The causes and effects of public regulation the Royal Swedish Academy of Sciences



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Prêmios Nobel de Economia e a Organização Industrial

20 October 1982

THIS YEAR's PRIZE IN ECONOMICS IS AWARDED FOR RESEARCH ON MARKET PROCESSES AND THE CAUSES AND EFFECTS OF PUBLIC REGULATION



The Royal Swedish Academy of Sciences has decided to award the 1982 Alfred Nobel Memorial Prize in Economic Science to

Professor George Stigler, University of Chicago, USA,

for his seminal studies of industrial structures, functioning of markets and causes and effects of public regulation.

George Stigler's Principal Contribution
Through long and extensive research efforts with strong empirical orientationGeorge Stigler has made fundamental contributions to the study of market processes and the analysis of the structure of industries. As part of this research he has investigated how markets are affected by economic legislation. His studies of the forces which give rise to regulatory legislation have opened up a completely new area of economic research.

Stigler's achievements establish him as a leader in applied research on markets and industrial structure - a field often known as industrial organization. Through particular features of his research, Stigler is also recognized as the founder of "economics of information" and ''economics of regulation", and one of the pioneers of research in the intersection of economics and law.



Market Processes and Industrial Structure
Despite strong simplifications, basic economic theory has proved effective in explaining and predicting the dominant features of market events. At the same time, the high level of abstraction has left many individual market phenomena unexplained. This is the premise for Stigler's research work. His underlying ambition has been to seek explanations for the distinctive features and peculiarities of markets and structural developments within the framework of basic theoretical assumptions about firms' and households' optimizing behavior and the interplay between supply and demand.

This is exemplified in Stigler's studies of the role of information in market processes. According to traditional theory, the result of optimization and market processes should be that every commodity, except for transport costs, is sold for one and the same price everywhere. But, in practice, price variation is observed on most markets. Stigler has shown that this can be explained if the costs of searching for, and diffusing information about, goods and prices are incorporated in the model along with production and transport costs. The basic properties of traditional theory do not have to be challenged. It has merely been too schematic by assuming "perfect information", in the same way that fundamental theories in physics simplistically assume the existence of a vacuum.

A market participant's lack of knowledge about goods and prices can, of course, be alleviated by collecting and furnishing information. The amount of information a firm or household acquires is guided by the same comparisons between costs and benefits as the production of any commodity. That is, information is gathered until the expected utility of further search no longer outweighs additional search costs. The information a subject acquires is consciously chosen. Conversely - and more provocatively - even a lack of market information is rationally and deliberately chosen

These, and similar achievements prove an indispensable complement to basic theory. Subsequent research has shown how phenomena such as price rigidity, variations in delivery periods, queuing and unutilized resources, which are essential features of market processes, can be afforded a strict explanation within the framework of basic economic assumpions. They are no longer unnecessary market imperfections which can give rise to government intervention. The results have also contributed to explaining inflation and unemployment. An appreciable amount of the research on these phenomena during the last decade has also followed this line of reasoning. Thus, Stigler is not only the foremost originator of economics of information. He is also among those who have provided the basic postulates for today's research on the theoretical foundations of macroeconomics.

In another important study, Stigler examines the traditional theoretical prediction that differences in rates of return are rapidly erased though movements of capital and from low-yield to high-yield firms - one of the cornerstones of the neoclassical concept of market mechanisms. On the basis of extensive compilation of American earnings and capital data - in itself a pioneering effort in economic statistics - Stigler also finds that differences in rates of return are effectively equalized, even if the process might take as long as a decade. The fact that an industrial sector is profitable, or unprofitable, one year indeed indicates that it can be expected to remain so in the coming 2-3 years. But it says hardly anything whatsoever about the condition of the sector after 7-8 years. Sluggishness can postpone equalization, but it will emerge eventually. Differences in rates of return between firms or sectors may appear to last a long time, but this is often because new, highly-productive firms and sectors rise, while firms and sectors which were profitable fall. There are many indications that these tendencies have recently been reinforced by increased internationalization of the economic system. In principle, these processes appear to be equally prevalent in many countries as they are in the USA.

In another study, Stigler shows that, in practice, clear-cut conclusions about economies of scale and similar phenomena cannot be drawn on the basis of traditional cost data in order to determine optimal firm size in every industrial sector. A firm's vitality and development capacity are only weakly related to cost conditions in production itself, but depend instead on various factors which are difficult to observe. This brought Stigler to the so-called survivor principle which states that, first, those categories of firms which actually exhibit an ability to survive should be determined; then, the properties which yield this ability should be sought. Stigler himself has carried out a study along these lines which has had many successors.

Stigler's contributions to the empirical study of markets and sectoral structure based on economic theory also include a number of further investigations. One of them is a survey of pricing behavior in American industry. Others refer to the significance of monopoly and oligopoly.

Causes and Effects of Public Regulation
As early as the 1940s, Stigler studied the effects of some features of regulatory legislation in the USA, particularly rent controls and minimum-wage legislation. He indicated that far-reaching, unintended side-effects could arise alongside the primary desired effects. A later study showed that regulation of electricity rates completely lacked observable effects. As a conceivable explanation, Stigler saw that regulation can be based on erroneous perception of real conditions and thus, in practice, be difficult to implement, and on the fact that the intended effects can be neutralized by external pressures. This work on the consequences of regulatory legislation have set a pattern for numerous similar studies, performed by other researchers in many countries.

In later studies of regulatory legislation, Stigler has emphasized its causes rather than its effects. Preliminary observations led him to the hypothesis that, in practice, some regulations protect firms, organizations and professional and occupational groups - i.e., producer interests - instead of the general public that, according to stated motives, they were intended to protect. Stigler himself found firm empirical support for this hypothesis in a number of studies; it is still too early to assess its ultimate scope. But Stigler's results do show that legislation can also be an outflow of market participants' optimizing behaviour. To the extent that this is so, legislation is no longer an "exogenous" force which affects the economy from outside, but an "endogenous'' part of the economic system itself. This approach constitutes a further step towards extending the sphere of application for the basic assumption of economic theory.

Stigler's studies have opened up a new area of research known as economics of regulation. In many quarters, it has resulted in fundamental testing of the forces, purposes and effects of different aspects of legislation. These achievements have also made Stigler one of the pioneers in another new field of research, law and economics.

 

15 October 1991



The Royal Swedish Academy of Sciences has decided to award the Sveriges Riksbank (Bank of Sweden) Prize in Economic Sciences in Memory of Alfred Nobel, 1991, to

Professor Ronald Coase, University of Chicago, USA,



for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy.

Breakthrough in Understanding the Institutional Structure of the Economy
Until recently, basic economic analysis concentrated on studying the functioning of the economy in the framework of an institutional structure which was taken as given. Efforts to explain the institutional structure were usually considered unnecessary or futile. For instance, the existence of organizations of the type we call firms seemed almost self-evident. Observed variations in contract forms in the economic sphere were also regarded as a given fact, and the laws and rules of the legal system were perceived as an externally imposed setting for economic activity.

By means of a radical extension of economic micro theory, Ronald Coase succeeded in specifying principles for explaining the institutional structure of the economy, thereby also making new contributions to our understanding of the way the economy functions. His achievements have provided legal science, economic history and organization theory with powerful impulses and are therefore also highly significant in an interdisciplinary context. Coase's contributions are the result of methodical research work, where each segment was gradually added to the next over a period of many years. It took a long time for his approach to gain a foothold. When the breakthrough finally occurred during the 1970s and 1980s, it was all the more emphatic. Today Coase's theories are among the most dynamic forces behind research in economic science and jurisprudence.

Coase showed that traditional basic microeconomic theory was incomplete because it only included production and transport costs, whereas it neglected the costs of entering into and executing contracts and managing organizations. Such costs are commonly known as transaction costs and they account for a considerable share of the total use of resources in the economy. Thus, traditional theory had not embodied all of the restrictions which bind the allocations of economic agents. When transaction costs are taken into account, it turns out that the existence of firms, different corporate forms, variations in contract arrangements, the structure of the financial system and even fundamental features of the legal system can be given relatively simple explanations. By incorporating different types of transaction costs, Coase paved the way for a systematic analysis of institutions in the economic system and their significance.

Coase also demonstrated that the power and precision of analysis may be enhanced if it is carried out in terms of rights to use goods and factors of production instead of the goods and factors themselves. These rights, which came to be called "property rights" in economic analysis, may be comprised of full ownership, different kinds of usership rights or specific and limited decision and disposal rights, defined by clauses in contracts or by internal rules in organizations. The definition of property rights and their distribution among individuals by law, contract clauses and other rules determine economic decisions and their outcome. Coase showed that every given distribution of property rights among individuals tends to be reallocated through contracts if it is to the mutual advantage of the parties and not prevented by transaction costs, and that institutional arrangements other than contracts emerge if they imply lower transaction costs. Modifications of legal rules by courts and legislators are also encompassed by these arrangements. Property rights thus constitute a basic component in analyses of the institutional structure of the economy. In perhaps somewhat pretentious terminology, Coase may be said to have identified a new set of "elementary particles" in the economic system. Other researchers, to some extent under the influence of Coase, have also made pioneering contributions to the study of property rights.



Coase's Contributions: First Stage
In his first major study entitled, The Nature of the Firm, Coase posed two questions which had seldom been the objects of strict economic analysis and, prior to Coase, lacked robust and valid solutions, i.e. , why are there organizations of the type represented by firms and why is each firm of a certain size? A key result in traditional theory was to show the ability of the price system (or the market mechanism) to coordinate the use of resources. The applicability of this theory was diminished by the fact that a large proportion of total use of resources was deliberately withheld from the price mechanism in order to be coordinated administratively within firms.

This is the point at which Coase introduced transaction costs and illustrated their crucial importance. Alongside production costs, there are costs for preparing, entering into and monitoring the execution of all kinds of contracts, as well as costs for implementing allocative measures within firms in a corresponding way. If these circumstances are taken into account, it may be concluded that a firm originates when allocative measures are carried out at lower total production, contract and administrative costs within the firm than by means of purchases and sales on the market. Similarly, a firm expands to the point where an additional allocative measure costs more internally than it would through a contract on markets. If transaction costs were zero, no firms would arise. All allocation would take place through simple contracts between individuals.

An important element in the model is that there are two types of contracts: those which stipulate the parties' total obligations (or, the reverse, rights) and those which are deliberately made incomplete by not specifying all obligations, but intentionally allow a free margin for unilateral decisions by one of the parties. Such "open" agreements may be exemplified by employment contracts, which usually leave room for direction and giving orders. According to Coase's theory, the firm is characterized by the latitude for decision created by a particular cluster of such open contracts. The firm in fact consists of this array of contracts and is related to the rest of the world by other fully specified contracts regarding purchases of inputs, sales of products, and loans under prescribed terms.

Coase's formulation has proved to be exceedingly practicable and has given rise to intensive examination of the contract relations which characterize firms. It is now clear that every type of firm is comprised of a distinctive contract structure and thereby a specific distribution of rights and obligations (property rights). Coase's work on the firm has become the basis for rapidly expanding research on principal-agent relations. It has also influenced vital aspects of financial economics, such as the lively research devoted to explaining the pattern of financial intermediaries.



Coase's Contributions: Second Stage
In retrospect, it is easy to realize that these examinations of firms' basic characteristics would provide a basis for more general conclusions regarding the institutional structure of the economic system. Coase himself laid the groundwork in a subsequent stage.

In another major study entitled, The Problem of Social Cost , Coase introduced the set-up in terms of rights or property rights. He postulated that if a property right is well defined, if it can be transferred, and if the transaction costs in an agreement which transfers the right from one holder to another are zero, then the use of resources does not depend on whether the right was initially allotted to one party or the other (except for the difference which can arise if the distribution of wealth between the two parties is affected). If the initial holding entailed an unfavorable total result, the better result would be brought about spontaneously through a voluntary contract, as it can be executed at no cost and both parties gain from it. In other words, all legislation which deals with granting rights to individuals would be meaningless in terms of the use of resources; parties would "agree themselves around" every given distribution of rights if it is to their mutual advantage. Thus, a large amount of legislation would serve no material purpose if transaction costs are zero. This thesis is a direct parallel to the conclusion in The Nature of the Firm that firms under the same conditions are superfluous. All allocations could be effectuated through simple, uncomplicated agreements without administrative features, i.e. , through frictionless markets.

This led Coase to conclude that it is the fact that transaction costs are never zero which indeed explains the institutional structure of the economy, including variations in contract forms and many kinds of legislation. Or, more exactly, the institutional structure of the economy may be explained by the relative costs of different institutional arrangements, combined with parties' efforts to keep total costs at a minimum. Alongside price formation, the formation of the institutional structure is regarded as an integral step in the process of resource distribution. Hence, economic institutions do not require a "separate" theory. It is sufficient to render existing theory complete and formulate it in terms of the primary componentsi.e., property rights.

These conclusions concerning the radical effects of ever prevalent transaction costs are thus the main result of Coase's analysis. Somewhat paradoxically, circumstances have ordained that it is the preceding conclusion about the consequences of overlooking transaction costs which has come to be called the "Coase Theorem". Of course, the situation without transaction costs is only a hypothetical norm of comparison. However, it can facilitate the analysis of real-world conditions. It may also inspire studies of contracting which can actually be observed, in areas where earlier theory prematurely took it for granted that transaction costs are so high that contracts are inconceivable. Further examinations by Coase himself or students and others inspired by him have shown that in some such cases, transaction costs are not so high as to preclude a contract. Such contracts are found to have strong peculiarities, created by the parties in order to alleviate the drawbacks of high transaction costs. These observations are wholly in line with Coase's main conclusion. In cases where transaction costs absolutely prevent a contract, there is - as inferred by the theorem - a tendency for other institutional arrangements to arise, for example a firm or amended legislation. The circle is closed; this is exactly the message conveyed by The Nature of the Firm.

As regards legislation, in The Problem of Social Cost , Coase developed a hypothesis concerning the behavior of courts in rather frequent cases where two (or more) parties dispute rights and where agreements are impossible or extremely difficult because of high transaction costs. Coase found that courts probably try to distribute the rights among the parties so as to realize the solution which would have been the outcome of an agreement, if such an agreement had been possible. The underlying idea is that this is a natural and rational way for a court to reason if it is more intent on setting a precedent to generate expedient incentives for the future than solving a particular dispute. This means that common pleas courts serve as an extension of the market mechanism to areas where it cannot function due to transaction costs. This hypothesis has become immensely important because, along with the general formulation in terms of rights or property rights, it has become the impetus for developing the new discipline of "law and economics" and, in prolongation, for renewal of many aspects of legal science.

 

11 October 1994



The Royal Swedish Academy of Sciences has decided to award the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, 1994, jointly to

Professor John C. Harsanyi, University of California, Berkeley, CA, USA,


Dr. John F. Nash, Princeton University, Princeton, NJ, USA,
Professor Dr. Reinhard Selten, Rheinische Friedrich-Wilhelms-Universität, Bonn, Germany,

for their pioneering analysis of equilibria in the theory of non-cooperative games.


Games as the Foundation for Understanding Complex Economic Issues
Game theory emanates from studies of games such as chess or poker. Everyone knows that in these games, players have to think ahead - devise a strategy based on expected countermoves from the other player(s). Such strategic interaction also characterizes many economic situations, and game theory has therefore proved to be very useful in economic analysis.

The foundations for using game theory in economics were introduced in a monumental study by John von Neumann and Oskar Morgenstern entitled Theory of Games and Economic Behavior (1944). Today, 50 years later, game theory has become a dominant tool for analyzing economic issues. In particular, non-cooperative game theory, i.e., the branch of game theory which excludes binding agreements, has had great impact on economic research. The principal aspect of this theory is the concept of equilibrium, which is used to make predictions about the outcome of strategic interaction. John F. Nash, Reinhard Selten and John C. Harsanyi are three researchers who have made eminent contributions to this type of equilibrium analysis.



John F. Nash introduced the distinction between cooperative games, in which binding agreements can be made, and non-cooperative games, where binding agreements are not feasible. Nash developed an equilibrium concept for non-cooperative games that later came to be called Nash equilibrium.

Reinhard Selten was the first to refine the Nash equilibrium concept for analyzing dynamic strategic interaction. He has also applied these refined concepts to analyses of competition with only a few sellers.

John C. Harsanyi showed how games of incomplete information can be analyzed, thereby providing a theoretical foundation for a lively field of research - the economics of information - which focuses on strategic situations where different agents do not know each others' objectives.

Strategic Interaction
Game theory is a mathematical method for analyzing strategic interaction. Many classical analyses in economics presuppose such a large number of agents that each of them can disregard the others' reactions to their own decision. In many cases, this assumption is a good description of reality, but in other cases it is misleading. When a few firms dominate a market, when countries have to make an agreement on trade policy or environmental policy, when parties on the labor market negotiate about wages, and when a government deregulates a market, privatizes companies or pursues economic policy, each agent in question has to consider other agents' reactions and expectations regarding their own decisions, i.e., strategic interaction.

As far back as the early nineteenth century, beginning with Auguste Cournot in 1838, economists have developed methods for studying strategic interaction. But these methods focused on specific situations and, for a long time, no overall method existed. The game-theoretic approach now offers a general toolbox for analyzing strategic interaction.



Game Theory
Whereas mathematical probability theory ensued from the study of pure gambling without strategic interaction, games such as chess, cards, etc. became the basis of game theory. The latter are characterized by strategic interaction in the sense that the players are individuals who think rationally. In the early 1900s, mathematicians such as Zermelo, Borel and von Neumann had already begun to study mathematical formulations of games. It was not until the economist Oskar Morgenstern met the mathematician John von Neumann in 1939 that a plan originated to develop game theory so that it could be used in economic analysis.

The most important ideas set forth by von Neumann and Morgenstern in the present context may be found in their analysis of two-person zero-sum games. In a zero-sum game, the gains of one player are equal to the losses of the other player. As early as 1928, von Neumann introduced the minimax solution for a two-person zero-sum game. According to the minimax solution, each player tries to maximize his gain in the outcome which is most disadvantageous to him (where the worst outcome is determined by his opponent's choice of strategy). By means of such a strategy, each player can guarantee himself a minimum gain. Of course, it is not certain that the players' choices of strategy will be consistent with each other. von Neumann was able to show, however, that there is always a minimax solution, i.e., a consistent solution, if so-called mixed strategies are introduced. A mixed strategy is a probability distribution of a player's available strategies, whereby a player is assumed to choose a certain "pure" strategy with some probability.



John F. Nash
John Nash arrived at Princeton University in 1948 as a young doctoral student in mathematics. The results of his studies are reported in his doctoral dissertation entitled Non-cooperative Games (1950). The thesis gave rise to Equilibrium Points in n-person Games (Proceedings of the National Academy of Sciences of the USA 1950), and to an article entitled Non-cooperative Games, (Annals of Mathematics 1951).

In his dissertation, Nash introduced the distinction between cooperative and non-cooperative games. His most important contribution to the theory of non-cooperative games was to formulate a universal solution concept with an arbitrary number of players and arbitrary preferences, i.e., not solely for two-person zero-sum games. This solution concept later came to be called Nash equilibrium. In a Nash equilibrium, all of the players' expectations are fulfilled and their chosen strategies are optimal. Nash proposed two interpretations of the equilibrium concept: one based on rationality and the other on statistical populations. According to the rationalistic interpretation, the players are perceived as rational and they have complete information about the structure of the game, including all of the players' preferences regarding possible outcomes, where this information is common knowledge. Since all players have complete information about each others' strategic alternatives and preferences, they can also compute each others' optimal choice of strategy for each set of expectations. If all of the players expect the same Nash equilibrium, then there are no incentives for anyone to change his strategy. Nash's second interpretation - in terms of statistical populations - is useful in so-called evolutionary games. This type of game has also been developed in biology in order to understand how the principles of natural selection operate in strategic interaction within and among species. Moreover, Nash showed that for every game with a finite number of players, there exists an equilibrium in mixed strategies.

Many interesting economic issues, such as the analysis of oligopoly, originate in non-cooperative games. In general, firms cannot enter into binding contracts regarding restrictive trade practices because such agreements are contrary to trade legislation. Correspondingly, the interaction among a government, special interest groups and the general public concerning, for instance, the design of tax policy is regarded as a non-cooperative game. Nash equilibrium has become a standard tool in almost all areas of economic theory. The most obvious is perhaps the study of competition between firms in the theory of industrial organization. But the concept has also been used in macroeconomic theory for economic policy, environmental and resource economics, foreign trade theory, the economics of information, etc. in order to improve our understanding of complex strategic interactions. Non-cooperative game theory has also generated new research areas. For example, in combination with the theory of repeated games, non-cooperative equilibrium concepts have been used successfully to explain the development of institutions and social norms. Despite its usefulness, there are problems associated with the concept of Nash equilibrium. If a game has several Nash equilibria, the equilibrium criterion cannot be used immediately to predict the outcome of the game. This has brought about the development of so-called refinements of the Nash equilibrium concept. Another problem is that when interpreted in terms of rationality, the equilibrium concept presupposes that each player has complete information about the other players' situation. It was precisely these two problems that Selten and Harsanyi undertook to solve in their contributions.

Reinhard Selten
The problem of numerous non-cooperative equilibria has generated a research program aimed at eliminating "uninteresting" Nash equilibria. The principal idea has been to use stronger conditions not only to reduce the number of possible equilibria, but also to avoid equilibria which are unreasonable in economic terms. By introducing the concept of subgame perfection, Selten provided the foundation for a systematic endeavor in Spieltheoretische Behandlung eines Oligopolmodells mit Nachfrageträgheit, (Zeitschrift für die Gesamte Staatswissenschaft 121, 301-24 and 667-89, 1965).

An example might help to explain this concept. Imagine a monopoly market where a potential competitor is deterred by threats of a price war. This may well be a Nash equilibrium - if the competitor takes the threat seriously, then it is optimal to stay out of the market - and the threat is of no cost to the monopolist because it is not carried out. But the threat is not credible if the monopolist faces high costs in a price war. A potential competitor who realizes this will establish himself on the market and the monopolist, confronted with fait accompli, will not start a price war. This is also a Nash equilibrium. In addition, however, it fulfills Selten's requirement of subgame perfection, which thus implies systematic formalization of the requirement that only credible threats should be taken into account.

Selten's subgame perfection has direct significance in discussions of credibility in economic policy, the analysis of oligopoly, the economics of information, etc. It is the most fundamental refinement of Nash equilibrium. Nevertheless, there are situations where not even the requirement of subgame perfection is sufficient. This prompted Selten to introduce a further refinement, usually called the "trembling-hand" equilibrium, in Reexamination of the Perfectness Concept for Equilibrium Points in Extensive Games (International Journal of Game Theory 4, 25-55, 1975). The analysis assumes that each player presupposes a small probability that a mistake will occur, that someone's hand will tremble. A Nash equilibrium in a game is "trembling-hand perfect" if it is robust with respect to small probabilities of such mistakes. This and closely related concepts, such as sequential equilibrium (Kreps and Wilson, 1982), have turned out to be very fruitful in several areas, including the theory of industrial organization and macroeconomic theory for economic policy.

John C. Harsanyi
In games with complete information, all of the players know the other players' preferences, whereas they wholly or partially lack this knowledge in games with incomplete information. Since the rationalistic interpretation of Nash equilibrium is based on the assumption that the players know each others' preferences, no methods had been available for analyzing games with incomplete information, despite the fact that such games best reflect many strategic interactions in the real world.

This situation changed radically in 1967-68 when John Harsanyi published three articles entitled Games with Incomplete Information Played by Bayesian Players, (Management Science 14, 159-82, 320-34 and 486-502). Harsanyi's approach to games with incomplete information may be viewed as the foundation for nearly all economic analysis involving information, regardless of whether it is asymmetric, completely private or public.

Harsanyi postulated that every player is one of several "types", where each type corresponds to a set of possible preferences for the player and a (subjective) probability distribution over the other players' types. Every player in a game with incomplete information chooses a strategy for each of his types. Under a consistency requirement on the players' probability distributions, Harsanyi showed that for every game with incomplete information, there is an equivalent game with complete information. In the jargon of game theory, he thereby transformed games with incomplete information into games with imperfect information. Such games can be handled with standard methods.

An example of a situation with incomplete information is when private firms and financial markets do not exactly know the preferences of the central bank regarding the tradeoff between inflation and unemployment. The central bank's policy for future interest rates is therefore unknown. The interactions between the formation of expectations and the policy of the central bank can be analyzed using the technique introduced by Harsanyi. In the most simple case, the central bank can be of two types, with adherent probabilities: Either it is oriented towards fighting inflation and thus prepared to pursue a restrictive policy with high rates, or it will try to combat unemployment by means of lower rates. Another example where similar methods can be applied is regulation of a monopoly firm. What regulatory or contractual solution will produce a desirable outcome when the regulator does not have perfect knowledge about the firm's costs?



Other Contributions of the Laureates
In addition to his contributions to non-cooperative game theory, John Nash has developed a basic solution for cooperative games, usually referred to as Nash's bargaining solution, which has been applied extensively in different branches of economic theory. He also initiated a project that subsequently came to be called the Nash program, a research program designed to base cooperative game theory on results from non-cooperative game theory. In addition to his prizewinning achievements, Reinhard Selten has contributed powerful new insights regarding evolutionary games and experimental game theory. John Harsanyi has also made significant contributions to the foundations of welfare economics and to the area on the boundary between economics and moral philosophy. Harsanyi and Selten have worked closely together for more than 20 years, sometimes in direct collaboration.

Through their contributions to equilibrium analysis in non-cooperative game theory, the three laureates constitute a natural combination: Nash provided the foundations for the analysis, while Selten developed it with respect to dynamics, and Harsanyi with respect to incomplete information.



8 October 1996

The Royal Swedish Academy of Sciences has decided to award the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, 1996, to

Professor James A. Mirrlees, University of Cambridge, U.K. and

Professor William Vickrey, Columbia University, New York, USA,


(deceased October 10, 1996)

for their fundamental contributions to the economic theory of incentives under asymmetric information.

Information and Incentives
One of the most important and liveliest areas of economic research in recent years addresses situations where decision-makers have different information. Such informational asymmetries occur in a great many contexts. For example, a bank does not have complete information about borrowers' future income; the owners of a firm may not have the same detailed information about costs and competitive conditions as the managing director; an insurance company cannot fully observe policyholders' responsibility for insured property and external events which affect the risk of damage; an auctioneer does not have complete information about the willingness to pay of potential buyers; the government has to devise an income tax system without much knowledge about the productivity of individual citizens; etc.

Incomplete and asymmetrically distributed information has fundamental consequences, particularly in the sense that an informational advantage can often be exploited strategically. Research on the economics of information has therefore focused on the question of how contracts and institutions can be designed to handle different incentive and control problems. This has generated a better understanding of insurance markets, credit markets, auctions, the internal organization of firms, wage forms, tax systems, social insurance, competitive conditions, political institutions, etc.

This year's laureates have laid the foundation for examining these seemingly quite disparate areas through their analytical work on issues where informational asymmetries are a key component. An essential part of William Vickrey's research has concerned the properties of different types of auctions, and how they can best be designed so as to generate economic efficiency. His endeavors have provided the basis for a lively field of research which, more recently, has also been extended to practical applications such as auctions of treasury bonds and band spectrum licenses. In the late 1940s, Vickrey also formulated a model indicating how income taxation can be designed to attain a balance between efficiency and equity. A quarter of a century later, interest in this model was renewed when James Mirrlees found a more thorough solution to the problems associated with optimal income taxes. Mirrlees soon realized that his method could also be applied to many other similar problems. It has become a principal constituent of the modern analysis of complex information and incentive problems. Mirrlees's approach has become particularly valuable in situations where it is impossible to observe another agent's actions, so-called moral hazard.

Income Taxation
Philosophers, economists and political scientists have studied the principles of income taxation for a long time. Different principles of justice have governed the structure of taxation. In a classical essay published in 1897, Oxford professor Francis Y. Edgeworth adopted a utilitarian welfare perspective; he concluded that all differences in income should be neutralized, which requires strongly progressive tax rates. Vickrey's analysis, in the mid-1940s, emphasized that a progressive tax schedule would affect individuals' incentives to exert themselves. He therefore reformulated the problem with respect to both incentive problems - that each individual takes the tax schedule into account when choosing his work effort - and asymmetric information - that, in practice, the productivity of individuals is not known to the government. He formulated a solution to the problem in principle, but did not succeed in mastering its mathematical complications.

It was not until 25 years later that the problem was reconsidered by James Mirrlees, who solved it in a way which has established a paradigm for analyzing a broad spectrum of economic issues where asymmetric information is a prime component. Mirrlees identified a critical condition (known as single crossing) which drastically simplifies the problem and enables a solution. His analysis also proved to contain the germ of a general principle: the revelation principle. According to this principle, the solution to incentive problems under incomplete information belongs to the relatively limited class of so-called allocation mechanisms which induce all individuals to reveal their privat information truthfully, in a way which does not conflict with their self-interest. By applying this principle, it becomes much easier to design optimal contracts and other solutions to incentive problems. It has therefore had a large bearing on the treatment of many issues of economic theory.



Moral Hazard
For a long time, a well-known problem in connection with insurance is that damage to insured objects depends not only on external factors such as weather and attempted theft, but also on the care taken by the policyholder, which is costly for an insurance company to monitor. Corresponding problems also arise regarding different kinds of social insurance, such as health and disability insurance. Generous insurance coverage can exaggerate risktaking and affect the way individuals care for themselves and their property. Many other two-party relations involve an outcome that is observable to both parties, where the outcome depends on one party's (the agent's) actions, which cannot be observed by the other party (the principal), as well as on a random variable. In the relation between the owner and the management of a firm, for instance, the action would be the executive's work effort, the outcome would be the firm's profit and the random variable could be the firm's market or production conditions. The owners of both the insurance company and the firm want to choose terms of compensation, a "contract", which gives the agent incentives to act in accordance with the principal's interests, for example, by maximizing the owner's expected profits.

The technical difficulties encountered in analyzing these so-called moral hazard problems are similar to the income tax problems emphasized by Vickrey and solved by Mirrlees. In the mid-1970s, by means of an apparently simple reformulation of the problem, Mirrlees paved the way for an increasingly powerful analysis. He noted that an agent's actions indirectly imply a choice of the probabilities that different outcomes will occur. The conditions for the optimal terms of compensation thus provide "probability information" about the agent's choice and the extent to which insurance protection has to be restricted in order to provide the agent with suitable incentives. In designing an incentive scheme, the principal has to take into account the costs of giving the agent incentives to act in accordance with the principal's interests. The higher the agent's sensitivity to punishment and the larger the amount of information about the agent's choice contained in the outcome, the lower these costs. This is stipulated in a contract; the agent bears part of the cost of undesirable outcomes or receives part of the profits from favorable outcomes. The policyholder takes care of the insured object almost as if it were uninsured, and the executive manages the firm almost as if it were his own.



Auctions
Asymmetric information is also an essential component of auctions, where potential buyers have limited knowledge about the value of the asset or rights up for sale. Vickrey analyzed the properties of different kinds of auctions in two papers in 1961 and 1962. He attached particular importance to the second-price auction or, as it is now often called, the Vickrey auction. In such an auction, an object is auctioned off in sealed bidding, where the highest bidder gets to buy the item, but only pays the next highest price offered. This is an example of a mechanism which elicits an individual's true willingness to pay. By bidding above his own willingness to pay, an individual runs the risk that someone else will bid likewise, and he is forced to buy the object at a loss. And vice versa, if an individual bids below his own willingness to pay, he runs the risk of someone else buying the item at a lower price than the amount he himself is willing to pay. Therefore, in this kind of auction, it is in the individual's best interest to state a truthful bid. The auction is also socially efficient. The object goes to the person with the highest willingness to pay, and the person in question pays the social opportunity cost which is the second highest bid. Other researchers have later developed analogous principles, for example in order to elicit the true willingness to pay for public projects. Thus, Vickrey's analysis has not only been momentous for the theory of auctions; it has also conveyed fundamental insights into the design of resource allocation mechanisms aimed at providing socially desirable incentives.

Other Contributions
In addition, both James Mirrlees and William Vickrey have made noteworthy contributions to other areas of economics. In collaboration with the U.S. economist Peter Diamond, Mirrlees analyzed the structure of consumption taxes in a world where tax wedges give rise to social inefficiency. They arrived at an unambiguous and highly universal result by showing that under relatively general conditions, it is worthwhile to maintain full production efficiency. In concrete terms, this means that small open economies should not impose tariffs on foreign trade and that taxes on factors of production such as labor and capital should not be levied on the production side, but at the consumption stage. The latter result has had important consequences for project appraisal and economic policy in developing countries. In work with the British economist Ian Little and based on his research with Diamond, Mirrlees himself has set up criteria for evaluating development projects.

Efficient pricing of public services permeates Vickrey's scientific production. He has not only made significant theoretical contributions, but - unlike most excellent theorists - he has also followed up on his proposals all the way to their practical application. An example is Vickrey's famous study of the New York subway fare system in the 1950s. His proposal was an early attempt at efficient pricing of public services, under the restriction that the authorities should receive full cost coverage. His study represents more than an improvement on the basic pricing principle (so-called Ramsey pricing); it is also fascinating in its wealth of detail.



James A. Mirrlees was born in 1936 in Minnigaff, Scotland. He received his M.S. in Mathematics in Edinburgh in 1957, and his Ph.D. from the University of Cambridge in 1963. He was Edgeworth Professor of Economics at Oxford University between 1969 and 1995, and currently holds a professorship in Economics at the University of Cambridge.

Professor James A. Mirrlees
Department of Economics and Politics
University of Cambridge
Sidgwick Avenue
Cambridge CB3 9DD
U.K.

William Vickrey was born in 1914 in Victoria, British Columbia, Canada. He received his B.S. from Yale University in 1935. He then began postgraduate studies at Columbia University, New York, where he received his Master's degree in 1937 and his Ph.D. in 1947. He has been affiliated with the faculty of Columbia University since 1946, and also served as a tax advisor between 1937 and 1947. He was Professor Emeritus at Columbia University.
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