Why You Should Care About the 2007 Economic Nobel

"Is there something interesting to say about this year’s Nobel Prize winners?" challenged my colleague next door. Could I explain what Leonid Hurwicz, Eric S. Maskin, and Roger B. Myerson did that was so great?

"Yes!" I replied. "Their research on 'mechanism design theory' broadly, and incentive compatibility and preference revelation specifically, are an important part of several sub-fields including game theory, public economics, and even some social choice theory."

"No," he said, "something interesting to the broader public." Hmm, well that’s harder. I sent him packing (literally -- he caught a flight to LA). And I also sent the idea to the back-of-the-brain.

Fortunately, the back-of-the-brain has lots of things bouncing around. While there, "mechanism design" met Al Gore and had a chat with carbon cap-and-trade policy. And I realized that the way to understand the importance of this year's economics Nobel was to take a look at how we debate the usefulness of markets.

A key insight of mechanism design theory is that real-world economic transactions differ from an abstract "market" where a price falls from heaven and trade happens. When engaging in trade in the real world, economic actors (buyers and sellers), must abide by certain rules and/or norms (e.g. Is it ok to negotiate? Can you make more than one counter offer?). Mechanism design shows that the economic outcomes, including market efficiency, can be dependent upon those rules.

Thus all "free-markets" are not equal. In fact a marketplace does not exist independently from its rules and norms -- they one and the same. Saying that "the market works" to allocate resources depends on the specific market design and conditions. Thus (and contrary to much conservative rhetoric) economic theory -- of which mechanism design is a part -- does not say that markets always achieve an efficient outcome. Mechanism design can help us better understand when markets do perform well. And when markets no not reach an efficient outcome, mechanism design theory can suggest mechanisms that might work better.

The theory also points out that economic actors have an incentive to hide their true feelings about the product. So, if you walk onto a used car lot, you would be foolish to let the salesman know exactly how much you like that '67 Chevy. And the seller would be foolish to let you know that he has not gotten a single offer on the car in the six months it’s been on the lot. But at some point, either you or the salesman will have to make an offer to the other -- and in doing so, reveal some, but perhaps not all, of your true preferences.

The fact that people have an incentive to not reveal their true preferences has obvious important consequences for public policy. If people are asked if they want a new highway built, they might rightly worry that they will be asked to pick up some of the expense, and so might not fully reveal their true preference, opting instead to try to game the system as a free-rider. Economic research building from the Nobel winners’ work analyzed ways to get around this -- to provide a mechanism by which people would volunteer their true valuation of the highway, and thus better evaluate the merits of a project that would benefit an entire community. (The key of this particular mechanism is to link an individual’s valuation response to the decision to build or not, but to de-link the exact amount they would pay).

The Nobel prize in economics was awarded not so much for the particular insights noted above, but rather for working out all the implications for economic thinking in various situations -- for example, deriving conditions under which there are efficient equilibriums (an exercise only an economist would love). More generally however, the insights from the theory help to explain how we can better design markets and public policy to reach an outcome that works for more people.

This brings us to global warming and cap-and-trade policy. If we -- and by "we" I mean the entire planet -- ever take global warming seriously, we will have to adopt some mechanism for reducing carbon emissions. A real program will require nations to implement some form of regulation and/or market mechanism to reduce carbon. But what kind of mechanism? How do we design a program that reduces carbon across nations? Some nations will be harmed significantly by global warming, while others will be better able to adapt, but in a negotiation, countries will have incentives to hide their true valuations, just like in the used car example above. Can we design a mechanism that is more likely to get nations to commit to reducing global greenhouse gases?

Now some of this analysis of global warming problem is pretty much standard economics of externalities (a la fellow Nobelists A.C. Pigou and Paul Samuelson), where the abatement of carbon pollution is seen to be a public good. But I suspect that the information asymmetries across nations will make the problem more complicated at the international level than a simple analysis would suggest. And the research by this year’s Nobel prize winners may prove to be very valuable indeed.

But that will have to wait for another day. For now, all I can think of is Al Gore riding around in a convertible '67 Chevy with three economists in the back seat.