Mechanism design theory

2007-10-29

in Economics, Geek stuff, Law, Politics

Window and shadows in Montreal

The 2001 Nobel Prize in Economics was awarded to George Akerlof, Michael Spence, and Joseph Stiglitz for their work on asymmetric information. One standard assumption in neoclassical economic models is that all participants in a transaction have ‘perfect information’ about the goods or services being exchanged. The field of behavioural economics is now seeking to deepen such models, so that they can better reflect the kind of dynamics that exist in real markets.

Asymmetric information is a key factor in the functioning of real markets. When you buy a used car, the person at the lot probably knows more about it than you do. The salesperson knows more about used cars in general, may have spoken with the original seller, and may have investigated this specific car. Conversely, you know more about your health risks than your health insurer (provided you live somewhere where health insurance is private). You might know, for instance, that all your relatives die of heart attacks on their 35th birthdays and that you personally drink 3L of whisky per day.

This year’s Nobel Prize in Economics was awarded to Leonid Hurwicz, Eric S. Maskin, and Roger B. Myerson for their work on mechanism design theory. The basic purpose of the theory is to deal with problems like those of assymetric information: take a situation where people would normally have an incentive to behave badly (lie, cheat, etc) and establish rules to make it no longer in their interest to do so. We might, for instance, require used car salespeople to provide some sort of guarantee, or we might allow health insurers to void the policies of individuals who lie about their health when premiums are being set.

Reading about mechanism design feels a bit like watching engineers try to create religious commandments. This section from the Wikipedia entry illustrates what I mean.

Mechanism designers commonly try to achieve the following basic outcomes: truthfulness, individual rationality, budget balance, and social welfare. However, it is impossible to guarantee optimal results for all four outcomes simultaneously in many situations.

While it does seem a bit counterintuitive to try to achieve these things through economic means, it is probably more durable than simply drilling axioms into people’s heads. That is especially true when the counterparty they are dealing with is some distant corporation; people who would never cheat someone standing right in front of them are much more willing to deceive or exploit such a distant and amorphous entity.

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{ 3 comments… read them below or add one }

. October 29, 2007 at 10:08 am

From Nature:

Time to ditch Kyoto
Climate policy after 2012, when the Kyoto treaty
expires, needs a radical rethink. More of the same
won’t do, argue Gwyn Prins and Steve Rayner.

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Neal October 30, 2007 at 1:36 am

“we might allow health insurers to void the policies of individuals who lie about their health when premiums are being set.”

I see no potential for abuse here.

Milan October 30, 2007 at 10:07 am

Neal,

The potential for abuse by both or either parties is exactly the issue under consideration. I agree that health insurers could abuse an ability to void coverage. Theoretically, this is the kind of problem mechanism design theory lets us solve.

I would like to see a comprehensive example of how the theory is applied.

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