The 2007 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was won by Leonid Hurwicz, Eric S. Maskin, and Roger B. Myerson, all three American economists, "for having laid the foundations of mechanism design theory." Their work has been in the field called "game theory," in which the players engage in strategic interaction.
For example, if a seller wants to get the highest possible price for something not sold in mass markets, an auction would be a good solution, and the design to get the highest prize would be that the highest bidder wins but pays the bid of the second highest bidder, or a small increment above that. This auction design generates an incentive to bid high.
Mechanism design is not confined to game theory, as it applies to designing institutions in general. Following are some applications that would generate the incentives for policies that provide for democracy, liberty, prosperity, equity, and sustainability.
1. Demand revelation.. When a those in a club or governmental jurisdiction decide on providing themselves with a collective good, voting can result in bad outcomes, where the total benefit is greater than the total cost, yet the group votes against it. Demand revelation is a design in which instead of voting yes or no, each member states the most he would be willing to pay for the good. The group buys it if the total of stated values is greater than the cost. Then if any stated value changed the outcome relative to having stated the average cost, that person has to pay an extra amount equal to the net values of all the others, their stated values minus their costs. That creates an incentive to truthfully reveal one's true value, and the outcome is better than "yes no" voting.
2. Cellular democracy. Mass voting is dysfunctional because it creates a huge demand for campaign funds, and special interests provide much of the funding in return for favors. Cellular democracy is a design that puts all voting in small groups. People vote for local neighborhood councils, which in turn elect representatives to a regional council, and these in turn elect higher-level councils on up to the national legislature. That greatly reduces the demand for campaign funds and provides leverage for individuals to influence policy as power flows bottom up.
3. Land-value taxation. Taxes on wages, business profits, buildings, and sales create an excess burden on the economy, a waste of resources caused by the tax costs. We can redesign the public finance mechanisms to the ultimate tax reform, shifting taxation to land value or land rent. Since land is fixed in supply, and land rent reflects the benefits from civic services, tapping site values for public revenue is efficient and equitable. Shifting to land value taxation creates the incentives for the efficient use of land and eliminates the disincentives of punitive taxes.
4. Constitutional liberty. Putting rules in a constitution makes them more difficult to remove and makes them better known. The Liberty Amendment would make it illegal for government to restrict peaceful and honest activity. This constitutional law would in one fell swoop eliminate all laws that create crimes without victims.
5. The Green Tax Shift. An economic design mechanism to reduce pollution and boost the economy at the same time is the green tax shift, which replaces taxes laden with excess burdens with taxes proportional to damage from pollution. Combined with land value taxation, the green tax shift would eliminate all the excessive burdens of taxation, providing economic gains rather than losses from reducing climate-changing emissions.
These five design mechanism shows how we can design our institutions to create better outcomes. We can have more effective democracy, greater economic growth and prosperity, less pollution, and more liberty with mechanism design theory. So the 2007 economics prize is well deserved and could help us pay more attention to institutional design.
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FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.
Foldvary is the author of The Soul of Liberty, Public Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.
Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.