Intelligent design A theory of an intelligently guided invisible hand wins the Nobel prize. Oct 18th 2007 From The Economist print edition http://www.economist.com/finance/economicsfocus/displaystory.cfm?story_id=9988840 WHAT on earth is mechanism design? was the typical reaction to this years Nobel prize in economics, announced on October 15th. In this era of Freakonomics, in which everyone is discovering their inner economist, economics has become unexpectedly sexy. So what possessed the Nobel committee to honour a subject that sounds so thoroughly dismal? Why didnt they follow the lead of the peace-prize judges, who know not to let technicalities about being true to the meaning of the award get in the way of good headlines? In fact, despite its dreary name, mechanism design is a hugely important area of economics, and underpins much of what dismal scientists do today. It goes to the heart of one of the biggest challenges in economics: how to arrange our economic interactions so that, when everyone behaves in a self-interested manner, the result is something we all like. The word mechanism refers to the institutions and the rules of the game that govern our economic activities, which can range from a Ministry of Planning in a command economy to the internal organisation of a company to trading in a market. Leonid Hurwicz, Eric Maskin and Roger Myerson won their third-shares of the $1.5m prize for shaping a branch of economics that has had a broad impact, both in academia, in subjects such as incentive theory, game theory and the political science of institutions, and in the real world. It affects everything from utility regulation and auctions to structuring the pay of company executives and the design of elections. Mr Hurwicz must be especially delighted as, aged 90, he is the oldest ever Nobel winner, and may have thought his chance had gone. He worked long ago with one previous winner, Kenneth Arrow, and was the graduate adviser to another, Daniel McFadden. One of his most influential papers was published when he was 55, about the same age his co-winners are now, which proves, if nothing else, that making big intellectual breakthroughs is not exclusively a young persons game. Mechanism-design theory aims to give the invisible hand a helping hand, in particular by focusing on how to minimise the economic cost of asymmetric informationthe problem of dealing with someone who knows more than you do. Trading efficiently under asymmetric information is hard, for how do you decide what price to offer someone for somethinga product, say, or their labourif you do not know at what price they would sell it? On the one hand, you may not offer enough to get them to deliver the product or work, or at least do so adequately; on the other, you may overpay, wasting resources that might have been better used elsewhere. Mr Hurwicz took up economics at a time when debate was raging about the relative merits of central planning and the market mechanism. While agreeing with the great libertarian, Friedrich von Hayek, that the dispersion of information was at the heart of the failure of planning, Mr Hurwicz saw that it went deeper than that. He observed that there was a lack of incentive for people to share their information with the government truthfully. Moreover, although the market mechanism was far less afflicted than central planning by such incentive problems, it was by no means immune from them. His big idea was incentive compatibility. The way to get as close as possible to the most efficient economic outcome is to design mechanisms in which everybody does best for themselves by sharing truthfully whatever private information they have that is asked for. Even this cannot guarantee an optimal outcome, Mr Hurwicz showed, because the existence of any private information precludes the economists holy grail, known as Pareto efficiency, even if everyones incentives are compatible. But it will get closer to it than if incentives are incompatible (ie, when some people can do better by not sharing information or lying). Pareto efficiency means that no one can be made better off without someone becoming worse off. Mechanism design has incentive efficiency: given compatible incentives, no one can do better without someone doing worse. Across the spectrum Mr Hurwiczs theories deployed some very elegant mathematics. Starting in the 1970s mechanism design was taken to a new level of sophistication and complexity thanks to the simultaneous boom in computing power and game theory. It was increasingly put to work on tasks ranging from how to auction a radio spectrum to devising a better way of paying defence contractors than cost-plus contracts (which create incentives for the contractor to be inefficient) or fixed-price contracts (which may result in overpaying). Mr Myersons biggest contribution to mechanism design is his work on the revelation principle, a mathematical method that simplifies calculation of the most efficient rules of the game for getting people to reveal their private information truthfully. Mr Maskins breakthrough was implementation theory, which clarifies when mechanisms can be designed that only produce equilibria that are incentive efficient. He has also given his name to a statistical condition called Maskin monotonicity, which might not be the sort of thing to mention at parties. The work of this years winners is closely related to that of several earlier laureates, including William Vickrey and James Mirrlees, John Harsanyi and John Nash, the game theorist whose life story was made into an Oscar-winning film, A Beautiful Mind. Mr Maskin lives in a house in Princeton once home to Albert Einstein (and at least one other Nobel laureate), and he dresses up as the great physicist at Halloween, so there may be the makings of a plot there. Yet, despite the importance of the topic, The Economist suspects there are no plans for Mechanism DesignThe Movie.
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