Hamid JavanbakhtMicroeconomics, T. Mosleh

Mechanism Design Theory

Modern EconomicsGame TheoryDecision TheoryMechanism Design

Theory

Game Theory Attempts to mathematically capture behavior in strategic

situations, in which an individual's success in making choices depends on the choices of others. Traditional game theory attempts to find equilibria in these games.Cooperative Game

Group of players (“coalition”) may enforce cooperative behavior. Competition between coalitions of players rather than individual players. Coalitions may enforce coordinated behavior on the members of a coalition through a third party.

Non-cooperative Game How intelligent individuals interact with one another to achieve

their own goals. Players make decisions independently, although they may cooperate, it must be self-enforcing. (Nash Equilibrium: An outcome of a game in which each player is doing the best he or she can, given the action of the other players)

Solution Concepts: Equilibrium

In game theory, a solution concept is a formal rule for predicting how the game will be played. These predictions are called "solutions", and describe which strategies will be adopted by players, therefore predicting the result of the game. Solution concepts, for many

games, will result in more than one solution. This puts any one of the solutions in doubt, so a game theorist may apply a refinement to narrow down the solutions.

In economics, economic equilibrium is simply a state of the world where economic forces are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal.

Decision TheoryDecision theory is

concerned with identifying the values, uncertainties and other issues relevant in a given decision, its rationality, and the resulting optimal decision.Preferences among risky

alternatives can be described by the maximization of the expected value of a numerical utility function.

Mechanism Design TheoryThe 2007 Nobel Memorial Prize in Economic

Sciences was awarded to Leonid Hurwicz, Eric Maskin, and Roger Myerson.How should a planner reach a decision when the quality of the

decision relies on information spread among a number of people?

The mathematical formulation of this problem is at the heart of mechanism design theory. Among his key insights is the idea that any solution should take into account the incentives of self-interested agents.

Game "designer" chooses the game structure rather than inheriting one, and that the designer is interested in the game's outcome.

Differs from game theory in that game theory takes the rules of the game as given, while mechanism design theory asks about the consequences of different types of rules.

Relevance to Environmental PolicyEnvironmental policy has benefited from the insights

of mechanism design theory. The theory tells us that cap-and-trade systems, such as the system put in place by the Kyoto Protocol, are more cost-effective ways to reduce carbon dioxide emissions than command-and-control mechanisms. Mechanism design theory also tells us how to design environmentally sustainable fishing and hunting schemes in natural reserves. A few years ago, the UK government called on Maskin to help design a scheme that would maximize the corporate sector’s commitment to carbon dioxide emissions reduction for a given budget. Mechanism design theory was again put at work to provide a solution.

Aligning Public and Private Goals

“Mechanism Design: How to Implement Social Goals” Eric S. Maskin Prize Lecture Discusses how most

economic theory concerns itself with explaining social systems and how they work under various conditions.

In contrast, Mechanism Design approaches economics from another point – designing systems or mechanisms that meet a social goal.

Imagine two siblings fighting over the last piece of cake. Their mother wants to end the squabble by making sure that the cake is divided in such a way that both children feel they're getting their fair share.

Beginning with the End in Mind

"Is there some mechanism that she can design which will lead to a fair division even though she herself doesn't know what a fair division consists of?“One mechanism that resolves the problem is to have one

child divide the cake and the other child choose a piece. Both children are happy, one because he is sure that he

divided the cake exactly in half and the other because he is sure he picked the choicest piece.

First, the mechanism designer does not know ahead of time which outcome is optimal.In the cake example, the mother does not know what

constitutes big or small or fair in her children's eyes, yet once one child has cut the cake and the other has chosen his piece, the dispute is resolved.

Incentive-Compatible Mechanism

Second, the designer's goals and the goals of the mechanism's participants do not have to be the same. In most mechanisms, the designer's goals are

immaterial to the participants, provided they are compatible.

It wouldn't be possible to implement a mechanism in which the designer wants the exact opposite of the participants. In this example, the mother's objective is to distribute the cake fairly between her two children. The children, however, are not interested in fairness. They're interested in getting the bigger piece of cake. The mechanism is able to satisfy both the mother and the children.

Designing a MechanismThe real power of the theory: it doesn't require the

participants to behave in idealized ways nor does it require the designer to determine the participants' particular motivations ahead of time. Instead, the theory assumes participants will act according

to whatever is in their best interest and focuses instead on designing a mechanism that brings "public goals in line with private goals," says Maskin.

Implementation Theory: closely related to mechanism design where an attempt is made to add into a game a mechanism such that the equilibrium of the game conforms to some concept of social optimality.Tells whether goals are implementable or not, and if they

are implementable, can find a mechanism that will achieve that implementation

Public via Private This is helpful in complex situations

such as regulation or greenhouse gas reduction in which there is an obvious public goal but no real incentive for the numerous participants to change their behavior.

In the case of emissions reductions, each country in the world, although it agrees that this is an important goal, has its own individual incentives to take into account too.

Each country would like somebody else to make the reduction, naturally. Mechanism Design can be used to provide acceptable compromises between public and private interests before extreme market forces come into play.

We can't rely on the private sector alone. Using mechanism design, government can push private companies with private self-serving goals to nonetheless achieve public goals.