How do economists tackle real-world markets? Alvin Roth reveals all in his wonderful book on matching markets.
It’s that time of the year when students wait anxiously to hear back from universities on their applications for further studies. The process of college admissions, especially in American colleges, can be understood as a matching market. The actors in this market are the students and college admission committees. A student’s capital is her credentials, the number of letters of recommendation her professors are willing to provide, and the money she can afford to pay in application fees. On the other hand, an admission committee has only a limited number of offers it can extend. While students prefer Ivy League colleges and the admission committees want the best students, in reality both these parties must acknowledge the reality of the marketplace – an incomplete knowledge of how their competitors are interacting with their preferred choices.
In economic terms, a matching market like the one above is characterized as one where price is not the only determinant for a trade. Unlike in commodity markets, in matching markets buyers and sellers care about whom they are dealing with and sometimes even make an effort to woo each other. Taxi aggregator apps like Uber, short-term lodging services like Airbnb, dating apps like Tinder, and corporate hiring are all examples of matching markets where price is just one of the many factors that seals the deal between two parties.
However, like commodity markets, matching markets can be prone to failures and inefficiencies. If not carefully designed, a matching market runs the risk of remaining underdeveloped or even facilitating sub-optimal allocations. It is the design of matching markets that Nobel laureate Alvin Roth studies in his book Who Gets What and Why. In fact, Roth won the Nobel prize (with Lloyd Shapley) “for the theory of stable allocations and the practice of market design.” In Roth’s words, “What often makes matching markets especially challenging is that everyone has to puzzle through not only their own desires but also those of everyone else and how all those other market participants might act to achieve their preferences.”