"WHAT on earth is mechanism design?" was the typical reaction to this year's Nobel prize in economics, announced on October 15th. In this era of "Freakonomics", in which everyone is discovering their inner economist, economics has become unexpectedly sexy. So what possessed the Nobel committee to honour a subject that sounds so thoroughly dismal? Why didn't they follow the lead of the peace-prize judges, who know not to let technicalities about being true to the meaning of the award get in the way of good headlines?
In fact, despite its dreary name, mechanism design is a hugely important area of economics, and underpins much of what dismal scientists do today. It goes to the heart of one of the biggest challenges in economics: how to arrange our economic interactions so that, when everyone behaves in a self-interested manner, the result is something we all like. 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.
The real world rarely behaves like economics models do, so mechanism design is used to design markets and auctions that will better reflect the actions of the participants. Mechanism design is also used to look at how companies behave and to consider how governments can best provision public goods like defense or infrastructure. In general, mechanism design is applied to interactions where people or companies participating in the mechanism may have reasons to behave in a non-truthful or less than optimal way, and attempts to create rules and incentives to discourage this unwanted behavior.
The winners of the 2007 Nobel Memorial Prize in Economics, announced yesterday, are Leonid Hurwicz, Eric Maskin, and Roger Myerson. The three men received the prize for their work on "mechanism design theory," a field of economics that focuses on creating incentives and rules for an economics interaction such that the desired outcome or some desirable properties are achieved.
Hurwicz began working on mechanism design over 50 years ago by applying mathematical analysis to companies and economics systems like capitalism and socialism. His major theoretical contribution is "incentive compatibility," where participants in a mechanism will want to vote or play honestly. It's an important result, since we tend to want mechanisms like voting systems to encourage truthful voting, rather than encouraging people to disguise their true opinions.
Although "mechanism design theory" may not sound like something you or I would need to interact with very much, it pops up in quite a few places. Take the upcoming 700MHz spectrum auctions, for example. For this auction, the government has some set of goals, including perhaps getting some payment and fairly allocating the spectrum. The companies also have goals, which may be to gobble up as much of the spectrum as possible. By applying some mechanism design theory to the situation, economists can then design an auction mechanism that best meets the goals of all the parties. This type of game theoretical analysis of auctions has been done by Roger Myerson, whose work has influenced these types of spectrum auctions.
Software patents are another area where mechanism design comes into play. One of the Nobel laureates, Eric Maskin, has done some work on patent valuation. In particular, Maskin is critical of the software patent system, which he believes is harmful to innovation when new inventions are closely related to old ones. His (very) basic argument is that in many technology fields, competition is actually better for firms in the long run. Patents generally lead to less innovation in a particular field, and also lead to less competition since companies can't work on the same types of products. Thus, in the end, patents are bad for software and technology companies, because of how they limit competition.
If you're at all interested in mechanism design theory, I would highly recommend checking out the scientific background for the prize, since it provides a nice overview of the key results from the work of Hurwicz, Maskin, and Myerson. It can be a bit daunting to delve into, particularly since it's not a field of economics that gets talked about at your average cocktail party, but it's worth a look due to the sheer number of social and governmental situations that rely on mechanism design to operate more efficiently