27 May, 2019

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Nobel Laureates In Economics 2012: Recognised For Designing Unusual Markets

By W.A. Wijewardena

Dr. W.A. Wijewardena

The failed market for kidneys

Some time back, a sister of a friend of this writer had been seriously ill with the malfunctioning of both her kidneys. The available medical treatment was to get a donor with a compatible kidney to donate one. The donation in this case is just a pretext on paper and it is actually a sale of a kidney for profits, since in Sri Lanka there is no legal market for live human body parts. Hence, there is a thriving underground market for kidneys in which many people earn a living. They are the touts who find potential kidney sellers and arrange for the sale, the seller himself and medical practitioners who do the transplanting, in good faith of course, ignoring the sale-fact behind it.

Eight years ago, driven by desperation, my friend too found a potential kidney seller through a tout and the price was agreed upon at half a million rupees. But on the day the transplant was to be done, the seller backed out pretending ill-health. Perhaps, he would have found another buyer who had been ready to pay more. Nothing could be done about it at that last minute because the tout had disappeared with the advance money he had collected. My friend’s sister had to die under these tragic circumstances, but he could not seek redress through legal channels though the seller had dishonoured his contract. That is because he did not get legal protection since he had been dealing in a market not permitted by law. Though there is a price and the price is determined through negotiations, obviously there is a market failure in the sense that the transaction could not be completed to the satisfaction of the parties involved. But in this case, the market failure has been activated by a governmental ban imposed on the ground that selling live human body parts is immoral, unethical and unjustifiable.

2012 Nobel Laureates honoured for designing markets

Surely, the markets for human body parts, and many others of similar nature, are quite different from the markets which one would go through on a day to day basis. But these markets too should have an equilibrium point, stability and satisfaction for all the parties who do trading in them.
This was the subject matter studied by Lloyd Shapley of the University of California, Los Angeles and Alvin Roth of Harvard University, both in USA, with an extraordinary passion and that earned them a Nobel Prize in economics in 2012.

Gale-Shapely Algorithm: Best choice through repeated action 

The work of these two economists and that of many others who work in this area is based on an optimal decision making process known as ‘Gale-Shapley Algorithm’ which became known after a paper which Lloyd Shapley authored with David Gale of the University of California, Berkley in 1962. In this paper titled “College Admissions and Stability of Marriage” and published in American Mathematical Monthly, the two authors presented a way of matching market participants for a stable transaction through a process of repeating ‘the search and find’ until they come up with an acceptable match for making an ideal choice. That process is known in science as ‘algorithm’ and in algorithm, people will iterate or repeat what they have started till they just hit the best for them. For instance, if I seek a job and I am not the best in the opinion of my most preferred employer, I cannot have the job because the employer will not hire me. Then, I have to go down and make my search until I find an employer to whom I am the best candidate for the job. At that stage, there is no reason for me to make further search of employers who would hire me and my employer also has no reason to go looking for another worker because he too has found his best. So, algorithm or the iteration stops there.
This is similar to the auctioneer proposed by Leon Walras, the 19th century French mathematical economist, where the auctioneer would just go on until he finds the market clearing price set by matching demands and supplies.

Marriages can be perfect if done according to Gale-Shapley Algorithm

David Gale and Lloyd Shapley analysed two events in their 1962 paper that gave rise to Gale-Shapley Algorithm. Those two events were marriages and admission to colleges. In the case of marriages, the stability in marriage happens when the two partners have no any further incentive to look for new partners because both of them are now fully satisfied with their chosen partners. Gale and Shapley pointed out that people can have the best match for them by following an algorithmic or in other words, an iterative process. The same choice can be made by people when they seek admission to colleges. They will go on repeating the search until they find a college which is ready to accept them as students.
For instance, take the matching in marriages. Assume that our marriage market consists of five men and five women searching for suitable partners. If man one’s best choice is woman one, but woman one’s best choice is not man one but, say, man three, then, there cannot be a match between them. Man one has to look for a woman who chooses him as her best choice. Suppose that man three’s best choice is not woman one but woman two. Then, woman one and man three cannot be matched. Everyone therefore has to go on searching until they get a match and at that stage, they can make a choice and end up pairing themselves. Those who have got married through the market or those who have sought admission to their preferred colleges can certainly talk about this experience which they would have had.

Implications of Gale-Shapley Algorithm

But, in my view, this has several implications. Implication one is that we have to reduce the human emotions like the best marriage partner or the most preferred job or the most liked college to an objective market good. Once, the good is acquired by following an iterative process, we have to assume that people are happy forever. It gives rise to the second implication that people’s choices remain fixed and do not change over their lifespan. Whatever that happens over the lifespan, once they have made the choice, they have to stick to those choices. A third implication is that though people prefer the best, there is always disappointments and they have to settle for what is available to them as the second or even the third best. A fourth implication is that despite this, people do not seek to destablise the markets by trying to look for the best which had been denied to them earlier. Yet a fifth implication is that there is no loss of pleasure, or welfare as the economists call it, due to the additional costs involved in activating the iterative process. In other words, there is no money or time cost of working on the iterative search engine. A sixth implication is that no one leaves the market after getting tired of looking for an acceptable match for him. If people leave the market not because they have no buying power at the prevailing price but because human emotions are such that they cannot have a match, then there is a market failure. Gale and Shapley showed that if people do not leave the market, then, the algorithm will guarantee that every man and woman will have a matching partner and every student seeking college admission will have a college.

Alvin Roth: Do laboratory experiments to design economic theories

Alvin Roth took this analysis forward by conducting laboratory experiments in economics combining neuroscience and economics together. His research has mainly been in game theory, experimental economics and market designs. He earned Nobel Prize in economics in 2012 on account of research he has conducted in market designs but his work has to be appreciated as a combination of all the three areas of research. Before Alvin Roth, a group of economists led by Herbert Simon gave birth to a new field of economics known as ‘behavioural economics’ but all the behavioural economists were simply economists and there was no drawing of scientists from other fields into the subject. But, a new filed called ‘neuroeconomics’ which is studied under his experimental economics courses at Harvard University has drawn together both economists and neuroscientists.

Neuroeconomics: Marriage between brain and economic behaviour

According to Alvin Roth’s colleague at Harvard David Laibson, neuroeconomics is simply the “study of the biological microfoundations of economic cognition and economic behavior”. In laymen’s language, it means how people would see the economic world around them and make adjustments to their behaviour in that area guided by how they have been built at the tiniest level of their body systems like the brain systems, neurons, genes and neurotransmitters. Thus, people are what they are made-up neurologically and that make-up affects their perception, beliefs, decision making, mental representations, emotions, expectations, learning, memory and likes and dislikes and so on. Changes to the neurological systems can change these behavioural patterns as well. An important finding in neuroeconomics is that the brain makes use of signals from multiple sources within the system when it makes decisions rather than relying on a single source. It thus integrates information from different systems and finally leads to a certain type of behaviour, a view one finds in complexity economics that too looks at economic systems from a multi-dimensional point. The best example is choosing between an iPhone 5 and a Samsung Galaxy S3. That decision is affected by information acquired and processed at various centres of brain and not by a single piece of information.

 Experimental economics: New science of making economic theories

Alvin Roth took this to laboratories to test the behaviour of people at large and how it would change according to the changes in the biological system, external inducements and environmental changes. In a course in experimental economics he teaches at Harvard, he has combined the economic theory with laboratory experiments and the neuroeconomics as taught by David Laibson. Roth in a draft paper on Experiments on Market Designs he has made available to his students at Harvard in January 2012 emphasised its importance as follows: “Experiments seem to have been most useful in practical design when they are used as complements to other empirical and theoretical work. Used together with other tools, experiments have played multiple roles, not only in designing new marketplaces and institutions, but in helping diagnose and understand market failures and successes, and in communicating results to policy makers”. So, Roth’s contribution has been to take pure economic theory to practice in terms of developments in psychological behaviour of people for use in practical policy making. With this type of experiments, many others have moved into experimental economics and it is reported that on the other side of the globe at Monash University in Australia, there is an active group of economists who have moved into research in this field. A notable feature about this group is that almost all of them have got their education in USA and later they have set up camp in Australia to work for the advancement of knowledge in experimental economics.

Alvin Roth: Create markets where there are no markets

So, Roth’s contribution is to design markets that work perfectly where there is no market either due to prohibitive governmental laws or social taboos but there is a demand for as well as a supply of such products. In the failed kidney market that we talked about earlier in this article, Roth’s solution is to create a clearinghouse that will match the demand and supply. It works as follows: Suppose your loved one needs a kidney but your kidney is not the right type. You have to get the right type of the kidney which is available with someone whose identity or the location is not known. This pertains to the problem of informational efficiency in the market. You offer to donate your kidney on behalf of your loved one which can be transplanted to someone else who needs a kidney of your type. The clearinghouse matches all the demand and supply orders and clears the excess demand. It does not rely on touts who will run away with your money or kidney sellers who will without notice back out from the agreed transaction.

Blood bank is a simultaneous clearinghouse

This appears to be bizarre and dreamlike. But this is exactly how the blood bank in Sri Lanka operates. Four decades ago, this writer’s sister had to undergo cardiac surgery and the writer’s blood group was not the type which his sister needed. Anyway, out of family feelings, he had to donate 2 pints of blood to the blood bank and there were others who too had done the same on behalf of their loved ones. So, the demands and supplies were matched and the needed blood was supplied to the writer’s sister during her cardiac surgery. As long as there are patients who need blood and there are relatives who are willing to donate their blood on their behalf, the blood bank matching system will work perfectly. But it will fail if there is a patient with no relative or a friend to donate blood on his behalf. At that stage, the merciful government has to allocate blood to that patient as a governmental intervention but when there are many patients like that the whole system will fail for lack of the required quantity of blood.

The Government has to enforce contractual obligations

In my view, there is a fundamental difference between the blood bank and the type of the kidney clearinghouse proposed by Alvin Roth. A relative or a friend of a patient is most willing to part with his blood when the patient in question is struggling between life and death in a hospital bed. All brain neurons as neuroeconomics has suggested will work simultaneously compelling that person to donate his blood. Thus, blood can be extracted from the willing donors and kept in store in the blood bank for some time for later use. A kidney is not like that and at the time the patient is in hospital, struggling between life and death, a relative may be most willing to express his desire to donate one of his kidneys and allow the clearing house to supply a matching kidney to his patient. If there is another patient with a willing relative with a matching kidney at the same time, then, there is no problem for the clearinghouse to supply the required kidney. However, a problem arises when the delivery has to be dome later and by that time, he may not have the same willingness to donate his kidney to another unknown patient. At that stage, the enforcement of the contractual obligation will be a problem and the clearing house may not have enough and a regular supply of kidneys for matching with the demands of the patients.
Thus, markets can be hypothetically designed, but for them to work properly, the government has to enforce contractual obligations through independent judiciary systems by maintaining law and order and observing the Rule of Law.

*Writer is a former Deputy Governor – Central Bank of Sri Lanka and teaches Development Economics at the University of Sri Jayewardenepura. This article first appeared in Daily FT  – W.A. Wijewardena can be reached at waw1949@gmail.com

 

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