Economics entered the Nobel league much after its counterparts. While physics, chemistry, medicine, literature and peace had their first awardees in 1901, the first prize in economics was given as late as in 1969. The latest to join the illustrious list are Leonid Hurwicz, Eric S Maskin and Roger B Myerson. These three American economists have been awarded the 2007 Nobel Prize for their pioneering contributions to the field of mechanism design theory.
To those unfamiliar with the concept, mechanism design might appear to be more in sync with applied sciences and engineering rather than economics. Indeed, the concept is so mathematical that it tends to the realm of abstraction. That doesn?t, however, mean that the Nobel committee has chosen the right people for the wrong reasons, or vice-versa.
Mechanism design is an important arm of game theory?a subject that has deeply influenced the evolution of modern economic theory. Game theory studies the interaction between different economic agents. It tries to visualise strategies that economic agents adopt under different situations to maximise returns. In other words, it tries to identify games that agents play to achieve their means, and the rules for such games.
Mechanism design employs mathematical tools and economic concepts to classify situations where markets fail to provide efficient solutions. Ideally, freely functioning markets, courtesy the ?invisible hand?, should clear prices that leave both producers and consumers happy. Such happiness, however, presupposes the presence of efficient institutions and adequate information on the part of both buyers and sellers.
Classical economics assumes that markets function under perfect conditions. In real life, however, imperfections characterise markets for practically all products and services. This is most relevant for public services. Market-clearing prices for many of these services create problems of affordability for a large numbers of consumers.
Mechanism design has also contributed to the better understanding of problems arising from the lack of adequate information on the part of market participants. This insufficient information leads to transactions that yield inefficient outcomes. Information asymmetry has indeed been a serious problem for arm?s-length transactions in knowledge-intensive products. Markets for technology and technology-intensive applications tend to suffer most in this regard.
Typically, buyers of advanced technologies from developing countries tend to be unaware of the intrinsic features of these technologies. Sellers, therefore, do not expect a premium for quality and are prone to transfer inferior products. Knowing this, buyers tend to bid lower. Sellers also tend to suppress information, as they fear disclosures might eat into their domain knowledge. Anticipating this again, buyers quote even lower prices. As the game goes on, with each party trying to anticipate and outdo the other, the market produces inefficient outcomes through adverse selection of low quality products.
Dismissing mechanism design as an abstract exercise in mathematical application with no relevance to real economic problems is grossly erroneous. In many ways, game theory and mechanism design not only help in identifying market imperfections, but also in proposing solutions. They pinpoint instances where the probability of market failure is high, thereby justifying a greater role for government. It?s ironic that even in supposedly free economic regimes, imperfections cripple the effectiveness of policy.
Such examples abound in emerging market economies like India, which despite embracing market-based principles, continues to rely on government intervention in several sectors to achieve efficient solutions. This apparent dichotomy is not hard to explain. While policies have become market-driven, institutions–at least most of them–have not. Imperfections, and the concomitant interventions, are therefore expected to continue.
So can mechanism design be used to achieve desired policy outcomes? Certainly, to the extent of drawing up the rules of the game in a manner that is conducive to yielding specific results. One of the best examples is designing auctions. This was effectively pursued during the sale of 3G mobile phone licenses in the UK in 2000. While one shouldn?t visualise the direct transplantation of game models in policy documents, the paradigms are germane enough to draw up efficient operating frameworks.
This is not the first time that pioneers of game theory have been awarded Nobel prizes in economics. Kenneth Arrow, George Akerlof and Joseph Stiglitz are notable examples. So there is little surprise in Hurwicz, Maskin and Myerson being picked for their contributions to the subject. Indeed, the award is probably long overdue, at least for Hurwicz, who first wrote about the subject more than six decades ago (?The Theory of Economic Behaviour?, American Economic Review, 1945). He now becomes the oldest person to receive the Nobel Prize. As game theorists will certify, in terms of outcomes, late is always better than never.
?The writer is a visiting fellow at Icrier. These are his personal views