After reading some of the work on market design by Alvin Roth and Lloyd Shapley that earned them the Nobel Prize in Economics this year, I realized it has some implications for those of us in the start-up and social media/gaming space. In particular, the underlying research on market design could help make raising capital more efficient.
It is interesting to understand the underlying principles of market design that Roth and Shapley helped explain. According to the theory, there are many markets that operate where the assumption of perfect competition is not satisfied. There are many goods that are individual and heterogeneous, whereby the market for each type of good becomes very thin. A great example is tech and social media start-ups. Each company is different and there is not a direct trade-off between investing in company A and company B, as each has a different management team, concept, etc.
If a worker is hired by Employer A but would have preferred to work for Employer B, who also would have liked to hire this worker (but did not), then there are unexploited gains from trade. If employer B had hired the worker, both of them would have been better off. Shapley, in research with David Gale, defined a pairing to be stable if no such unexploited gains from trade exist.
This analysis by Gale and Shapley led to a “deferred-acceptance” procedure, which is easy to understand and always leads to a stable outcome. The procedure specifies how agents on one side of the market make offers to those on the other side, who accept or reject these offers according to certain rules. This thesis led to the branch of economics called market design.
Proper market design encourages stability and incentive compatibility. Stability encourages groups to voluntarily participate in the market, where versus trading directly. Incentive compatibility discourages strategic manipulation of the market; there is no incentive to lie about your choices. If we apply these principles to tech and social media companies seeking investment, stability would imply start-ups would not prefer working directly with investors, and incentive compatibility would prompt investors and entrepreneurs to make and accept, respectively, the offers they truly wanted.
In the Gale-Shapley algorithm, one side makes offers to agents on the other side, each agent reviews the proposals, holds on to one and rejects the others. The crucial element is that desired offers are not immediately accepted but held onto, which the authors refer to as “deferred acceptance.” Anyone whose offer is rejected can make an offer to someone else, and the procedure continues until nobody wishes to make another offer, at which time the agents accept the offer they are holding. Using the Gale-Shapley algorithm, an equilibrium is reached when there is not a better alternative for all parties (though one side might benefit from imperfect information).
Another crucial element of the Gale-Shapley algorithm is a “revelation mechanism.” A revelation mechanism is incentive compatible if truth-telling is a dominant strategy, so that participants always find it optimal to submit their true preference orderings. There is no benefit to the participants to lie or mislead.
Also, when a market is successfully designed, many agents are persuaded to participate, thereby creating a “thick” market with many trading opportunities (and one where it is not preferable to trade outside the marketplace). Such a market creates more good matches, which generates more interest in it. A perfect example of this phenomenon is eBay.
The opportunity for start-ups
Having raised institutional money and brokering the sale of Merscom, I have seen first-hand the weaknesses of the investment and M&A markets. They are highly inefficient, with buyers and investors often reacting to individual opportunities rather than assessing the full market, and entrepreneurs not seeing all available options. Individual investors and entrepreneurs can probably improve their positions by implementing some of the principles of deferred acceptance, while there is probably a meta-opportunity to reinvent the capital market for tech and social media companies.