# Outside the Beltway

## The Nobel Prize in Economics

This year the Nobel Prize for Economics went to Leonid Hurwicz, Eric S. Maskin, Roger B. Myerson for the rather esoteric field of mechanism design.

What is mechanism design? Well it is basically a branch of game theory (a field in mathematics) that looks at how to come up with ways to do things so that everybody’s incentives are in alignment. The basic example is cutting a cake. Suppose you have two kids who tend to squabble quite a bit and you want them to share a cake. So how do you get them do split the cake and at the same time keep them from fighting about it? Have one child cut the cake and the other gets first pick. This “mechanism” will induce the child cutting the cake to make the cut so that the resulting pieces are as equal as possible.

In terms of more real world applications the mechanism that mechanism design come up with are a bit more complex…to put it mildly. Mechanism design takes into account the institutional frame work in which exchange takes place and also takes into account the incentives of the actors in question and incorporates different information structures. For example, you might have a firm that wants to higher people who will put forth a given level of effort. However, the amount of effort that people put into work is not immediately available to the firm. So, how do you structure a mechanism that induces everyone to reveal the truth, and can you come up with such a mechanism?

Another application is public goods. The primary problem with private provision of public goods is that each individual has an incentive to lie about how much they value the public good. If everyone else tells the truth and I lie, then I’ll pay very little for the public good while everyone else pays their “fair share”. In this case the level of the public good provided (assuming a decent number of tax payers) will be close to optimal, and given the nature of public goods, I’ll still get to consume it. If everyone else lies and I tell the truth, then the amount of the public good will be quite low and I’ll have a fairly high tax. If everyone lies, the amount of the public good provided wont be that much different than the previous case and I’ll have a low tax burden. So lying about how much I value the public good is always the best strategy. In game theory terms this is called a dominant strategy.

Mechanism design looks at these kinds of issues in a mathematically rigorous manner and tries to find the best outcome given various incentive constraints that have to be met. The knee jerk reaction by some is that this field of research is nothing more than an attempt to justify socialism, government interference, etc. This is silly since mechanism design has in some cases pointed out that private institutions are better than collective/governmental mechanisms. For example, double blind auctions. A double blind auctions can be efficient even when traders have private information about how much they each value the good being auctioned off.

Hurwicz is the the grandfather of mechanism design. It was Hurwicz that introduced the key notion of incentive-compatibility. The idea here is that for any mechanism to work it must be compatible with all the participants incentive constraint. The incentive constraint insures that the participant will want to participate in the “game” versus walking away to find a more lucrative game. The contributions of Maskin and Myerson are a bit more…esoteric.

I agree with Alex Tabarrok’s view of mechansim design,

More realistically, I see mechanism design as a tool to make markets more powerful. In some situations, for example, mechanism design shows that public goods can be voluntarily provided. In other situations, mechanism design can make government more effective, but it will do so by making government more “market-like.” Contracting-out of government services like garbage pickup, prisons, and roads, for example, can be carried out even farther if contracts are more carefully designed. The theory of mechanism design provides the template for thinking about the best possible types of contracts.

One of the key points here is that incentives matter, and when crafting policy if you ignore incentives put everything at risk. For example, was there due consideration to the effects of Social Security on the incentives to save for one’s retirement? How about Medicare and saving for future medical expenses? Given when these policies were put in place my guess is the answer is a big fat NO, which is why we are facing some of the problems we are today.

##### About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

1. ken says:

And when the highways were built I bet there wasn’t due consideration given to the adverse effect this would have on peoples need to store grain for winter either. If people could put off storing grain in their homes just because they could easily buy it whenever they wanted to in a grocery store what kind of society would we have? French?

2. yetanotherjohn says:

As the father of two boys, I highly resent the implication that ‘first one cuts, second one chooses’ is in any way not a ‘real world application.

What is even more fun is seeing them divvy up the days chore list. I hold both of them responsible if the chores are not done and if they use me to “record” their chore division, I’ll enforce their agreement (I think that gets into the incentive compatibility issue). Some chores are just about every day (emptying the dish washer, setting the table), some are once a week (taking the trash can to the curb) and some have no periodicity. So they will negotiate between them as to who does what. Some chores they split (you unload the top half and I’ll unload the bottom half of the dish washer) while others are split by job 1 vs job 2. They have become pretty efficient at estimating the work, proposing a division of labor and implementing the work.

Now if I can just find an incentive to get them to anticipate the chore list so that they get the chores done without my having to ask.

3. Tano says:

“So lying about how much I value the public good is always the best strategy.”

Thanks for this light-bulb moment Steve. Suddenly I understand Republican propaganda in a whole new light.

4. Steve Verdon says:

Thanks for this light-bulb moment Steve. Suddenly I understand Republican propaganda in a whole new light.

You Tano, you shouldn’t let your ideological biases blind you so. The idea about lying about one’s preferences are true irrespective of political party…unless of course you also hold the belief that Democrats are simply stupid.

Then again, that would explain alot.

5. Mithras says:

Given when these policies were put in place my guess is the answer is a big fat NO, which is why we are facing some of the problems we are today.

With regard to social security, there is no problem. The program works fine, and will work fine for decades to come with some minor tweaking, such as increasing both the employer and employee shares from 6.2% to roughly 7.05%. We could further reduce this already trivial tax increase by doing something like raising the cap.

I know it’s rightwing conventional wisdom that social security is in trouble, but it’s just not true.

6. yetanotherjohn says:

Mithras,

All the SSI has is government paper saying the government owes itself. It would be like you writing an IOU to yourself for a billion dollars and then declaring yourself a billionaire. But then, maybe that is the solution. We just have everyone write a check to themselves for each SSI payment and then we won’t have to worry about the SSI not being able to make the payments.

7. Steve Verdon says:

With regard to social security, there is no problem. The program works fine, and will work fine for decades to come with some minor tweaking, such as increasing both the employer and employee shares from 6.2% to roughly 7.05%.

So you actually advocate increasing an already rather regressive tax. And that is a pretty big increase in taxes (a 13% increase) and considering that for low income earners labor markets are pretty comepetitive the actual tax change would be going from 12.4% to 14.1%. And last, that assumes an increase immediately. The longer it is put off the bigger the tax increase will have to be to return the system to balance.

Nevermind that if we had fixed this back in the early 80’s by allowing more choice on what to do with Social Security payments we’d probably not be in this mess. And lets also ignore that back in the early 80’s the fix then was supposed to solve the problem for the next 75 years at least. Nope, lets keep “permanently fixing” a program that wont stay fixed.

8. Ed Clarke says:

On mechanism design “solutions” to the public goods problem, see Clarke weblog. Also, letter to Nobel Prize Committee on “Originality in Mechanism Design” at Ed Clarke’s weblog