Reconciling private and public objectives through mechanism design theory

Complex problems like global warming are difficult to solve because there are so many interests involved — most of them hidden agendas. Can we ever reasonably expect individuals and institutions to reconcile their self-interest with a widely acknowledged social or political objective? Mechanism design theory may offer a way. Eric Maskin, the Albert O. Hirschman Professor at the Institute for Advanced Study and 2007 Nobel Laureate in Economics, talked about his work in this sub-field of economics at the Fifth Annual Shanghai National Accounting Institute-Arizona State University Executive Forum.

Everyone is talking about global warming, everyone agrees something needs to be done about greenhouse gas emissions, and everyone is complaining about the alarming rise in energy costs. So why are they still driving around in SUVs? Ask them and they'll tell you it's not really their problem.

They'll admit to consuming more fuel and producing more carbon than their economy-car-driving neighbors, it's true, but the real perpetrators, they say, are corporations who offset their massive greenhouse emissions with carbon credits rather than actually reducing them.

Ask the corporations and they'll cite market competition and point accusing fingers at a government that refuses to abide by the Kyoto Accords. Ask the government and you'll get an earful about India and China. Which begs the question: can we ever reasonably expect individuals and institutions to reconcile their self-interest with a widely acknowledged social or political objective?

Mechanism design theory

We can, provided we carefully design the mechanism by which they do it, maintains Eric Maskin, the Albert O. Hirschman Professor at the Institute for Advanced Study and 2007 Nobel Laureate in Economics. Maskin has devoted much of his career to the study and advancement of mechanism design theory, a sub-field of economics that studies the creation of systems which achieve a desired outcome even though participants act in their own self-interest without disclosing their preferences.

This is, Maskin said, "the engineering part of economic theory." Rather than considering existing institutions or procedures, "we begin with the outcomes we want and then we ask, are there institutions or procedures or mechanisms that we can build or design to achieve those goals?"

Maskin was speaking at the Fifth Annual SNAI-ASU Executive Forum, entitled "Transformation of China's Industrial Structure: Opportunities and Challenges of the Financial Market." He described the benefits and potential real-world applications of mechanism design theory.

To use an example that Maskin borrowed from the Old Testament, 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.

"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?" asks Maskin. 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.

Designing a mechanism

The example highlights the benefits of mechanism design that make it useful in much more complex situations, such as a struggle to obtain a non-divisible resource (a business license or a plot of land) or deciding between numerous alternatives. First, the mechanism designer does not know ahead of time which outcome is optimal. This information is generated by participating in the mechanism.

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. Second, the designer's goals and the goals of the mechanism's participants do not have to be the same. In fact, in most mechanisms, the designer's goals are immaterial to the participants, provided they are compatible.

It wouldn't be possible, for instance, 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. And therein lies the 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. The general theory, he says, "can tell whether goals are implementable or not, and if they are implementable, can find a mechanism that will achieve that implementation."

Policy applications

This is especially helpful in complex situations such as financial market 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, Maskin notes, "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."

So how can mechanism design help? For one thing, it can be used to provide acceptable compromises between public and private interests before extreme market forces come into play. In the case of the recent housing crisis (for which Maskin lays the blame squarely on lax government regulation) mechanism design could have contributed to the creation of regulatory mechanisms palatable to lenders even at the height of the housing bubble, providing them with what he calls "good incentives not to make these bad loans."

In the case of greenhouse emissions reduction, mechanism design can kick-start a process that market forces have been holding up. "Alternative sources of energy have been developed and are being developed, but not nearly quickly enough," says Maskin. "We all live on market incentives and we all live on prices, and if the price of oil is low, we all go on using it."

John Rajchert, Vice President and General Manager of Honeywell Building Solutions for South Asia Pacific, echoed Maskin's concerns, explaining that market incentives just aren't sufficient to really promote alternative energy. "It's a little bit difficult at the moment because while we have very high energy prices we also have this credit crunch which means that projects that companies like Honeywell are involved with in energy efficiency are much harder to finance," he said recently in Shanghai.

According to Maskin, "the long-run answer to our energy problems, the long-run answer to the climate change problem that we face, will come from industry — that's where new ideas come from — and from having stronger incentives to generate those ideas." But we can't rely on the private sector alone, he said. Using mechanism design, government can push private companies with private self-serving goals to nonetheless achieve public goals.

"As a private company, I may not have enough incentive on my own to take everybody else's goals into consideration," explains Maskin, "and that's where government can help. What government can do is to add on to private market incentives to encourage the development of such new technology."

Shortsighted market forces are responsible for many of the crises that currently face the economy and the environment. Mechanism design theory provides benevolent policymakers with a way of not only devising but also assessing the implementability of broader public goals through public and private institutions, treaties, and agreements. Though it's certainly no panacea for the world's ills, it might just be the spoonful of sugar that market regulators and environmental crusaders have been looking for.

Bottom Line:

Mechanism design theory is a sub-field of economics first formulated by Leonid Hurwicz in 1960 that studies the creation of systems which achieve a desired outcome even though participants act in their own self-interest and without disclosing their preferences. According to this theory, it is possible to:

• Design mechanisms — contracts, treaties, incentives, transactions — that can achieve objectives of which the participants are not aware while still satisfying the participants' private objectives;
• Determine whether a particular situation has an implementable solution;
• Arrive at acceptable compromises in extremely complex situations;
• Align institutional goals with public goals.