Tuesday, October 16, 2007

Mechanical Economics

2007's Economic Nobel was awarded to Leonid Hurwicz, Eric S. Maskin, and Roger B. Myersonfor for their dissection of the "mechanism design theory" of economies and nations.

Who cares, you say? I can understand that. Economic understanding is a driving factor behind nearly every political debate or decision we make as individuals and obviously as a nation, but it is often so insufferably boring to read about (no offense to my fellow SideTrack-ean who managed to somehow fool a university into giving him a degree for doing just that) that it may be one of the most misunderstood key elements of our national and personal identity.

So, when I stumble upon something that interests me, or helps me to understand more about economic theory, I feel obligated to share it. Today The American Prospect has an article explaining what "mechanism design theory" is, and why these guys got a piece of gold for researching it:

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.
I've written semi-frequently on the myth of the free market, and it's use (incorrectly) in political debate, but there is also a larger issue at play here. Do American's really understand economic theory enough to know what it is that best represents their values, and if not, how do they make those decisions when it comes time to vote? And isn't this further complicated if voters are pretending different values in order to avoid perceived economic burdens?

3 comments:

  1. Macrocompassion12/06/2007 10:13 AM

    How very disappointing! I was hoping to read about how our macroeconomic system as a whole is at last within the understanding of the system's engineers whose mechanisms are sufficiently clear to see, and all I see is a whole lots of tripe.

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  2. How very disappointing! I was hoping to read an intelligent argument that would lead to an engaging debate, with both parties walking away having learned a thing or two, and all I see is a definitive and baseless refutation in a brief comment without a single ounce of substance to back it up.

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  3. Do you really want a mechanical system to describe how macroeconomics actually works? I have invented one, but you have to appreciate that along with the beams and pulleys must run a certain amount of logic based on economic axioms which are not a built-in part of the machinery. To see this model write to me at chesterh@hotmail.com

    I kid you not!

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