What is Mechanism Design? - Explaining the research that won the 2007 Nobel Prize in Economics

What is Mechanism Design? – Explaining the research that won the 2007 Nobel Prize in Economics

Posted on October 17, 2007 / 3 Comments

The 2007 Nobel Prize in Economics was awarded to Leonid Hurwicz, Eric Maskin, and Roger Myerson “for having laid the foundations of mechanism design theory”. But what on earth is “mechanism design theory”?

Adam Smith’s classical metaphor of the invisible hand refers to how the market, under ideal conditions, ensures an efficient allocation of scarce resources. But in practice conditions are usually not ideal; for example, competition is not completely free, consumers are not perfectly informed and privately desirable production and consumption may generate social costs and benefits. Furthermore, many transactions do not take place in open markets but within firms, in bargaining between individuals or interest groups and under a host of other institutional arrangements. How well do different such institutions, or allocation mechanisms, perform? What is the optimal mechanism to reach a certain goal, such as social welfare or private profit? Is government regulation called for, and if so, how is it best designed?

These questions are difficult, particularly since information about individual preferences and available production technologies is usually dispersed among many actors who may use their private information to further their own interests. Mechanism design theory, initiated by Leonid Hurwicz and further developed by Eric Maskin and Roger Myerson, has greatly enhanced our understanding of the properties of optimal allocation mechanisms in such situations, accounting for individuals’ incentives and private information. The theory allows us to distinguish situations in which markets work well from those in which they do not. It has helped economists identify efficient trading mechanisms, regulation schemes and voting procedures. Today, mechanism design theory plays a central role in many areas of economics and parts of political science.

A concise but useful introduction is at http://reason.com/news/show/122998.html while those who need advanced information will find the following two links interesting.

http://nobelprize.org/nobel_prizes/economics/laureates/2007/info.pdf
http://nobelprize.org/nobel_prizes/economics/laureates/2007/ecoadv07.pdf

3 Comments

Amith
October 23, 2007, 4:07 am
Chanuka, good to see somthing simple written on the subject. But, why make it so verbose? Isn’t this simply a way of trying to model economic activity. taking into account of more realistic scenarios?

-Amith
Chanuka
October 23, 2007, 10:20 am
Amith,

Thanks for your input. Strictly speaking I am not an economist and according to what I understand designing a mechanism (institution) is like doing a Cesarean operation. Support the ‘natural’ process clearing the obstructions. (only in some cases.) The economist plays the role of the surgeon.

For example, in Sri Lanka both demand and supply exist for private university education, but it does not happen because of the state monopoly. Mechanism design, as I understand, involves designing a reform process that makes the supply meets the demand optimally. ie. largest number of students gets quality university education at the lowest cost. I do not think the market itself can automatically take care of it in this case. So somebody has to design a mechanism.

Is it simply a way of trying to model economic activity? I am not fully sure, but I think it is going one step ahead than modeling. If I take an analogy from electronics which is more familiar to me, it appears like closing the feedback loop of an amplifier.

When Rohan was at PIPU its motto was ‘Competition whenever possible, regulation where necessary’. Aren’t we talking the same thing in different words?
samarajiva
October 24, 2007, 12:08 am
Truly profound ideas in social science can always be expressed simply, but that does not mean that the rigor with which they are developed is meaningless. What appears simple now, was not simple or accepted when it was being developed.

See Myerson on Hurwicz:

http://home.uchicago.edu/~rmyerson/research/hurwicz.pdf