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.

... contd.