The Hindu Business Line : ‘Mechanism design’ in this year’s Nobel

Irritated about the Rs 75,000 that he had lost in the stock market, Krishnan sat in a corner. “I am never…I mean NEVER going to that wretched place again…I have had enough of it,” he said to his wife Savithri who looked worried.

Both sighed as Krishnan slowly folded his socks into the shoes, anguish written all over his wrinkled face. As their daughter Priya came back after economics tuition, the couple quickly changed their mood and began humming a new Hindi song.

“Dad have you been trading again?” Priya asked.

“Yes”, he admitted for a change and confessed that he had just lost the money earned as performance bonus last year.

“Papa why do you trade…it isn’t an efficient system. Yet, even the Nobel committee seems to honour the idea,” Priya wondered.

Bridging the info gap

“The information gap between buyers and sellers, and the costs and consequences for the efficient operation of a market, are at the heart of the pioneering research by the winners of this year’s Nobel prize in economics…,” Krishnan’s teenage daughter read out from the newspaper which she handed over to him.

The Sveriges Riksbank Prize (Nobel Prize) in Economic Sciences has been awarded to the troika — Leonid Hurwicz, Eric S Maskin and Roger B Myerson — for having laid the foundations of mechanism design theory, he read aloud. “Where is the efficient markets thing…I can’t find it,” he looked rather annoyed.

“Hurwicz has been honoured for developing the mechanism design theory,” Priya said, donning the mantle of a teacher. “The theory basically analyses imperfections in the marketplace and helps set rules for transactions…ummm…His theories and mathematical models were later applied to problems far outside the usual reach of economists, helping to shed light on corporate policies, bond auctions, government structures, and even elections.”

Stock market connection

“But tell me how this is related to the Nobel Prize and the stock markets?” her father asked impatiently.

“See, mechanism design theory provides a coherent framework for analysing a great variety of institutions, or allocation mechanisms with a focus on the problems associated with incentives and private information.”

Why do some economic markets work efficiently, while others do not...Is this not a fundamental question that everybody asks when the final outcome of a transaction does not match the expectations?

“Let’s start from the beginning,” Priya suggested. The newspaper says there is a hole in the information. In economics that gap in knowledge is known as ‘information asymmetry’. It is one of the most widely studied aspects of the discipline… Did you know that the stocks you bought last week would be hit by the rules the government announced today?”

“No, I did not…which is why I bought them at a seemingly cheap price,” Krishnan replied as he rubbed his hands in despair.

“So obviously the person who sold you the shares had some information that others did not know of at that point of time. And the lower price was just a titillation, which worked well in his favour…because he probably knew that this was the best price he would get in some time,” Priya elaborated.

“Yes…Yes…obviously that crook knew it,” Krishnan said, jumping out of the chair.

“Because sellers seek the highest possible sale price, and buyers the lowest, and both parties have different levels of knowledge about the overall value of the transaction, the final outcome may not be efficient for the economy as a whole,” Priya explained.

“It is such breakdowns that mechanism design theory attempts to identify and avoid where possible,” she said.

“The field of mechanism design theory strives to methodically take into account the realities of economic existence, as real-world conditions have a propensity to make matters worse,” she added.

“Yes that’s very true,” Krishnan said. “Competition is not completely free; we, the consumers are not perfectly informed…then.

In everybody’s interest

Priya continued, “Now what this year’ Nobel prize winners did was to devise a theory that looks at how to come up with ways to do things so that everybody’s incentives are taken care of.

“You must have seen how two siblings fight for one piece of chocolate…haven’t you? So how to get them to split the chocolate bar and, at the same time, keep them from fighting about it?”

“Have one child break the chocolate bar while the other gets the first pick,” Priya answered coolly even as Krishnan understood the true potential of the statement.

Going into a longish silence, he realised that this results in inducing the child to break the chocolate in such a way that the resulting pieces are as similar in size as possible.

“Okay little lady I get the point,” he whispered after a few minutes.

When matters turn complex

“But in more real world applications, the mechanism that ‘mechanism design’ comes up with are a bit more complex as it takes into account the institutional framework in which exchange takes place, the incentives of the people in question and incorporates different information structures,” Priya continued.

“This is because it tries to look at issues in a mathematically rigorous manner and find the best outcome given the various incentive constraints. It’s like reverse engineering part of economics. Maskin has been quoted as saying that the starting point is an outcome that is being sought. Then through the design one works to design a system that aligns private incentives with public goals. This can really happen as Hurwicz introduced the key notion of “incentive-compatibility”.

“What is that? It’s getting confusing now,” Krishnan interrupted.

“It’s pretty simple. The idea here is that for any mechanism to work it must be compatible with all the participants’ incentive constraint. ‘Incentive constraint’ ensures that the participant will want to participate in the game as opposed to walking away to a more profitable game.

Like in an auction, the mechanism design theory can in fact squeeze potential buyers into making bids that reflect what they saw as the true worth of the asset/commodity. This, in a way, also prevents participating parties from conspiring to pay lower prices.

While Professor Hurwicz began working on forms of game theory (mechanism design is a branch of that), Myerson is one of the authors of an influential principle in the mechanism design theory — the Myerson-Satterthwaite theorem, which found that one side of a transaction stands to make a loss of some kind when two parties trade an article where they each have hidden and differing information. The last of the troika, Maskin has worked on the optimal design of auctions.

“Dinner is ready”, Savithri announced.

“Papa…The point is that by employing the mechanism design theory, authorities can keep in check the natural diversion of information between sellers and buyers to the point where the economy or society as a whole is not adversely effected,” Priya concluded.

“They ought to get such a system in the stock markets too,” Krishnan said as he washed his hands.

“Maybe they are doing it right now…but remember everybody will have to reduce their payoffs to protect others,” Priya chuckled.

“One last question, where did you learn all this?” Krishnan asked, surprised at the depth of his daughter’s knowledge.

“Elementary my dear Watson as Sherlock Holmes used to say. Our economics teacher explained to us in the evening and I just repeated what I learnt,” Priya confessed, as she drowned the small piece of chapatti that her nimble fingers held in dahi.

Racy@TheHindu.co.in

http://Racycases.blogspot.com

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