Friday, 21 August 2009

Mechanism design and the free market

Having been reading up on mechanism design recently I was interested to come across this piece by Robert P. Murphy at the Ludwig von Mises Institute on the awarding of the 2007 Nobel Prize in economics to Leonid Hurwicz, Roger Myerson, and Eric Maskin for laying the foundations of "mechanism design theory". Murphy writes
The official press release made it quite clear that although the Invisible Hand works well in the simplistic world of Adam Smith, it doesn't always succeed in our complex real world, with its private information, transaction costs, and externalities. According to the official statement, mechanism design theory is essential to "distinguish situations in which markets work well from those in which they do not." The press largely followed this lead; the Washington Post's headline read, "3 U.S. Economists Share Nobel for Work on Flawed Markets."
Fortunately Murphy also points out that such doubts about the market economy are unfounded and mechanism design says little about the case for (or against) laissez-faire capitalism. Like most tools, it all depends on how it is used. Murphy goes on,
For those who equate "the free market" with "atomistic individuals who reduce everything to money," it is obvious why the insights of mechanism design appear to impugn pure capitalism, and to justify enlightened government tinkering with spontaneous outcomes. Yet this view relies on a false caricature of the market economy, and a naïve faith in political action.
Naive to say the least. The article continues,
First, the market economy is not characterized by the "rational fools" ridiculed by Amartya Sen. To oppose government intervention in private property is not to don a top hat and send the crippled to be quartered and sold on the market for body organs. For example, people living in a purely free-market society could quite consistently give to charities, make "investments" with no rate of return such as the X-Prize, and even feed and house their children without charging them the market rate for boarders. Those who think these are "exceptions" to capitalism don't understand what capitalism is; in their view, nobody should ever spend money on a sports car because cheaper modes of transportation are available and hence more "profitable."

When we reflect that the free market is far more nuanced than the mainstream model of perfect competition, it becomes clear that the insights of mechanism design are comparable to, say, Henry Ford's innovations with the assembly line, or Peter Drucker's recommendations for better corporate management. Successful entrepreneurship upsets the status quo; this is the market in action, not evidence of "market failure." To the extent that mechanism design in the past shed light on inadequacies in auction rules and other organizational proceedings, it merely showed the ability of a free society to constantly improve.

In the second place, even if we concede that Pareto-inefficient outcomes can occur in a free market, as demonstrated in certain mathematical models, it doesn't follow that therefore the government ought to "fix it." To rush to this judgment assumes away all of the problems of government failure. In particular, this conclusion only holds if we assume that (a) the politicians are smart enough to set up the model correctly, with all of the relevant information to plug into the parameters, and then derive the "optimal" policy, and (b) the politicians are noble enough to ignore their campaign donors and actually implement this ideal policy. I am personally not convinced on either account.
Murphy then discusses the mechanism design approach to the Socialist Calculation Debate. This I think is the weakest part of mechanism design since mechanism design misses much of thrust of the Austrian argument in the calculation debate. The design approach, put very simply, concludes that socialism does well from an adverse-selection viewpoint, but poorly from a moral-hazard viewpoint. But this approach, Murphy argues, misses the point the Austrian economists were trying to make in the first place.

Mechanism design has, however, been more successfully used in implementing efficient voting, trading, and regulatory schemes. An obvious example being the use of auctions and auction-like mechanisms. These are an important part of modern economic life, in which many different goods, from flowers to fish to radio spectrum, are sold this way.

All this said I would also agree with Murphy's conclusion,
Notwithstanding the official press release and subsequent media coverage, the goal of mechanism design is, generally speaking, to study how best to harness markets. As Hurwicz himself said in a famous passage, "[W]hat economists should be able to do is to figure out a system that works without shooting people." It's true that Hurwicz's definition of coercion is much narrower than the typical libertarian's, but, even so, Austrian economists should not dismiss this field simply because of a few misleading stories in the media. Mechanism design poses no threat to the free market.

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