A golden age of micro

MICROECONOMISTS are on the march, winning top awards, helping battle the crisis, and advising the world’s most innovative firms. This week the trend continued, with the Nobel Prize going to two microeconomists. Why are they doing so well?

First up, microeconomists seem to be very good at building new findings on old foundations. Take the Nobel Prize, covered by a colleague in the Free exchange print article—Game, set and match—this week. The prize went to economists who built on cooperative game theory, an ancient development by economic standards (one of the main papers was published in 1962). Cooperative game theory looks at how well people can do when acting together; by examining all the possible combinations, theorists can spot outcomes that individuals acting alone cannot achieve. They then focus on something called the “core” of the game—those outcomes that are “stable” in the sense that no subgroup would do better by breaking away and acting alone. So far, so theoretical. But the theory is pivotal in understanding how to set up medical job-matching system in a stable way so that no hospital or medical school wants to break off and set up alone. Fifty years on, there are other applications too: cooperative game theory is still being used in cutting edge auction design.

And the Nobel is just one example of real-life problems solved by micro. A thoroughly macroeconomic problem—unconventional monetary policy—is another. In 2007 and 2008, central banks and finance ministries decided that it was a good idea to follow this policy which involves exchanging good assets (cash or treasury bills, for example) for illiquid ones. But working out exactly how to do it was a very different question. One major stumbling block was to work out what price to pay for the bad assets: markets were thinly traded and prices often did not exist.

Micro theorists came up with the answers. In America, various academics advised the US Treasury in 2008. But the best example of micro in action is Britain, where the Bank of England uses a new type of auction—the Product Mix auction—designed by Paul Klemperer. The Bank’s Governor, Sir Mervyn King, clearly finds micro theory useful:

“The Bank of England’s use of Klemperer auctions in our liquidity insurance operations is a marvellous application of theoretical economics to a practical problem of vital importance to financial markets.”

There is an important lesson about making cutting edge economics accessible here. Auction theory uses very tough mathematics to grind out results. But micro theorists also work hard on the intuition for their work. As an example, the results from Mr Klemperer’s auction can be set out in a simple graphical format, see (here). This means non-specialists (like central bank governors) can access it easily, making it much more useful in policy settings. In macroeconomics, the opposite seems to be true: the maths is actually easier, but it is just hard enough to exclude non-specialists, and this shields models from popular scrutiny.

Micro has made big recent developments in much more familiar areas too, including how we should think about the economics of Facebook, stock exchanges, newspapers and money. These are all platforms or intermediaries that link two types of user (Facebook connects users and advertisers, exchanges connect buyers and sellers). The economics of these platforms has spawned a new branch of micro, first developed by Jean Tirole and Jean Charles-Rochet in the early 2000s, (There is a good introduction by David Evans here).

The big idea is that changing prices in a two-sided market triggers a more complex chain of events that the simple “price up, quantity down” of a regular firm. Consider a local newspaper considering a price hike. A higher price may mean more profit, at the expense of a lower circulation. But the lower readership makes the paper less useful for advertisers, who cut job adverts. That makes the paper less useful for job-searching readers, so the circulation falls again. And so on.

These types of new insight explain why leading academic microeconomics are also top advisers at innovative technology firms. Hal Varian, probably the world’s best known microeconomist is also the top economist at Google; other firms keen to pay for micro advisors are Microsoft (Susan Athey); Amazon (Patrick Bajari) and eBay (Steve Tadelis). Granted, this happens with banks and business-school academics too, but in microeconomics the “real world” experience seems to be nourishing the discipline in a way that is less clear in macro.

A final strength may come from geographic diversity. In micro, while American universities lead the field, there are lots of other world-class hubs too. Mr Tirole and Mr Rochet are based in Toulouse, and Britain is still an excellent place to do micro. Macroeconomics, by comparison, is an all-American affair. Maybe this means a means a more diverse set of ideas about how firms, consumer and markets work are being brought to academic work in micro. Whatever the reason, microeconomists are on the up.

economist