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Markets for Breakfast and Through the Day

MARKET DESIGN IS so pervasive that it touches almost every facet of our lives, from the moment we wake up. The blanket you chose to sleep under, the commercial playing on your clock radio—even the radio itself—embody the hidden workings of various markets. Even if you eat only a light breakfast, you likely benefit from the global reach of multiple markets. And while most of those markets are easy to participate in, even that apparent simplicity may disguise a sophisticated market design.

For example, you probably don’t know where your bread was baked—but even if you do, your baker doesn’t have to know who grew the wheat that went into the flour used to make the bread. That’s because wheat is traded as a commodity—that is, it is bought and sold in batches that can all basically be considered the same. That simplifies things, although even commodities need to be designed, so that the market for wheat doesn’t have to be a matching market, as it was as recently as the 1800s.

Every field of wheat can be a little different. For that reason, wheat used to be sold “by sample”—that is, buyers would take a sample of the wheat and evaluate it before making an offer to buy. It was a cumbersome process, and it often involved buyers and sellers who had successfully transacted in the past maintaining a relationship with one another. Price alone didn’t clear the market, and participants cared whom they were dealing with; it was at least in part a matching market.

Enter the Chicago Board of Trade, founded in 1848 and sitting at the terminus of all those boxcars full of grain arriving in Chicago from the farms of the Great Plains.

The Chicago Board of Trade made wheat into a commodity by classifying it on the basis of its quality (number 1 being the best) and type (winter or spring, hard or soft, red or white). This meant that the railroads could mix wheat of the same grade and type instead of keeping each farmer’s crop segregated during shipping. It also meant that over time, buyers would learn to rely on the grading system and buy their wheat without having to inspect it first and to know whom they were buying it from.

So where once there was a matching market in which each buyer had to know the farmer and sample his crop, today there are commodity markets in wheat, corn, soybeans, pork bellies, and numerous other food items that are as anonymous—and efficient—as financial markets. Just as investors don’t worry about which particular shares of AT&T stock they buy, buyers don’t care which particular 5,000 bushels of number 2 hard red winter wheat they have shipped to them. Thanks to the rating system, they can buy wheat without seeing it. Commodifying wheat via a reliable grading system helped make the market safe.

Wheat can even be sold before it’s harvested, as wheat futures—a promise of wheat to come. This allows big millers and bakers to make their purchases and lock in their costs in advance. They can do so without fear, because the standardized description of what is being purchased means they don’t have to worry about what will be delivered. The purchase of wheat futures is a purely financial transaction, with no wheat even present in the marketplace.

As for the transaction itself, brokers inspecting and buying lot by lot have been replaced by commodity traders on the floor of the Chicago Board of Trade signaling and calling out their bids and offers in the trading pits of the open outcry markets that came to dominate this kind of transaction. Nowadays traders also buy and sell enormous volumes of grain while sitting at computer screens.

Turning a market into a commodity market helps make it really thick, because any buyer can buy from any seller, and any seller can sell to any buyer. At the same time, it also helps the market deal with one of the main sources of congestion in matching markets, since in a commodity market each offer to sell can be made to all buyers, and each offer to buy can be made to all sellers. So unlike in the market for jobs, or for houses, no one has to wait for an offer to be made to him personally; anyone who sees (or hears) a price he likes can take it. We’ll see in more detail how such markets can work when we look into financial markets in chapter 5, and we’ll see just how fast commodity markets can sometimes operate.

 

Coffee and More

 

Turning a product into a commodity can affect not just how it’s bought and sold but even what is produced. Still keeping our sleepy eyes squarely on the breakfast table, let’s shift our attention to coffee and its own remarkable market tale.

Coffee beans have been grown in Ethiopia for centuries, but until the twenty-first century they were traded a lot like nineteenth-century American wheat. If you wanted to buy Ethiopian coffee in bulk at the source, you had to have an agent there who could extract a sample from deep inside each sack to taste and evaluate it.

That changed in 2008 with the creation of the Ethiopia Commodity Exchange. At its heart is a system of anonymous coffee grading, in which professional tasters sample and grade each lot put up for sale. (By the way, there was also some thoughtful market design that went into the rules—that is, the market design—involved in organizing quality grading. For example, tasting must be “blind”; the tasters can’t know whose beans they’re tasting. Otherwise they could be bribed by the seller to inflate the grades.)

The standardization of coffee can actually improve the quality of the coffee harvest. Coffee beans grow inside a “cherry,” and the best coffee is harvested when the cherry is ripe and red. But the beans are sold after being removed from the cherry and dried. So when buyers simply see coffee beans, they can’t tell whether they were harvested from ripe red cherries or from unripe green ones. Before coffee was graded, coffee farmers sometimes were tempted to harvest a whole hillside at once, red and green beans, ripe and unripe. But now that tasters can tell the difference, it makes sense to have coffee pickers pluck only the red cherries and to come back later to harvest the rest of them when they are ripe. Since the graders can tell the difference, the market reliably rewards such care with a higher grade and a higher price. The ultimate result is that foreign buyers can now buy Ethiopian coffee beans in bulk from a distance, without having to taste them on the spot, and from multiple sellers, without worrying about the sellers’ reputation or pedigree.

So as you sip your morning coffee, you are benefiting from some fairly recent design in the marketplace for an ancient agricultural commodity, which wasn’t always as standardized—or as good—as it is today.

That said, your coffee doesn’t necessarily come to you anonymously, even if you don’t know who grew the beans. You may run out to pick up your coffee already brewed from Starbucks or a more local coffee shop, but in either case you know quite a bit about the seller. You may have chosen your coffee joint for its convenience, for the pastries it sells with the coffee, or even for the designs the barista swirls into the foam on your latte. And if you’re a regular, that seller may also know a lot about you—for instance, getting your “usual” ready when she sees you walking in.

Coffeehouses try hard to differentiate their products so that customers will want to return and buy regularly from them. Of course, if you’re in a strange city, you may find yourself seeking a big chain such as Starbucks precisely because of the standardization of the drinks it sells, since you haven’t had a chance to locate a more idiosyncratic coffee shop that might suit you better.

Notice the tension between commoditization and product differentiation—that is, between wanting to sell in a thick market to buyers even if they don’t care who you are, and trying to make your product special enough that many buyers will care enough about you to seek you out. Sellers enjoy selling in a thick market of buyers, but they don’t enjoy being interchangeable with other sellers. Giant brand leaders such as Apple and Microsoft sell products that are enough like commodities that you don’t care which particular iPhone or copy of Microsoft Office you have, but they are different enough that you can’t buy the same phones and software from anyone else. Part of Apple’s success is that it sells a unique brand of laptop computers, while the PCs pioneered by IBM became a commodity that could be sold by other companies as well. This opened the door to Microsoft’s near monopoly on the operating system that runs all PCs, since their spread created a big, thick market for software on the PC platform.

In much the same way, there’s a tension between commodity markets and matching markets. You care who brews your coffee, but your coffee shop sells to all comers. That is, in the market for a cup of coffee, your coffee shop has to be chosen, but you get to choose—and you care whom you choose. So the distinction between perfectly anonymous commodity markets and relationship-specific matching markets isn’t a thin bright line. Rather, there are markets at different points along a spectrum from pure commodity to pure matching. When I buy bread in the supermarket, I don’t really know the baker, but I can recognize that it’s the usual bakery, since the baguettes I get come with the bakery’s name printed on the bag, along with the information that it has been cheerfully baking bread since 1984.

Buyers have some of the same ambivalence as sellers: while we like the fact that some goods are commodities that we can buy without inspecting, we also enjoy variety and seek out unusually high and hard-to-standardize quality. Sometimes on Sunday mornings, my wife and I buy our breakfast at a local farmers’ market—an ancient format that still attracts busy city dwellers. It’s an attractive place to shop, not least because of the perceived freshness available in a marketplace that is open only one day a week. You know for sure that the goods came to the market that day and didn’t languish in a supermarket’s storage room before being put on the shelf.

Moreover, the farmers showing their wares are typically local. And because the farmers themselves (or their families) are usually manning the stand, you can easily find out something about them. The result is more of a matching market than when you stock up in your local grocery store, although that store is open every day, which makes it more convenient.

The grocery store may be open every day, but it’s not open all the time, because it’s costly to keep a store open when there are only a few potential shoppers. But whether you shop at the farmers’ market or the local supermarket, you still have to go there to make your purchases. The Internet is changing all that and making markets more ubiquitous.

 

Marketplaces in the Air . . . and Everywhere

 

These days, with your smartphone and your credit card, you can buy a plane ticket, make a hotel reservation, order a meal to be delivered, or purchase a pair of shoes. On the Web, you can buy from millions of different sellers—and if you point the browser on your phone or your computer at a big Internet marketplace such as Amazon, you can fill your virtual shopping cart with items from multiple sellers and buy them in a single transaction. That’s part of what makes Internet markets so easy to use and so successful. When my watch breaks, I might go to Amazon to buy a new one. But I might also buy a mirror for my bike helmet and a book I’ve been planning to read, then pay for them all with a credit card and have them shipped to my home. It looks to me like a single transaction, even though I may have bought each item from a different seller that subscribes to Amazon’s marketplace services.

In attracting so many shoppers and so many merchants, Amazon has created a thick marketplace, one in which there are many participants ready to make many different kinds of transactions. The thickness of the Amazon marketplace—the ready availability of so many buyers and sellers—is self-reinforcing. More sellers will be attracted by all those potential buyers, and more buyers will come to this marketplace because of the ever-expanding variety of sellers. So Amazon lets me shop easily for many different things in the same place, and my phone lets that place be wherever I am.

Your smartphone is a marketplace not only for goodies from Amazon but also for software applications, or apps, that expand what your phone can do. That’s why your phone almost certainly runs on one of the two most popular smartphone operating systems, Apple’s iPhone or Google’s Android. People want phones with a long list of apps to choose from, and they know that they’ll want some apps later that haven’t even have been invented yet. At the same time, a software developer writing an app wants to sell it in a marketplace with lots of potential buyers so the app will have a chance to become a big hit.

Phone buyers and app developers are looking to meet in a thick marketplace—one with many possibilities on the other side of the market. That’s why independent developers first write apps for phones with many users, and phone buyers look for phones with an abundance of apps. Your phone’s operating system is the key to the marketplace, since each app has to be written to be compatible with a particular operating system.

Apple and Google both launched their proprietary operating systems with a multitude of apps already available so that customers would be attracted immediately by their thickness. But Apple and Google made other, notably different choices when designing their markets. Apple chose a “closed” operating system that allowed it to control which apps could be sold to iPhone users. Google, which came later to the game, opted for an “open” system, publishing the code so that any developer could build for it. These choices echoed similarly opposing strategic decisions made by Apple and Microsoft at the dawn of the personal computer age. Anybody could make software for the PC platform, but only Apple (or those developers it allowed to do so) could make software for its personal computer, the Mac. These choices allowed the market for PC software to grow thick much more quickly than the market for Mac software. But Apple’s decision to keep both its hardware and software on a proprietary standard eventually allowed it to reap huge profits.

As with other kinds of markets, popular operating systems quickly get more and more popular, as they attract both new buyers and new sellers. In time, they become de facto industry standards—meaning they essentially establish a marketplace in which products (new applications) can be sold. Once this happens, they can, at least for a time, so completely dominate their markets that competing operating systems can’t attract enough users and developers to be anything but niche offerings.

That’s exactly what happened in the smartphone market. The two most popular operating systems, iPhone and Android, have captured so much of the market that they’ve become almost self-perpetuating. In the process, they have displaced earlier popular Internet phone operating systems, notably the BlackBerry, which in turn had replaced non-Internet phones and non-phone digital assistants such as the PalmPilot.

Notice how markets interact with one another. Amazon couldn’t have become the marketplace it is without the Internet, which couldn’t have become a marketplace without first computers and then smartphones. And smartphones couldn’t have become marketplaces without a way to pay for purchases over the phone. At the farmers’ market and the supermarket, anyone can pay in cash if they want to. On the Internet, it’s convenient to pay with a credit card. And a credit card is also a marketplace, which is why there’s a good chance you have one of the big ones: Visa, MasterCard, or American Express. Consumers who use credit cards and merchants that accept them are all looking for a thick market, with lots of participants on the other side.

I’m old enough to remember when people paid for most things by cash or check. It was hard to pay by check if you were away from home, since merchants didn’t like to take the risk that your check would bounce and they wouldn’t get paid. But if you were a regular at a local restaurant, the owner was usually glad to take your check—although even then you’d sometimes see a sign over the cash register that read IN GOD WE TRUST; ALL OTHERS PAY CASH.

Credit cards offered merchants safety, but that safety came at the cost of transaction fees. Most merchants were willing to pay those fees because accepting credit cards brought in customers they might otherwise have missed, and also because credit cards made it safe for them to take noncash payment from customers they didn’t know well, since the bank guaranteed payment as a form of insurance.

It took a while for the markets facilitated by credit cards to become thick by settling on just a few major cards, but it is hardly surprising that this happened. Imagine how much less useful credit cards would be if the markets had moved in the other direction and every store used a different one. In the early days, some people carried several credit or charge cards, and various businesses accepted only certain ones. This sometimes led to embarrassing moments when the check was delivered at a restaurant. So the cards that were most popular became the most useful ones to carry and to accept, since they gave access to the thickest markets—that is, to the most restaurants and shops on one side, and the most diners and buyers of other goods and services on the other. By the late 1960s, an industry shakeout had already begun. A number of famous cards—most notably Diners Club, which was the first credit card in widespread use—faded into the background.

Part of what makes credit cards work is that they simplify transactions for both buyers and sellers. Concentrating on just a few cards further simplifies matters on both sides of the market. Thus ever since the big shakeout, no new credit cards have joined the ranks of the majors; the barrier to market entry has proved to be too great. That said, in recent years the Internet revolution has opened the door to competition from wholly new directions—including new kinds of payment services, such as PayPal; an international network of automatic teller machines to challenge old standbys such as traveler’s checks; and maybe even new types of “virtual money” such as Bitcoin. As I write this in 2014, Apple has announced a new payment system on the latest iPhones, and we can reasonably expect that it and/or other new payment systems that make use of mobile devices will become commonplace.

The bank that handles Amazon’s transactions, or the one that manages the account of your favorite restaurant, is typically different from the bank that issued your credit card and takes your payment. So behind the scenes, there is an interbank market, too, through which payments flow. This hidden market eases the congestion that could otherwise result from settling very large numbers of relatively small transactions, in the same way that Amazon itself eases the congestion of making several little purchases from different sellers. This interbank market lets each merchant deal with just one bank, just as your monthly credit card statement enables you to make a single payment that settles your account with many merchants.

Your credit card also acts as a lender. (That’s what distinguishes credit cards from charge cards, which offer only the ease of a cashless transaction.) It offers you access to the market for credit, so any time you want to buy something, you can borrow money, though typically at an exorbitantly high interest rate, simply by not paying the full amount you owe when your bill arrives. The bank that issued your credit card can get away with such high rates because once you’ve made your purchase, the bank isn’t facing a lot of competition in offering you easy credit. In fact, you might have chosen this card because it provided cash back on some purchases. It turns out that lots of people who do that never pay much attention to the interest rate, because they’re planning to pay their bills in full. But then they seldom switch cards. So there isn’t much pressure on banks to lower their rates. I hope you don’t borrow on your credit card very often: it’s a bad deal—the kind of deal you’re likely to be offered when the other side of the market isn’t thick.

In thicker markets, where customers have ready alternatives, it’s harder for a seller to get away with such bad deals. At one time, merchants tried to pass on the cost of credit card purchases to consumers by charging a premium for using the card instead of cash. This didn’t catch on, in part because credit card purchasers disliked it so much and could take their business elsewhere. Instances in which consumers recoil from offers that strike them as unfair are more common than you might think. Even marketing giants are sometimes surprised by what they can’t get away with. In 1999, for example, Coca-Cola tested vending machines that could automatically raise prices in hot weather. The backlash was quick—and the company abandoned the idea just as quickly. So regular folks who find certain transactions particularly distasteful do have some recourse when they can take their business elsewhere or simply withhold it—and this, too, plays a role in shaping markets.

Incidentally, the fact that most purchases cost the same whether they are paid for by credit card or by cash opens the door to an attractive-looking kind of competition among credit cards that may not be as attractive as it seems. Many credit cards now compete on how much “cash back” they offer to consumers. Those refunds come out of the fees that credit card companies charge to merchants and are reflected in the prices that merchants charge their customers. So when two customers stand in line at the cash register with identical purchases, and one pays with a credit card and one pays cash, the one who is paying cash is paying for the discount that the credit card customer is receiving. That is, as more consumers are attracted to higher cash-back deals, and as credit cards successfully compete for customers by raising these kickbacks, merchants pay larger credit card fees and raise prices in response. And a discount from a higher price isn’t such a good discount, especially for those who are paying cash. To put it another way, we pay a cost for the convenience of using a middleman, and that is partly because the middlemen—in this case, the credit card companies—compete for our business in a way that mutes the price competition among merchants that might otherwise bring prices down. It’s something to remember: competition can take many forms, and it isn’t always easy to see who gains and who loses.

 

Each of these ubiquitous marketplaces has found a way to succeed not only in making markets thick, uncongested, and safe, but also in making them simple to use. Making a market simple to use, however, may not be simple. Behind Amazon’s one-stop shopping, for example, are storage and shipping, fast Web servers, and secure ways of paying, with encrypted credit card numbers on file so that regular customers don’t have to be troubled each time they make a purchase.

Simplicity is a competitive tool that sometimes allows new market platforms to displace old ones. Credit cards replaced paper checks, and it remains to be seen whether mobile payment systems will replace credit cards. If they do, it will be because it’s simpler to swipe your phone than your credit card, more secure, or simpler for the merchant to accept payment that way. Notice that when competition among marketplaces causes previously successful markets to fail, it is often the result of undermining the previous success in establishing a thick market. If, for example, mobile payments turn out to be more attractive to merchants than credit cards, then as the mobile payment market becomes thick, some merchants might stop accepting credit cards that charge them a high fee. That would in turn make those credit cards less attractive to consumers, which would make them unattractive to even more merchants, and a previously thick market would start to become thin.

 

In the chapters to come, you will begin to see markets in sharper focus, with more attention to the details of how they work, the “rules of the game.”

A few of the marketplaces I’ll tell you about are ones that I’ve helped design or that I’ve studied carefully. Others are just markets that I participate in, as you do—such as the market for phones, credit cards, or that morning cup of coffee.

When we think of markets, most of us typically imagine the stock exchange, or a retail shop offering products to customers, or the surging demand for new smartphones, or maybe just a traditional farmers’ market. But as we’ve already seen, we encounter many other markets every day, and our world would be utterly different (and a lot less pleasant) without them. These markets include not only our experiences at the supermarket or phone store but also those in getting into college, finding a job, eating breakfast—even getting a kidney transplant.

One thing we’ll see is that the “magic” of the market doesn’t happen by magic: many marketplaces fail to work well because of poor design. They may fail to make the market thick or safe, or to deal with congestion, and so there’s an opportunity to help them work better. And sometimes there’s an opportunity to build a marketplace from scratch, to serve an entirely new market, to facilitate a new kind of exchange. We’ll see that in the next chapter, where I tell you about kidney exchange.