Mechanism Design and Why Government Auctions Matter

All roads lead to mechanism design. It is the last topic covered by any advanced microeconomics course here in the US.

The setup is thus: we want to achieve a social goal. Maybe it is the efficient allocation of resources or the equitable distribution of wealth. Whatever it is, we imagine how a most benevolent dictator would do things, and that is the aim we envision.

The problem is almost philosophical. People have different motivations, different goals that compete. These goals are not stated explicitly and people cannot be counted on to care for society's aim as a whole, although some might.

How can we then fashion the rules of the game in such a way that people, diverse as they are, left on their own devices, can move towards the goal we envision. Does such a "rule" exist? If so, what are the possible rules or mechanisms we can implement to drive people towards this goal?

These are the questions I have pondering on for the past few days. We are given problems where we are tasked to find appropriate mechanisms. Quite interestingly, the answer is almost never "let the markets run freely," although it seems outsiders always think that as economists, this should always be our answer. Free markets only work under the assumption that information is perfect, everyone's goals are well known, and there are no externalities. This is not the case. And surely, the world works in a different way.

I think mechanism design can be most clearly explained through the classic problem of who the government should task to build the next tollroad. The government wants to make sure the selected contractor is the best one for the job, that it could build the highway in the least cost with the best materials. But the problem is the government doesn't know what the motivations of each firm is, how efficient their production would be, and how each of them value the project. The government could spend loads just figuring this out. The contract might be given to the wrong firm.

In such a case, we find that an appropriate mechanism is to auction off the contract, like in a first price auction. Auctions work because it can be proven that each firms best strategy would be to submit bids equal to their true valuation. This allows the government to identify the most efficient firm, the one most worthy of the project. It provides the government with most revenue. BUT this only works as long as -- and the proof heavily relies on this --  firms are prevented from colluding and rigging the ballot. This is why the way government procurement is done matters a lot.

My head hurts from studying too much. But at the moment, I'm relishing the realization that there's a load of theory that goes behind such simple things as auctions.