Inequality-aware Market Design

Project Information

IMD

Grant agreement ID: 101040122

DOI

10.3030/101040122

EC signature date 15 February 2022

Start date 1 July 2022

End date 30 June 2027

Funded under

• European Research Council (ERC)

Total cost

€ 1 191 561,00

EU contribution

€ 1 191 561,00

Coordinated by

FUNDACJA ADEPTOW I MILOSNIKOW EKONOMII
Poland

Periodic Reporting for period 1 - IMD (Inequality-aware Market Design)

Reporting period: 2022-07-01 to 2024-12-31

Summary of the context and overall objectives of the project

Policymakers frequently introduce policy instruments that distort the market mechanism with the objective to redistribute resources towards disadvantaged populations. Rent control policies shield tenants from rent hikes; public provision of health care ensures access to basic services for all citizens, even those without the means to cover the cost; and recent electricity price caps in many European countries protect financially vulnerable households that might otherwise struggle with energy bills. Yet, despite the prevalence and public support for such policies, economic theory tends to oppose them. This is because—unlike well-functioning markets—such policies introduce inefficiencies. They imply that resources are no longer allocated to those who value them the most. They also lead to supply shortages and rationing. A basic economic lesson is that redistribution should not be taking place through markets; rather, governments should give financial transfers to those in need, and let markets handle the rest.

In this project, we challenge this conventional wisdom and explore the optimal design of marketplaces in the presence of underlying inequalities, leading to a theory of Inequality-aware Market Design (IMD). Our theory is based on two fundamental premises. First, the policymaker is concerned about the welfare of the most disadvantaged market participants. To capture that, we introduce welfare weights that reflect the redistributive goals of the policymaker. Second, market participants have private information both about their preferences and their level of need. In other words, the policymaker cannot easily identify those most in need and must instead design the rules of the market to ensure that no one is left behind.

The core of the project is to study various market designs from the perspective of efficiency and equity. Our objective is to improve the understanding of optimal policy in such an environment. When is it preferred to let the market decide about the allocation of scarce resources, and when is a government intervention justified? Are in-kind transfers ever preferred to cash transfers? Should we introduce price caps or queues? Are such instruments made redundant by progressive income taxation?

By answering these questions, IMD provides novel solutions to the acute problem of inequality. We explore the connections between market design and public finance to clarify the interaction between various redistributive policies. We aim to provide researchers and policymakers with an effective framework for thinking about the equity-efficiency trade-off in market-design settings.

You can read more about the IMD project here: https://grape.org.pl/project/inequality-aware-market-design#info.

Work performed from the beginning of the project to the end of the period covered by the report and main results achieved so far

The theory of Inequality-aware Market Design is being developed in a series of research papers.

One of the first papers in the IMD agenda presents the baseline IMD framework: A policymaker allocates a set of resources of heterogeneous quality to agents differing in their preferences and level of need. The policymaker only observes an imperfect signal about these parameters and attempts to maximize the overall welfare of the population. We show that a non-market mechanism (allocating the resources at prices that are lower than the market-clearing price) can be optimal in two cases. First, if the designer can identify a group of agents with a high level of need but giving a cash transfer to these agents is impossible (e.g. due to political reasons), it may be optimal to effect redistribution to that group via in-kind transfers. Second, if there is strong and negative statistical association between willingness to pay and the level of need (e.g. if demand is driven mostly by wealth and not the true level of need), it may be optimal to offer low qualities of the good at below-market prices. These results help explain why free provision of basic health care may be a good idea, while controlling prices of most everyday consumption goods is probably not.

Our approach offers novel insight into the age-old challenge in economics: balancing equity and efficiency. In applications, we show that the prescriptions of our theory often differ from conventional wisdom and offer valuable guidelines to policymakers. In a paper about the optimal allocation of vaccines during a pandemic, we demonstrated that—while a market mechanism for vaccines would be inefficient and inequitable—an improvement can nevertheless be made by using prices in limited circumstances. In an article studying electricity prices, we pointed out that a uniform price cap on energy is regressive: It gives a higher effective subsidy to those who consume the most—typically the relatively wealthy consumers. A better policy is to offer a subsidized price for relatively low levels of consumption and increase the price for units consumed above a certain threshold.

In ongoing work, we investigate the optimal interaction between market-level policies and income taxation. We derived conditions under which income taxes alone are sufficient; next, we will explore cases when market interventions are required to complement the redistribution toolset of the policymakers.

Progress beyond the state of the art and expected potential impact (including the socio-economic impact and the wider societal implications of the project so far)

Prior work in economics emphasized allocative inefficiencies of distorting the market mechanism, without fully exploring its benefits. We go beyond the state-of-the-art knowledge by bridging microeconomic theory of market design with public finance literatures. Inequality and redistribution have been rarely studied within microeconomic theory, mostly because of the conviction that they should be addressed within the public-finance framework. Classical public finance results, on the other hand, opposed redistribution through markets because they took an aggregate perspective to consumption that did not account for the heterogeneity in consumers’ tastes and needs for various goods and services. By explicitly modeling that heterogeneity—alongside the redistributive preferences of the policymaker—we demonstrated that there is scope for redistribution in individual markets.

From a methodological perspective, we contributed to the theory of mechanism design by introducing unobserved social welfare weights to the canonical framework. The presence of welfare weights ushered in a number of technical challenges, and we extended existing techniques to handle them. This allowed us to offer a wide range of novel economic insights about the equity-efficiency trade-off.

Going forward, we want to develop a deeper understanding of how IMD interacts with income taxation. Even though our existing work demonstrates that income taxation does not render IMD obsolete, we must still address the question of how to optimally combine these tools. The question comes with its own technical challenges because studying income taxation together with market design requires a rich model of behavior. We are currently building a tractable framework to address those challenges and derive policy implications. In addition, we will study extensions accounting for various real-life constraints and considerations.

Illustration of IMD