Nobel winners’ work improve market efficiency

By James McCusker

Where can we find help when prices are not enough to clear the market and ensure efficiency?

The Royal Swedish Academy of Sciences knew exactly who to call when they awarded this year’s Nobel prize in economics to Alvin Roth and Lloyd Shapley for their work on “the theory of stable allocations and the practice of market design.”

There are many non-price markets in our world; markets where something is proposed or offered and is either accepted or declined, but there is no price specifically attached to that something. Because there is no specific price, these markets do not behave like the markets for automobiles, cellular phones, or house paint.

Much of the best work in economics is either theoretical with practical implications, or practical with theoretical implications. In this year’s award, the Swedish Academy was able to recognize both.

Professor Shapley, at UCLA, and Professor Roth, now at Stanford, are not really colleagues and did not work together, but in one sense they resemble a economics team’s “Mr. Inside” and “Mr. Outside.”

Professor Shapley’s groundbreaking theoretical work, initially done in collaboration with the late David Gale, analyzed how non-price markets really worked. Later, Professor Roth found applications for the theory in understanding how hospitals selected graduating medical students, how kidney donors were matched up with those needing transplants, and even how New York City’s students were enrolled in high schools. Every one of those markets was restructured after Roth’s analysis, each time with visible improvements and sometimes, as in the hospital-student and city high school markets, with dramatic results.

Roth’s contribution to economics included developing an algorithm that could be used to reshape a market so that it worked more efficiently. It was an effective way to apply Shapley’s theory and to amplify the even earlier work on optimal exchanges done by Wilfredo Pareto — another economist whose work had both theoretical and practical implications. Pareto’s work had focused on two-party exchanges, but Shapley’s and Roth’s mastery of game theory allowed a seamless expansion to broader markets.

The “stable allocations” mentioned in the prize citation refers to a market situation where, after decisions are reached, each participant is sufficiently happy with his or her situation to be content with it and not decide to move on.

The use of “stability” to describe markets, as opposed to the more common economic term “equilibrium,” is actually a reference to Shapley’s original work, which explored how courtships and partner selection did or did not produce stable marriages. It was done in the early 1960s as the U.S. began to experience unprecedented rates of marriage instability and divorce.

The awarding of the economics prize to Professors Shapley and Roth represents a restatement of what economics is all about…the efficient allocation of scarce resources. It also is a most welcome recognition that game theory can be used for something more useful to humanity than bilking investors.

From an economic policy standpoint, the idea of designing or restructuring markets is still a very new area. The initial publication of the theory prompted a significant amount of research and the subsequent success of Professor Roth’s applications to real world problems brought a considerable amount of attention to the market structure concept.

Still, the mark of maturity for economic policy ideas these days is how much ideological and political heat they generate. From that standpoint, the idea of market design is still blissfully off the political radar screen. The concept’s potential is so visible, though, that its days of youthful innocence may soon be over.

The ideological conflict comes from those who believe that meddling in markets is always a mistake. In their view, markets do not need redesigning and would work just fine if we simply removed the restrictions that have been imposed on them.

The record of government meddling, intervention, and even participation in markets certainly gives a lot of credibility to that argument. It is inaccurate, though, to apply it to the work of Shapley and Roth. The applications of their work are in non-price markets.

Non-price markets do not work the same way as markets based on supply and demand curves driven by prices. From an economic theory standpoint, then, they cannot make the same claim of efficiency. They may serve a useful purpose, but they are not efficient.

As our society and our economy become increasingly complex and interdependent, more and more goods and services are allocated by non-price markets, and efficiency becomes a significant issue. The analytical and restructuring tools that professors Shapley and Roth developed could make these markets more efficient. They also offer a golden opportunity for economists to do something of critical importance for our country. If you’re an economist, it doesn’t get better than that.

James McCusker is a Bothell economist, educator and consultant.