Optimal Market Design

This paper introduces three methodological advances to study the optimal design of static and dynamic markets. First, we apply a mechanism design approach to characterize all incentive-compatible market equilibria. Second, we conduct a normative analysis, i.e. we evaluate alternative competition and innovation policies from a welfare perspective. Third, we introduce a reliable way to measure competition in dynamic markets with nonlinear pricing. We illustrate the usefulness of our approach in several ways. We reproduce the empirical finding that innovation levels are higher in markets with lower price-cost margins, yet such markets are not necessarily more competitive. Indeed, we prove the Schumpeterian conjecture that more dynamic markets characterized by higher levels of innovation should be less competitive. Furthermore, we demonstrate how our approach can be used to determine the optimal combination of market regulation and innovation policies such as R&D subsidies or a weakening of the patent system. Finally, we show that optimal markets are characterized by strictly positive price-cost margins. ∗Boone: Department of Economics, University of Tilburg, P.O. Box 90153, 5000 LE, Tilburg, The Netherlands, and Tilec, CentER and CEPR. Goeree: Institute for Empirical Research in Economics, University of Zürich, Blümlisalpstrasse 10, CH-8006, Zürich, Switzerland, and Division of the Humanities and Social Sciences, California Institute of Technology, Mail code 228-77, Pasadena, CA 91125, USA, and CEPR. We gratefully acknowledge financial support from the European Research Council (Goeree, ERC Advanced Grant, ESEI-249433) and from the Dutch National Science Foundation (Boone, VICI 453.07.003). We would like to thank Michelle Goeree for helpful comments and suggestions.