Alex Tabarrok on the Economics Nobel Prize

He writes:

Marginal Revolution: Mechanism Design for Grandma: Ok, Grandma may still have some difficulty but in honor of today's Nobelists, Hurwicz, Maskin and Myerson let's give it a go.  Suppose that you are selling a rare painting for which you want to raise the maximum revenue.  There are two potential buyers, Tyler, who values the painting at $100,000, and Alex who values it at$20,000.  The problem would be simple if you knew this information - you would then set the price at $99,999 and Tyler would buy maximizing your revenue. But how much Tyler and Alex value the painting is their own private information. How then should sell the painting? One possibility that springs quickly to mind is an auction. In a standard English open-cry auction Alex and Tyler will bid for the painting and the bids will keep rising until Alex is forced to drop out at$20,001.  Thus the auction earns you \$20,001.  Not bad, but is this the maximum revenue possible?...

You want to design the mechanism to achieve a certain outcome.  The mechanism can be as complicated as you want but it must satisfy certain conditions.  First, the bidders must participate voluntarily....  At the end of the day the bidders must expect to be at least as well off as if they did not play the mechanism game.... Second, there is an incentive compatability constraint. You don't know how much Alex and Tyler truly value the painting so suppose that Tyler mimics whatever Alex does - Tyler can do this since he values the painting at least as much as Alex does.  It follows that whatever outcome the mechanism assigns to Alex, Tyler must get at least as much.  This is a significant constraint because it means that if you want Tyler to do something different than Alex, and you do, you want Tyler to bid more, then you must give Tyler something in return. Thus, even in the optimal mechanism you, the seller, are not going to get everything. Tyler is going to walk away with some surplus....

Maskin and Myerson proved something very useful about mechanisms with these types of constraints.  It turns out that if you follow the constraints then you can restrict attention to mechanisms in which Tyler and Alex always tell the truth about their values, this is called the revelation principle....

In the case of auctions the direct mechanism is well known, a second price auction.  In a second price auction the high bidder wins but pays the second highest-bid.  In this auction it makes sense for every bidder to bid his true value....

The basic set-up of agents with private information submitting "bids" which are then fed into a mechanism resulting in outcomes is very general.  How to raise taxes, regulate a monopolist, fund a public good (here's my own contribution to mechanism design), allocate organs, assign interns to hospitals, split common costs, allocate electricity across a grid - all can be thought of as mechanism design problems.   The tools that Hurwicz, Maskin and Myerson developed and their methods of paying attention to participation and incentive compatability constraints and using the revelation principle helps us to design, at least in principle, the best solutions to all of these problems.