Book Report: The Inner Lives of Markets

“Markets are a means of resource allocation, and often a really effective one at that. But they’re not good for everything – or at least not without a lot of engineering and tweaking. That’s something both free-market advocates, as well as those who find markets wholly repugnant, need to hear. We need to develop the wisdom to know when to deploy the market in some situations and not in others. This requires developing a better understanding of what markets can and can’t accomplish and entertaining their strengths and shortcomings with an open mind.” (The Inner Lives of Markets)

Title: The Inner Lives of Markets – How People Shape Them – and They Shape Us

Author: Ray Fisman and Tim Sullivan

Publisher: PublicAffairs

Publication Date: 2016

Origin: Like most people, I enjoy a hearty laugh at the amazing ignorance of economists…what with their ‘models’ and ‘assumptions’ and perfectly rational actors, and so on. However, I also recognize the real-world pragmatism and, in some cases, necessity of markets in their many forms. In The Inner Lives of Markets, I hoped to find to plain-language explanation of markets that would help me better understand and appreciate them.

Summary: Early on, the authors note that their goal is, “to clarify the relationship between the markets we interact with every day, innovations in economic theory over the past fifty years or so, and how the world has changed because of it.”

To do so, after a brief introduction they start their exposition by visiting the markets that sprang up in World War 2 prisoners-of-war camps (Why People Love Markets: R. A. Radford’s Stiff Upper Lip and the Economic Organization of POW Camps), to illustrate how markets are, at their core, a way of allocating scarce resources to those who value them.

The next chapter, The Scientific Aspirations of Economists, and Why They Matter: How Economics Came to Rule the World, explains how economics shifted from a field dominated by dialogue and essay-based theories into one that was much more mathematical in nature, with economics papers shifting from text-based into being characterized by dense formulae.

From there, in How One Bad Lemon Ruins the Market: That’s for Me to Know and for You to Find Out (But Only When It’s Too Late), we learn how information asymmetries can make markets prone to collapse.

With information being a prerequisite for efficient market function, the next chapter – The Power of Signals in a World of Cheap Talk: Face Tattoos and Other Signs of Hidden Qualities – looks into ways in which information can be shared via signals.

The next chapter, Building an Auction for Everything: The Tale of the Roller-Skating Economist, dives deeply into auctions, examining different varieties and showing how they can serve as an effective means of ensuring goods and services go to those who value them most, at a fair price. Of course, things don’t always run perfectly, so in addition to learning about some successes (e.g., Google’s AdWords), we also see how auctions can and have failed in the real world.

The Economics of Platforms: Is That a Market in Your Pocket or Are You Just Happy to See Me? helps us better understand our world, which is increasingly full of platforms masquerading as online services. This chapter will have particular interest for folks who harbour entrepreneurial ideas, and such folks would do well to heed the lessons taught by the Champagne fairs.

Having dealt so far with price-based markets, our attention shifts to a slightly different sort in, Markets Without Prices: How to Find a Prom Date in Seventeen Easy Steps. Here, we learn about the deferred acceptance algorithm, and how it can be applied in a wide range of matching scenarios.

The final two chapters, Letting Markets Work: How a Hardcore Socialist Learned to Stop Worrying and Love the Market and How Markets Shape Us: The Making of King Rat, address how markets need to overcome some image problems, how they often require some form of monitoring, revision – and potentially regulation – to work as planned, and how they shape our behaviour and lives.

Far from free-market zealots, the authors take a pragmatic and seemingly objective approach, recognizing both the pros and cons, the successes and failures, of markets in the real world: “If there’s one lesson you should take away from this book, it’s that we’ve come to understand that in practice markets depart in many ways – some predictable, others less so – from textbook models of competition.”

Throughout, the point is made that if we’re participating in markets – either willingly or out of necessity, then we should at least understand them. For instance, in the chapter on platforms, the authors point out, “If we’re to avoid the extremes of just acceding to the visions of platform zealots, or alternatively giving in to their technophobic critics, understanding the logic of what platforms do is surely a good start.”

Ultimately, they see well-designed and well-functioning markets as an efficient means of allocating scarce resources, but a means that should be carefully and cautiously put to use: “We need to be clear about what we’re looking for from our markets, and then think about how to go about designing them (and if necessary regulating them) so they do what we want them to do. Otherwise, we run the risk of thoughtlessly letting markets run amok or being paralyzed by a knee-jerk reaction to anything with a whiff of market exchange.”

My Take: The Inner Lives of Markets conveys a well-timed message about the importance of understanding the markets all around us.

I was as impressed with the authors’ objectivity as I was with their straightforward, but illustrative, explanations.

In addition to being a useful educational resource (I learned all sorts of new things), The Inner Lives of Markets really seems like an honest assessment of markets and their roles in society.

I appreciated the authors’ points about the pervasiveness of markets, and their honesty in stating that much of what’s in place now hasn’t been tried before (and so hasn’t yet had the chance to fail). It’s a sobering, but – in my opinion – important message.

As the authors say: “Markets have changed things for the better – overwhelmingly so. But progress doesn’t come without costs. Not least, we’re entirely uncertain about where all of this change will take us. We’re in the midst of a grand social experiment that has elevated efficiency above all other virtues. Even the experts can’t know where we’re going, even when they claim they do (maybe especially so then). To even have a conversation about this experiment in increasing marketization in the name of ever-increasing efficiency, we all need a deeper understanding of the ideas that are driving it.”

Read This Book If: …You want a decent explanation of how market economics have evolved and how markets pervade modern life.

Notes and Quotes

“To even have a conversation about this experiment in increasing marketization in the name of ever-increasing efficiency, we all need a deeper understanding of the ideas that are driving it.”

• From px, of the Preface, explains the origin and intention of the book: “When we looked at that list of [economic] papers and thought about what we could do with the information, it occurred to us that these relatively esoteric academic papers had had, like their counterparts in physics, an outsized influence. That seemed worth exploring, not by reprinting the original papers but by examining how those ideas have lived in the world.”
• p3, from the Introduction: “Our goal is to clarify the relationship between the markets we interact with every day, innovations in economic theory over the past fifty years or so, and how the world has changed because of it. The Inner Lives of Markets weaves together those three strands, aiming to understand how economic theories have illuminated the real world and how those theories have in turn helped shape the way the world works.“

“We’re in the midst of a grand social experiment that has elevated efficiency above all other virtues.”

• p3 continues: “To telegraph where we’ll end up: markets have changed things for the better – overwhelmingly so. But progress doesn’t come without costs. Not least, we’re entirely uncertain about where all of this change will take us. We’re in the midst of a grand social experiment that has elevated efficiency above all other virtues. Even the experts can’t know where we’re going, even when they claim they do (maybe especially so then). To even have a conversation about this experiment in increasing marketization in the name of ever-increasing efficiency, we all need a deeper understanding of the ideas that are driving it.”

Why People Love Markets: R. A. Radford’s Stiff Upper Lip and the Economic Organization of POW Camps

“Democracy wasn’t designed to be as smooth, as fast, as profitable, or as efficient as possible.“

• p15: “As the virtue of efficiency, quietly and without much notice, becomes an end rather than a means, other values that we as a society aim to uphold get the cold shoulder. Democracy wasn’t designed to be as smooth, as fast, as profitable, or as efficient as possible.”

The Scientific Aspirations of Economists, and Why They Matter: How Economics Came to Rule the World

“To understand what’s going on, you want a model that’s just complicated enough (and no more complicated) to capture the essence of the problem.“

• p33, with some generally good advice: “To understand what’s going on, you want a model that’s just complicated enough (and no more complicated) to capture the essence of the problem.”
• p36 triggered recent memories of Scale, which taught us that cities in the same country or region are remarkably self-similar and obey predictable scaling laws: “You would never, for example, build a generic scale model of a ‘City’ to try to understand the urban landscapes of Cairo, Mexico City, Amsterdam, and New York.”

How One Bad Lemon Ruins the Market: That’s for Me to Know and for You to Find Out (But Only When It’s Too Late)

“When the seller knows more about the quality of her wares than the buyer does, the market is prone to collapse.“

• p51, speaking of The Market for ‘Lemons’, a paper by George Akerlof: “The paper’s main insight is, in a sense, a warning for all businesses where information is of paramount importance: when the seller knows more about the quality of her wares than the buyer does, the market is prone to collapse.”

The Power of Signals in a World of Cheap Talk: Face Tattoos and Other Signs of Hidden Qualities

“Although there is only a single way that information can be perfect, there are an infinite number of ways it can be imperfect.“

• p63, alluding to why references and ‘success stories’ are so important when everyone is sending the same signals (i.e., messages): “The challenge facing sellers of genuine Tiffany and the buyers in search of them is to prove that they’re not just full of empty words.”
• p72, on corporate charitable generosity: “We’re not talking chump change, either: companies are spending hundreds of millions of dollars apiece to make the world a better place, and then even more to tell us about it.”
• p76 with a shockingly simple but important insight (the same applies to project management!): “Although there is only a single way that information can be perfect, there are an infinite number of ways it can be imperfect.”
• p76 also references the following endnote, which basically describes a cynic’s view of markets in general and relates to the previous bulleted excerpt: “Akerlof never imagined that all consumers were aware of their own ignorance; for him the lemons model was merely a next step in a larger agenda. In Phishing for Phools: The Economics of Manipulation and Deception (Princeton, NJ: Princeton University Press, 2015), Akerlof and his coauthor Robert Shiller lay out a theory of markets where there are economic agents who are unaware of their ignorance (and hence by too many subprime mortgages) or lack self-control (and eat too much ice cream). Such problems lead to what they call a ‘phishing equilibrium’ where weak or ignorant consumers (‘phools’) are taken advantage of by exploitative firms.”

Building an Auction for Everything: The Tale of the Roller-Skating Economist

“A Vickrey auction achieves the holy grail of efficiency, and does it through a mechanism that’s transparent and straightforward.“

• p85 mentions the concept of “cumulative averaging”, proposed by William Vickrey for use in taxes…which apparently is used for fisheries and farming in Canada
• p88, on Vickrey auctions: “This is what makes a second-price sealed-bid auction so special: it has the amazing property that, under a wide range of circumstances, the only task confronting a prospective bidder is figuring out how much she’d be willing to pay for whatever is on offer, writing that number on a piece of paper, and sending it in.”
• p89 continues: “Thus, a Vickrey auction achieves the holy grail of efficiency, and does it through a mechanism that’s transparent and straightforward.”
• p98, on a problem (man, people ruin everything!): “Auction theorists figured out that, in sales involving more than a single item, the Vickrey mechanism made it even easier for bidders to benefit from preauction backroom meetings.”
• p101, yep: “You can have the best-designed mechanism, but it doesn’t do you the least bit of good if the process is corrupted.”
• p101: “The reason buyers would be well-advised to [bid the maximum amount they’re willing to pay for each click on an ad] is because AdWords is essentially a Vickrey auction.”

The Economics of Platforms: Is That a Market in Your Pocket or Are You Just Happy to See Me?

“The rules you choose in building a platform matter a great deal, but there are many paths to success.“

• p109: “The market maker’s job is to attract participants – to get the right people (and enough of them) to show up. In fact, on a platform, the value for one side grows as more people show up on the other.”
• p111: “If there isn’t a problem with buyers and sellers already finding one another or some other reason for a market to fail (or never form), then there isn’t much call for a platform in the first place. If you build it, there’s a good chance no one will come.”
• p112, I just loved this term: “It’s an example of what our friend and MIT strategy professor Pierre Azoulay calls ‘the internet of what my mom won’t do for me anymore.'”
• p116, with a useful lesson: “Bank of America, American Express, and Sears had set out to solve the same problem – creating a credit card platform that would unite a particular set of consumers on one side with a large number of retailers on the other. Yet they ended up with subtly different solutions to getting the two sides they wanted on board. The rules you choose in building a platform matter a great deal, but there are many paths to success.”
• p126, with another important lesson, this one about thinking long-term and seeing what really matters: “But any profits that Sony might have made from winning control of the DVD market had long since been spent in the fight for dominance. Even worse, with their focus on the DVD wars, they took their eye off the larger technological shift – video streaming – that ended up killing the DVD business altogether.”

“The count intuitively knew how to make the fair-cum-platform work. He avoided selling privileges to special interest groups. Instead, he made generalized institutional guarantees to everyone. He established an impartial law and enforced it at multiple levels.”

• p126, speaking of the Count of Champagne and the Champagne fairs, and with important lessons for aspiring platform-builders and regulators: “The count intuitively knew how to make the fair-cum-platform work. He avoided selling privileges to special interest groups. Instead, he made generalized institutional guarantees to everyone. He established an impartial law and enforced it at multiple levels.”
• p129: “If we’re to avoid the extremes of just acceding to the visions of platform zealots, or alternatively giving in to their technophobic critics, understanding the logic of what platforms do is surely a good start.”

Markets Without Prices: How to Find a Prom Date in Seventeen Easy Steps

“The very definition of economics is figuring out how to do the best you can with the resources you’ve got.“

• p146: “At the risk of repeating ourselves, the very definition of economics is figuring out how to do the best you can with the resources you’ve got.”
• p149: “This is how science – and society – progresses. We make well-meaning attempts at socially improving innovations. Sometimes they work exactly as we had hoped: the deferred acceptance high school match in New York is still running today in essentially its original form. More often there are tweaks and adjustments along the way, or as was the case in Boston, we’re blindsided by something serious enough that we need to return to the drawing board. But hopefully we return to it a good deal wiser than before.”

Letting Markets Work: How a Hardcore Socialist Learned to Stop Worrying and Love the Market

“We need to develop the wisdom to know when to deploy the market in some situations and not in others. This requires developing a better understanding of what markets can and can’t accomplish and entertaining their strengths and shortcomings with an open mind.“

• p152: “The free market has long had an image problem, and a well-deserved one at that. Markets aren’t well suited to some things – voucher schools in Sweden, some would argue. But they are good for others, like assigning school hooks. Unfortunately, it’s easy to mistake circumstances that look like coat hooks for circumstances that look like misguided voucher programs, especially if you hold a dim view of markets to begin with. Why does this concern us? Because that image problem gets in the way of using markets to do some good for society. Markets are a means of resource allocation, and often a really effective one at that. But they’re not good for everything – or at least not without a lot of engineering and tweaking. That’s something both free-market advocates, as well as those who find markets wholly repugnant, need to hear. We need to develop the wisdom to know when to deploy the market in some situations and not in others. This requires developing a better understanding of what markets can and can’t accomplish and entertaining their strengths and shortcomings with an open mind.”
• p156, relating to that image problem: “From where the socialist, peace-loving Arnold sat, markets looked, first and foremost, like institutions of exploitation, not allocation.”
• p162 talks about kidney markets…and I’m sure I’ve read about these before (or maybe heard on a podcast?)…but I can’t recall the location (and it’s bugging me)
• p166 makes a great point, about ideas needing a chance to fail: “If there’s one lesson you should take away from this book, it’s that we’ve come to understand that in practice markets depart in many ways – some predictable, others less so – from textbook models of competition. If a global kidney market seems such a great idea in theory, it may be in part because it’s never had the chance to fail.”
• p169, with more good advice: “We need to figure out how to adapt our models to reality, not the other way around.”
• p172, reminiscent of what happened when New York City looked to regulate cryptocurrency (the guy who wrote the rules immediately left government to run a consulting company that helped companies navigate the insanely complex set of rules): “Industry associations that argue for heavy government regulation do so for their own benefit, not for some soft-hearted concern for their customers. After all, what better way to create a monopoly than to have it legislated into existence?”

“Although proponents of the sharing economy tout its ability to reduce market frictions, the only way they’re going to make the kinds of profits they (and their investors) want is to create new ones.”

• p173: “Although proponents of the sharing economy tout its ability to reduce market frictions, the only way they’re going to make the kinds of profits they (and their investors) want is to create new ones. That’s something they’re not interested in talking about to the public at large, or to their representatives in government. This leaves a bit of a paradox in the techno-utopian free-market narrative. A great entrepreneur will use technology to create a fantastic new market, then will use technology to set up market frictions to protect it.”
• p174: “Free-market extremists take any evidence of active design as a violation of market logic per se, a view that’s every bit as much of a pathology as the visceral reaction against anything involving money or market-like exchange.”
• p174 continues: “We need to be clear about what we’re looking for from our markets, and then think about how to go about designing them (and if necessary regulating them) so they do what we want them to do. Otherwise, we run the risk of thoughtlessly letting markets run amok or being paralyzed by a knee-jerk reaction to anything with a whiff of market exchange.”

How Markets Shape Us: The Making of King Rat

“To a large extent, we haven’t really noticed the creep of markets into every area of our lives. Taken together, the evidence about how markets can affect our behavior combined with the new ways that markets are impinging on our lives should make the rest of us at least a bit uneasy about our future.“

• p178 talks about the fundamental attribution error
• p181: “Remember the book’s central premise: our present and future are built upon the skeleton of yesterday and today’s economic theory, ideas that originally appeared in the pages of esoteric academic journals. When loosed upon the world, those theories have contributed to the growth of new kinds of markets and market-like mechanisms that now define much of how we interact. To a large extent, though, we haven’t really noticed the creep of markets into every area of our lives. Taken together, the evidence about how markets can affect our behavior combined with the new ways that markets are impinging on our lives should make the rest of us at least a bit uneasy about our future.”
• p182, paraphrasing Nobel laureate Joseph Stiglitz: “sometimes we can’t see the invisible hand of the market working not because it’s invisible, but because it isn’t there at all.”