Matching behaviour: Financial Express 22nd October 2012

The Nobel prizes show that behavioral economics has become the new hotbed of researchAfter bestowing the Nobel Prize to the EU for peace, it would not have been a surprise if the Nobel for Economics was given to the ECB, considering that this institution has done a lot to keep the eurozone from disintegrating. Evidently, the award has not gone to an institution but been conferred upon Alvin Roth and Lloyd Shapley, both of who have worked on a similar path albeit independently, to come up with their own theories on match-making that are distanced from prices. Normally, all demand and supply factors lead to a price determination, which then decides who is in and who is out. This is the efficient markets theory. However, at times prices do not matter and there may be a need for alternative systems to bring about equilibrium. Working on cases where prices do not matter is Roth and Shapley's way of looking at economic isues.They have looked at marriages, school allocations, jobs, hospitals and donations to prove their theory. At a very rudimentary level, when prices do not matter, school admissions are first based on the applications made by parents who express their choice through a pecking order. The school decides on who to take based on parents' preferences--such as distance from home, availability of transport, status of household etc while allotting seats. Based on matching the parents' criteria with their own, schools fill seats, through ‘first, second and third lists’. Does this work in India? On the face of it, matching theory does not work where prices decide the equilibrium. The starting point for the sellers' market is that there is a predetermined price which rations out the commodity that is available. As all commodities have a price, it is possible for the market to match demand with supply. If demand is high, then supply gets created as producers set in motion processes to optimise use of their capacity.But when it comes to non-commodities, it would work even if the price separates effective demand from desire, that is, when demand is greater than its supply. Schools, hospitals and similar services have an attached price, which decides the inclusion criteria. After that, ‘matching theory’ can be applied. For hospitals, it is more democratic and works on a first-in basis; no further criterion comes into play. In case of education, at the school level it is the fee or the donation that is the starting point. After the fee threshold, the matching takes place through a pecking order. First, those with a certain background are permitted entry based on maintenance of culture. Second, those who have to be given a seat based on recommendation are admitted. Last, there are the principles of matching that come into play in allocation. Therefore, even when price matters and lots of people qualify, the institution has other ways of discovering potential candidates. However, if the institution is publicly run, then the matching principles work from the start.An interesting area that can be explored is marriages in the Indian context. Roth and Shapley have discussed at length the so called couple discovery, which today is used in dating web sites. The Indian system of arranged marriages has long had this implicit arrangement wherein advertisement in dailies, which is also a revenue earner for dailies, helps to bring about such compatibility. These are all signalling mechanisms, which are similar to mechanisms created by another Nobel Laureate, Michael Spence, to create efficient markets in the presence of information asymmetry. The newspaper or dating site provides a signalling mechanism for concerned parties who then narrow down their choices and begin exploration of compatibility.In case of jobs, matching again takes place through a tangible medium, that is, employment agencies, consultants or advertisements. There is no pricing here, but there is an intermediary who decides which profiles fit the employer’s requirements and then takes the process forward through a short listing procedure. Various criteria such as qualification, salary drawn, designation , and experience are used.When it comes to choosing a doctor or any other professional, the matching takes place through a reputation check. While qualifications and price matter, one goes for a professional based on other people’s experiences. Hence, here it is the seller of the service who reaches out to the buyer by sending signals through the way in which clients are serviced. Therefore, all these theories of matching demand and supply assume different tones depending on the service one is talking of. Public services are more democratic and are open to all, generally on a ‘time preference’. But, in the case of private services, price is certainly the first criterion, which then would contest the views of Roth and Shapley. However, given that a supply gap exists for all such services, there is a rationing system that comes into play where these principles operate. Quite interestingly, the recipients of this prestigious award in recent years have been on the behavioural side which is practical. The day of the macro-theorist appears to be over. This could probably be indicating that there are few new theories on the macro front that have dominated economic thought. We still talk of Keynes, Friedman, Hayek or Sarjent, whose works were written prior to the eighties. We are yet to see new theories that explain what has caused the crises we see around us. This has raised more criticism and cynicism, but not sown the seeds of new economic ideas that provide a solution.