Markets and All That
Updated: Nov 13, 2021
By Ishan Kashyap Hazarika and Govind Gupta
What do DU cutoffs, vegetable prices and Tinder matches have in common? We may ask this in the fashion of a typical Freakonomics chapter. And this article may appear as another attempt to talk about things clearly not economic, by simply ‘insisting’ that they are Economics- a reprehensible ploy of Economists to dominate other fields, the ploy of “Economics Imperialism” as many call it.
The anger is understandable, however, as many such books do not tell us "why" crime, admissions or romance is essentially Economics. To begin with, Economics as the study of the allocation of scarce resources, trade-offs and incentives, includes much more than markets. But in this article, we will stick to the idea of markets, which is one area considered undoubtedly economic, and show how many institutions- that we do not typically view as markets- are in reality, markets. In this attempt of ours to establish unconventional territories of markets, and thus Economics, we will inevitably also look at the deep philosophical underpinnings of Economics, scarcity and information, which go beyond the realm of money and finance.
Markets and Magic: Value and Price
Whenever we think of markets, the intuitive image is of the stock exchange, a retail store or a traditional vegetable shop. But markets are a nuanced conception and to tweak Roald Dahl words ... watch with glittering eyes the whole world around you because the most intriguing markets are found in the most unlikely places. Those who don’t believe in markets will never find them.
Our story begins with the origins of Economics itself- the study of wealth: anything that is valuable. But such a definition inevitably leads to the question of what constitutes value. In fact, for hundreds of years, 'Political Economy' as it was called, was primarily concerned with the question of value. The question of the origin of value perplexed the greatest minds for millennia. Aristotle gave up. Adam Smith argued that this substance is 'labour'. Karl Marx greatly expanded on this idea. But in the inconsistencies and paradoxes of this Labour Theory of Value, the question lived on.
The answer, or at least the currently accepted answer, came perhaps from the Austrian School. In the works of Menger and Mises, the concept of scarcity in the face of wants, as the source of value took shape. We live in a world of scarcity, and resources must be allocated wisely. This is the source of value. An efficient system will give the goods and services to those who value it the most. But who decides what is wise? How do we know what is preferred or what is scarce? Especially, if there is no pivotal agency to collect data on all of this, how can an unplanned, chaotic market work? To answer this, Friedrich Hayek developed an argument, which is perhaps one of the most fascinating ideas in Economics.
Hayek argued that a market is simply an ‘information system’. The system works through the means of ‘information signals’. The information signals tell sellers how much to produce, given the preferences of the consumers, and tell consumers how much to demand, given the costs of the sellers. This coordinating signal itself is called “price”. Prices are not dictated, but discovered through the interaction of people, and the flow of information.
Thus a market is an information system that works through ‘price signals’to coordinate activity. If consumers feel a commodity is less valuable, prices fall and inform producers about it, and they produce less of it. Firms whose costs exceed the price stop producing it. Thus, the commodity is produced most efficiently, with the least cost. Similarly, if costs rise, prices rise to inform consumers about it, who reduce demand. Consumers who value the good less than the price, stop demanding it, and the scarce commodity is allocated efficiently, to those who value it the most.
This view of the market as an information system is evidently quite general; and does not appeal to money for price at all. Money, as the most liquid asset, is highly convenient for the transfer of value and thus in price formation. But even in systems where money is not used such price signals exist and coordinate economic activity to lead it to efficiency.
Imagine that "free" coffee is being distributed in the premises of the Delhi School of Economics. But there are 20 people in the queue before you. Only people who value the coffee more than the hardship of waiting in the queue for that long and missing out a few minutes of a lecture will join the queue and demand coffee. Thus, here again, there is an efficient distribution of the commodity- the price is the length of the queue, that discriminates against people who value the coffee less. The free coffee is not as free as it first seemed.
While we have shown how non-monetary signals too can act as prices, which are only information signals, we have still discussed only “goods and services” as bearers of value. As we shall see next, we can generalize markets not only to the non-monetary, but also to the non goods-and-services realm.
Markets everywhere
In a departure from the restricted perspective, we begin to see markets of different shapes and sizes, forms and intent.
Imagine you are one of the students standing in line for coffee at DSE. You were lucky enough to get admitted before the pandemic, to enjoy the coffee on campus. But how did that happen? While scrolling your phone one day, you received a notification about the release of this year’s Delhi University cutoffs. The idea of a cutoff is that the choicest of colleges under DU in the country can’t admit every student who wishes to attend. Consider in what other way this could have been achieved. DU could have kept its cutoffs at forty per cent and raised its fees until the demand reduces to equal the supply of seats. Only those who can afford it get in. But the goal of DU is perhaps not to earn the highest revenue, but to get the brightest students. So it keeps its fees at a minimum and raises its cutoffs, until the demand reduces enough to equal the supply. Consider how monetary prices aren’t important here at all. But the cutoffs work exactly as prices, conveying the information of the supply and demand of the seats in a college. The admissions are a market too.
Many markets you would notice, including DU admissions, are quite different from ordinary commodity markets. While in an apple market, apples do not have preferences, only people do-- in the admissions, both the students and the colleges have preferences over each other. In these two-sided "matching markets", the preferences and desires of both sides need to be "matched" in often complicated ways using prices, but also in other ways. Sometimes explicit prices are absent completely. To push the admissions' example further, an admission to an Ivy League college would entail even more preferences, which can't be signaled by mere cutoffs, let alone monetary prices. To get into a college like Princeton or Harvard, you put in an application comprising your Personal Essays, recommendation letters and achievements besides your transcripts. And if the college chooses you as well, the transaction takes place.
Similarly, our economics undergraduate at Delhi University is also looking for a job after college. The wages of a firm (the price of your labour) alone doesn't determine who all ends up working that job. To begin with, you've to choose to apply to the firm, considering its compensation offerings among competing prospects and then the firm itself has to choose you among the applicants' pool. Thus the transaction needs a matching of preferences of both the buyer (the firm) and the seller (you).
The term 'matching' used in such markets' context actually had its genesis in the marriage market, wherein you merely can't just choose your spouse, he/she has to in return choose you for the match to take place. And yes, marriage is a market! If you look closely it is a transaction, sealed with a vowed contract between two people for domestic partnership. Jane Austen's readers might already recognize its features in her novels, where the preoccupation of many a heroine is navigating the tradeoff of opportunities for financial security and weighing them against the associated risks of various suitors. And just as the inheritance of a suitor although instrumental was never enough without mutual love for the match to take place, in matching markets monetary signals fall short and sometimes are not even needed.
Problems exist
It is clear that this simple idea of signaling the worth and scarcity of objects can turn complicated very soon, as soon as complex preferences from more than one dimension arise.
The idea can be made more clear by considering the differences between booking a traditional hotel and an Airbnb apartment. While in the former case, you pay the price and get your room, it is different in the case of Airbnb, where you select your desired room to rent and the transaction takes place only after the host allows you to stay after reviewing your profile. This is another market, but with an added layer of complexity due to the need to match two-sided preferences.
You might be raising your brows by now, thinking that such matching markets are a hassle and much less convenient than traditional price clearing commodity markets. Exactly! When you book on Airbnb, it is usually after the host agrees to let you stay that you get your room and this may take a while.
When the marketplace trades in a commodity, the standardized nature of the commodity due to the mandatory rules of the markets, provides you with a relief as then you can indulge in a transaction, indifferently - the identity and preferences of the buyer or seller doesn’t matter, you just bother with the commodity’s price. But matching markets aren’t like that and in general, are understandably relatively less efficient.
To begin with, there are the issues of ‘congestion ’and ‘thinning’.
To understand congestion, let us visit a variant of the marriage market - the dating market (the 'applications lingo' of which even includes the word 'match'). An attractive and popularly desired lady may be flooded with many messages than she can respond to, making men like our DU student send even more (not so heartfelt) messages to even more ladies to increase the likelihood of eliciting a response. To tackle this, the dating apps work in a way such that only 'mutually matched' people can send messages to each other and some platforms also include a 24-hour window of response, after which even the match is undone. This regulates the traffic in the marketplace. Similarly, AirBnB uses a threshold ratings enabled instant booking wherein if one has a certain average ratings, she can instantly book a room with a host without waiting for approval.
To understand thinning, let us consider the journey of our above mentioned DU student to his college this morning- via an e-rickshaw. Since the e-rickshaw starts only when it can fill all four of its seats with passengers, every e-rick driver tries to get his four passengers first. This strategy makes the drivers park their vehicle ahead of the designated stand, from where the passengers are coming. Thus each driver spreads out the rickshaw stand and tries to get passengers first. Unchecked, this leads to dilution of the market as now both the passengers and drivers try to transact with very few options. A regulated and ordered 'one place' e-rickshaw stand would've made the market much more efficient.
Making it work: Market Design or Economic Engineering
This devised construct of rules regarding the workings of a market, as in the e-rickshaw ‘one place’ stand or the ‘matching rules in dating apps,’ is the idea behind ‘market design’. The field of market design essentially serves to bring science to matchmaking, and to markets in general. That is why economists often equate markets with languages - something which is a human construct as well as has its own life and evolution. If the rules governing the market are designed by humans in a way that they more or less tackle various market failures, the market functions efficiently, else it unravels.
Markets as designed institutions also ingrain within their design, the values and ethics of the stakeholders involved in it- remember how DU cared more about marks and less about money? But values are subjective and thus it leads us to some kind of markets for which there is no uniform consensus - whether to allow a kind of transaction to take place or not. Nobel laureate Alvin Roth terms such markets as “repugnant markets.” Some markets are prohibited by law because the pitfalls and consequences are too severe to control by any design or regulation. For instance - slave markets. But other repugnant markets could be much more benign.
Some repugnant markets, benign or not, are slavery, organ market and prostitution. Even the current raging contention over immigration is one such example where a contract between a willing employer and a third world worker is opposed by some due to xenophobia or as Bryan Caplan calls it: “global apartheid”.
Marketplaces like these also present quizzical revelations when money steps in, as it often complicates our feelings towards things - a non-monetary transaction of consensual sex is allowed but a monetary transaction as in the case of prostitution is not. Purchasing and selling organs is illegal but kidney donation is legal. In fact, if it is just the medium of exchange that poses the moral dilemma, thank economists for the solution.
Prices are merely one of the various ways of aggregating information. Prices are one of the most powerful and efficient tools mankind has created, but it has its limitations. In a commodity market, prices are paramount in the sense that they alone clear the market - the only thing which matters for traders are the quoted stock prices, or for the commonplace shopper in a retail store, the quoted MRP. But in several non-commodity markets, we may employ a host of alternate strategies.
Lifesaving Markets (literally)
Ingenious market design has in fact helped save the lives of thousands of patients every year in the recipient list waiting for kidney donations. Consider a patient who needs a kidney. Since there is an acute dearth of donated kidneys, and he might have to wait years to get one, a family member agrees to donate him one. But the donor's kidney needs to be matched with the patient for the medical transplant to take place. But if it doesn't (which is the thick probability), by constructing an exchange program for kidneys through a cycle of kidney exchange - the first incompatible patient-donor donates a kidney to a second incompatible patient-donor whose needs to match the kidney from the first pair, and simultaneously the second pair (whose donated kidney matches with the needs of the first) donates to the first- the double coincidence of wants is taken care of.
Theoretically, even longer chains and webs can be created for efficient allocation, using variants of the Top Trading Cycle Algorithm. The market reaches an equilibrium without price signals, but with extensive coordination and control.
Practically, this market is still evolving and it pressingly needs a ‘thickening ’of more participants to facilitate smooth transactional matches. Besides, there are regulatory hurdles and logistical concerns to design an organ exchange market which can save lives. Despite the limitations, however, this designed market has been saving thousands of lives every year.
What can be gleaned from the above discussions is that markets are an amazing way to allocate resources and price clearing markets are really efficient as they convey value in absolute objective terms. The price signals need not be monetary only, but can also be embodied in virtually any other measure. But when we do not have one quantitative measure to quantify value, when prices can't or aren't allowed to encompass the desires and preferences of individuals, the matching process is cumbersome. Had there been one index incorporating all preferences, say a graduate student skill score, firms would've been indifferent buyers of labour and graduates would've been more like a standardized commodity. The index would've acted as the market-clearing agent (the 'price'), but that's wishful thinking of a counterfactual.
Reality is far from perfect and in non-commodity markets, we are still designing and fine-tuning frameworks to facilitate potential beneficial transactions and pick up the bills left on sidewalks.
Govind Gupta and Ishan Kashyap Hazarika are third year students of economics at Hansraj.