Mechanism Design and the Theory of the Firm

15 October 2007 at 5:30 pm 5 comments

| Peter Klein |

I’ve been asked a few times today what I think of the Nobel Prize to Hurwicz, Maskin, and Myerson for mechanism design. (And, more than once, “What the heck is mechanism design?”) Briefly, mechanism design is the study of rules or contracts (“mechanisms”) that give agents incentives to do what a designer wants — for instance, revealing private information. A simple example is the ticket-pricing rules used by airlines. To maximize revenue, airlines want to charge high prices to business travelers (with presumably inelastic demands) and lower prices to leisure travelers (with more elastic demands). But airlines don’t know which travelers are which type. They can’t can’t simply ask, upon booking, “Are you going on a business trip?” because people would lie. Instead, the airlines give lower-priced tickets to travelers who buy their tickets in advance, will take a non-refundable ticket, are willing to stay over a Saturday night, and so on, assuming that people willing to abide by those restrictions are probably leisure travelers. These rules constitute a mechanism that provides incentives for agents to reveal their types to the principal (or “proposer”).

The WSJ offers this roundup of economics commentary on the Prize. You can find plenty more using your search engine of choice. What does any of this have to do with organizational economics, the theory of the firm, institutions, entrepreneurship, and other topics enjoyed here at O&M? Here are some random thoughts (I hope Nicolai and Dave will chime in soon with their own reactions).

1. To start with the obvious, this is very abstract work, highly technical and mathematical. You’ll read a lot in the news and on blogs about applications to auction design, voting rules, regulation under incomplete or imperfect information, and the like. But there are few example of real-world policies, institutions, or contracts that are informed by the specific technical results of mechanism design theory (aside from the general, intuitive results, such as those described in the airline example above).

2. Though the work has obvious implications for organizational design, Hurwicz wasn’t originally interested in firms, but in central planning. He and his colleagues at the Cowles Foundation in the 1960s wanted to build on the Walrasian market-socialist theory of Lange, Lerner, and Taylor to create formal, mathematical models of economies with imperfect information.

Combining these first two themes, Philip Mirowski puts it this way in his interesting 2002 book Machine Dreams:

What strikes the outside reader [about Hurwicz’s work in the 1960s] is the extent to which issues of the specification of actual market coordination . . . were persistently elided in favor of notional comparisons to the benchmark Pareto optimality of the posited Walrasian model. These supposed “mechanisms” bore no detectable relationship to specific market institutions or to well-defined algorithmic or cognitive science conceptions of information processing. It was yet another manifestation of the Cowles fascination with an “institution-free” market, as Hurwicz was the first to acknowledge: it was the formal investigation of “many constructs which according to my definition are mechanisms, although they may not resemble any mechanisms which exist or even one that I would seriously propose.”

3. An important paper using mechanism design to understand the internal organization of the firm is Holmstrom and Tirole’s 1991 JLEO paper on transfer pricing. They model transfer-pricing schemes as mechanisms general managers can use to elicit truthful information about revenues and costs from divisional managers. In general, though, the literature on the theory of the firm has moved in the direction of incomplete contracting (under the influence of Williamson and Hart), rather than the complete-contracting framework of mechanism design and formal agency theory. Williamson (1985, p. 182) says mechanism design is appropriate for “the case where parties are opportunistic and assets are specific but economic agents have unrestricted cognitive competence.” In other words, not many cases. More specifically:

[Mechanism design] is akin to the earlier contingent claims contracting literature [i.e., the Arrow-Debreu model] but moves beyond it by admitting contracting complications in the form of private information. Complex problems of incentive alignment are posed (which the contingent claims contracting literature had ignored) if full and candid disclosure of private information cannot be assumed. In other respects, however, the mechanism design and contingent claims literature are very similar: both resolve all of the relevant contracting issues in a comprehensive ex ante bargain, and both assume that court ordering is efficacious. (p. 192)

4. Hurwicz is apparently a terrific teacher. Three of my colleagues are Minnesota PhDs and they say his classes were legendary. (They also tell me he pronounces his name “HER-vich,” with a hard v.)

Update (16 October ): Of all the commentaries I’ve read over the last two days, only this one from Joshua Gans focuses on the revelation principle, the main result of modern mechanism design. Joshua also has a delighfully simple illustration:

I use [mechanism design] I use it in the house to reveal the truth from children. A typical claim made by them is: “I’m hungry. Can we have some ice cream?” To test this, I put forward the mechanism: “No, but if you are really hungry, I have some carrots.” That reveals the hunger truth every time.

Entry filed under: - Klein -, Theory of the Firm.

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5 Comments Add your own

  • 1. dhoopes  |  15 October 2007 at 9:07 pm

    Seems like a pretty odd choice for a Nobel prize. As much as I stick up for economics, I wonder that there aren’t some economists whose work has been more useful. How about Demsetz? However, some of the other prizes this year are…questionable.

  • 2. dhoopes  |  18 October 2007 at 2:33 pm

    I’m a little disappointed in the lack of response to the Noble prize announcement. Other econ-type sites have many more comments. Does this mean that Peter is the only one around here that understands the award winning work enough to comment on it? Is it as detached as critics say? Or, is it more useful as others say? Shouldn’t the award have gone to Williamson? Let’s face it, Ollie is very influential. Coase would not have won had it not been for Williamson. Oliver Hart. My personal favorite (again) is Harold Demsetz. Has Alchian won? I had thought he had if not, that’s probably overdue (he is heavily cited in a few major literatures).

  • 3. srp  |  18 October 2007 at 10:20 pm

    I think the prize is well-deserved, because the logic of mechanism design is so fundamental to problems in taxation, contracting, regulation, etc. This kind of fundamental theoretical work is the capital investment of economics–it doesn’t have direct end uses most of the time (with exceptions such as auctions), but it assists in the roundabout production of theories and applications. It’s pretty hard, for example, to solve a lot of principal-agent models without recourse to the revelation priinciple, so proving when it’s valid is important.

    I certainly think Alchian would be very deserving for his pioneering idas in search theories of unemployment, or his analysis of costs, or his paper on evolutionary arguments for competitive efficiency. His only realistic chances, in my opinion, would be a package deal with Demsetz and Williamson for theory of the firm or a hookup with Nelson and Winter for evolutionary economics.

  • […] This problem is example of mechanism design theory, which is the study of creating rules and incentives to allocate resources in what the designer sees as an efficient or fair way. The field has gotten attention recently because of the recent American Nobel Prize winners. Mechanism design is the theoretical basis for why markets in general work, but it also comes up in many situations, like how airlines creatively price tickets. […]

  • 5. Ed Clarke  |  28 October 2007 at 1:15 pm

    See letter on:
    Originality in Mechanism Design
    Clarke weblog

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