October 18, 2007


Intelligent design: A theory of an intelligently guided invisible hand wins the Nobel prize (The Economist, 10/18/07)

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 person's 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 information”—the 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 something—a product, say, or their labour—if 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 economist's holy grail, known as Pareto efficiency, even if everyone's 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.

When Darwin applied economic theory to biology he just imported the intelligently designed mechanisms without understanding what he was doing.

Posted by Orrin Judd at October 18, 2007 6:21 PM
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