LAST YEAR, THREE AMERICANS WON THE NOBEL MEMORIAL PRIZE in Economics for laying the foundations of “mechanism design” theory. The work of Leonid Hurwicz, Roger Myerson and Eric Maskin was cited for its help in implementing efficient voting, trading and regulatory schemes.
In the laureates’ terms, a mechanism is a specification of the strategies available to every agent in an economy, along with the outcomes that would occur under every combination of strategies the agents might choose. The information available to an agent may be hidden from others, and an agent’s actions may affect not only his own welfare but also that of other agents. This situation is far more complicated than the old economic models of perfect competition.
Although fairly abstract, mechanism design allows for a much clearer understanding of efficient insurance policies, which retain the advantages of risk-pooling without inviting reckless behavior. Mechanism design has also been used to refine voting procedures in NCAA football rankings, match organ donors with recipients, and improve trading rules on stock exchanges.
The theory has had the biggest impact in the design of auction rules. Suppose there is an auction with a single item and where each bidder’s valuation of the item is private information. A natural design is the so-called first-price rule, where all participants submit secret bids, and the high bidder pays the amount he wrote. Unfortunately, a first-price auction can be economically inefficient, because it won’t necessarily channel the item to the bidder who values it most. This is because of strategic considerations; the bidder with the highest valuation may underestimate the bid of the person with the second-highest valuation, and so end up losing because he did not reveal his true valuation.
Switching to a second-price auction, where the high bidder only pays the second-highest bid, eliminates this problem. Here, it is a “weakly dominant” strategy for each bidder to write down his true valuation of the object; no one would ever regret doing so, because no matter what everyone else bids, it can only hurt to lie. The object thus goes to the bidder who values it most.
Second-price rules aren’t yet common, but they have been used in mail-order (and now Internet) auctions of stamps and other paper collectibles. Economic historians have documented a Massachusetts second-price stamp auction as far back as 1893.
The unfamiliar second-price auction with secret bids is actually strategically equivalent to the standard ascending-price oral auction. In both cases, the high-value bidder will win the item and end up paying about the value perceived by the second-highest bidder. The second-price secret auction is obviously much easier to implement than the ascending oral auction when the bidders aren’t all in the same place.
It’s real-world considerations such as these that upset the theoretical economist’s attempts to understand — let alone improve — market institutions. For a different example, many theorists are coming to realize that the only way to really make sense of certain features of e-Bay is to assume that the participants enjoy the process itself. They don’t merely view the auction as a means to acquire items as cheaply as possible, but (apparently) enjoy the competition and the thrill of victory. Single secret bids in a second-auction would be just as efficient, but maybe not as much fun.
Summing up the three economists’ work, the Nobel Prize spokesmen declared that mechanism design theory is essential to “distinguish situations in which markets work well from those in which they do not.”
Such doubts about the market economy are unfounded. The work of the Nobel laureates shouldn’t embarrass real capitalists.
Those who think that the insights of mechanism design constitute a critique of capitalism are making a fundamental mistake. Henry Ford revolutionized American industry, and greatly disrupted the existing pattern of resource usage. Does that mean Ford exposed flaws in capitalism? On the contrary, his pioneering achievements demonstrate the strength of the free market, which can tap the creative genius latent in the population.
The same is true when it comes to the innovations of Hurwicz, Myerson, and Maskin. Yes, the labor models of early 20th century economics did not capture the conflict of interest between shareholders and management. Yet this wasn’t evidence of a need for government regulation. The free market could and did come to the rescue with stock options and other novel compensation approaches to overcome the problems indicated by mechanism design.
Although some of the laureates’ theoretical results indicate the limits of markets, their greater goal was to learn the best way to exploit particular markets, since they are so much more capable of mobilizing what Friedrich Hayek called the “dispersed knowledge” in the economy. As Hurwicz said in a famous passage, “What economists should be able to do is to figure out a system that works without shooting people.”