ECON 498/598:

MARKET DESIGN
Introduction to Market Design and
Matching Market Applications

Szilvia Papai
Winter 2019
Market Design

 What are markets and marketplaces?

 What are they for?
 How do they work?
 How do they fail?
 How can we fix them when they are broken?
 Commodity markets
Fruit market NY Stock Exchange

4
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 NY Stock
Exchange, the price decides who gets what.
 The market helps do “price discovery” to find prices that work.
 But in many markets prices don’t work
 Concordia doesn’t raise tuition until just enough applicants
remain to fill the available places.
 Universities don’t rely on prices 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.
 Similarly, public schools are not allowed to charge tuition
to reduce demand.
 There are many other “markets” where business
transactions are not desirable.
Matching Markets

Matching is economist-speak for how we get the

many things that we can’t simply choose.

You can't just inform Concordia that you are enrolling,

or the Bank of Montreal that you are showing up for
work. You also have to be admitted or hired.
Neither can Concordia or BMO simply choose who
will come to them, any more than one spouse can
simply choose another: each also has to be chosen.

This is where market design comes in!

• Economists, game theorists in particular, have started to take a
substantial role in economic and market design.
• Design involves taking care of detail.
• Theory involves simplifications and generalizations away
from detail.
• Game theory, and mechanism design, provide a framework
with which design issues can be addressed.
• Dealing with complexity will require new tools, to supplement
the analytical toolbox of the traditional theorist.
• To give you an idea of the interplay between simple theory and
institutional complexity, we will look at a few examples from
matching theory and its practice in real-life markets.
In the last decades, economists have worked on the
design of matching markets and discrete resource
allocation.
Some work has influenced policy makers to adopt new
policies and institutions:
 Entry-level labor markets: medical doctor matching
 Public school choice
 Live-donor kidney exchange
 Course allocation
Other work is aimed at real-life problems which raised
new economic design questions, but they have not
influenced the policy yet:
 On-campus housing at colleges
 Army “branch of choice” contracts and cadet-branch
matching
 Favor and “tuition” exchange markets
 Dynamic assignment of teachers, kindergarden
kids, organs, etc.
This work has led to a deeper understanding of how
matching markets work and what properties make
allocation rules (mechanisms) good.
O

Introduction to matching market

applications

• Two-Sided Matching: Entry-Level Labor Markets

• Discrete Resource Allocation: School Choice
• Discrete Resource Exchange: Kidney Exchange
• Many-to-Many Resource Allocation: Course Allocation
 Two-Sided Matching:

Entry-Level Labor Markets

 Entry-level labor markets
Two-Sided Matching: Entry-Level Labor Markets
Some entry level labor markets can be modeled as two-sided
matching markets.
An example is the American hospital-intern markets. Each year
thousands of physicians look for residency positions at hospitals in
the United States.
 Before the 1950s, these markets were decentralized, which led
to the unraveling of appointment dates.
 Positions were offered to medical students as much as two
years in advance of their graduation.
 The students’ performance and quality were not known well at
the time of the offers.
 This led to inefficiencies.
Entry-Level Labor Markets

Entry-level labor markets

 A centralized clearinghouse was established in 1952:

students submitted rank order lists over hospitals,
hospital residency programs submitted rank order lists over
students, and these were processed to create a matching of
students and hospitals.
 The system prevented unraveling until the 1990s.
 Some problems started in the 1990s, and a new design was
instituted in 1998.
 The system has been working well since then.
Entry-level labor markets - theory
 Two game theorists/mathematicians David Gale and Lloyd Shapley
wrote a paper in 1962 about marriage markets and college
admissions markets (symbolic names to describe one-to-one and
many-to-one matching models).
 They proposed a mechanism to find a stable matching in these
matching markets.
 The so-called “Deferred Acceptance” algorithm became a
cornerstone mechanism in designing good matching mechanisms.
 Game theorist/operation researcher Alvin Roth pointed out in a 1994
article that essentially the same mechanism that was proposed by Gale
and Shapley to find a stable matching was actually already used in the
American medical residency matching (NRMP).
 Without the use of market design, the evolution of the market led
to a mechanism with good theoretical properties.
 In 1998, a new “heuristic” was developed by Roth and Peranson
(1999) for this market.
 Entry-level labor markets - practice
Entry-Level Labor Markets

 The theory of Gale-Shapley fits real-life markets perfectly,

unless some complex issues are to be taken care of.
 In the NRMP matching two doctors can apply as a couple by
submitting a joint rank-order list of hospital positions (e.g.,
to be in the same city). In theory in such a market a stable
matching may not exist. Nevertheless market designers need
to design mechanisms for such markets with couples.
 Computational simulations and laboratory experiments can
complement theory in such situations.
Entry-level labor markets
– new theory inspired by the practice

 The unraveling phenomenon is not specific to this

particular market. It turns out that more than 20 labor
markets experienced the same or are experiencing a similar
phase currently.
 Lessons drawn from the NRMP medical matching or other
markets can help us develop a more general theoretical
understanding of unraveling.
Discrete Resource Allocation:

School Choice
 School choice

Traditionally parents send their children to public schools in

their own district.

In the US some cities have started “school choice” programs in

which students submit preferences over different district
schools and, based on the priorities of students in different
districts, students are matched to schools.
 School choice: priorities and incentives

• In New York, the “priorities” of schools are determined by

exam scores (priorities are essentially preferences)
• In Boston, priorities are based on the walk zone and on the
attendance of older siblings (priorities are determined by
regulations)
• Students are strategic agents
• When school priorities are not by law, but are based on the
preferences of schools, schools are also potentially strategic
agents
 School choice practice in the US

• Some of the school choice mechanisms (Boston,

Minneapolis) did not work well.
• Abdulkadiroğlu and Sönmez (2003) was the first to
analyze school choice mechanisms and offer alternatives.
• Chen and Sönmez (2005) ran an experiment comparing
competing school choice algorithms, and showed that the
Boston mechanism had bad incentive properties.
• Based on market design theory and these experiments, in
Boston the mechanism was replaced by the Deferred
Acceptance (DA) algorithm in 2005.
• New York also adopted the DA mechanism in 2004.
 School choice practice: incentive
problems

The original Boston mechanism was not incentive

compatible.
 Even if a student had a very high priority at some
school, unless she listed it as her top choice, she could
easily lose her priority to students who top-ranked this
school.
 The Boston mechanism gave parents strong incentives
to over-rank schools where their child had a high
priority.
Discrete Resource Exchange:

Kidney Exchange
Organ transplant

Donation is the only source of organs. There is a world-wide

shortage for transplant organs: kidney, lung, liver, bone
marrow, heart, pancreas, etc...

 Deceased donation (all except bone marrow)

 Live donation (organs that come in pairs or are

regenerative, e.g., kidneys or liver)

 New development due to market design:

Live-donor organ exchange
Compatibility

A donor needs to pass two compatibility tests before

transplantation:
1. Blood type compatibility
2. Tissue type compatibility
 Kidney Exchange: Transplants
Transplants are the standard treatment for patients with failed
kidneys.
Transplants come from two sources:
1.Cadaveric transplants (deceased donation):
Centralized priority allocation. Waiting time is prioritized,
but to different degrees for different organs.
Often a first-in-first-out (FIFO) queue is used in a country
or geographical area.
2. Living donor transplants: Typically relatives or spouses
of the patient come forward as donors, and if one is compatible
with the patient, the transplant is performed.
Kidney Exchange: Shortage

There is a shortage of transplant kidneys:

 There are over 4500 people waiting for an organ
donation in Canada. 76% of the Canadian donation
waiting list are in need of a kidney transplant.
 The average patient on the waiting list for a kidney will
wait for four years for their new kidney.
 About 260 of those people waiting for a transplant in
Canada will die every year: that’s about five deaths per
week that could be saved if they had a viable donor.
 Kidney Exchange: how to resolve
the shortage?
 Buying and selling kidneys is illegal in most
countries (exception: Iran)
 How to increase the supply of cadaveric kidneys (e.g.
make donation the default)?
 How to provide better incentives to increase the
supply of living donor kidneys?
How to end up with more kidney transplants via
live-donor kidney exchange? If the live donor who
came forward is not compatible with his intended
recipient, his organ is swapped with the organ from
similar patient-donor pairs to provide a compatible match
for each patient.
Institutional constraint for organ exchange:
All transplants in an exchange have to be done simultaneously
to prevent reneging of a donor whose intended recipient had
already received a transplant.
2-pair exchange: 4 simultaneous surgeries
 Many-to-Many

Resource Allocation:

Course Allocation
 Course Allocation

 A complex combinatorial assignment problem

 Each student enrolls in several courses, and each
course is taken by many students: a many-to-many
matching problem
 Applications: business schools (Harvard, Columbia)
 Market Design Summary:

Theory versus Practice

The Toolkit of the Market Designer

The economist as engineer
Game theory/mechanism design theory:
A combination of strategic and approaches.
Other tools:
• Empirics: Empirical analysis of data from matching markets.
• Computation: Sometimes we need to give evidence or advice
beyond theoretical knowledge - use computation/simulation.
• Controlled laboratory experiments: There are lots of design
questions that can’t be answered in small scale lab experiments,
but there are also questions that can’t be answered any other
way.

Theory and practice interact, and lead to new policies and

real-life outcomes, as well as to new theory.