Economics is about more than balance sheets, house prices and financial crises. It concerns much more important issues.
As Al Roth reminds us at the outset of his recent book, Who Gets What and Why, economics concerns the efficient, or social-welfare maximising, allocation of scarce resources. It affects and informs government policy and individual decision-making across every sector, from health, education and employment to deciding what we eat for lunch or how many children we have.
Roth's book belongs to a growing body of popular economics books that present economic research in an accessible way and relate it to everyday decisions and experience. Think Daniel Kahneman's Thinking Fast and Slow, Steven Levitt's Freakonomics and Richard Thaler's Nudge. Like Kahneman's popular book, Roth received a Nobel prize in economics for the research that Who Gets What and Why introduces to a broader audience.
In most of the world, markets are the primary means to coordinate the exchange of goods, services and resources between individuals, businesses and other economic actors. But markets may not exist in situations where they could generate more efficient outcomes. Existing markets can work poorly or sometimes fail completely.
Both the absence and failure of markets can result in the confluence of many discrete economic decisions generating collectively and individually undesirable outcomes. Regulation by governments and other oversight bodies can, and should, prevent such outcomes by creating the decision space and rules of engagement for market participants to pursue their objectives in a manner consistent with the efficient allocation of resources and, hence, higher, if not always maximal and perfectly equitable, levels of social welfare.
An engaging account of how markets work, fail and can be made to work better is the primary contribution of Who Gets What and Why. In the introduction, Roth makes an important statement sure to confound people who think "cutting red tape" is an end rather than a means to either more or less efficient markets: "When we speak about a free market, we shouldn't be thinking of a free-for-all, but rather a market with well-designed rules that make it work well."
Roth compares a market to a wheel that turns freely, but which could not turn at all without the support of an axle, bearings and axle grease. The turning wheel is the actions of market participants, and the axle, bearings and grease are the laws, rules and regulations provided by government and other regulatory bodies to ensure the smooth and efficient operation of that market.
He identifies four key components of a well-designed "free market":
- Many participants on both sides of transactions (i.e. buyers and sellers), or a thick market.
- Uncongested, or the capacity for willing participants to evaluate a range of potential transactions quickly and easily.
- Simple, or low transaction costs and less need to engage in strategic decision-making, or "gaming of" the system, to achieve a preferred outcome.
- Safe participation in which both sides of a transaction know the other side will fulfil their obligations.
The book focuses in particular on the "matching markets" that Roth has both researched and designed in practice. A "matching market" is one in which two sides must be matched up, typically involves some structured process, such as employment applications, and no financial exchange.
In the first part of Who Gets What and Why, Roth demonstrates how successful markets in kidney donations have been created in the United States. The inherent obstacle to kidney donation is blood-type incompatibility between a person with kidney disease and a donor, usually a family member, who is willing to donate one of their healthy kidneys. However, matching two compatible donor-recipient pairs creates a mutually beneficial trade. Roth shows how his research, and the creation of databases and cooperation between hospitals, has allowed these simple matches to be extended into thicker "kidney exchange" markets wherein unmatched donors, either living volunteers or dead organ donors, can create chains of up to 20 donations that end with a recipient who does not have an accompanying donor.
The second and third parts of Who Gets What and Why focus on broken markets and how to fix them.
Employment of recent graduates in law and medicine is a case in point. To find the best law clerks and medical residents, judges and senior residents in the US have incentives to lock in the best-performing graduates before their competitors. In both cases, this had led to very early take-it-or-leave-it offers, sometimes several years before graduation. Inefficient allocation results because the graduates with the best final grades are not paired with the best employers. In the case of doctors, this system forces graduates to specialise in a particular field even before they have taken any classes in it.
Roth shows that regulation of the market by professional bodies, which had to catch up with the strategic behaviour of participants, was needed to remove the incentives for early offers in both these markets. In medicine, excessively early offers were prevented by imposing sanctions banning doctors who made early offers from the top conferences. (A clearinghouse designed by the author also helped improve matches.) In law, however, the courts only utilised voluntary codes of conduct to control this behaviour. While this had temporary benefits, with the highest tier of courts holding out the longest, all judges eventually defected and began making early offers again.
Inefficient outcomes in the market for law clerkships have implications beyond market design. We would think of judges as being moral, virtuous actors (at least compared to many other professions), who would seek cooperation to achieve socially efficient outcomes. But the behaviour of market participants is driven by incentives. There is no point following rules if your competitors are not and if you incur no costs if you break them. The onus is on the regulator of a market to provide the incentives for individual actions to produce collectively beneficial outcomes.
In the Australian context, it is misguided to demonise the un- or underemployed, working mothers and property investors for benefiting from welfare benefits, maternity-leave top-ups and negative gearing respectively. If you perceive the behaviour of these groups as somehow detrimental to the national interest, the onus to change that behaviour lies elsewhere. Each individuals' choices will, by and large, be rational, strategic responses to the decision set available to them. Government policy determines what that set is and it is policy that can change incentives, not people's self-interest in maximizing their welfare.
The fourth and final part of Who Gets What and Why is equally engaging but slightly disconnected from the previous sections.
First, there is a discussion of what the author calls "forbidden and repugnant markets". The premise here is that the goods and services society deems acceptable to exchange for money is framed by culture and evolves over time. Slavery and lending money with interest are examples of how attitudes have changed. The author shows that repugnance is a challenge for market design but, as the case of opposition to selling kidneys demonstrates, one that can be overcome by careful thinking. He also argues, somewhat tentatively, that people who wish to engage in transactions in banned markets – for drugs or sex, for example – will inevitably find a way to do so, and that the costs associated with illegal black markets could be more harmful than those involved in legal, regulated markets.
Roth ends the book with an earnest exposition on the concept of the "free market". It raises the need for adaptive regulation of markets to ensure they operate efficiently. He argues the profession is now moving beyond understanding markets to actively intervening and redesigning them, as well as creating new markets where beneficial. This is an important call for applied economics in a profession where mathematical abstraction has become the dominant trend in its teaching.
It is unfortunate, however, that only cursory reference is made to some important areas beyond the matching and consumer markets where Roth has worked or take part in as part of his everyday activities. Water markets in California are mentioned briefly, but further exploration of this and other (missing) markets for natural resources would have strengthened the book much further. Also absent is a thorough discussion of where poorly designed market intervention, such as price regulation in energy and food markets, can create perverse incentives, the misallocation of resources and inefficient social outcomes.
Who Gets What and Why deserves to be read widely. It provides an accessible understanding of why there is a role for regulators to intervene in markets and provide incentives that result in the efficient allocation of resources. Roth underlines the importance of design and adaptive regulation to ensure that markets operate efficiently and are, indeed, "free". The challenge for policymakers is to find the interventions that make the wheel turn more freely rather than slow it down.
Paul Wyrwoll is a PhD student with the Crawford School of Public Policy at the Australian National University. paul.wyrwoll@anu.edu.au
Who Gets What and Why: The Hidden World of Matchmaking and Market Design, by Alvin E. Roth. William Collins, June 2015. RRP: $20.99
