Meet the economists who are making markets work better
Nov 24th 2012 | from the print edition
ON THE face of it, economics has had a dreadful decade: it offered no
prediction of the subprime or euro crises, and only bitter arguments
over how to solve them. But alongside these failures, a small group of
the world’s top microeconomists are quietly revolutionising the
discipline. Working for big technology firms such as Google, Microsoft
and eBay, they are changing the way business decisions are made and
markets work.
Take, for example, the challenge of keeping costs down. An important
input for a company like Yahoo! is internet bandwidth, which is bought
at group level and distributed via an internal market. Demand for
bandwidth is quite lumpy, with peaks and troughs at different times of
the day. This creates a problem: because spikes in demand must be met,
firms run with costly spare capacity much of the time.
This was one of the first questions that Preston McAfee, a former
California Institute of Technology professor, looked at when he arrived
at Yahoo! in 2007. Mr McAfee, who now works for Google, found that uses
of bandwidth fall into two categories: urgent (displaying a web page)
and delayable (backups and archiving). He showed how a two-part tariff
(high prices when demand peaks, low ones otherwise) could shift less
time-sensitive tasks to night-time, allowing Yahoo! to use costly
bandwidth more efficiently.
The solution—two types of task, two prices—has intuitive appeal. But
economists’ ideas on how to design markets can seem puzzling at first.
One example is the question of how much detail an online car auctioneer
should reveal about the condition of the vehicles on offer. Common sense
would suggest some information—a car’s age and mileage—is essential,
but that total transparency about other things (precise details on
subpar paintwork) might deter buyers, lowering the auctioneer’s
commissions. Academic theory suggests otherwise: in some types of
auction more information always raises revenues.
To test the idea, Steve Tadelis of the University of California at
Berkeley (now also working for eBay) and Florian Zettelmeyer of
Northwestern University set up a trial, randomly splitting 8,000 cars
into two groups. The first group were auctioned with standard
information, including age and mileage. The second had a detailed report
on the car’s paintwork. The results were striking: cars in the second
group had better chances of a sale and sold for higher prices. This
effect was most pronounced for cars in poorer condition: the probability
of a sale rose by 23%, with prices up by 5%. The extra information
meant that buyers were able to spot the type of car they wanted.
Competition for cars rose, even the scruffier ones.
But more information is not always better. Studies show that shoppers
overwhelmed by choice may simply walk away. Mr Tadelis tested whether
it would be better to tailor eBay’s auctions to users’ experience level.
The options for new users were narrowed, by removing sellers who are
more difficult to assess (for example those who had less-than-perfect
feedback on things like shipping times). When new users had a simpler
list of sellers to choose from, the number of successful auctions rose
and buyers were more likely to use eBay again. Tailoring the market
meant gains for buyers, sellers and eBay.
The desire to use theory to challenge conventional thinking is one
reason economists are valuable to firms, says Susan Athey, of Stanford
University and Microsoft. When Ms Athey arrived at the software giant in
2007 it faced what was seen as an unavoidable trade-off: online
advertising was good for revenues, but too much would deter users. If
advertisers gained, users would lose. But economic theory challenges
this, showing that if firms are dealing with two groups (advertisers and
users, say), making one better off often benefits the other too.
Ms Athey and Microsoft’s computer scientists put that theory to work.
One idea was to toughen the algorithm that determines whether an ad is
shown. This means ads are displayed fewer times, so advertisers lose out
in the short-term. But in the longer run, other forces come into play.
More relevant ads improve the user experience, so user numbers rise. And
better-targeted ads mean more users click on the advert, even if it is
shown less often. Empirical evidence showed that although advertisers
would respond only after some time, the eventual gain was worth the
wait. Microsoft made the change.
Microeconomists have their sights on problems outside their home turf
too. At the moment the policies picked by central banks and finance
ministries are based on old news, since things like GDP, inflation and
unemployment are measured with long lags. A team at Google headed by its
chief economist, Hal Varian, is using search-engine data to provide
more timely measures. Search terms like “job”, “benefits” and
“solitaire” are closely correlated with unemployment claims (see chart).
These types of relationship help construct new indexes that offer a
real-time picture of the economy. If policymakers start to use these in a
systematic way, their decisions could be based on how the economy
looked yesterday, rather than months ago.
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