The 2007 Nobel Prize: Mechanism What?

The 2007 Nobel Prize in Economics went to Leonid Hurwicz, Roger Myerson, and Eric Maskin for “having laid the foundations of mechanism design theory.”

Mechanism design isn’t covered in the typical introductory economics class. The narrative of your first econ class usually goes something like this: “The ‘invisible hand’ of the free market is the most efficient way of answering the fundamental economic questions: what to produce, how to produce it, and who consumes it. Sometimes the market doesn’t work—for example, in the case of externalities or public goods.”

In short, a single mechanism—the “market”—is usually the topic of discussion for intro courses. But there are lots of other mechanisms for answering these fundamental questions. And unlike the market, which is a decentralized mechanism (meaning it is not run by a central authority), there are plenty of man-made institutions that are centralized mechanisms. One example of such a mechanism is an auction, which allocates goods according to bids. Another is a political election, which allocates political power according to the preferences of the electorate. Both auctions and elections have rules, and these rules determine the optimal behavior of bidders and politicians.

One of the biggest challenges of designing an economic mechanism is that people have private information about their own preferences. One of the most famous examples of a mechanism design problem is the provision of public goods. Suppose a small town is considering the establishment of a public park in the town square. Should it ask the citizens how much each of them would value the park, and ask them to contribute that amount? Clearly, each of the citizens would have an incentive to “free ride” on their neighbors by understating their own value of the public good—so as a mechanism, just asking for voluntary contributions leaves a lot to be desired.

We will be creating a news analysis assignment about mechanism design for professors who use Aplia in their classrooms. In the meantime, here are some discussion questions to get the ball rolling.

Discussion Questions

1. “Market failure” often occurs when dealing with things other than purely private goods—for example, public goods, common resources, or goods with externalities. One solution to market failure can be broadly categorized as “market solutions.” An example of such a market solution is the levying of a Pigovian tax, which keeps the basic mechanism of the market but alters the incentives of participants. Another solution to market failure would be to replace the market with another institution entirely. For example, the right to use a specific frequency of the wireless spectrum is allocated by the Federal Communications Commission using an auction mechanism. Can you think of other examples of market failure that we address by using centralized mechanisms? What are the advantages and disadvantages to centralized mechanisms as opposed to market solutions?

2. The term “asymmetric information” refers to cases in which parties hold private (or hidden) information about their preferences or costs. One of the core challenges of mechanism design is to encourage people to reveal their private information in a truthful and credible way. For example, it is easy to show that the optimal strategy for a bidder in a Vickrey auction like eBay is to bid one’s true value. Think of a situation in which asymmetric information causes problems. What kind of mechanism could you design to elicit truthful information from the participants in that situation?

3. A recent Washington Post article has provoked a fair amount of discussion about the effectiveness of torture in acquiring information from prisoners. The most heavily quoted passage of the article reads:

“We got more information out of a German general with a game of chess or Ping-Pong than they do today, with their torture,” said Henry Kolm, 90, an MIT physicist who had been assigned to play chess in Germany with Hitler’s deputy, Rudolf Hess.

What do you think the economic study of mechanism design would have to say about torture? Is it an effective method for eliciting private information? How would an economist interrogate a suspected terrorist?