Father of Mechanism Design Wins Nobel

Economist Leonid Hurwicz helped identify the fatal flaw in centrally planned economies, but the theory isn't easy on capitalism, either

Leonid Hurwicz was born in Moscow in 1917, the year that Vladimir Lenin led the Bolshevik seizure of power in Russia. Ninety years later—on Oct. 15, 2007—Hurwicz was awarded a Nobel prize in economics, in part for explaining the fundamental flaw in the central planning that Lenin imposed in the Soviet Union.

But Hurwicz's work does not point to the complete superiority of free markets, either. In fact, Hurwicz won the Nobel for creating an intellectual framework that can evaluate the pros and cons of any possible economic mechanism. In a world riven between free markets, managed economies, and the "Third Way," Hurwicz and his co-recipients offer a neutral, pragmatic system for figuring out which mechanisms work and which ones don't. "They set up tools that will be of lasting value," says Paul Klemperer, an economist at Oxford University.

Applications of the Theory

The Nobel prize "for having laid the foundations of mechanism design theory" was split three ways between Hurwicz, an emeritus professor at the University of Minnesota; and two academics from the next generation who built on his work: Eric Maskin of the Institute for Advanced Study in Princeton, N.J., and Roger Myerson of the University of Chicago. Maskin and Myerson were PhD candidates in applied mathematics at Harvard University in the 1970s.

Most write-ups on these Nobelists focus on how their work underpins the design of auctions, such as those for use of the airwaves and the right to emit carbon dioxide. But because the work is fundamental and highly theoretical, it relates to a much wider range of economic issues. "How to raise taxes, regulate a monopolist, fund a public good…allocate organs, assign interns to hospitals, split common costs, allocate electricity across a grid—all can be thought of as mechanism design problems," Alex Tabarrok, an economist at George Mason University, wrote on his blog, Marginal Revolution.

Hurwicz diagnosed the core flaw of centrally planned economies more accurately than did his predecessor, Friedrich von Hayek, the Austrian-born free-market economist who shared the Nobel in 1974. It wasn't just that economies were too complicated to be run efficiently by a central planner. It was that people had the wrong incentives. Centrally planned systems, he found, suffered from "moral hazard," meaning essentially that people could get ahead by cheating—for example, not working hard enough.

Free Markets' "Lemon Problem"

But mechanism design theory finds that free markets have their own problems with misaligned incentives. Myerson, the co-Nobelist from the University of Chicago, says the biggest incentive problem in free markets is "adverse selection," also known as the lemon problem. Health insurers, for example, suffer from this because the only people who sign up for high-cost policies are the ones who secretly know they have big health problems, for whom the cost of the coverage is worthwhile. Myerson, while acknowledging that he is not a health-care economist, said in an interview that the adverse selection problem gives "fundamental reasons why everybody or almost everybody might be better off with universal, compulsory health insurance."

The Nobelists' work also explains why property rights can be overdone in a capitalist economy. People who own their own companies are tempted to gain an edge by withholding information from each other. That's why companies hire employees, who tend to cooperate better because they don't fight over property rights the way outside contractors do, says Myerson. "When it comes to information," Myerson says, "less property ownership is better."

So take your pick: moral hazard under socialism, or adverse selection under free markets. In practice, economists have found that free markets are still the better choice because it's usually easier to tweak the design of markets to minimize adverse selection than it is to expunge moral hazard from centrally planned systems.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE