Market Design

Introduction

Prepare to challenge your assumptions about markets. In this tutorial, we'll explore how markets, like algorithms, can be designed to solve complex coordination problems, from allocating resources to shaping governance structures. We'll explore the interplay of rules, incentives, and trust to create efficient and equitable markets. Through real-world examples, like how food banks can use market mechanisms and the transformative potential of blockchain for market design, you'll gain a newfound appreciation for the power of markets as tools for social good. By the end, you'll have a deeper understanding of how to harness markets to build a better future.

Economics, Markets, Institutional Technology (Recap)

In our first module we discussed that economics isn't all about cold calculations and confusing charts. It's about how we – as individuals, communities, businesses, and whole countries – make choices about what to produce, how to share resources like our time, and what we decide truly matters. Our choices shape the world around us, and they're influenced by a complex web of factors.

Think of the economy almost like a living, ever-shifting network of connections, individual decisions, and, for our purposes in this tutorial, the interaction of rules that shape how we interact.

We've talked about how the rules we live by often seem set in stone – laws, regulations, and all the unwritten norms that guide behaviour. Here's the exciting part: we have the power to redesign those rules! Not just to make things more efficient, but to make them fairer, to unlock new possibilities, to create a system that rewards people for doing good, not for getting rich.

This is where market design and blockchain technology converge. Imagine a world where we can represent the tiniest of ideas, rights, interactions, or even access as digital tokens that embody some concept of value. By carefully designing these tokens and the rules around them, we can align individual goals with the collective good, creating markets that benefit everyone.

Markets - what they are and what they do

At their core, markets have rulebooks that shape the way we play the game of economics. Like the rules of a board game, they determine how we exchange things, set prices, and define everyones roles.

Imagine playing Monopoly: the rules dictate your moves, defines goals, and who wins or loses. Markets are similar. Those rules, whether they're formal laws or just unspoken social norms, aren't neutral. They shape our behaviour and the outcomes we see. Good rules encourage fair play and cooperation, while bad ones can lead to greed and exploitation.

Think about it: the purpose of a market is defined by its rules. If the goal is to have fun (like in a game), the rules should maximise enjoyment. If the goal is to create financial wealth, the rules will focus on financial profit.

Markets are powerful tools because they help us coordinate actions and make collective decisions about how to use resources. Effective markets build trust, reduce friction, and make collaboration easier. It's like having a built-in navigation system guiding us towards outcomes that benefit everyone.

But markets aren't the only way to organise ourselves. Governments and Firms with their top-down structures and reliance on political power also have rules, but markets are different because they give more power to individuals to make their own choices, guided by prices and incentives.

The key takeaway here is that markets aren't just places where we buy and sell stuff. They're systems of rules that influence our behaviour and shape collective well-being. By understanding these rules and how they're designed, we can build markets that create a more prosperous and equitable future for everyone.

Markets as a governance tool

In Radical Markets^[1], Posner and Weyl reveal that markets aren't just about buying and selling; they're powerful tools for collective decision-making. Imagine markets as the beating heart of a self-organising society, where the rules of the game shape our economic, social and political landscapes.

Katharina Pistor, in Code of Capital^[2], emphasises that these rules aren't just abstract concepts. They are the building blocks of our institutions, influencing power dynamics and resource allocation. We can redesign these rules using tokens and blockchain.

Traditionally, we rely on voting or committees to make collective decisions. But in a token-economy, ownership and voting rights intertwine. We can represent even the smallest of interests. Imagine a community where token holders directly participate in shaping the future, deciding everything from resource allocation to community rules. The act of exchanging tokens becomes a vote, a powerful way to voice your preferences and impact the world.

The exciting part? Markets are dynamic, constantly adapting with new technologies and social needs. Their rules can be continuously negotiated and improved, allowing us to address emerging challenges and explore new opportunities.

In Discovering Prices^[3], Milgrom highlights one of the key ways markets govern is through prices. Prices act as signals, conveying valuable information about scarcity, demand, and what people truly value. By aggregating the knowledge of countless individuals, market mechanisms can efficiently allocate resources and coordinate complex activities. It's important to note that price is almost never a simple question of scarcity and preference, supply and demand. And incentives are rarely just about financial gain.

Radical Markets, Code of Capital, and Discovering Prices all argue that many societal problems stem from limited competition and information asymmetry. Well-designed markets can address these issues. For example, in Quadratic Voting^[1:1], the strength of your conviction matters more than just a single vote. This helps prevent special interests from dominating, leading to fairer and more representative outcomes.

Of course, for markets to function effectively as governance mechanisms, the rules must be carefully crafted. We need to strike a balance between encouraging innovation and ensuring fairness, inclusivity, and stability. This is where the evolving field of token engineering is crucial.

Token engineering, coupled with insights from legal frameworks like those in Code of Capital and Rules for a Flat World^[4] by Hadfield, empowers us to design resilient and representative governance systems. By leveraging the power of markets, we can incentivise participation, aggregate preferences, and foster more effective decentralised decision-making.

Markets, Bureaucracies and Entrepreneurs: A tale of economic modes

So, if markets are so great, what about the alternatives – bureaucratic hierarchies like firms and governments?

Both models represent contrasting approaches to governance, each with its strengths and weaknesses. While both rely on rules to shape behaviour, their underlying mechanisms and philosophies differ significantly.

Markets, as we've discussed, are decentralised systems that rely on price signals and incentives to allocate resources and make decisions. Elinor Ostrom's^[5] research highlights their effectiveness in managing complex systems, fostering innovation and adaptability by their ability to harness the distributed knowledge and diverse preferences of individuals. However, markets, like biological evolution, are blind, responding to immediate signals but potentially overlooking long-term goals or lacking strategic intent.

Bureaucracies, on the other hand, are centralised hierarchies that rely on authority, expertise, and political capital to make decisions. They can be efficient in implementing well-defined tasks, but can also become rigid, unresponsive, and prone to corruption. While bureaucracies often can act over longer timeframes, they may struggle to proactively address larger goals that fall outside of their established purview.

Here's where entrepreneurship enters the scene, not just as a disruptive force, but as a crucial element in the evolution of governance systems. Ostrom emphasised the importance of rules that are created and adapted by individuals closest to the local context – "rules of form" – over rules imposed by remote central planners. Entrepreneurs, in this context, are the rule-makers, the innovators who identify inefficiencies and propose new solutions. They can bridge the gap between the short-term focus of markets and the rigidity of bureaucracies, introducing new rules and adapting existing ones to better serve community needs.

Think of markets as bustling marketplaces, where countless individuals interact freely. This decentralised environment, when coupled with the entrepreneurial spirit of rule-making, can lead to surprising innovations and efficient outcomes. Bureaucracies, in contrast, are like well-ordered factories, resistant to change. This rigidity can create opportunities for entrepreneurial experimentation with new market designs. Ostrom's research revealed that the most successful governance systems often combine elements of all three modes, starting with a strong understanding of the local context.

Enter blockchain. By enabling the low-cost implementation of transparent, tamper-proof rule enforcement, it empowers bottom-up innovation. For example, we can use market mechanisms to efficiently allocate resources, while relying on bureaucratic structures to provide a framework for governance to evolve. This creates fertile ground for entrepreneurial exploration, allowing for the rapid prototyping and testing of new market designs tailored to specific communities. Through real-world experimentation and feedback, these entrepreneurial endeavours help the broader system remain responsive and evolve to meet the community's changing needs.

Why Trust Matters ... and a word about Transaction Costs

Trust is the secret sauce of a well-functioning market. To understand why, consider transaction costs – the hidden costs beyond the price tag when you buy something. These include time spent searching, negotiating, even just worrying about a fair deal.

Imagine buying a used car. Researching models, visiting dealerships, getting a mechanic's inspection... it all adds up, and there's still the risk of ending up with a lemon. Those are your transaction costs.

But what if you could trust the seller completely, with transparent information and a fair price? Your transaction costs would plummet, leaving you more time to enjoy that new ride.

Well-designed markets achieve this by reducing transaction costs through transparent information, clear rules, and even smart contracts on blockchains that automate and enforce agreements. This fosters trust, making cooperation and exchange easier.

The takeaway? Trust is essential for any thriving market. It's not just about efficiency; it's about creating a system where everyone feels confident to participate. With the right tools and design, we can build markets that deliver on that promise.

Markets as a network of local algorithms

Think of markets not as a single, all-knowing machine, but as a network of interconnected algorithms. Each market, whether it's for deciding the best use of group finances or rewarding community contributions, acts like its own algorithm, constantly processing data – transactions, bids, and offers – to allocate resources and determine value.

Every transaction, every exchange, is a piece of data being fed into this algorithm. Each market processes this data to make decisions and allocate resources. The output of this computation is a price, which signals scarcity, demand, and preferences. But price isn't just dollars. In token economies, price represents a well-defined ratio between any two things, tangible or intangible.

Like any algorithm, markets need clear rules to function effectively. These rules ensure fair play and unbiased information processing. As Elinor Ostrom's research suggests, the most effective rules are often those crafted by individuals closest to the local context.

But price isn't the only feedback mechanism. Incentives are also drivers of behaviour. In traditional markets, the pursuit of financial profit – is a powerful incentive. In token economies, incentives and profit can take many forms, like rewards for community contribution, access to exclusive resources, or even governance rights. They guide participants towards behaviours that ideally benefit the whole system.

Viewing markets as a network of interacting algorithms is especially relevant to token engineering. Blockchains provide a transparent, tamper-proof platform for designing and implementing these algorithms on a decentralised, global scale. In fact, Cardano's EUTXO model, with its ability to encode multi-dimensional prices, is a prime example of how blockchains can create richer, more informative market signals. A digital price becomes a dynamic feedback loop, constantly adjusting to reflect the unique context of each market.

Rules Make Markets... But Not How You Think

Now, let's dive into the heart of what makes markets tick: rules. When people talk about "free markets," it's easy to picture a Wild West scenario where anything goes. But in reality, markets thrive on rules – not restrictions, but the kind of rules that create a fair and level playing field.

Think of it like any board game: without rules, it's chaos. But with clear guidelines on what moves are allowed, and how to win, the game becomes fun. The same goes for markets. Well-designed rules create the structure for healthy competition, innovation, and ultimately, a thriving economy.

One of the most fundamental sets of rules in any market is property rights. These rights, as Katharina Pistor explores in Code of Capital, are the legal and social codes that define who owns what and how it can be used or exchanged. They're like the deed to your house, the copyright on a song, or even the reputation you've built online.

But property rights are more than just individual entitlements. As law professor Emily Jane Carpenter argues, they encompass a bundle of interests, including not just individual rights, but also relational and public dimensions. This means that property rights aren't just about what you can do with something, but also about how it affects others.

Beyond property rights, markets rely on other rules too. Contracts, backed by a reliable enforcement mechanism, ensure that agreements are upheld. Regulations help prevent monopolies and unfair practices. Transparency requirements empower consumers to make informed choices.

All of these rules work together to create a truly free market – not one without rules, but one where the rules are carefully crafted to enable choice, foster trust, and protect everyone's interests.

A key point: Blockchains and smart contracts are fundamentally institutional technologies for implementing fair and transparent rules with global reach, radically lowering the costs of what typically requires large bureaucracies. At the moment, we've primarily used them to create simple digital monies, define basic property rights, and implement simple financial exchanges, but we can do so much more.

Incentive mechanisms and incentive compatibility

Markets are all about incentives – the rewards and penalties that motivate us to act. Just like game designers craft levels and challenges to keep players engaged, market designers create mechanisms that guide our behaviour in the economic arena.

The goal? Incentive compatibility. It's about creating an environment where everyone benefits when they act in their own self-interest. Like a well-designed multiplayer video game, where individual players can strive for personal victory while contributing to an exciting and balanced experience for all.

Think of a massively multiplayer online role-playing game (MMORPG). Each player has their own character, quests, and goals, but the game's mechanics are designed to encourage cooperation and teamwork. Players can join guilds, participate in raids, and contribute to the overall community, all while advancing their own progress.

In a well-designed market, the rules define the "incentives," and they steer participants towards actions that benefit themselves and the entire system. Game theory helps us understand how people make strategic decisions when the outcomes depend on what others do. Market designers use these insights to create mechanisms that align individual and collective goals.

Auctions are a classic example of an incentive-compatible market mechanism. The rules of an auction encourage bidders to reveal their true valuations, leading to efficient outcomes where the item goes to the person who values it most.

But incentive design goes far beyond auctions. It's about creating free markets for food banks to allocate rescued food efficiently, allocating airplane landing slots, matching donors with organs, assigning students to schools, show ads on websites, and even shaping how we make collective decisions in online communities. By carefully crafting the rules and rewards, we can design systems that promote fairness, efficiency, and positive social impact.

Of course, creating perfect incentives is a constant challenge. There will always be those who try to game the system. By adapting to new information and constantly refining our market designs, we can create markets that work for everyone, not just the privileged few. In digital markets, where rules can be encoded in smart contracts and data is readily available, this process of refinement becomes even more agile and effective.

Principal-Agent Problems: The Challenge of Information Asymmetry

Even the best-designed markets face a challenge: the inevitable imbalance of information between different parties. This is known as the principal-agent problem.

Think of it like this: you're the "principal," and you hire someone to act as your "agent" – whether it's a real estate agent selling your home, a financial advisor managing your investments, or a CEO running your company. In an ideal world, their incentives would perfectly align with yours, maximising your interests.

But information asymmetry throws a spanner in the works. Your agent likely knows more about the market than you do. They have access to specialised knowledge and insights that you don't. This informational advantage can tempt them to act in their own self-interest, potentially at your expense.

For example, your real estate agent might push for a quick sale at a lower price to secure their commission, even if waiting a bit longer could get you a better deal. Or your financial advisor might recommend investments that earn them higher fees, even if those investments aren't the best fit for your risk tolerance.

Information asymmetry arises anywhere there's delegation and specialised knowledge. Even as consumers, we often lack the information to fully understand the products we buy.

Traditionally, we've relied on reputation and regulation to mitigate these problems. But they aren't foolproof. Reputations can decay, be manipulated, and individuals can easily mask their true identities online. Regulations often lag behind evolving market needs.

Blockchains offer an alternative. By encoding market rules and incentives into transparent smart contracts and recording transactions on-chain, we can create more accountable and trustworthy systems where information is harder to manipulate or conceal.

While not a magic bullet, blockchain can significantly mitigate the effects of information asymmetry. Problems like moral hazard, adverse selection, and conflicts of interest all stem from principal-agent challenges. Vigilant market designers must anticipate these dynamics when crafting incentives. It's a constant balancing act, requiring continuous adaptation and refinement to create markets that foster trust and cooperation.

A Closer Look at Auctions: Feeding America's Innovative Solution

Let's bring all the concepts we've discussed into focus with a real-world example: how auctions have transformed food allocation for those in need.

Before 2005, Feeding America, a major network of food banks, relied on a simple queuing system to distribute donated food. This led to major inefficiencies. Donations were often mismatched with local needs, leading to waste and shortages.

But then, they embraced a radical idea: a market-based solution. They created an online auction platform where food banks could bid on rescued food using virtual "shares" tailored to their specific needs. And here's the key: these shares weren't U.S. dollars. They were tokens designed specifically for this system, aligning incentives and ensuring that the food went to those who needed it most.

This market design provided many key benefits:

• Price Discovery: Bidding allowed food banks to reveal their true preferences and how much they valued different types of food. This meant that high-demand items, like cereal, could be allocated to the food banks that needed them most.
• Customised Allocation: The auctions ensured that food was sent to the places where it would have the greatest impact, considering factors like local demand and transportation costs.
• Supply Incentives: Food banks could even re-list excess inventory, creating a secondary market that further incentivised donations and reduced food waste.

By decentralising decision-making and relying on market signals, Feeding America was able to significantly reduce waste, increase overall food supply, and ensure that resources were allocated where they were most needed. This success story demonstrates the power of market design to optimise resource allocation, even in non-profit settings, and how token-based systems can play a crucial role in achieving these goals. It's a testament to how, with the right rules and incentives, we can harness the power of markets to create a more efficient, equitable, and sustainable world.

I strongly encourage you to listen to the Planet Money episode linked below^[6] to learn more about this fascinating example.

Conclusion

Markets are powerful engines fuelled by human behaviour, but their true potential is unlocked through intentional design. Well-constructed rules and incentives harmonise individual self-interest with collective goals, creating powerful mechanisms for economic exchange, governance, and social coordination.

We've seen how markets, like sophisticated algorithms, process vast amounts of data through the price mechanism, optimising resource allocation and adapting to changing conditions. We've also explored how game theory can help us craft incentive-compatible mechanisms that align individual motivations with the greater good.

While achieving perfect alignment is an ongoing challenge, responsible market design offers a powerful toolkit for transforming self-motivated human behaviour into a collaborative force for innovation and progress. Tokens, including token-based reputation systems, transparent protocols, and the continuous refinement of incentive architectures can help safeguard against inefficiencies and manipulation.

The potential applications of market design are vast and transformative. From Feeding America's groundbreaking auction model to the emerging world of decentralised autonomous organisations, we're just beginning to scratch the surface. As our understanding deepens and technology evolves, purposeful market design promises to revolutionise not just economics, but also governance, policy-making, even how we interact with each other on a global scale.

By embracing the principles of market design, we can unlock the extraordinary potential of human cooperation, harnessing the power of incentives to create a more efficient, equitable, and sustainable world.

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1. Posner, Eric, and Eric Weyl. Radical markets: Uprooting capitalism and democracy for a just society. Princeton University Press, 2018. ↩︎ ↩︎

2. Pistor, Katharina. The Code of Capital: How the law creates wealth and inequality. Princeton University Press, 2019. ↩︎

3. Milgrom, Paul. Discovering prices: auction design in markets with complex constraints. Columbia University Press, 2017. ↩︎

4. Hadfield, Gillian Kereldena. Rules for a flat world: Why humans invented law and how to reinvent it for a complex global economy. Oxford University Press, 2017. ↩︎

5. Ostrom, Elinor. Governing the commons: The evolution of institutions for collective action. Cambridge university press, 1990. ↩︎

6. Planet Money Episode 665: The Free Food Market, 2017 ↩︎