Why markets can, and should, be better designed

One good consequence of the global financial crisis is the rethink of the foundations of economic analysis. Of the thousands of ideas that challenge economic orthodoxy, two stand out. The first is Nassim Taleb's idea of anti-fragility, which undermines the whole basis of conventional risk management. The other is Nobel laureate Alvin Roth's pioneering work on market design.

Roth's new book, Who Gets What - and Why: The New Economics of Matchmaking and Market Design, goes back to the fundamentals of markets. He makes the common-sense argument that free markets can only exist if there are effective rules, effectively enforced. The financial crisis demonstrated how free markets can fail under certain circumstances. Roth's insight is that markets are as old as human behaviour - they evolve and adapt, but we can always design markets to function better. In other words, the state has a key role in markets, though this does not mean it replaces the market as a mechanism to allocate resources and facilitate price discovery.

There are two broad types of market - public and private (or matching) markets. We are all familiar with public markets, which succeed because they are efficient, transparent and generally have high turnover and public confidence.

Roth points out that matching markets exist everywhere, from dating services and kidney exchanges to job placement and college selection, but they are illiquid, opaque and often do not work very well. They match demand and supply, but not always successfully, because of information asymmetry and mistrust between buyers and sellers.

Most markets evolved through history and experience, mostly through failure and reform. Developing economies have more incidences of market failure because of the learning process. For example, stock exchanges were often introduced to developing countries without fully understanding local culture and characteristics. In the 1980s, it was assumed that if a copy of the New York Stock Exchange was put into a developing country, it would work well. But recent experience showed otherwise. The A-share debacle in China showed that market manipulation, margin losses, illiquidity, inadequate regulation and bad corporate governance were a consequence of market design. These were flaws that need to be fixed.

Good market design means that we don't assume all Chinese investors have the same degree of sophistication and experience as traders on the more mature New York exchange.