Monday, October 15, 2007

Designer markets 

James wonders if someone can explain what Prof Hurwicz and these two other guys that won the Nobel this morning did. Let me see if I can help here. Cowen and Tabarrok have different takes on this (on the same blog even!) than I might offer. Tabarrok tries to explain it in terms his grandmother could understand.

As I hinted in the previous post, in most exchange situations potential buyers and potential sellers have different information about a good. They communicate in a variety of institutions that we call "markets". There are times when that communication generates a piece of information that is vital, which is the price. That tells the buyer enough about the availability of a good that they can decide whether or not it's socially optimal for him to acquire it and use it the way he wants. It tells the seller whether she should transfer it to someone else.

Usually, but not always. In auctions, for example, where there's only one unit of the good being sold or bought, the prices bid or asked might be distorted by the fact that winning the auction means the others lose. A setting where this is often found is in the bidding of public works contracts; those who wondered about how the highest bid won the I-35W bridge contract would be interested in the work of these economists. What these economists do, in short, is figure out ways in which we can design better auctions that get the information needed to make a good decision about who gets these contracts. (That's not its only use, of course, but it's a good example of its usefulness.)

Stationary Bandit points out a paper by Hurwicz that gets at that idea. Titled "But Who Will Guard the Guardians?", Hurwicz says the question has two dimensions. First, who has enough information to watch over them? And secondly, how will they communicate the information?
Even a casual perusal of daily newspapers should be sufficient to convince us that there is nothing absurd about the present day �guardians��leaders and officials of political, economic, and social entities�needing, and indeed getting a great deal of oversight. The question is rather as to the extent oversight is, or even can be, effective. ...

Much economic analysis is based on the perfectly competitive model. Implicitly, at least, this model (or, more precisely, its applicability) requires strong assumptions concerning the information available to �agents� (individuals, firms, etc.) engaging in economic activity as well as the existence of implementation mechanisms such as the enforcement of contracts and absence of collusion. Similarly, conclusions concerning the effects of alternative forms of taxation, subsidies, social insurance depend in an essential way on implementation mechanisms supplying information concerning obligations and entitlements, entities facilitating financial flows, as well as enforcement of payments or disclosure of relevant information. I think it may be fair to say that until recently in economic model building [as distinct from obiter dicta] much more attention has been paid to the information requirements (and uncertainty when precise information is not available) than to problems of implementation. Yet if implementation is impossible or prohibitively costly, even the most attractive mechanism remains a utopia. (pp. 1-3)
So we know a set of circumstances in which the market gets the allocation right; what they do is show how to create a market that mimics those circumstances when the institutions that develop in an economy don't do it naturally. It's interesting to me that people are characterizing this as "going out of style" and that "it's hard to understand". The math in it certainly is -- I confess to not understanding it fully myself -- but the idea is not.

Peter Boettke points out the connection between Hurwicz et al. and Hayek's work on the use of knowledge in a society.