Copyright © 2016 by Ray Fisman and Tim Sullivan Published in the United States by PublicAffairs™, a Member of the Perseus Books Group All rights reserved Printed in the United States of America No part of this book may be reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews For information, address PublicAffairs, 250 West 57th Street, 15th Floor, New York, NY 10107 PublicAffairs books are available at special discounts for bulk purchases in the U.S by corporations, institutions, and other organizations For more information, please contact the Special Markets Department at the Perseus Books Group, 2300 Chestnut Street, Suite 200 Philadelphia, PA 19103, call (800) 810-4145, ext 5000, or e-mail special.markets@perseusbooks.com Book Design by Jack Lenzo Library of Congress Cataloging-in-Publication Data Names: Fisman, Raymond, author | Sullivan, Tim, 1970– author Title: The inner lives of markets: how people shape them—and they shape us / Ray Fisman and Tim Sullivan Description: First edition | New York : PublicAffairs, [2016] | Includes bibliographical references and index Identifiers: LCCN 2016001296 (print) | LCCN 2016006755 (ebook) | ISBN 9781610394932 (ebook) Subjects: LCSH: Economics | Free enterprise | Markets | Consumer behavior | BISAC: BUSINESS & ECONOMICS / Economics / Microeconomics | BUSINESS & ECONOMICS / Purchasing & Buying | BUSINESS & ECONOMICS / Consumer Behavior Classification: LCC HB171 F545 2016 (print) | LCC HB171 (ebook) | DDC 381—dc23 LC record available at http://lccn.loc.gov/2016001296 First Edition 10 To my priceless children—RF To Wendy—TS CONTENTS Preface Introduction: Terms of Service Why People Love Markets: R A Radford’s Stiff Upper Lip and the Economic Organization of POW Camps The Scientific Aspirations of Economists, and Why They Matter: How Economics Came to Rule the World 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) The Power of Signals in a World of Cheap Talk: Face Tattoos and Other Signs of Hidden Qualities Building an Auction for Everything: The Tale of the Roller-Skating Economist The Economics of Platforms: Is That a Market in Your Pocket or Are You Just Happy to See Me? Markets Without Prices: How to Find a Prom Date in Seventeen Easy Steps Letting Markets Work: How a Hardcore Socialist Learned to Stop Worrying and Love the Market How Markets Shape Us: The Making of King Rat Acknowledgments Notes Index PREFACE T his book started about ten years ago with a trip to The Coop bookstore at the Massachusetts Institute of Technology On a shelf in the science section was a book that contained reprints of the most important physics papers of the twentieth century, together with an explanation of what they accomplished and why they were important The book included, for instance, Einstein’s work from 1905, his annus mirabilis, when he published four papers that changed how physicists (and eventually the rest of us) thought about time, space, mass, and energy It also included papers that led to innovations like the first atomic bomb—science that had a direct impact, quite literally (sorry), on the world This was important stuff, but the source material was often impenetrable to nonscientists— certainly too technical for the likes of us But even for scientists, why a particular idea was so revolutionary can often be lost because few scientists study the history of their field The idea, though familiar, loses its historical and social context So each article in the book was accompanied by a lucid, engaging essay explaining the innovation in lay person’s terms, and placing the idea in context Otherwise, most of the papers would have remained so much indecipherable mathematics to all but a trained physicist It was, we thought, an interesting approach to the history of science, told through both scientific importance and social change, written for people who had more than a passing interest in physics but who lacked the expertise to parse the original source material.1 Being economics nerds (one of us is a real economist, one of us just pretends), we thought it might be fun to the same thing with economics To that end, we informally surveyed a bunch of economists to find out which academic economics papers they thought were the most important within the rough boundaries of World War II on the one end and, say, the early 2000s on the other, reasoning that it would be hard to judge the long-term historical importance of ideas published any later than that When we looked at that list of papers and thought about what we could 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 This half-century’s worth of economic thought—often as incomprehensible to outsiders in its original formulations as Einstein’s investigations into the theory of Brownian motion is to nonphysicists—has been used to make markets work better and, in an ever-widening set of applications, has helped them reach more deeply into our lives The Inner Lives of Markets explores the intersection of those economic ideas and our lives INTRODUCTION TERMS OF SERVICE At 109 Lincoln Street in Rutland, Vermont, stands a dilapidated yellow clapboard building Rutland was incorporated in the late nineteenth century, flush with money from the marble quarries just outside town But the past few decades haven’t been kind to the city, notable these days as much for its opioid epidemic (the subject of several New York Times stories), as for the nearby mountains, which still draw leaf peepers in the fall and skiers in the winter To one side of 109 Lincoln is an empty parking lot Across the street stands the former Lincoln Elementary School, which now houses Rutland Area Christian School, private and interdenominational, serving pre-K through grade twelve In many ways, Rutland is classic small-town America, and the yellow clapboard building is emblematic of that life It was, once upon a time, Percy P Woods, a neighborhood grocery store Percy himself was an enterprising young man, born around 1886, just as the city was taking off He started on his road to entrepreneurial glory in the 1920s, selling maple syrup by mail order and using the money he made to open Percy P.’s (as it was known) as a dry-goods store, updated by the next owner into a small local grocer Around 1970, Bob Dow, a former traveling tombstone salesman, and his wife, Edna, bought the store Bob became a whiz at the butcher counter, and Edna took over business operations in the tiny upstairs office She also cooked a widely renowned roast beef and made subs in the deli They lived within walking distance of the store, in the house on Adams Street where Edna had grown up Lincoln Elementary, the school across the street, served the families in the surrounding neighborhoods, kindergarten through grade six That also meant that moms (and it was mostly moms in those days) who picked up their kids could swing by Percy P.’s (as it was still called) and grab a missing dinner ingredient or some detergent They’d also get an avuncular greeting from Bob and have their order checked out by Dot, the cheery cashier And if they needed a babysitter, they could check to see if Bob and Edna’s daughter might be available Percy P.’s was subject to the laws of supply and demand that define every market, no matter how big or small Bob and Edna balanced the books in their upstairs office They thought about how it would affect sales if they marked up the price of Tide and carefully calculated how many boxes of detergent they’d need to meet their customers’ monthly demand They decided what to put on sale and used markers—the king-size permanent ones (that smelled so distinctively toxic they aren’t made anymore)—to make the signs that called customers’ attention to the lower prices Some customers bought on credit, which they’d pay at the end of the month, but not everyone was afforded this privilege Edna kept track of who had too big a tab or had passed a bad check and politely but firmly demanded that they pay in cash Bob was nice and polite, too, but he kept an eye on the front door, all the more so when the end-of-school bell rang next door, sending a gang of preteens into the store (And yes, they tracked inventory “shrinkage” resulting from the pilfered candy and soda that walked out of the store despite Bob’s efforts.) markets 18th-century book, 90–91 competitive, 35, 124–126, 172–174, 180–181 design, 133, 137–142 dysfunction of, 36, 75–77, 143 economics of platform, 107–112 equilibrium, 33 fixed-price versus auctions, 96–97 food bank system, 154–160 image problem of, 152–153 labor, 48, 64–66 lemon, 44–51, 58–59, 64, 112 multisided, 108–112, 118–124 one-sided, 108–112 in POW camps, 4, 7–13, 175–177 rules for platform, 112–117 school choice in Sweden, 151–152 selfishness in, 177–179 technology and, 169–173 trade with uninformed parties, 166–169 transformation of, 13–17 two-sided, 108–112, 118–124 See also auctions; economics; platforms Marx, Karl, 20, 23 matching problems middle school dance partners, 131–132, 134, 137–140 student to school, 138–139, 141–142, 143–149 mathematics algebraic topology, 44–45 economic theory transformed by, 15, 19–27 game theory, 136 general equilibrium model, 29, 31–34, 36–37, 40, 45, 76 kidney exchange algorithm, 163–165 models, 20, 24–25, 30 in real world economics, 35–37 Samuelson connecting economics and, 28–29 Shapley-Gale algorithm, 137–140 Matsuzaka, Daisuke, 79–81, 87–89 Maxwell, James Clark, 24 McManus, Brian, 73–75 mechanism design, 133, 134 medical residency programs, 140 merchant from Prato, 105–107 middle school dance-matching, 131–132, 134, 137–140 Milgrom, Paul, 70–71, 98, 102–103 mobile market platform, 116 modeling applied theory, 45, 50, 75–76 competition, 35, 166, 172–173 congestion pricing, 86, 94 dysfunction of, 75–77 economic, 15, 24–29 mathematical, 20, 24–25, 30 reality-based economic, 35–37, 45, 49–51, 141 models auction, 82–84 eBay, 43, 46, 48 general equilibrium, 31–34, 36–37, 40, 76 lemons, 44–51, 58–59, 64, 112 Solow, 35 See also platforms; signaling model Moldovanu, Benny, 90–91 money burning costs, 70–71 money-back guarantees, 69–71 Morals & Markets: The Development of Life Insurance in the United States (Zelizer), 153 Morgenstern, Oskar, 25–27 mortality rates, of Japanese vs German POW camps, 10–13 MS-13 gang, 67 multisided markets, 108–112, 118–124 multisided platform, 14 multiunit Vickrey auction, 93 Murphy, Frank, Nasar, Sylvia, 29 Nash, John, 32 National Archives’ World War II Prisoners of War Data File, 11 network externalities, 121–124 New England Program for Kidney Exchange, 164–165 New York Department of Education, 143–144, 145, 149 Nobel Prize in Economics, 34 See also Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel noncustomers, paying, 123–124 Nordstrom’s return policy, 69–70 no-risk money-back guarantees, 69–71 normal good, 180 no-trade rule, Japanese POW camps, 10–13 nuclear deterrence, 26 Omidyar, Pierre, 39–40 one-sided markets, 108–112 online retail, 41–43, 52–55 optimized efficiency, 85–86, 133 organ sales, 160–161 organizations, sick, 142–143 out-of-town bids, for auctions, 83–84 Pareto, Vilfredo, 20, 21–22 Pareto efficiency, 22 Penny Black stamp, 82–84 Percy P Woods store, 1–2 person’s life, value of, 166–167 philanthropic commitments, 72–75 Pillow Pets, 128–129 platforms babysitting, 121 Champagne fairs as, 126–128 competition, 124–126 credit card, 113–116 economics of, 107–112 greed in, 128–129 mobile market, 116 multisided, 14 rules for, 112–117 video game system, 116 See also economics Podolny, Joel, 39, 43 poker, bluffing in, 26 See also chess; Cold War Pontiff, Jeffrey, 11–12 posting system, 79–81, 100–101 POW camps, 7–13, 175–177 power law distributions, 22 practice, market, 14–15 Prendergast, Canice, 154–160 “Price and Advertising Signals of Product Quality” (Milgrom and Roberts), 70–71 price discovery, 83 priceless, when something is, 132–133 prisoners’ dilemma game, 178–179 property, expected value of, 56 Radford, R A., 7–10, 22–23 Ranau Japanese POW camp, 10–11 RAND Corporation, 25, 27, 134–136 reality-based economic modeling, 35–37, 49–51, 141 See also lemon markets theory recessions, 36, 48, 75 Roberts, John, 66, 70–71 Ross, Lee, 177–179 Roth, Al, 140, 141, 163–165 rush, fraternity/sorority, 140 Rutland, VT, Rysman, Marc, 109 Samuelson, Paul, 28–29, 44 Samuelson, William, 55–57 San Fernando Valley gangs, 61–62 San Fers gang, 61–62 Sandakan camp, Borneo, 10–11 Sauget, IL, 168–169 scams internet, 52–55 money-back, 69–70 Scarf, Herbert, 163–164 school choice, in Sweden, 151–152 school to student matching, 138–139, 141–142, 143–149 Schultz, Theodore, 35 Schumpeter, Joseph, 24, 49–50 Scottish auctions, 82 Sears, 115–116 second-bid auction, 81–82 second-price sealed-bid auctions, 87–89 “Selection process starts with choices, ends with luck” (article), 146 self-destructive behaviors, signaling theory and, 67–68 selfish, markets making us, 177–179 seller misrepresentation, 52–55 sellers, knowing more than buyers, 41, 44–55 Seven Minute Abs, 172 Shakin’ Cat Midgets gang, 61 Shapley, Lloyd, 134–136, 137–138, 163–164 Shapley-Gale algorithm, 137–140 Shi, Peng, 148 Shleifer, Andrei, 180–181 shopping malls, as two-sided markets, 122–123 Shoup, Carl, 85 sick organizations, 142–143 signaling model applications of, 66–68 commitment signs, 62–66 competitive signaling, 69–71 integrity, 71–75 Silicon Valley, market friction and, 169–173 Skoll, Jeff, 39–40, 43, 51 Smith, Adam, 21 Snider, James, 42 social efficiency, auctions, 89 social well-being, assessing, 22 Solow, Robert, 35 Solow model, 35 Sönmez, Tayfun, 144 Sony’s Blu-ray format war, 125–126 sorority rush, 140 spectrum auction theory, 102–103 Spence, Michael, 62–66 Stack, Charles, 42–43 Stalag VII-A POW camp market, 5–6, 7–10, 13 stamp collecting, 82–84 Stiglitz, Joseph, 35–36, 76, 182 strategy proofness mechanism, 145 student to school matching, 138–139, 141–142, 143–149 Summers, Larry, 166–167 Super Bowl advertising, 70–71 supply and demand, 96 survival rates, of Japanese vs German POW camps, 10–13 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, 34 Sweden, market-like approach to education in, 151–152 Sword, Morgan, 99–100 talk-is-cheap expressions, 62–66 Tanaka, Masahiro, 99 tattoos, as gang markings, 61–62, 67–68 Tauson, Bob, 62 taxi drivers, Uber vs., 169–170, 172 technology, market friction and, 169–173 Tenney, Lester, 12–13, 176 “terms of service” agreements, Theory of Games and Economic Behavior (Morgenstern and von Neumann), 25–27 Theory of Industrial Organization (Tirole), 117–118 There’s Something About Mary (movie), 172 Thiel, Peter, 173 third-party merchants, Amazon, 52 “Thirteen Reasons Why the Vickrey-Clarke-Groves Process Is Not Practical” (article), 99 Tietzel, Manfred, 90–91 Tiffany jewelry counterfeits, 52–53 time-interval auctions, 82 Tirole, Jean, 117–118 Torres, Robert, 61 Toshiba’s HD DVD format war, 125–126 traditional economics, 110, 133 Trafigura company, 168 two-sided markets, 108–112, 118–124 Uber, 2, 3, 5, 16, 50, 109, 111, 119, 125, 128, 129, 132, 169–173 unethical conduct, in competition, 180–181 uninformed parties, trade with, 166–169 unnetworked products, 121–122 US Department of War, 25 used car markets See lemon markets theory usury, 180 value debate on, 23 of person’s life, 166–167 van Hengel, John, 154–155 Vickrey, William, 84–87 Vickrey auctions example of, 87–89 Goethe’s precursor to, 89–92, 101 origin of, 83–84 problems with, 98–103 stamp collecting and, 82–84 versatility of, 92–97 Vickrey-Clarke-Groves algorithm, 93, 99 video game system platform, 116 Vieweg, Mr., 90–92, 101 Visa, 115 Vlascho, Jonas, 151–152, 174 von Neumann, John, 25–27 Wald, Abraham, 32 Wall Street game, 178–179 Walras, Léon, 20 warm glow hypothesis, 74–75 Wealth of Nations (Smith), 21 welfare principle, Pareto efficiency, 22 West Michigan Food Bank, 157, 160 Williams, Joseph, 113–114 Wilson, Robert, 102–103 wireless spectrum auction theory, 102–103 Woods, Percy P., 1–2 World War II Japanese and German POW camp treatment compared, 10–13 Prisoners of War Data File, 11 Stalag VII-A POW camp market, 7–10, 13 World Wide Web, 41–43 worldly philosophers, economists as, 21 write-in bids, for auctions, 84 Yellen, Janet, 44 yvonne9903, 52–54 Zelizer, Viviana, 153 Zhu, Feng, 128–129 Ziporyn, Terra, 42 Ray Fisman is the Slater Chair in Behavioral Economics at Boston University Previously, he was Lambert Family Professor of Social Enterprise and codirector of the Social Enterprise Program at the Columbia Business School He is the author of The Org, with Tim Sullivan, and Economic Gangsters, with Ted Miguel Credit: Ray Fisman ©Jackie Ricciardi Tim Sullivan is the editorial director of Harvard Business Review Press and has worked at Basic Books, Portfolio, and Princeton University Press, where he helped build one of the most successful academic economics lists in the world Credit: Tim Sullivan ©Leslye Smith PublicAffairs is a publishing house founded in 1997 It is a tribute to the standards, values, and flair of three persons who have served as mentors to countless reporters, writers, editors, and book people of all kinds, including me I F STONE, proprietor of I F Stone’s Weekly, combined a commitment to the First Amendment with entrepreneurial zeal and reporting skill and became one of the great independent journalists in American history At the age of eighty, Izzy published The Trial of Socrates, which was a national bestseller He wrote the book after he taught himself ancient Greek BENJAM IN C BRADLEE was for nearly thirty years the charismatic editorial leader of The Washington Post It was Ben who gave the Post the range and courage to pursue such historic issues as Watergate He supported his reporters with a tenacity that made them fearless and it is no accident that so many became authors of influential, best-selling books ROBERT L BERNSTEIN, the chief executive of Random House for more than a quarter century, guided one of the nation’s premier publishing houses Bob was personally responsible for many books of political dissent and argument that challenged tyranny around the globe He is also the founder and longtime chair of Human Rights Watch, one of the most respected human rights organizations in the world ••• For fifty years, the banner of Public Affairs Press was carried by its owner Morris B Schnapper, who published Gandhi, Nasser, Toynbee, Truman, and about 1,500 other authors In 1983, Schnapper was described by The Washington Post as “a redoubtable gadfly.” His legacy will endure in the books to come Peter Osnos, Founder and Editor-at-Large ... balanced the books in their upstairs office They thought about how it would affect sales if they marked up the price of Tide and carefully calculated how many boxes of detergent they? ??d need to meet their... 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. .. deregulate the world and enslave us all and, on the other, market fundamentalists who see free and open markets as the solution to all the world’s ills? ?and then some But we have to understand the fundamental