Six people could be involved in a trade, and six operations would happen at the same time.

Over the last 15 years, many countries worldwide have set up systems to pool all the information of the kidney patients and kidney donors to find compatible matches. Despite its simple economics, this small marketplace alone saves hundreds of lives every year. As such, it’s being adopted by more and more countries. Indeed, there are profitable trades to be made, but they must be found. This marketplace accomplishes that.

People have even begun thinking about even more complex donation systems. In particular, they’re thinking about how the donations for lungs and livers might even work. Of course, the situation is more complicated because the lungs’ medical function is very different from the kidneys’ medical function. Nevertheless, there are suggestions about how we could create these other marketplaces involving no money whatsoever. If the necessary infrastructure is created, hundreds or even thousands of lives can be saved every year without costing additional resources.

Discover more about

Market Design

Kominers, S.D.,, Teytelboym, A., & Crawford, V.P. (2017) An invitation to market design. Oxford Review of Economic Policy, 33(4), 541–571.

Roth, A.E. (2016) Who Gets What — and Why: the New Economics of Matchmaking and Market Design. HMH Books.

About Alex Teytelboym

I am an Associate Professor of Economics at the University of Oxford, where I specialise in market design and network economics.
About Alex Teytelboym →

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