The Nobel Prize in Economics for 2007 has been awarded to Leonid Hurwicz, Eric Maskin, and Roger Myerson for mechanism design. Mechanism design is an answer to the question: what institutions and allocation mechanisms can work when the market fails to deliver efficient allocation of resources? Traditional microeconomic theory assumes that markets will provide perfectly efficient outcomes. However, it turns out that markets offer efficient outcomes only under very unrealistic assumptions. Markets often fail to allocate resources efficiently. No money would be spent on roads or sewage if left to the market. And, when markets fail, the crucial question is how to allocate resources efficiently. Mechanism design theory explains why there is no good solution to the provision of public goods. As people do not reveal their preferences as each wishes to be a free rider, markets fail to provide public goods.
While Soviet-style planners, including those in India, believed that the centralised state knew all the answers, Hurwicz, Maskin and Myerson tried to lay the foundations for understanding how second best solutions to the market could be found. Could markets be designed in such a way that the government/planner is able to allocate resources efficiently using the market mechanism? One example of the allocation of resources using the market mechanism by the state is an auction for telecom spectrum. While one option could be for the government to arbitrarily allocate spectrum, thinking that it knows best, another would be to set up an auction so that the spectrum is used most effectively to provide the services and outcomes it desires, while at the same time maximising the revenue that it earns from such an auction. The work of the Nobel Prize winners of this year lays the foundations for the work that led to auction design. This is only one example and the story is not over yet. Indeed, it may be argued that with the fall of the centralised planning system in many countries, this work will find more and more uses. The question about how to create incentives for revealing private information so that trading takes place in an manner that leads to efficient allocation of resources is going to be the focus of economics for many years to come.