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Top-down Market Design Sometimes Works and Sometimes Doesn't

May, 2003

STANFORD GRADUATE SCHOOL OF BUSINESS—When the iron curtain fell, many Western economists rushed into Soviet Bloc countries with reform prescriptions. It didn't take long to learn that reforming an entire economy from the top down is as difficult as planning one centrally. While economic theories can suggest fruitful directions to politicians, finding good economic policies requires experimentation and are cognition that grassroots folks also create economic change, says Stanford Business School economist John McMillan. Theorists, however, have been useful to state, national, and local governments on a less encompassing scale, he writes in a review of recent market design policies, "Market Design: The Policy Uses of Theory."

Theories of competition and information economics have proved successful recipes for cutting waste in government procurement and air pollution, he writes. They have aided competition in the face of corporate merger proposals and increased government revenues from sale of licenses to use airwaves for telecommunications.

On the national economy scale, however, China has been the most successful at growing its economy, something McMillan attributes mostly to grassroots action. "Economists at the Chinese Academy of Social Sciences debated various incentive mechanisms for the state firms, ranging from freed prices to shareholding to contractual incentives, some of which were run experimentally in certain cities," he writes. "What carried the day in state-firm restructuring, however, was not theory but the precedent of agriculture's post-reform boom." Farmers spontaneously broke agricultural communes into individual plots, quickly boosting their productivity. The government then relaxed restrictions on new non-state-owned firms, and village governments stepped in to build businesses that boomed.

Theory has a mixed record in energy market reform, privatizing state-owned firms, and in marketing government bonds, McMillan says, with politics strongly influencing the first two. "In California's botched deregulation [of electricity], impartial experts had too little impact and interests groups too much," he writes. He also quotes the assessment of MIT economist Paul Joskow, perhaps because McMillan's Stanford colleague, Robert Wilson, was one of those who tried to give California advice. Joskow concluded that ignorance sometimes played a role in energy market missteps, "but more often it was private financial interests that were at work to steer design decisions in the wrong direction."

Politics always plays a role, McMillan says, but it was minimal in the airwaves spectrum auctions. He was one of those who advised the Federal Communications Commission on the auction designs, which economists generally regard as successful because they produced record revenues. In the U.S. case, Congress also wanted to ensure minority-owned firms received some licenses, so the designers gave minorities a price preference that increased competition and pushed the non-minority firms to bid higher.

Auction designers have tried to improve revenues from government bond auctions but so far the alternative pricing rules designed to reduce bidders' fears of overbidding have produced results that appear to go both ways. A U.S. Treasury experiment was inconclusive, McMillan says, while one in Mexico brought increased competition to the market.

Success is clearer in the case of an auction of air pollution credits in March 2002. The British government offered $350 million in incentive payments to companies in return for reducing carbon dioxide emissions that contribute to global warming. "The government posted a price per ton of carbon dioxide and the firms bid quantities of emission reductions. In successive rounds, the government lowered the price and the firms revised their bids until the total emission reduction bids multiplied by the price equaled the budget. When the bidding stopped, the firms had committed to 4million tons of pollution cuts," which was substantially more than the companies had said they could do with $350 million.

The U.S. Federal Trade Commission uses microeconomic theory in anti-trust decision-making. McMillan cites an example from book publishing the acquisition by Pearson Inc. of Viacom's educational arm. "The FTC,judging there would be undue concentration of textbooks in certain college courses, specified 55 titles to be sold off. This may appear to be overzealous micro management, but it is based on theory," he says."Knowing less than the firms about the business, the FTC is at risk of adverse selection. Divestiture is intended to foster post-merger competition. If the merging firms chose what to sell, they could undermine this policy by picking low-quality assets."

Diagnosing defects in existing policies is another role for theory,says McMillan, who is the Jonathan B. Lovelace Professor of Economics. After scandals over $50 hammers, the Pentagon tried to drive down its procurement costs by using competition theory in place of negotiating deals with single firms. A dual-sourcing policy required two rivals to bid on building a particular kind of submarine, and ensured each some orders. Economists pointed out that each firm could earn more by getting the smaller share at a higher price than by being low bidder, which made the policy counterproductive. The policy was based on a "pre-game theory view that competition is always and automatically a good thing,"McMillan says.

In general, he says, the view now should be that common sense can be wrong; the political context always should be taken into account; and theory can sometimes bring mutual gains. On the other hand, economies rely"not just on formal rules but also informal norms like reciprocity," he cautions. "Since informal rules simply emerge,they cannot be set by theorists, but only by the market participants 'trial and error."

—Kathleen O'Toole

Related Links

From "Market Design: The Policy Uses of Theory," by John McMillan, GSB Research Paper#1781, January 2003

Reinventing the Bazaar, by John McMillan, Wiley & Sons, 2002

A Natural History of Markets, GSB News Release, May 2002 Details