2007 “Nobel prize” in economics

(The quotes are there because the real name of the prize is The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2007.) This year’s prize went to Leonid Hurwicz, Eric S. Maskin, and Roger B. Myerson, “for having laid the foundations of mechanism design theory” in the words of the official announcement. Here is the Riksbank’s scientific background document. I am delighted, because learning mechanism design theory has permanently changed my view of what economics is. I am also currently writing a book, with four graduate students as coauthors (make them write, they learn better), on this very subject. Even though I have not yet written a research article in the very heart of the subject, all my work and thinking in economics has been informed by it.

But what is this subject? In the simplest of terms, it is what economics has been from its inception, but put in formal mathematical terms for deeper understanding: it is the study of how the economic system works via the incentives it creates in its participants, with the purpose of fiddling with it it make it work as well as possible. Mechanism design, our subject, leaves the question of what criterion to use to evaluate “as well as” open. Hence mechanism design is very widely applicable: if you want to figure out how to run an auction to rake in the most money, or how to limit free-riding of goods everyone can use without “using them up” (think highways, defense, basic research, the justice system, the kinds of goods economists call public goods), mechanism design theory is your friend.

Mechanism design also leaves the specifics of how people respond to incentives open, thus gaining very general applicability. The basic tool for examining incentives is game theory. Game theory traditionally assumes that people are “rational decision makers” and has succeeded well in explaining many features of social and economic behavior with this assumption, even when the “people” are animals other than of our cherished homo sapiens classification, as biologists have learned to their surprise.

Yet, a mounting criticism of game theory has been that people depart from its traditional version of “rational” behavior altogether too often and in a systematic way. Critics therefore would love to accuse mechanism design theory of using the wrong tool in relying on game theory, and many do so. But the very abstraction of mechanism design theory, derided today at the EconLog blog, means that it is open to change. Nothing prevents mechanism design theorists from using improved game theoretic tools, tools that incorporate more realistic behavior of individuals, to give ever better recommendations for improvement of our rules for interacting with one another.

Contrast this with the fate of economic theory that insists on the “market” paradigm (quotes again: just like “rational” above, “market” is a term without a good definition, despite its widespread use, but this topic could be another very long blog post). Such market theory must, and does, distort every aspect of economic behavior so it can be discussed in terms of demand and supply. For important economic fields (here go those public goods again), this approach is fundamentally misguided. That’s how you can get deregulation efforts to lead to entrenched oligopolies (telecommunications, anyone?) and ENRON type frauds.

Without understanding incentives, you cannot understand markets (whatever they are). And without understanding them, you are bound to misapply what you think you know about them. Mechanism design theory attempts to shed light to market and non-market activity. It is basic research, it is abstract and sometimes difficult to follow, but it is our best chance for making progress in improving our economic and other institutions.

Hurray for this year’s winners! And a sincere thank you to them for opening up this road to understanding and improving human interaction.

Addendum: Here’s Alex Tabarrok’s attempt to explain the prize to Grandma, on marginalrevolution.com. Here are four more posts on the same blog on the topic: one, two, three, four. The last three give overviews of each winner’s contributions. As the one on Maskin concludes, “good luck reporters!” Yes, it is hard what these guys did, but someone needs to do the rocket science!