What Is Mechanism Design Theory?

Mechanism design theory is an economic theory that seeks to study the mechanisms in which a particular outcome or result can be achieved.

In particular, mechanism design theory allows economists to analyze, compare and potentially regulate certain mechanisms associated with the achievement of a particular outcomes that focuses on how businesses and institutions can achieve desirable social or economic outcomes given the constraints of individuals' self-interest and incomplete information.

Key Takeaways

  • Mechanism design theory is an economic framework for understanding how businesses can achieve optimal outcomes when individual self-interest and incomplete information may get in the way.
  • The theory is derived from game theory and accounts for individual incentives and motivations, and how these can work for the benefit of the company.
  • The theory's creators were awarded the Nobel prize in economics in 2007.

How Mechanism Design Theory Works

Mechanism design is a branch of microeconomics that explores how businesses and institutions can achieve desirable social or economic outcomes given the constraints of individuals' self-interest and incomplete information. When individuals act in their own self-interest, they may not be motivated to provide accurate information, creating principal-agent problems.

Mechanism design takes private information and incentives into account to enhance economists' comprehension of market mechanisms and shows how the right incentives (money) can induce participants to reveal their private information and create an optimal outcome.

Mechanism design theory is thus used in economics to study the processes and mechanisms involved with a particular outcome. The concept of mechanism design theory was broadly popularized by Eric Maskin, Leonid Hurwicz, and Roger Myerson. The three researchers received a Nobel Memorial Prize in Economic Sciences in 2007 for their work on the mechanism design theory and were branded as foundational leaders on the subject.

Considerations in Mechanism Design Theory

Mechanism design theory built on the concept of game theory which was broadly introduced by John von Neumann in his 1944 book “Theory of Games and Economic Behavior.” Game theory is known in economics for the study of how different entities work together both competitively and cooperatively to achieve outcomes and results.

Various mathematical models have been developed to efficiently study this concept and its results. Game theory has also been recognized throughout the history of economic studies with eleven Nobel Prizes going to researchers in this area.

Mechanism design theory generally takes a reverse approach to game theory. It studies a scenario by beginning with an outcome and understanding how entities work together to achieve a particular outcome.

Both game theory and design theory look at the competing and cooperative influences of entities in the process towards an outcome. Mechanism design theory considers a particular outcome and what is done to achieve it. Game theory looks at how entities can potentially influence several outcomes.

Mechanism Design Theory and the Financial Markets

There are a wide range of applications for mechanism design theory and as a result many mathematical theorems have been developed. These applications and theorems allow researchers to manage restrictions and information control of the entities involved for the purpose of achieving the desired outcome.

One example deploying the use of mechanism design theory occurs in an auction market. Broadly, regulators seek to produce an efficient and orderly market for participants as the primary outcome.

To achieve this result, several entities are involved with varying levels of information and association. The use of mechanism design theory seeks to regulate and control information available to participants in order to achieve the desired result of an orderly market. Generally, this requires the monitoring of information and activity at various levels for exchanges, market makers, buyers, and sellers.