Review of

An invitation to market design

Daniel Sebastião Abreu

January 20, 2020

1 Introduction
In the last 30 years, economic research and ideas have gained an increasingly
important role in the organization and practical design of markets. By now,
the number of examples where economic theory and analysis influenced the de-
sign of market institutions is very significant. In fact, these developments led
market design to evolve into a discipline of its own. This field builds upon the
framework provided by game theory, auction theory and mechanism design and
complements it with tools drawn from experimental economics and computa-
tional science. The contributions of market design to solve real-world problems
were recognized in 2012, when Alvin Roth was awarded the Nobel prize for
economics for his work in this discipline.
In this essay, I provide a brief exploration of this literature. In particular, I
follow the guided tour provided by Kominers, Teytelboym and Crawford (2017,
KTC) who analyse three real world applications to illustrate how market design
can improve improve market outcomes. The applications are the following: i)
design of medical residency matching programs; ii) design of a system to allo-
cate food donations to food banks; and a iii) auction system to organize the
transfer of wireless spectrum from television broadcasters to telecoms. These

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examples provide vivid illustrations of how market design can increase market
participation, eliminate perverse incentives and aggregate and summarize mar-
ket information, therefore contributing to more efficient and liquid markets.
This text is structured as follows: in section 2 I introduce and define some
basic concepts of market design; in section 3 I discuss the three illustrations of
the application of market design provided by KTC; section 4 concludes.

2 What is market design?

Before exploring the examples presented by KTC, I provide a brief discussion of
what are markets and what is market design. In particular, I will present some
important ideas underlying market design and motivate the usefulness of this
discipline.
Firstly, it is important to emphasize that marketplaces consist of a set of
rules, infrastructures and customs that allow for the exchange of information and
the realization of transactions with participants that act strategically. Market
design ultimate objective is to understand how the characteristics of markets
influence market outcomes, and how this knowledge can be used to fix market
failures and to create new marketplaces.
The characteristics of marketplaces can differ significantly. Commodity mar-
kets (as the New York Stock Exchange) allow for transactions between a large
set of potential participants to be settled by defining a relatively small number
of prices, as there is an unique price per commodity. The high degree of stan-
dardization of commodities and the particular infrastructures and procedures
of the market ensure that trade can be performed efficiently and anonymously.
In particular, buy and sell offers can be directed to the market at large, with-
out participants knowing the respective counterparty of the transaction. In this
setting, prices do all the work of deciding what transactions take place. The
marketplace simply acts as a mechanism that facilitates the discovery of the
price at which supply equals demand.
Now consider the case of matching markets as, for instance, the market for
college education. In general, colleges do not raise tuition until the number of

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students applying equals the number of available positions. Instead, they set
the tuition in a way that many students would like to apply. In this case, prices
are insufficient to determine which transactions take place: there must also be
a match between the choice of colleges and students. Each transaction involves
the searching and mutual selection from both sides of the market and proposals
are not made to the market at general but to particular individuals or colleges.
Therefore, matching markets have to do more than price discovery. In general,
different marketplaces may face very different objectives and may be subject to
different sorts of market failures or constraints.
The challenge for market design is to examine why market mechanisms
(which we can think of as a set of rules and infrastructures) fail or succeed,
and how these can be improved and modified to promote desirable market prop-
erties as efficiency, simplicity or fairness. In the next section I will examine in
detail three real world examples of the application of market design to improve
market outcomes.

3 Three applications of market design

3.1 Medical residency matching

In many countries, doctors start their careers by applying for an internship in
their field of specialization. When this internship market first appeared in the
US during the early 1900s, students typically applied by the time of completion
of medical school. However, competition for good students quickly resulted in
a crisis of unravelling as offers would be made earlier and earlier each year. By
1940, students were accepting positions as early as two years before the date of
completion of medical school. This development resulted in the deterioration of
the quality of matches: on one hand, residencies did not have full information on
the medical school performance; on the other, students were accepting positions
without having much exposure to the corresponding field of specialization.
In 1945, serious market reforms were taken. Medical schools agreed to stop
submitting offers to students until an agreed date, typically around the end of

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the senior year of medical school. This measure was successful in eliminating
the inefficiencies related to unravelling. However, new problems emerged as
the market became chaotic and congested. Contracts between hospitals and
candidates were being settled in a very short period of time which ultimately
led to lots of last minute decisions which students came to regret or even failed
to honor, leaving multiples positions unfilled.
The congestion problem became so severe that in 1950 a clearinghouse was
organized and introduced in the market. Hospitals and doctors submitted the
preferences to the clearinghouse, which would then assign residencies according
to a version of the deferred acceptance algorithm. The algorithm functions
in an iterative fashion. In the first step, students apply to their first choice
and hospitals tentatively assign the available positions to each application (this
is, they defer acceptance), rejecting the remaining applications. In a second
step, students who were rejected apply to their second choice and hospitals once
again assign all the available positions considering the pool of new candidates
together with the students chosen in the first step; this process is repeated until
every student finds a position. The deferred acceptance algorithm was shown
to produce stable matching: there is no preferable outcome to both students
and hospitals than the match they were assigned. This implies that students
and hospitals can not obtain a better outcome by setting transactions outside
the matching mechanism and, therefore, there is no incentive to circumvent the
match.
The implementation in 1951 of a clearinghouse based on the deferred accep-
tance algorithm has played an important role in providing successful matches in
the medical residency programs. Over time, small changes were accommodated.
For instance, during the 1980s, the clearinghouse market rules were changed in
order to allow couples who wish to find a placement in the same city, to submit
pairs of positions in their ranking. In the early 1990s, the market suffered a
crisis of confidence as the matching algorithm was seen to be more beneficial to
hospitals than to students. This suspicion raised concerns that students may en-
gage in strategic behavior, in the sense of misrepresenting their preferences, and
led to the adoption of an improved version of the deferred acceptance algorithm

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which is still being used to the present date.
The market for medical residency provides a clear example of how the de-
sign of market infrastructures (clearinghouse) and rules (deferred acceptance
algorithm) can contribute improve market outcomes, in the sense of more and
better quality matches between students and hospitals.

3.2 Allocation of food donations to food banks

A second illustration of how market design can contribute to find solutions to
real world problems is the marketplace design implemented by Feeding America
to allocate food donations to food banks.
Feeding America is an American nonprofit hunger relief organisation which
consists in a nationwide network of food banks. Their activity consists in working
with producers, distributors and retailers to collect and redistribute food, that
would otherwise go to waste, to families in need. In practice, food banks are
simply places where unwanted but perfectly edible food from the food industry
is stored and made available for consumption, in a similar fashion as banks store
and provide money.
Before 2005, Feeding America centralized all the donations from its collab-
orators to subsequently distribute them to the food banks. The allocation of
offers would be based on an indicator that aimed to measure the needs associated
with area of operations of each individual food bank. If a food bank accepted
the donation, it would be responsible for collecting and redistributing the food;
in case of rejection Feeding America would present the donation to another food
bank. The rejection of an offer was perceived as a signal of lower need and,
therefore, Feeding America would not contact the food bank for a longer period
of time when compared to the case of acceptance. In practice, Feeding America
was allocating offers of donations, rather then the donations themselves.
This system, although regarded as fair, was inefficient. On one hand, the
quality of the match between the offers of donations and the food banks were
not always the most optimal. For instance, some food banks may not have the
appropriate refrigeration unit or transport capacity to accept a large donation

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of a particular good. On the other hand, food banks have an incentive to accept
offers, even when they are not particularly needed, considering that a refusal
would lead to longer period of wait until the next offer.
To address these challenges, Feeding America abandoned the centralized
design and implemented a marketplace solution to allocate donations to food
banks. In practice, this market infrastructure enabled food banks to make offers
for donations using a script currency, internal to Feeding America. The market
based approach enabled a more efficient allocation of donations as the needs of
food banks could be summarized and signaled through prices. In addition to
enabling the market to clear, prices provide a mechanism that helped reveal the
relative preferences of food banks between goods.
There are a number of interesting features in the mechanism implemented by
Feeding America which contribute to the success of the marketplace design. For
instance, food banks that receive donations outside of Feeding America could
place these donations in the marketplace and sell them for script. Food banks
can also to place joint bids in order to share the costs with the transport of
the donation. There is even the possibility that food banks can obtain script-
denominated credit. In order to preserve a fair market for all the food banks,
Feeding America redistributes script from big to small food banks on a daily
basis according to reallocation procedure.
The implementation of this mechanisms proved to be very successful and the
result is that Feeding America’s food bank network is now able to accept more
donations, thus providing more help for families in need and further reducing
the amount of food wasted.

3.3 The US wireless spectrum Incentive Auction

The market for wireless spectrum licences in the US has undergone significant
changes. In particular, the consumer interest for new communication services
lead to an increase in the demand for spectrum licences by telecom companies.
Throughout the 20th century, broadband spectrum was attributed to television
broadcasters in the form of local licences. However, telecom companies require

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national networks to support wireless applications. Therefore, in the perspective
of telecom companies, local licences are complementary goods that are valuable
as far as the company is able to assemble a regional network.
In this setting, television broadcasters have an incentive to postpone the sale
of their licence since it’s value to telecom companies increases as they build
towards a regional network. This represents a problem of exposure: if the tele-
com companies can not complete a regional network the value of each individual
licence is significantly lower. The exposure problem reduces the probability of
efficient trading. The design challenge posed by this setting is the following: how
can an auction be organized in a way that each individual licence is sold at their
highest value (which is the value that takes into account other complementary
licences), without the bidder assuming too much risk of not being able to buy
all the licenses needed to assemble a national network.
The solution to the spectrum licence allocation problem was the design of
the so-called ’Incentive Auction’: a two-sided spectrum auction created by the
Federal Communications Commission (FCC). A number of features are worth
highlighting. In particular, the problem of television broadcasters holding on
to their licences was mitigated in three ways. Firstly, a descending auction for-
mat was adopted, which implies that, at each round of the auction, television
broadcasters were faced with a take it or leave price offer. Given this offer,
broadcasters could choose to continue in the auction, and being subject to be
bought by the corresponding price, or they could simply leave the auction irre-
versibly. At each round, the price offers were sequentially reduced. Secondly,
a change in the regulation determined that licences could be reassigned to a
different frequency. This contributed to the reduction of the degree of comple-
mentarity between licences. Lastly, since 2002 it is possible to place a bid on
a package of licences, instead of bidding on multiple individual licences simul-
taneously. The possible outcomes of the auction for the bidder are to win the
complete package (if he wins) or get none of the licences (if he loses).
The above mentioned features of the auction designed proved to be effective
in reducing the exposure problem. However, further additional improvements
were implemented to promote an efficient mechanism for price discovery and to

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ensure the success of the Incentive Auction. In particular, it was defined that
the auctions for all licences should take place simultaneously. Additionally, all
auctions should end at the same time when there were no more bids on any of
the licences. This design allowed bidders to correctly incorporate the value of
complementary licences in their price offers. The second feature was an activity
rule: bidders who were not active were not allowed to suddenly bid for a large
volume of licences. Activity was maintained by being the highest bidder or by
raising bids by a minimum percentage each round. The activity rule prevented
bidders from delaying their competitive offers to the most advanced stages of
the auctions and, therefore, implies a faster price discovery mechanism.

The packaging aspects of the bids created a number of additional challenges

for the design of the auction. A large pool of licences implies a large number
of potential packages that bidders can place on an offer. The sheer amount
of combinations can preclude the realization of an auction. Additionally, the
packaging setting creates the so-called threshold problem: small bidders, who are
interested in an individual licence, do not have an incentive to bid aggressively
and, therefore, large bidders interested in acquiring a package of licences may win
the auction even in a situation in which the licences have more value separately.
This is, licences are only sold in a package if the offer from the large bidder
surpasses the sum of the offers of each individual licence from the small bidders.
This implies a free-rider problem since each small bidder has an incentive to
wait for the other small bidders to raise their offers in a way that prevents the
purchase of the package from the large bidder. Computational economics have
played an important role in studying and creating solutions to deal with the
combinatorial complexity of the auction. In fact, a feasibility check is run in
between each round to ensure that the auction is viable.

The case of the FCC Incentive Auction shows how a complex market can
be designed in order to mitigate the exposure problem (by creating package
bidding) and increase the ability of the auction to allocate a good to the firms
that value them the most.

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4 Final remarks
The stories of success, as the ones highlighted in the previous section, motivates
the inclusion of market design in the policy makers’ toolkit. As market design
solutions continue to prove their value and ability to provide effective solutions
in applied settings, the wider becomes the range of possible future applications.
In fact, KTC identify a large number of sectors of the economy that could po-
tentially benefit from a market design approach. These include digital and finan-
cial markets, living-donor organ allocation, refugee settlement, natural ecosys-
tems, road and air transport and problems related to ownership of intellectual
property. Other paths for future work include, for instance, the transition to
a descarbonized economy, the design of financial regulation and the reform of
public institutions.

References
[1] Kominers, Scott Duke, Alexander Teytelboym, and Vincent P. Crawford,
An invitation to market design, Oxford Review of Economic Policy, 33.4
(2017): 541-571.