The Economics Nobel: Giving Adam Smith a Helping Hand
By Adrian Cho
ScienceNOW Daily News
15 October 2007

Scottish philosopher Adam Smith asserted that when everyone acts out of self-interest, everyone will eventually benefit, as if a benevolent "invisible hand" molds the economy. Economists now know that view is naive: They can prove that in some situations, rational people will act in ways that leave everybody a loser. But such dreary outcomes can sometimes be avoided, thanks to work that today earned three Americans the Nobel Prize in economics.
Leonid Hurwicz of the University of Minnesota, Twin Cities, Erik Maskin of the Institute for Advanced Study in Princeton, New Jersey, and Roger Myerson of the University of Chicago, Illinois, developed "mechanism design theory." Such study aims to find schemes, or "mechanisms," that ensure that acting in self-interest will indeed lead to benefits for all. Today, the theory's applications range from how best to auction broadcast rights and other public resources to contract negotiations and elections.

"I was surprised. At first, I thought it was some kind of a joke," says Hurwicz, of hearing of his award. At 90, Hurwicz is the oldest person to win a Nobel. He says colleagues had told him that he might win, "but not in recent years." The prize is well-deserved, others say. "I was riding in the car [and discussing the prize] with somebody yesterday, and these were the three names that came up," says W. Bentley MacLeod, an economist at Columbia University.

Mechanism design theory starts with the recognition that unbridled self-interest doesn't always lead to the greater good. For example, suppose the people of a town would benefit if they built a bridge across the river. Everyone is asked to estimate how much the bridge is worth to him personally and chip in accordingly. Rationally, each person benefits by underestimating his stake in the bridge and letting others bear the cost. So for lack of funds the bridge never gets built, and the whole community suffers. This lose-lose situation is known as a Nash equilibrium, and it's logically unavoidable because an individual can only make his own situation worse by paying more.

In the 1960s, Hurwicz pioneered the study of how to avoid such dead ends by fiddling with the rules of such an economic interaction. The trick is to fix things so that the most beneficial state and the inevitable result, or equilibrium state, are one and the same. "It's a little Machiavellian," says Gabrielle Demange of the Paris School of Economics. "Given a goal, you design a game so that in the end the Nash equilibrium comes out to be what you want." For example, in the case of the bridge, the amount each person pays could be based on only what others think the bridge should be worth, thus eliminating each person's incentive to lie about its value.

Maskin, 57, and Myerson, 56, expanded on Hurwicz's work. For example, in 1977, Maskin developed a criterion for determining just when it's possible to find a set of rules that will guide self-interested participants to the desired end. "This sets some boundaries on what mechanism design theory can do," says Massimo Morelli, an economist at Columbia. Starting in the late 1970s, Myerson showed that whenever a mechanism exists, it is also possible to find one that gives participants an incentive to tell the truth.

Relying heavily on game theory, the laureates' work has been largely abstract and formal. "My methodology is to invent simple little worlds in which there is just a bit that we don't understand and can study," Myerson says. Nevertheless, the theory may play a role in confronting perhaps the most complex and pressing problem facing humanity today, climate change, by helping to set up incentives that encourage consumers and countries to minimize greenhouse gas emissions. But first, politicians must identify the specific end they are working toward, Maskin says. "Mechanism design should definitely be pertinent to the problem," he says, "but first we have to decide exactly what we're trying to accomplish."