Epistemology and Synthetic Market Design: Examples from Ecosystem Services

From the KP archives

I was traveling for work this week and got caught in the thorny combination of United Airlines’ flight disruptions and Thursday evening’s violent weather in Denver (the hail in our back garden, yikes!), so I’m very out of my rhythm this week. In continuing to develop the foundational economics prisms for electricity policy that I’ve been writing about since January, I’ve returned to the essay below on market design in ecosystem services that I wrote in 2018. The questions that I raise in this essay are front and center in the analysis of how electricity technologies, regulation, and market designs are evolving, and should be evolving, which are not necessarily the same thing. I plan to return to my usual rhythm next week. For those of you in the US, I hope you enjoy the Independence Day holiday.

Forest, fields, hills, rocks, and sheep in Shropshire

Comparative Institutions and Market Design

Some of the most illuminating work in market design lately has been in payment for ecosystem services (PES). These projects provide examples of the continuing relevance of institutions to economic and policy outcomes, and the importance of Elinor Ostrom’s work on the diversity of governance institutions in common-pool resources; despite criticisms leveled at synthetic markets, they can lead to better outcomes compared to the realistic alternative, which is usually a regulatory response.

In 2017 my former colleague Seema Jayachandran and co-authors published (in Science) a thorough analysis of a randomized controlled trial they performed in Uganda with groups of private forest owners in 121 randomly-selected towns. The randomly-selected treatment group received payments if they chose not to cut down trees, and half of the villages had the experiment run for two years. These two dimensions of the experiment allowed the authors to test whether payment induced some people to leave trees standing that they would otherwise cut down, compared to the rate of cutting in the control group, and to test an income and duration effect across the villages. They also performed a benefit-cost analysis of the impact of the delayed carbon emissions using the EPA’s median estimate of the social cost of carbon from 2012. As summarized in the paper’s abstract:

We evaluated a program of payments for ecosystem services in Uganda that offered forest-owning households annual payments of 70,000 Ugandan shillings per hectare if they conserved their forest. The program was implemented as a randomized controlled trial in 121 villages, 60 of which received the program for 2 years. The primary outcome was the change in land area covered by trees, measured by classifying high-resolution satellite imagery. We found that tree cover declined by 4.2% during the study period in treatment villages, compared to 9.1% in control villages. We found no evidence that enrollees shifted their deforestation to nearby land. We valued the delayed carbon dioxide emissions and found that this program benefit is 2.4 times as large as the program costs.

This innovative paper combined economics, experimental methods, GIS mapping, and environmental science to study this important question (and I recommend Brad Plumer’s New York Times analysis of the research and its importance).

Another recent PES analysis from Krister Andersson and co-authors (in Nature Sustainability) uses a “framed field experiment” to simulate the effects of conservation payments on short-term decisions, and on the duration of those effects; it also tested the effects of communal versus individual decision-making:

To shed light on the debate, Andersson and his colleagues traveled to 54 villages near tropical forests in Bolivia, Indonesia, Peru, Tanzania and Uganda.

There, they staged a half-day table-top simulation game in which local forest users were divided into groups of eight and asked to make decisions about how many trees they would harvest from a shared forest.

They had the opportunity to earn more than a full day’s pay based upon their decisions.

In the first stage, they were not allowed to communicate with others in their group and made individual decisions based on their own needs and values. In the second stage, they were offered money to cut down fewer trees (to mimic a PES), asked to discuss for five minutes and decide as group, or both. In the third stage, they went back to making decisions alone with no cash incentive.

Participants who got cash in the second stage cut down 19 percent fewer trees. Those who got cash and were encouraged to communicate in their decisions cut down 48 percent fewer trees.

Even after payments stopped, those groups that had been paid continued to conserve, with the group that got cash and worked together maintaining a 23 percent reduction (compared to pre-payment) in the number of trees cut down.

Those who had indicated in surveys prior to the game that they trusted their other community members conserved the most, cutting down 35 percent fewer trees in the game post-payment than prior to payment.

“Our experimental results suggest that payments, especially when they are conditional on group cooperation, can help people realize the value of cooperation and that lasting cooperation can lead to better forest conditions,” said Andersson.

An important aspect of the underlying economics in both studies is the crucial role that institutions play in structuring social interactions and shaping incentives — the Ostrom point. The Andersson et. al. paper analyzes that dimension of the question more explicitly than the Jayachandran et. al. paper does (the bibliography of the Andersson et. al. paper reflects the Bloomington School influence and is worth exploring if you are interested in these questions). Both analyses use synthetic markets to achieve specific policy objectives, and involve careful institutional design to craft market rules.

Synthetic markets and deliberate institutional design are prone to criticisms, one of which is epistemic. Synthetic market designers engage in deliberate institutional design to create a market that did not exist before, in contrast to a more organic process of market emergence. Emergent processes, with distributed trial and error learning, more effectively capture and reflect the private and often tacit knowledge embedded in the subjective preferences and opportunity costs of the individual participants, and market designers ex ante do not have access to that knowledge when they are making design decisions unless they go out and try to learn about it.

Synthetic market designers are also teleological — they have a goal in mind, typically a policy goal, and design rules to shape incentives with the aim of achieving that goal — in contrast to the more open-ended nature of markets where the people who have the goals are the individual participants, and the market institutions evolve and change over time to better enable individuals to coordinate and to meet their individual goals mutually through markets. By designing to achieve a shared goal, synthetic market design prioritizes that goal without knowing the preferences of the participants and whether they value using resources toward that goal relative to the other ways they can use their resources and create new resources.

In cases where property rights are never going to be well-defined, though, synthetic markets can yield better outcomes than the realistic feasible political alternatives. In many environmental contexts the realistic alternative is command-and-control regulation rather than the utopian ideal of well-defined property rights and markets with low entry barriers.

I am concerned about these epistemic aspects of synthetic market design. Designing market rules to achieve specific outcomes can involve overlooking the wide range of unknowable incentives facing market participants, so they may not make choices in the way that the designers expect. The designers also may not pay enough attention to the emergent, organic nature of market processes, and may be overly prescriptive in their rules. And, to quote the great philosopher Yogi Berra, prediction is hard, especially about the future, so the designers may come up with an institutional framework that suits a specific context and goal, but then as economic and technological change happen, how well will that framework adapt to unknown and changing conditions? And will that framework foreclose choices that might be more beneficial/value-creating/cost-minimizing/innovation-inducing? Synthetic market design is really difficult, for all of these reasons.

These epistemic issues illustrate why testing is an essential aspect of synthetic market design (a point I argued in a paper in the Electricity Journal). Field experiments such as the two papers highlighted here provide estimates of how people respond to the incentives in a particular institutional framework, the magnitude of the responses, whether they yield any unintended consequences, and some estimate of whether or not the design process is worth it (which inescapably involves normative assumptions and value judgments). Doing comparative institutional analysis, where the treatments are different institutional arrangements, can deepen those insights and help minimize the costs associated with deliberate institutional design in an organic, complex system.