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PERSPECTIVES ON MECHANISM
DESIGN IN ECONOMIC THEORY
Prize Lecture, December 8, 2007
by
R
OGER
B. M
YERSON
1
Department of Economics, University of Chicago, 1126 East 59
th
Street,
Chicago, IL 60637, USA.
1. AN HISTORICAL PERSPECTIVE
Economics began with Xenophon’s “Oeconomicus” (c 360 BCE), in which
Socrates interviews a model citizen who has two primary concerns. He goes
out to his farm in the country to monitor and motivate his workers there.
Then he goes back to the city, where his participation in various political
institutions is essential for maintaining his rights to own this farm. Such
concerns about agents’ incentives and political institutions are also central in
economic theory today. But they were not always.
Two centuries ago, economics developed as an analytical social science by
focusing on production and allocation of material goods, developing meth-
odologies of national-income accounting and price theory. Questions about
resource allocation seemed particularly amenable to mathematical analysis,
because flows of goods and money are measurable and should satisfy flow-
balance equations and no-arbitrage conditions. From this perspective, the
classical economic problem was that people’s ability to satisfy their desires
is constrained by limited resources. The classical economic result was that
unrestricted free trade can achieve allocative efficiency, in the sense that real-
locating the available resources cannot improve everyone’s welfare.
A shift of focus from allocation of resources back to analysis of incentives
began from the time of Cournot (1838) when economic theorists began to
analyze optimal decisions of rational individuals as a tool for understanding
supply and demand in price theory (see Niehans 1990). In the first half of the
20th century, a few mathematicians began to formulate models for analyzing
rational competitive decisions in more general frameworks, laying the foun-
dations for game theory (Borel 1921, von Neumann 1928, von Neumann and
Morgenstern 1944, Nash 1951; see also Myerson 1999).
1
I am very grateful to the Prize Committee for inviting me today. I also want to thank my co-
authors and colleagues, at Northwestern University and at the University of Chicago, and my
friends and family who have come so far, especially Gina who has come the farthest with me.
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Within economics itself, a substantive need for analytical models that go
beyond the limits of price theory gradually became evident. In particular,
the inconclusiveness of economic theorists’ debates about socialism versus
capitalism showed the limitations of price theory for evaluating non-price
institutions like the socialist command economy (Barone 1935, Lange 1938,
Mises 1935, Hayek 1935). Price theory could show (under some conditions)
that free markets will achieve allocative efficiency, but such results about free
markets did not prove that socialist command economies could not achieve
similarly good outcomes. To allow analytical comparison of fundamentally
different forms of economic organization, a new and more general theo-
retical framework was needed. In an widely influential paper, Hayek (1945)
argued that a key to this new economic theory should be the recognition that
economic institutions of all kinds must serve an essential function of com-
municating widely dispersed information about the desires and the resources
of different individuals in society. That is, different economic institutions
should be compared as mechanisms for communication.
Hayek also alleged that the mathematical economists of his day were par-
ticularly guilty of overlooking the importance of communication in market
systems. But questions about fundamental social reforms require funda-
mental social theory. In a search for new fundamental theories, the abstract
generality of mathematics should be particularly helpful. So the failure that
Hayek perceived should not have been attributed to mathematical modeling
per se, but it was evidence of a need for fundamentally new mathematical
models. Among the mathematical economists who accepted this challenge
from Hayek, Leo Hurwicz was the leader.
The pivotal moment occurred when Hurwicz (1972) raised the basic ques-
tion of incentives to communicate information and introduced the general
concept of incentive compatibility. In doing so, he took a long step beyond
Hayek in advancing our ability to analyze the fundamental problems of insti-
tutions. From that point on, as Makowski and Ostroy (1993) have observed,
“the issue of incentives surfaced forcefully, as if a pair of blinders had been
removed.”
After Hurwicz (1972), many of us jumped into the breach to join the ad-
vance. From Harsanyi (1967), we had a general Bayesian model of games
where people have different information, and we had Harsanyi’s general
concept of Bayesian equilibrium to analyze rational behavior in such games.
In this framework, we saw Hurwicz’s theory of mechanisms as the foundation
of a theory about how to design Bayesian games. A coordination mechanism
is a plan for how social decisions should depend on people’s reported infor-
mation, and changing the coordination mechanism in a society effectively
changes the game that its members will play. Given the information, prefer-
ences, and resources that people have in a society, different social coordi-
nation mechanisms could yield different games, each of which could have
many different equilibria. But remarkably, the set of all possible equilibria
of all possible games can be simply characterized by using the revelation prin-
ciple, which many of us (Dasgupta, Hammond and Maskin 1979, Harris and