1. Silicon Valley Roundtable October 8, 2002 “What’s a tenured professor going to teach me about the market economy?” John McMillan [quote from Sun CEO Scott McNealy] Based on Reinventing the Bazaar, Norton, 2002

2. The age of the market The 1990s could be labeled the age of the market: 1. Massive shift of resources from state to market: - privatization in over 100 countries - communist economic planning died 2. With the advent of electronic commerce, the internet became a worldwide bazaar. But the pendulum is swinging back...

3. The end of the age of the market? (a) Public goods are needed: 9/11 prompted an expansion of gov’t spending on security and defense. A high-tech economy needs education and other forms of public investment

4. The end of the age of the market? (b) Markets can fail if their underpinnings aren ’ t set right: The scandals of Enron, Worldcom, etc. may herald new regulation - failure of oversight mechanisms The third world ’ s plight is in part a failure of markets (its economies are mostly market-run) - 2.8 billion people live on < $2 per day

5. Modern microeconomics New thinking about markets, based on a recognition of - strategic interactions - game theory, as in “A Beautiful Mind” - asymmetric information - knowledge in unevenly distributed

6. Game theory Game theory is about interdependence. The outcome depends on the actions of all, so each person’s payoff depends on the others’ decisions. E.g., bargaining between buyer and seller, competition in an oligopoly. Rational behavior in a game entails anticipating your rivals’ actions: putting yourself in the others’ shoes. “A game ends where each expects the other not to expect to be expected to retreat.” - T. Schelling

7. Information economics From the 2001 Nobel citation: The Nobel Prize in Economic Sciences is awarded to George Akerlof, Michael Spence, and Joseph Stiglitz Many markets have asymmetric information: those on one side of a market have better information than those on the other. Borrowers know more than lenders about repayment prospects, managers know more than shareholders about a firm's profitability, clients know more than insurance companies about their accident risk. The Laureates’ work forms the core of modern information economics.

8. The biggest use of the theory so far The spectrum auctions :

9. Market design The potential for inefficiency plagues most deals; transaction costs are ubiquitous. Any market can underperform unless it has mechanisms to underpin transacting. Market design means the devices that serve to allow transacting to proceed smoothly: - the mechanisms for buying and selling - channels for information flow - rules sustaining property rights and contracting - the market’s culture: its self-regulating norms, codes, and conventions governing behavior.

10. Design for effective markets Markets don’t work well automatically, but only if their platform is sound. Much of a market’s design arises bottom-up, from the market participants. Some of it necessarily comes top-down, from the state Market design has five elements...

11. 1.Information flows smoothly Afghani traders conceal prices by bargaining with hand signals under a shawl:

12. 2. People can be trusted Signaling is one way of credibly conveying information:

13. 3. Competition is fostered The Aalsmeer flower market:

14. 4. Property rights are protected Ownership is crucial (though it isn’t everything, and sometimes it comes in forms that are ad hoc)

15. 5. Externalities are curtailed Externalities prevent markets from fully realizing the gains from trade.

16. The blind watchmaker In biological systems, natural selection is like a blind watchmaker. Amazingly complex organisms, like the human eye, are “designed” by unconscious evolution. In economic systems, also, there is evolution. Much of the economy arises via the trial and error of millions of market participants.

17. The blind watchmaker (cont’d) But in addition, in economic systems, there are sighted watchmakers. Some of the rules of the market game are imposed by the state or other organizations. Any economy has some central control. The rules in any well-functioning market come both from top-down and bottom-up processes (or formal and informal)..

18. Bottom-up market creation Once a roadway, this Hanoi street is now a maze of market stalls.

19. Markets as subjects of analysis “I believe in God and I believe in free markets.” - Kenneth Lay, 2001