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You can today quite easily book a taxi in your city, rent a holiday apartment in London or buy a rare book online. The explosive growth in online marketplaces across the world is often seen as an exclusively technological feat. Far less attention is lavished on the economic principles that are used to make online marketplaces successful. Many digital commerce companies now employ economists and game theorists who work with data scientists to design more efficient markets.

A new paper by economists Liran Einav, Chiara Farronato and Jonathan Levin offers several fascinating insights into peer-to-peer (P2P) markets. Consider what happens with taxi service Uber. It has a centralized matching system since customers are more interested in getting an immediate ride rather than trying to judge the quality of the car that will come to pick them up. Apartment rental service Airbnb needs to decentralize its choice architecture because customers will be very particular about the details of what they get: the number of bedrooms, the location, the price, the look of the apartment. You will allow a computer to pick your taxi but not your holiday apartment.

The way pricing is structured can also be complicated. Some P2P markets such as eBay use auctions to discover prices. A P2P financing market such as Lending Club sets interest rates based on what its proprietary algorithm estimates is the riskiness of the borrower, after adjusting for market conditions as well as the required risk premiums.

Others allow borrowers to quote a maximum interest rate at which they are ready to take money while prospective lenders compete by offering lower rates. The lender with the lowest rate wins the auction. Uber famously—or infamously—uses its surge pricing algorithm to match the demand for taxis with the supply on offer.

Then there is the issue of trust. All markets require trust. The traditional village market solves the problem through personal interaction. More complex markets use sophisticated techniques such as brands or credit ratings to build trust.

P2P markets involve dealing with an anonymous person who you are unlikely to ever meet or trade again with. What prevents an eBay seller from palming off a dud product or an Airbnb user from trashing the apartment he has used? They will both want to protect their reputation for future transactions. That is why P2P markets use reputation and feedback mechanisms to build trust.

But there are subtleties here as well: should reviews be one-sided or two-sided? Should only the customer provide a quality review of his Uber driver or should the latter be able to rate his customer as well? And there are some studies that suggest that reviews on sites such as TripAdvisor can be manipulated.

Einav, Farronato and Levin write: “Businesses that hope to create successful marketplaces or platforms for matching buyers and sellers have to solve several problems. They need to help buyers and sellers find each other, either by developing a centralised assignment mechanism or by allowing effective search. They need to set prices that balance demand and supply, or alternatively ensure that prices are set competitively in a decentralised fashion.

And, importantly, they have to maintain an adequate level of trust in the market, by developing mechanisms to guard against low quality, misbehaviour and outright fraud".

Markets work best when incentives are thoughtfully designed. One of the simplest examples often used to explain the problem is as follows. A mother has to leave her two children at home for a few hours. There is a large slice of cake for them in the refrigerator. She wants the two children to have an equal share of the cake but cannot trust their good sense. So she sets out a simple rule: one child cuts the cake while the other child gets to pick the first piece. Now the child cutting the cake has a clear incentive to be fair unless he wants his sibling to walk away with more cake.

The P2P markets that are growing in importance in our lives are also being built out by using the principles of good market design. They are using economists to help them do the job. And this is also an interesting development. Economists have traditionally been seen as people who study existing markets rather than those who are involved in building new ones. In their new role of designers, builders and innovators, economists have perhaps begun to resemble engineers more than ever before.

The economist as engineer—now that is an idea worth pondering about.

P.S.: One of my favourite economics books on the central institution of our economic life is written by the late John McMillan of Stanford University, Reinventing the Bazaar: A Natural History of Markets. McMillan wrote it in 2002, so eBay gets some initial coverage, but the book obviously does not anticipate the spectacular rise of online markets.

Niranjan Rajadhyaksha is executive editor of Mint.

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