Prize for guessing

“Adam Smith’s classical metaphor of the invisible hand refers to how the market, under ideal conditions, ensures an efficient allocation of scarce resources,” the Nobel Committee stated, while awarding the world’s highest award an economist can aspire for. “But in practice conditions are usually not ideal; for example, competition is not completely free, consumers are not perfectly informed and privately desirable production and consumption may generate social costs and benefits.”

The question the three economists have answered is: when the invisible hand is not working and transactions take place as bargains between individuals and interest groups and “under a host of other institutional arrangements”, how well do such allocation mechanisms perform? Is there an “optimal mechanism” to serve goals like social welfare? Or, how important and relevant is government regulation and how is it best designed?

In three words the answer is: mechanism design theory — initiated by Hurwicz in the 1960s and 1970s and developed by Maskin and Myerson in the 1970s and 1980s. “The theory,” says the Committee, “allows us to distinguish situations in which markets work well from those in which they do not. It has helped economists identify efficient trading mechanisms, regulation schemes and voting procedures.”

Trading, of course, is an important application, but according to the Committee, “The theory admits a sophisticated analysis of institutions for the provision of public goods, of optimal forms of regulation, and of voting schemes.” The theory delivers a coherent framework for analysing “allocation mechanisms”, including the dilemmas associated with incentives and private information.

Most importantly, there are policy gleanings to be extracted, particularly under conditions when the market mechanism is not the most efficient allocator of resources. “In such cases, mechanism design theory can be used to identify other, more efficient institutions. A classic example concerns public goods, such as clean air or national security,” the Committee notes.

The theory has lessons for regulators too. From an ad hoc rate that a monopolist must earn and one that regulators generally sanction to the understanding that the regulatory process is a game of incomplete information, for instance. The work of this troika has generated new tributaries of knowledge that, over the years, “has provided a solid theoretical foundation for evaluations of alternative regulatory mechanisms, such as price caps versus cost- and profit-sharing schemes.” Knowledge that policymakers here must use as they model future physical and financial infrastructure through PPPs and regulatory infrastructure through SROs, disclosures and transparency.

From policy, the theory expands its application base to the polity as well, and intrudes very elegantly into the realm of political economy. “More generally, the theory can be used to analyse the economic efficiency of alternative institutions for the provision of public goods, ranging from markets and consensual collective decision-making through majoritarian decision rules all the way to dictatorship.” Maybe there are lessons for the UPA administration on how best to negotiate the Congress-Left face-off on 123.

Hurwicz’ two papers — ‘Optimality and informational efficiency in resource allocation processes’ (1960), and ‘On informationally decentralised systems’ (1972) — provided the base for the theory, when he defined a mechanism as a “communication system”, that contains within it private information (or lack of it) and within which each economic agent tries to maximise utility. Later, in 1977, Maskin expanded the theory with Nash equilibrium and welfare optimality; and Myerson in 1981 with optimal auction design.

Among all of them, I found Maskin’s (co-authored by Jean Triole) March 2004 paper ‘The Politician and the Judge: Accountability in Government’ interesting as it explores a model (economists just can’t do without it) that attempts to capture the virtues and drawbacks of making public officials accountable, by which they mean “subjecting them to re-election”. It further explores “when decision-making powers should be allocated to the public directly (direct democracy), to accountable officials (called “politicians”), or to nonaccountable officials (called “judges”).

Minus the math, their conclusions (“Nonaccountability is most desirable when (a) the electorate is poorly informed about the optimal action, (b) acquiring decision-relevant information is costly, (c) feedback about the quality of decisions is slow. Therefore, technical decisions, in particular, may be best allocated to judges or appointed bureaucrats”, for instance) should provide adequate intellectual spinach for anyone interested in governance issues — or even in governing.