Allocation, Information and Markets

Frontmatter

Efficient Allocation

Abstract

Analysis of efficiency in the context of resource allocation has been a central concern of economic theory from ancient times, and is an essential element of modern microeconomic theory. The ends of economic action are seen to be the satisfaction of human wants through the provision of goods and services. These are supplied by production and exchange and limited by scarcity of resources and technology. In this context efficiency means going as far as possible in the satisfaction of wants within resource and technological constraints. This is expressed by the concept of Pareto optimality, which can be stated informally as follows: a state of affairs is Pareto optimal if it is within the given constraints and it is not the case that everyone can be made better off in his own view by changing to another state of affairs that satisfies the applicable constraints.

Stanley Reiter

Adverse Selection

Abstract

Consider a market in which products of varying quality are exchanged. Both buyers and sellers rank products of different quality in the same way, but only the sellers can observe the quality of each unit of the good they sell. Buyers can observe at most the distribution of the quality of the goods previously sold. Without some device for the buyers to identify good products, bad products will always be sold with the good products. Such a market illustrates the problem of adverse selection.

Charles Wilson

Asymmetric Information

Abstract

The Arrow-Debreu model is the basic model in which the two classical welfare theorems of economics are expressed. Under quite general assumptions, it can be shown that, first, a competitive equilibrium allocation, or Walrasian allocation, is Pareto efficient (Pareto optimal); second, under somewhat different assumptions, any Pareto efficient allocation will be a competitive equilibrium allocation after some suitable redistribution of initial endowments. Implicitly or explicitly, the statement of the first welfare theorem assumes that all economic agents have the same information about all economic variables. This is not to say that uncertainty is ruled out; there may be uncertainty as long as all agents are identically uncertain. If this assumption of symmetric information is violated, the competitive outcome will no longer be guaranteed to be Pareto efficient. The introduction of asymmetric information into various economic problems has given us new insight into how market failures might arise and whether there may be governmental, or other non-market, corrections which can improve welfare. Several examples illustrating this are given below.

A. Postlewaite

Auctions

Abstract

Herodotus reports the use of auctions as early as 500 BC in Babylon (see Cassady, 1967, pp. 26–40 for references to this and the following historical notes). The Romans made extensive use of auctions in commerce and the Roman emperors Caligula and Aurelius auctioned royal furniture and heirlooms to pay debts. Roman military expeditions were accompanied by traders who bid for the spoils of war auctioned sub hasta (under the spear) by soldiers. In AD 193 the Praetorian Guard seized the crown from the emperor Pertinax and auctioned it to the highest bidder, Didius, who, upon paying each guardsman the winning bid, 6250 drachmas, was declared emperor of Rome. It would appear that the Romans used the ‘English’ progressive method of auctioning, since the word auction is derived from the Latin root auctus (an increase).

Vernon L. Smith

Bidding

Abstract

Auctions are studied because they are market institutions of practical importance. Their simple procedural rules to resolve multilateral bargaining over the terms of trade enjoy enduring popularity. They also present simply several basic issues of price determination: the role of private information, the consequences of strategic behaviour and the effect of many traders. These issues have influenced the subject since the initial work of Vickrey (1961), the early contribution of Griesmer, Levitan, and Shubik (1967), and the influential dissertation by Ortega-Reichert (1968). Useful introductory surveys are by Engelbrecht-Wiggans (1980), Engelbrecht-Wiggans, Shubik and Stark (1983), Milgrom (1985), and MacAfee and McMillan (1986); bibliographies are in MacAfee and McMillan (1986) and Stark and Rothkopf (1979); and Cassady (1967) provides an historical perspective.

Robert Wilson

The Coase Theorem

Abstract

Anyone who has taught the Coase Theorem to fresh minds has experienced first hand the wonder and admiration which it inspires, yet Coase never wrote it down, and, when others try, it probably turns out to be false or a tautology. The proposition, or propositions, called the Coase Theorem was originally developed through a series of examples (Coase, 1960). Like a judge, Coase steadfastly refused to articulate broad generalizations in his original paper. Like a judge’s opinion, for every interpretation of his paper there is a plausible alternative. Instead of trying to arrive at the ultimate answer, I will offer several conventional interpretations of the Coase Theorem and illustrate them with one of his examples. After more than twenty years of debate the conventional interpretations appear to have exhausted its meanings.

Robert D. Cooter

Decentralization

Abstract

The main question to be answered by the theory of resource allocation, or by the theory of economic organization, concerns the performances of alternative systems characterized by different degrees of centralization of decision taking. A fully centralized system runs the risk of being inefficient because it does not create proper economic incentives and the centre is poorly informed. A pure market system with its high degree of decentralization runs the risk of bringing inequitable results and being inefficient because markets can never be complete, externalities exist and public wants tend to be neglected. Can these risks be avoided within the two opposite extremes of pure centralization or full decentralization? Can intermediate systems better resolve the difficulties? And if so, how?

E. Malinvaud

Economic Organization and Transaction Costs

Abstract

One important extension of the Coase Theorem states that, if all costs of transactions are zero, the use of resources will be similar, no matter how production and exchange activities are arranged. This implies that in the absence of transaction costs, alternative institutional or organizational arrangements would provide no basis for choice and hence could not be interpreted by economic theory. Not only would economic organization be randomly determined; there actually would not be any organization to speak of: production and exchange activities would simply be guided by the invisible hand of the market.

Steven N. S. Cheung

Exchange

Abstract

The accepted purview of economics is the allocation of scarce resources. Allocation comprises production and exchange, according to a division between processes that transform commodities and those that transfer control. For production or consumption, exchange is essential to efficient use of resources. It allows decentralization and specialization in production; and for consumption, agents with diverse endowments or preferences require exchange to obtain maximal benefits. If two agents have differing marginal rates of substitution then there exists a trade benefiting both. The advantages of barter extend widely, e.g. to trade among nations and among legislators (‘vote trading’), but it suffices here to emphasize markets with enforceable contracts for trading private property unaffected by externalities. In such markets, voluntary exchange involves trading bundles of commodities or obligations to the mutual advantage of all parties to the transaction.

Robert Wilson

Experimental Methods in Economics

Abstract

Historically, the method and subject matter of economics have presupposed that it was a non-experimental (or ‘field observational’) science more like astronomy or meteorology than physics or chemistry. Based on general, introspectively ‘plausible’, assumptions about human preferences, and about the cost and technology-based supply response of producers, economists have sought to understand the functioning of economies, using observations generated by economic outcomes realized over time. The data of the astronomer is of this same type, but it would be wrong to conclude that astronomy and economics are methodologically equivalent. There are two important differences between astronomy and economics which help to illuminate some of the methodological problems of economics. First, based upon parallelism (the maintained hypothesis that the same physical laws hold everywhere), astronomy draws on all the relevant theory from classical mechanics and particle physics — theory which has evolved under rigorous laboratory tests. Traditionally, economists have not had an analogous body of tested behavioural principles that have survived controlled experimental tests, and which can be assumed to apply with insignificant error to the microeconomic behaviour that underpins the observable operations of the economy. Analogously, one might have supposed that there would have arisen an important area of common interest between economics and, say, experimental psychology, similar to that between astronomy and physics, but this has only started to develop in recent years.

Vernon L. Smith

Externalities

Abstract

Competitive equilibria are Pareto optimal when they exist if preferences are locally non-satiated and if externalities are not present in the economy. Why externalities upset the first fundamental theorem of welfare economics and which economic policies can remedy this failure are the major questions addressed below.

J.-J. Laffont

Fraud

Abstract

An agent is said to have committed fraud when he misrepresents the information he has at his disposal so as to persuade another individual (principal) to choose a course of action he would not have chosen had he been properly informed. The essential element of this phenomenon is the presence of two individuals both of whom have something to gain from co-operating with each other but who have conflicting interests and differential information. More specifically, it is critical that the agent be both better informed than the principal and in a position to use his superior knowledge to affect the principal’s actions so as to increase his own share of the total benefit at the principal’s expense. As the choice of terminology indicates, fraud is a special case of a more general class of economic phenomena known as agency relationships. (For a more elaborate discussion and citations see Arrow, 1985.)

Edi Karni

Hidden Actions, Moral Hazard and Contract Theory

Abstract

‘Moral hazard’ in the literal sense refers to the adverse effects, from the insurance company’s point of view, that insurance may have on the insuree’s behaviour. As an extreme but standard example, a fire insurance holder may burn the property in order to obtain the insured sums. Although the expression can be found in earlier literature, its extensive use in economics can be dated from Arrow’s Essays in the Theory of Risk-bearing (1971), which had a decisive influence in popularizing the term as well as in stimulating a systematic study both of the subject itself and of related phenomena. Arrow stresses that the complete set of markets required for first best efficiency often cannot be organized. The (so-called) Arrow-Debreu contracts which are needed would have to be contingent on states of nature. This term, ‘states of nature’, has to be taken in its meaning in decision theory where it refers to random events whose realization reflects an exogenous choice by ‘Nature’, and not an endogenous choice by agents. However, states of nature may not be observable either directly or indirectly, so that real contracts have to rely upon imperfect proxies. Take the overly simple fire insurance example. Arrow-Debreu contingent contracts would make indemnification conditional only on the occurrence of those natural events that can cause fire, such as thunderstorms, whereas actual real-world contracts make it dependent upon the occurrence of fire itself, whether due to an unusual exogenous event, or to a more normal exogenous event coupled with insufficient care.

Roger Guesnerie

Implicit Contracts

Abstract

An implicit contract is a theoretical construct meant to describe complex agreements, written and tacit, between employers and employees, which govern the exchange of labour services when various types of job-specific investments inhibit labour mobility, and opportunities to shed risk are limited by imperfectly developed markets for contingent claims. This construct differs from the more familiar one of a neoclassical labour exchange in emphasizing a trading process, frequently over a long period of time, between two specific economic units (say a worker and a firm, union and management, etc.) rather than the impersonal, and often instantaneous, market process in which wages decentralize and coordinate the actions of labour suppliers and labour demanders.

Costas Azariadis

Incentive Compatibility

Abstract

Allocation mechanisms, organizations, voting procedures, regulatory bodies and many other institutions are designed to accomplish certain ends such as the Pareto-efficient allocation of resources or the equitable resolution of disputes. In many situations it is relatively easy to conceive of feasible processes; processes which will accomplish the goals if all participants follow the rules and are capable of handling the informational requirements. Examples of such mechanisms include marginal cost pricing, designed to attain efficiency, and equal division, designed to attain equity. Of course once a feasible mechanism is found, the important question then becomes whether such a mechanism is also informationally feasible and compatible with ‘natural’ incentives of the participants. Incentive compatibility is the concept introduced by Hurwicz (1972, p. 320) to characterize those mechanisms for which participants in the process would not find it advantageous to violate the rules of the process.

John O. Ledyard

Incentive Contracts

Abstract

Incentives are the essence of economics. The most basic concept, demand, considers how to induce a consumer to buy more of a particular good; that is, how to give him an incentive to purchase. Similarly, supply relationships are descriptions of how agents respond with more output or labour to additional compensation.

Edward P. Lazear

Incomplete Contracts

Abstract

The past decade has witnessed a growing interest in contract theories of various kinds. This development is partly a reaction to our rather thorough understanding of the standard theory of perfect competition under complete markets, but more importantly to the resulting realization that this paradigm is insufficient to accommodate a number of important economic phenomena. Studying in more detail the process of contracting — particularly its hazards and imperfections — is a natural way to enrich and amend the idealized competitive model in an attempt to fit the evidence better.

Oliver Hart

Incomplete Markets

Abstract

Markets are complete when every agent is able to exchange every good either directly or indirectly with every other agent. When markets are not complete, two fundamental properties of a competitive equilibrium with complete markets may no longer be satisfied. First, stockholders may not agree on the optimal production plan for a firm. Secondly, even in a model of pure exchange, a competitive allocation may not be Pareto optimal even when we restrict attention to allocations which are ‘consistent’ with the market structure. It is with the failure of this optimality property that this essay will be concerned.

Charles Wilson

Market Failure

Abstract

The best way to understand market failure is first to understand market success, the ability of a collection of idealized competitive markets to achieve an equilibrium allocation of resources which is Pareto optimal. This characteristic of markets, which was loosely conjectured by Adam Smith, has received its clearest expression in the theorems of modern welfare economics. For our purposes, the first of these, named the First Fundamental Theorem of welfare economics, is of most interest. Simply stated it reads: (1) if there are enough markets, (2) if all consumers and producers behave competitively, and (3) if an equilibrium exists, then the allocation of resources in that equilibrium will be Pareto optimal. (See Arrow, 1951, or Debreu, 1959.) Market failure is said to occur when the conclusion of this theorem is false; that is, when the allocations achieved with markets are not efficient.

John O. Ledyard

Mechanism Design

Abstract

1. overview. A mechanism is a specification of how economic decisions are determined as a function of the information that is known by the individuals in the economy. In this sense, almost any kind of market institution or economic organization can be viewed, in principle, as a mechanism. Thus mechanism theory can offer a unifying conceptual structure in which a wide range of institutions can be compared, and optimal institutions can be identified.

Roger B. Myerson

Moral Hazard

Abstract

The problem of moral hazard is pervasive in economic activities. Economists have been well aware of its existence as the following quote from the Wealth of Nations will testify:

The directors of such companies, however, being the managers rather of other peoples’ money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own… Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company (Smith, 1776, p. 700).

Y. Kotowitz

Natural Selection and Evolution

Abstract

Important theoretical concepts tend to resist satisfactory definition (cf. Stigler, 1957). Such concepts are in the service of the expansive ambitions of the theories in which they occur, and must accordingly respond flexibly to the changing requirements for maintaining order in a changing intellectual empire. The term ‘evolution’ — obviously important in biology, but also in the physical and social sciences — provides a good illustration of this principle. A prominent biologist and author of a highly expansive treatise on biological evolution had the following to offer in his glossary:

Evolution. Any gradual change. Organic evolution, often referred to as evolution for short, is any genetic change in organisms from generation to generation, or more strictly, a change in gene frequencies within populations from generation to generation (Wilson, 1975).

Sidney G. Winter

Organization Theory

Abstract

Since all the social sciences deal with human organizations, (families, bureaucracies, tribes, corporations, armies), the term ‘organization theory’ appears in all of them. What has distinguished the economists’ pursuit of organization theory from that of sociologists, of political scientists and of psychologists (say those psychologists working in the field called ‘organizational behaviour’)? First, the real organizations that have inspired the theorizing of economists are the economy, the market and the firm. Second, economists, with their customary taste for rigour, have sought to define formally and precisely the vague terms used in informal discourse about organizations, in such a way as to capture the users’ intent. They have sought to test plausible propositions about organizations — either by proving that they follow from simple, reasonable and precisely stated assumptions, or (rarely) by formulating the propositions as statements about observable variables on which systematic rather than anecdotal data can be collected, and then applying the normal statistical procedures of empirical economics. (Here we shall only consider testing of the first type.) Third, much of the economists’ organization theory is not descriptive but normative; it concerns not what is, but what could be. It takes the viewpoint of an organization designer. The organization is to respond to a changing and uncertain environment. The designer has to balance the ‘benefits’ of these responses against the organization’s informational costs; good responses may be costly to obtain. In addition, the designer may require the responses to be incentive-compatible: each member of the organization must want to carry out his/her part of the total organizational response in just the way the designer intends.

Thomas Marschak

Perfectly and Imperfectly Competitive Markets

Abstract

In the competition between economic models, the theory of perfect competition holds a dominant market share: no set of ideas is so widely and successfully used by economists as is the logic of perfectly competitive markets. Correspondingly, all other market models (collectively labelled ‘imperfectly competitive’ and including monopoly, monopolistic competition, dominant-firm price leadership, bilateral monopoly and other situations of bargaining, and all the varieties of oligopoly theory) are little more than fringe competitors.

John Roberts

Principal and Agent

Abstract

The principal-agent literature is concerned with how one individual, the principal (say an employer), can design a compensation system (a contract) which motivates another individual, his agent (say the employee), to act in the principal’s interests. The term principal-agent problem is due to Ross (1973). Other early contributions to this literature include Mirrlees (1974, 1976) and Stiglitz 1974, 1975).

Joseph E. Stiglitz

Public Goods

Abstract

The development by Paul Samuelson ( 1954, 1955) of the modern theory of public goods must be counted as one of the major breakthroughs in the theory of public finance. In these two very short papers Samuelson posed and partly solved the central problems in the normative theory of public expenditure:

(1)

How can one define analytically goods that are consumed collectively, that is for which there is no meaningful distinction between individual and total consumption?

 

(2)

How can one characterize an optimal allocation of resources to the production of such goods?

 

(3)

What can be said about the design of an efficient and just tax system which will finance the expenditures of the public sector?

 

Agnar Sandmo

Revelation of Preferences

Abstract

Competitive rational consumers reveal their preferences through their market behaviour, as was made clear by Samuelson’s ( 1947) revealed preference approach and by the literature on demand theory. Any bundle of commodities less costly than his chosen bundle must be less appreciated by a rational consumer than his chosen bundle.

J.-J. Laffont

Search Theory

Abstract

Walrasian analysis presumes that resource allocation can be adequately modelled using the assumption of instantaneous and costless coordination of trade. In contrast, Search Theory is the analysis of resource allocation with specified, imperfect technologies for informing agents of their trading opportunities and for bringing together potential traders. The modelling advantages of assuming a frictionless coordination mechanism, plus years of hard work, permit Walrasian analysis to work with very general specifications of individual preferences and production technologies. In contrast, search theorists have explored a variety of special allocation mechanisms together with very simple preferences and production technologies. Lacking more general theories, we examine the catalogue of analyses that have been completed.

P. Diamond

Signalling

Abstract

If product quality of individual units cannot be observed at the time of purchase, but buyers do eventually learn average quality, goods will be traded at a price which reflects buyers’ beliefs about this average. The price will then adjust until buyers’ beliefs about average quality are confirmed ex post.

John G. Riley

Teams

Abstract

The economic theory of teams addresses a middle ground between the theory of individual decision under uncertainty and the theory of games. A team is made up of a number of decision-makers, with common interests and beliefs, but controlling different decision variables and basing their decisions on (possibly) different information. The theory of teams is concerned with (1) the allocation of decision variables (tasks) and information among the members of the team, and (2) the characterization of efficient decision rules, given the allocation of tasks and information.

Roy Radner

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