Wednesday, October 17, 2012

What would Coase think of the Market Design Nobel?

On reflecting on the recent Nobel Prize, I have come to wonder: What would Coase think of market design?  Part of me thinks he would be incredibly sympathetic.  Consider this classic passage from his tremendously-influential article, The Nature of the Firm (published: 1937).
It is convenient if, in searching for a definition of a firm, we first consider the economic system as it is normally treated by the economist. Let us consider the description of the economic system given by Sir Arthur Salter.3“The normal economic system works itself. For its current operation it is under no central control, it needs no central survey. Over the whole range of human activity and human need, supply is adjusted to demand, and production to consumption, by a process that is automatic, elastic and responsive.” An economist thinks of the economic system as being co-ordinated by the price mechanism and society becomes not an organisation but an organism.4 The economic system “works itself.” This does not mean that there is no planning by individuals. These exercise foresight and choose between alternatives. This is necessarily so if there is to be order in the system. But this theory assumes that the direction of resources is dependent directly on the price mechanism. Indeed, it is often considered to be an objection to economic planning that it merely tries to do what is already done by the price mechanism.5 
This last comment is, of course, a reference to Hayek's critique that the price system efficiently uses information. Coase goes on to say: 
Sir Arthur Salter's description, however, gives a very incomplete picture of our economic system. Within a firm, the description does not fit at all. For instance, in economic theory we find that the allocation of factors of production between different uses is determined by the price mechanism. The price of factor A becomes higher in X than in Y. As a result, A moves from Y to Xuntil the difference between the prices in X and Y, except in so far as it compensates for other differential advantages, disappears. Yet in the real world, we find that there are many areas where this does not apply. If a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so. Those who object to economic planning on the grounds that the problem is solved by price movements can be answered by pointing out that there is planning within our economic system which is quite different from the individual planning mentioned above and which is akin to what is normally called economic planning. The example given above is typical of a large sphere in our modern economic system. Of course, this fact has not been ignored by economists. Marshall introduces organisation as a fourth factor of production; J. B. Clark gives the co-ordinating function to the entrepreneur; Professor Knight introduces managers who co-ordinate. As D. H. Robertson points out, we find “islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk.”1 But in view of the fact that it is usually argued that co-ordination will be done by the price mechanism, why is such organisation necessary? Why are there these “islands of conscious power”? Outside the firm, price movements direct production, which is co-ordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-co-ordinator, who directs production.2 It is clear that these are alternative methods of co-ordinating production. Yet, having regard to the fact that if production is regulated by price movements, production could be carried on without any organisation at all, well might we ask, why is there any organisation? 
This question brings me to the crux of this post.  In essence, Coase is saying that there are times when explicitly organizing economic activity makes more sense than trying to coordinate everything through the price system.  Coase pointed out that firms arise when it makes sense to explicitly organize economic activity -- they are islands of command and control in an ocean of free market, so to speak.

Market design receives a similar criticism.  Why not just let the market work?  Ryan wrote about this yesterday, and he makes some important points, citing Roth's contribution to market design.
1) Some transactions are "repugnant" and a price-clearing market simply won't ever be allowed, but we should try to do the best we can anyway (e.g. Roth 2007 "Repugnance as a Constraint on Markets").
2) Market design is an "engineering approach" to solving economic problems; that is, it's "practical." When Roth is called in to "fix" a market, the solution needs to be arrived at quickly, and context of the market and politics surrounding the market matter (e.g. Roth 2002 "The Economist as Engineer"). Introducing prices, transfers, and perfectly competitive markets where they've never existed before might be too much to ask.
Fundamentally, these points are specific reasons why coordinating a "market design problem" using the price system may cost more than using the tools of market design.  In other words, an effective argument for market design research is Coasean -- problems suitable to market design are situations where transaction and coordination costs are high.  Given these costs (repugnance, unfamiliarity), there is room to improve on the status quo.

A final comment on Coase and Market Design.  Coase likely doesn't love the market design approach because it is incredibly mathematical.  Coase is famous for economics that can be developed through logic and clear prose.  As evidence, here is a quote from just this spring about Coase:
“Ronald belongs to an era before economics was taken over by mathematicians,” says Douglas Baird, the Harry A. Bigelow Distinguished Service Professor of Law. “He thinks about economics in intuitive terms. He does not think that there are any important terms in economics that you cannot understand using words, descriptions, and arithmetic. 
“Some people say that shows he is from a much earlier era. The better view is that there is something fundamentally healthy about his work that is too often lost on modern economists, who are sometimes so enchanted by mathematical models that they lose touch with planet Earth.”
To sum up, Coase probably doesn't think much of the market design prize, but his doppelgänger who loves math would be thrilled.

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