Gurus For The Information Age
In an age where information reigns supreme, it seems only fitting that the 1996 Nobel Memorial Prize in Economic Science be given to two pioneers in the theory of information. The winners, announced Oct. 8, were William Vickrey of Columbia University and Britain's James A. Mirrlees of Cambridge University.
Mirrlees has for years been on the short list of Nobel favorites. Working in the 1970s, he laid out theoretical rules for designing contracts between two parties with different interests and different information. These theories of "asymmetric information" are applicable to everything from insurance policies to performance-based CEO compensation. Vickrey, whose selection was more surprising, is best known for his research into bidding rules for auctions for items such as oil drilling rights, where the bidders may have done private evaluations about how much oil was likely to be found. Vickrey also helped lay the groundwork for the idea of "congestion pricing," which calls for higher tolls and fares on peak users because they put the heaviest load on the transportation system.
COMPROMISE. Why are these ideas important? Conventional economics has historically focused on making the buying and selling of goods and services as efficient as possible. But Mirrlees and Vickrey were among the first to point out that the transmission of information was equally crucial for modern economies, especially in cases where there's an incentive for people to not tell the truth.
For example, it may be very hard for a company's board of directors to evaluate the performance of the CEO. If the company's profits go down, is it because of bad luck, tough competition, or because the CEO was slacking off? Compared with the board, the top manager will have much better information about how hard the task is, how hard he or she is working, and whether he or she deserves to be rewarded or dismissed.
What the theory of asymmetric information says is that the design of an executive compensation plan involves a compromise in order to get around the lack of information. The manager's rewards must be tied at least in part to the performance of the company, since a flat salary may not give the manager an incentive to work hard, or to work in the shareholders' interest. But if the manager's rewards are too closely tied to the performance of the company, then the board will have to give the manager a richer pay package to compensate for the added risk, says Oliver D. Hart, an economist at Harvard University.
The work of Mirrlees and Vickrey also sheds light on other areas of the economy. In theory, it should be possible to buy an insurance policy that fully insures against the risks of events such as auto theft. But a totally insured car owner will have little incentive to take care against theft, such as locking the door and not parking in back alleys. Since insurance companies cannot observe the level of care--the missing information--most auto policies typically require a sizable deductible to encourage people to take care of their cars.
Similarly, in an ideal world, unemployment insurance would completely compensate the worker for his or her lost wages. But that makes it more attractive for someone to lose their job intentionally or not look hard for other work--something about which the government has a lot less information than the individual. The compromise solution that most countries use is to pay unemployment benefits that only partially make up for the lost earnings.
Economists still have a lot further to go in explaining the uses and impact of information in today's high-tech economy. But the concepts of Mirrlees and Vickrey will turn out to be the building blocks for the next generation of theories.