Market Design as Economic Engineering:

1. Market Design as Economic Engineering: Al Roth Stanford University June 2013

2. How is Economic Engineering different from Economic Theory? • Practical market design isn’t eternal: we can expect to do better as we learn more and as our needs change… • Sometimes our needs change because of the way people respond to previous technology

3. Mathematical theorems don’t change over time, or depend on the situation in which they were discovered…

4. Pythagoras’ Theorem/" Gōu gǔ dìnglǐ " (勾股定理)/" Shāng gāo dìnglǐ " (商高定理) But solutions to engineering problems can be different for different problems, and change over time.

5. Ming Dynasty bridge, ShòuníngXiàn • http://www.dailymail.co.uk/news/article-2253793/The-1-000-year-old-wooden-bridges-modern-China-moving-Stunning-timber-structures-withstood-test-time.html

6. 2002 Bridge, Shanghai Those two very different bridges use different technologies, they span different bodies of water, and they serve different amounts of traffic… http://www.chinapage.com/bridge/shanghai/lupu/lupu.html

7. Marketplaces as solutions to engineering/design problems • Marketplaces need make markets sufficiently • Thick • Enough potential transactions/participants available at one time • Uncongested • Enough time for offers to be made, accepted, rejected, transactions carried out… • Safe • Safe to participate, and to reveal relevant information

8. Today I hope to tell you about several different kinds of markets • Commodity markets • Matching markets • They present different market-design challenges

9. Commodity markets Chicago Mercantile Exchange NY Stock Exchange

10. Commodity markets can be arms-length and anonymous • When buying 100 shares of AT&T on the New York Stock Exchange, you don’t need to worry about whether the seller will pick you—you don’t have to submit an application or engage in any kind of courtship. Likewise, the seller doesn’t have to pitch himself to you. • The price does all the work, bringing the two of you together at the price at which supply equals demand. On the NYSE, the price decides who gets what. • When it’s working well, the market helps do “price discovery” to find prices that work.

11. But in many markets prices don’t do all the work • Harvard and Stanford don’t raise tuition until just enough applicants remain to fill the freshman class. • Selective colleges in the U.S. try to keep the tuition low enough so that many students would like to attend, and then they admit a fraction of those who apply. • Colleges don’t rely on prices alone to equate supply and demand • Labor markets and college admissions are more than a little like courtship and marriage: each is a two-sided matching market that involves searching and wooing on both sides.

12. Matching markets • In matching markets, you can’t just choose what you want (even if you can afford it): you also have to be chosen. • You can't just inform Harvard that you’re enrolling, or Google that you are showing up for work.You also have to be admitted or hired. Neither can Google or Harvard simply choose who will come to them, any more than one spouse can simply choose another: each also has to be chosen.

13. Some matching markets I’ve helped design: • Medical labor markets • Medical Residents: in the U.S.: NRMP in 1995 • Gastroenterology in 2006 , and other Fellowship markets • American labor market for new Ph.D. economists • Scramble March 2006 • Signaling December 2007 • School choice systems: • New York City since Sept. 2004 (high schools only) • Boston since Sept. 2006 • Denver, New Orleans—Sept. 2012 • In discussion with Chicago, Newark, D.C., • Kidney exchange • New England and Ohio (2004) • National US (2010-?)

14. Matching is important throughout our lives • Nursery School, Kindergarten and Schools • College: getting in, and after • Graduate schools • Transition to jobs: summer internships, on campus recruiting of undergrads and MBA’s, • Job markets • Dating and marriage markets • Medical care: Allocation of organs for transplant

15. How are commodity markets designed? • They may start as matching markets. • The U.S. market for wheat: • In the 1800’s, it was a matching market, you had to know your farmer • “selling by sample,” since each crop was different, and there were no standards for quality, etc.

16. The U.S. market for wheat today • There are eight classes of wheat: durum, hard red spring, hard red winter, soft red winter, hard white, soft white, unclassed, and mixed.  • There are grades: 1-5 • They are traded in centralized markets: the Kansas City Board of Trade, Chicago Board of Trade • Thus you can buy a contract for 5,000 bushels of No.2 Hard Red Winter Wheat. • You don’t have to sample: all offers are the same • http://www.wheatflourbook.org/p.aspx?tabid=1

17. Marketplace organizations Open outcry in a trading pit Electronic limit order book Order book stores offers to buy “bids” and offers to sell “asks” A limit order is an order to buy or sell at a certain price (i.e. when the matching bid or ask comes in). The order book is “in order” with the highest bid and lowest ask first. Anyone can accept the best bid or ask at any time.

18. Financial market design • High frequency trading • Presently both the New York Stock Exchange and the Chicago Mercantile Exchange use continuous limit order books. • First come first served: whoever accepts a bid or asked first gets the trade • This can create a race that doesn’t have an economic purpose • It can make the market thinner in costly ways • It can cause breakdowns like the “flash crash” in 2010

19. Budish, Crampton and Shim, 2013 790 miles by road Eyeblink: 100-400ms

20. Why is there demand for high frequency data and trading ability? • Because the market is first come, first served, and sometimes there are brief opportunities for arbitrage….

21. ES= E-mini S&P futures. SPY = SPDR S&P 500 Exchange Traded Funds

25. With high speed trading, arbitrage opportunites don’t last as long

26. But they haven’t become any less profitable. And the fastest trader gets the profit. So competition is by speed.

27. Why might high speed trading be a problem? • Rent seeking • Billions of dollars are spent on high speed lines and computers each year • Market inefficiencies • Traders compete on speed rather than on price • Bid-ask spreads become “stale” at any new news • So liquidity providers have to protect themselves by quoting higher spreads • At very high frequencies, the market becomes thin, and unstable • Flash crash (May 6, 2010)

28. A new market design proposal • Proposal: instead of “continuous” trading, trade once every second • A call market would collect the bids and asks that had come in in the last second, and produce the price at which supply equaled demand • In a call market run every second, the best price would make the trades. • Compete on price rather than time • Still provide rents for new economic information • A second is slow for a computer, but fast for economic news…

29. What has happened? • New technology has given participants incentives for new kinds of behavior. • These new kinds of behavior make the old market design work somewhat less well • … • So new designs may be called for.

30. Let me show you how this has happened in a very different market…

31. Organ transplantation • On Friday I spoke with the Ministry of Health in Beijing about the changing plans for organ donation and transplantation in China. • Today let me describe to you some recent developments in the U.S.

32. Kidney exchange--background • Many more people are in need of kidney transplants than there are available organs. • The waiting list in the US has almost 100,000 people on it • The wait can be many years, and many die while waiting. • Transplantable organs can come from both deceased donors and living donors. • Sometimes donors are incompatible with their intended recipient. • This opens the possibility of exchange .

33. 33

34. Notice that no money changes hands… • Kidney exchange is an “in kind” exchange

35. Section 301 of the National Organ Transplant Act (NOTA), 42 U.S.C. 274e 1984 states: “it shall be unlawful for any person to knowingly acquire, receive or otherwise transfer any human organ for valuable consideration for use in human transplantation”.

36. Charlie W. Norwood Living Organ Donation Act Public Law 110-144, 110th Congress, Dec. 21, 2007 • Section 301 of the National Organ Transplant Act (42 U.S.C. 274e) is amended--in subsection (a), by adding at the end the following: • ``The preceding sentence does not apply with respect to human organ paired donation.'' 36

37. 2-way exchange involves 4 simultaneous surgeries 37

38. 3-pair exchange (6 simultaneous surgeries) Donor 1 Recipient 1 Pair 1 Recipient 3 Donor 3 Donor 2 Recipient 2 Pair 3 Pair 2

39. Non-directed donors: cycles plus chains Pair 1 Pair 4 Pair 3 Pair 5 Non-directed donor Pair 6 Pair 2 Pair 7

40. Non-directed donor chains • Non-directed donors ND-D P1 P2-D2 P1-D1 ND-D P3

41. The graph theory representation doesn’t capture the whole story Rare 6-Way Transplant Performed Donors Meet Recipients March 22, 2007 BOSTON -- A rare six-way surgical transplant was a success in Boston. NewsCenter 5's Heather Unruh reported Wednesday that three people donated their kidneys to three people they did not know. The transplants happened one month ago at Massachusetts General Hospital and Beth Israel Deaconess. The donors and the recipients met Wednesday for the first time. Why are there only 6 people in this picture? Simultaneity congestion: 3 transplants + 3 nephrectomies = 6 operating rooms, 6 surgical teams…

42. ‘Never ending’ altruistic donor chains (non-simultaneous, reduced risk from a broken link) Since NEAD chains don’t need to be simultaneous, they can be long…if the ‘bridge donors’ are properly identified.

44. The First NEAD Chain (Rees, APD) July July Sept Sept Feb Feb Feb Feb March March 2007 2007 2007 2007 2008 2008 2008 2008 2008 2008 MI AZ OH OH OH MD MD MD NC MD OH 1 2 3 4 5 6 7 8 9 10 O O A A B A A A A AB AB O O A A B A A A A A 62 0 23 0 100 78 64 3 100 46 Cauc Cauc Cauc Cauc Cauc Hisp Cauc Cauc Cauc AA # * Recipient PRA Recipient Ethnicity Relationship Husband Wife Mother Daughter Daughter Mother Sister Brother Wife Husband Father Daughter Husband Wife Friend Friend Brother Brother Daughter Mother * This recipient required desensitization to Blood Group (AHG Titer of 1/8). # This recipient required desensitization to HLA DSA by T and B cell flow cytometry.

46. Chains become more important as patient pools become more “highly sensitized”

47. Feb 2012: a NEAD chain of length 60 (30 transplants)

48. Why do we have laws against simply buying and selling kidneys? • I sure don’t know the answer to this one, but I think it’s a subject that social scientists need to study… • Making markets illegal doesn’t stop illegal markets

49. Kidney Exchange… …achieves some of the benefits of a market, without using money, and thus without running into the barrier raised by the repugnance that kidney sales arouse.

50. What is a free market? • One with rules and institutions that let it operate freely… • Think of a wheel that can rotate freely, because it has an axle and well-oiled bearings • For matching markets, more than price discovery is needed: many important transactions aren’t mediated only by price. • But markets are tools for aggregating and disseminating information (and prices do that well in commodity markets). • Organized markets are different than central planning, and different than laissez-faire. • Marketplace designs are engineering solutions: as conditions change they may need to be revised and updated.