Mechanism Design Theory

DEFINITION of 'Mechanism Design Theory'

An economic theory that seeks to determine the situations in which a particular strategy or mechanism will work efficiently, compared to situations in which the same strategy will not work as efficiently. Mechanism design theory allows economists to analyze and compare the way in which markets or institutions, such as a government, efficiently allocate goods and services given a gap in information between buyers and sellers.

An example of mechanism design theory would be of an auction in which sellers (who want a higher price for the auctioned item) and buyers (who want a lower one) compete to set the value of the transaction, and in which neither buyers or sellers possess all available information because some is held by only one party. Mechanism design theory seeks to identify where the various gaps in information will occur so that parties can avoid them.

BREAKING DOWN 'Mechanism Design Theory'

Unlike traditional game theory, in which variables concerning the goods and services produced, level of competition and extent of shared information are strictly controlled, mechanism design allows analysts more flexibility. Information about competitors in markets can be very limited, known as "information asymmetry."

Since mechanism design theory allows economists to relax restrictions on some variables, such as the importance of information control, it allows researchers to determine how different parties can benefit when a particular strategy is used in varying situations.