Mechanism design is a field in
game theoryGame theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...
studying
solution conceptIn game theory, a solution concept is a formal rule for predicting how the game will be played. These predictions are called "solutions", and describe which strategies will be adopted by players, therefore predicting the result of the game...
s for a class of private information games. The distinguishing features of these games are:
 that a game "designer" chooses the game structure rather than inheriting one
 that the designer is interested in the game's outcome
Such a game is called a "game of mechanism design" and is usually solved by motivating agents to disclose their private information. The 2007
Nobel Memorial Prize in Economic SciencesThe Nobel Memorial Prize in Economic Sciences, commonly referred to as the Nobel Prize in Economics, but officially the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel , is an award for outstanding contributions to the field of economics, generally regarded as one of the...
was awarded to
Leonid HurwiczLeonid "Leo" Hurwicz was a Russianborn American economist and mathematician. His nationality of origin was Polish. He was Jewish. He originated incentive compatibility and mechanism design, which show how desired outcomes are achieved in economics, social science and political science...
,
Eric MaskinEric Stark Maskin is an American economist and Nobel laureate recognized with Leonid Hurwicz and Roger Myerson "for having laid the foundations of mechanism design theory." He is the Albert O...
, and
Roger MyersonRoger Bruce Myerson is an American economist and Nobel laureate recognized with Leonid Hurwicz and Eric Maskin for "having laid the foundations of mechanism design theory." A professor at the University of Chicago, he has made contributions as an economist, as an applied mathematician, and as a...
"for having laid the foundations of mechanism design theory".
Intuition
In an interesting class of
Bayesian gameIn game theory, a Bayesian game is one in which information about characteristics of the other players is incomplete. Following John C. Harsanyi's framework, a Bayesian game can be modelled by introducing Nature as a player in a game...
s, one player, called the “principal,” would like to condition his behavior on information privately known to other players. For example, the principal would like to know the true quality of a used car a salesman is pitching. He cannot learn anything simply by asking the salesman because it is in his interest to distort the truth. Fortunately, in mechanism design the principal does have one advantage. He may design a game whose rules can influence others to act the way he would like.
Absent mechanism design theory the principal's problem would be difficult to solve. He would have to consider all the possible games and choose the one that best influences other players' tactics. In addition the principal would have to draw conclusions from agents who may lie to him. Thanks to mechanism design, and particularly the revelation principle, the principal need only consider games in which agents truthfully report their private information.
Mechanism
A game of mechanism design is a game of private information in which one of the agents, called the principal, chooses the payoff structure. Following
HarsanyiJohn Charles Harsanyi was a HungarianAustralianAmerican economist and Nobel Memorial Prize in Economic Sciences winner....
(1967), the agents receive secret "messages" from nature containing information relevant to payoffs. For example, a message may contain information about their preferences or the quality of a good for sale. We call this information the agent's "type" (usually noted
and accordingly the space of types
). Agents then report a type to the principal (usually noted with a hat
) that can be a strategic lie. After the report, the principal and the agents are paid according to the payoff structure the principal chose.
The timing of the game is:
 The principal commits to a mechanism that grants an outcome as a function of reported type
 The agents report, possibly dishonestly, a type profile
 The mechanism is executed (agents receive outcome )
In order to understand who gets what, it is common to divide the outcome
into a goods allocation and a money transfer,
where
stands for an allocation of goods rendered or received as a function of type, and
stands for a monetary transfer as a function of type.
As a benchmark the designer often defines what would happen under full information. Define a social choice function
mapping the (true) type profile directly to the allocation of goods received or rendered,
In contrast a mechanism maps the reported type profile to an outcome (again, both a goods allocation
and a money transfer
)
Revelation principle
A proposed mechanism constitutes a Bayesian game (a game of private information), and if it is wellbehaved the game has a Bayesian Nash equilibrium. At equilibrium agents choose their reports strategically as a function of type
It is difficult to solve for Bayesian equilibria in such a setting because it involves solving for agents' bestresponse strategies and for the best inference from a possible strategic lie. Thanks to a sweeping result called the revelation principle, no matter the mechanism a designer can confine attention to equilibria in which agents truthfully report type. The revelation principle states: "For any Bayesian Nash equilibrium there corresponds a Bayesian game with the same equilibrium outcome but in which players truthfully report type."
This is extremely useful. The principle allows one to solve for a Bayesian equilibrium by assuming all players truthfully report type (subject to an
incentive compatibilityIn mechanism design, a process is said to be incentivecompatible if all of the participants fare best when they truthfully reveal any private information asked for by the mechanism. As an illustration, voting systems which create incentives to vote dishonestly lack the property of incentive...
constraint). In one blow it eliminates the need to consider either strategic behavior or lying.
Its proof is quite direct. Assume a Bayesian game in which the agent's strategy and payoff are functions of its type and what others do,
. By definition agent is equilibrium strategy
is Nash in expected utility:
Simply define a mechanism that would induce agents to choose the same equilibrium. The easiest one to define is for the mechanism to commit to playing the agents' equilibrium strategies for them.
Under such a mechanism the agents of course find it optimal to reveal type since the mechanism plays the strategies they found optimal anyway. Formally, choose
such that


Implementability
The designer of a mechanism generally hopes either
 to design a mechanism that "implements" a social choice function
 to find the mechanism that maximizes some value criterion (e.g. profit)
To implement a social choice function
is to find some
transfer function that motivates agents to pick outcome
. Formally, if the equilibrium strategy profile under the mechanism maps to the same goods allocation as a social choice function,
we say the mechanism implements the social choice function.
Thanks to the revelation principle, the designer can usually find a transfer function
to implement a social choice by solving an associated truthtelling game. If agents find it optimal to truthfully report type,
we say such a mechanism is truthfully implementable (or just "implementable"). The task is then to solve for a truthfully implementable
and impute this transfer function to the original game. An allocation
is truthfully implementable if there exists a transfer function
such that

which is also called the incentive compatibility (IC) constraint.
In applications, the IC condition is the key to describing the shape of
in any useful way. Under certain conditions it can even isolate the transfer function analytically! Additionally, a participation (individual rationality) constraint is sometimes added if agents have the option of not playing.
Necessity
Consider a setting in which all agents have a typecontingent utility function
. Consider also a goods allocation
that is vectorvalued and size
(which permits
number of goods) and assume it is piecewise continuous with respect to its arguments.
The function
is implementable only if
whenever
and
and x is continuous at
. This is a necessary condition and is derived from the first and secondorder conditions of the agent's optimization problem assuming truthtelling.
Its meaning can be understood in two pieces. The first piece says the agent's
marginal rate of substitutionIn economics, the marginal rate of substitution is the rate at which a consumer is ready to give up one good in exchange for another good while maintaining the same level of utility.Marginal rate of substitution as the slope of indifference curve:...
increases as a function of the type,
In short, agents will not tell the truth if the mechanism does not offer higher agent types a better deal. Otherwise, higher types facing any mechanism that punishes high types for reporting will lie and declare they are lower types, violating the truthtelling IC constraint. The second piece is a monotonicity condition waiting to happen,
which, to be positive, means higher types must be given more of the good.
There is potential for the two pieces to interact. If for some type range the contract offered less quantity to higher types
, it is possible the mechanism could compensate by giving higher types a discount. But such a contract already exists for lowtype agents, so this solution is pathological. Such a solution sometimes occurs in the process of solving for a mechanism. In these cases it must be "ironed." In a multiplegood environment it is also possible for the designer to reward the agent with more of one good to substitute for less of another (e.g.
butterButter is a dairy product made by churning fresh or fermented cream or milk. It is generally used as a spread and a condiment, as well as in cooking applications, such as baking, sauce making, and pan frying...
for
margarineMargarine , as a generic term, can indicate any of a wide range of butter substitutes, typically composed of vegetable oils. In many parts of the world, the market share of margarine and spreads has overtaken that of butter...
). Multiplegood mechanisms are an ongoing problem in mechanism design theory.
Sufficiency
Mechanism design papers usually make two assumptions to ensure implementability:
This is known by several names: the singlecrossing condition, the sorting condition and the SpenceMirrlees condition. It means the utility function is of such a shape that the agent's MRS is increasing in type.
This is a technical condition bounding the rate of growth of the MRS.
These assumptions are sufficient to provide that any monotonic
is implementable (a
exists that can implement it). In addition, in the singlegood setting the singlecrossing condition is sufficient to provide that only a monotonic
is implementable, so the designer can confine his search to a monotonic
.
Revenue equivalence theorem
Vickrey (1961) gives a celebrated result that any member of a large class of auctions assures the seller of the same expected revenue and that the expected revenue is the best the seller can do. This is the case if
 The buyers have identical valuation functions (which may be a function of type)
 The buyers' types are independently distributed
 The buyers types are drawn from a continuous distribution
 The type distribution bears the monotone hazard rate property
 The mechanism sells the good to the buyer with the highest valuation
The last condition is crucial to the theorem. An implication is that for the seller to achieve higher revenue he must take a chance on giving the item to an agent with a lower valuation. Usually this means he must risk not selling the item at all.
Vickrey–Clarke–Groves mechanisms
The Vickrey (1961) auction model was later expanded by Clarke (1971) and Groves (1973) to treat a public choice problem in which a public project's cost is borne by all agents, e.g. whether to build a municipal bridge. The resulting "Vickrey–Clarke–Groves" mechanism can motivate agents to choose the socially efficient allocation of the public good even if agents have privately known valuations. In other words, it can solve the "
tragedy of the commonsThe tragedy of the commons is a dilemma arising from the situation in which multiple individuals, acting independently and rationally consulting their own selfinterest, will ultimately deplete a shared limited resource, even when it is clear that it is not in anyone's longterm interest for this...
"—under certain conditions, in particular quasilinear utility or if budget balance is not required.
Consider a setting in which
number of agents have quasilinear utility with private valuations
where the currency
is valued linearly. The VCG designer designs an incentive compatible (hence truthfully implementable) mechanism to obtain the true type profile, from which the designer implements the socially optimal allocation
The cleverness of the VCG mechanism is the way it motivates truthful revelation. It eliminates incentives to misreport by penalizing any agent by the cost of the distortion he causes. Among the reports the agent may make, the VCG mechanism permits a "null" report saying he is indifferent to the public good and cares only about the money transfer. This effectively removes the agent from the game. If an agent does choose to report a type, the VCG mechanism charges the agent a fee if his report is pivotal, that is if his report changes the optimal allocation x so as to harm other agents. The payment is calculated
which sums the distortion in the utilities of the other agents (and not his own) caused by one agent reporting.
GibbardSatterthwaite theorem
Gibbard (1973) and Satterthwaite (1975) give an impossibility result similar in spirit to
Arrow's impossibility theoremIn social choice theory, Arrow’s impossibility theorem, the General Possibility Theorem, or Arrow’s paradox, states that, when voters have three or more distinct alternatives , no voting system can convert the ranked preferences of individuals into a communitywide ranking while also meeting a...
. For a very general class of games, only "dictatorial" social choice functions can be implemented.
A social choice function f is dictatorial if one agent always receives his mostfavored goods allocation,
The theorem states that under general conditions any truthfully implementable social choice function must be dictatorial,
 X finite and contains at least three elements
 Preferences are rational

MyersonSatterthwaite theorem
Myerson and Satterthwaite (1983) show there is no efficient way for two parties to trade a good when they each have secret and probabilistically varying valuations for it, without the risk of forcing one party to trade at a loss. It is among the most remarkable negative results in economics—a kind of negative mirror to the
fundamental theorems of welfare economicsThere are two fundamental theorems of welfare economics. The first states that any competitive equilibrium or Walrasian equilibrium leads to a Pareto efficient allocation of resources. The second states the converse, that any efficient allocation can be sustainable by a competitive equilibrium...
.
Price discrimination
Mirrlees (1971) introduces a setting in which the transfer function t is easy to solve for. Due to its relevance and tractability it is a common setting in the literature. Consider a singlegood, singleagent setting in which the agent has
quasilinear utilityIn economics and consumer theory, quasilinear utility functions are linear in one argument, generally the numeraire. This utility function has the representation U = x_1 + \theta...
with an unknown type parameter
and in which the principal has a prior
CDFIn probability theory and statistics, the cumulative distribution function , or just distribution function, describes the probability that a realvalued random variable X with a given probability distribution will be found at a value less than or equal to x. Intuitively, it is the "area so far"...
over the agent's type
. The principal can produce goods at a convex marginal cost c(x) and wants to maximize the expected profit from the transaction
subject to IC and IR conditions
The principal here is a monopolist trying to set a profitmaximizing price scheme in which it cannot identify the type of the customer. A common example is an airline setting fares for business, leisure and student travelers. Due to the IR condition it has to give every type enough a good enough deal to induce participation. Due to the IC condition it has to give every type a good enough deal that the type prefers its deal to that of any other.
A trick given by Mirrlees (1971) is to use the
envelope theoremThe envelope theorem is a theorem about optimization problems in microeconomics. It may be used to prove Hotelling's lemma, Shephard's lemma, and Roy's identity...
to eliminate the transfer function from the expectation to be maximized,
Integrating,
where
is some index type. Replacing the incentivecompatible
in the maximand,

after an integration by parts. This function can be maximized pointwise, a fantastic result because it dispenses with the need to use the
calculus of variationsCalculus of variations is a field of mathematics that deals with extremizing functionals, as opposed to ordinary calculus which deals with functions. A functional is usually a mapping from a set of functions to the real numbers. Functionals are often formed as definite integrals involving unknown...
.
Because
is incentivecompatible already the designer can drop the IC constraint. If the utility function satisfies the SpenceMirrlees condition then a monotonic
function exists. The IR constraint can be checked at equilibrium and the fee schedule raised or lowered accordingly. Additionally, note the presence of a hazard rate in the expression. If the type distribution bears the monotone hazard ratio property, the FOC is sufficient to solve for t. If not, then it is necessary to check whether the monotonicity constraint (see sufficiency, above) is satisfied everywhere along the allocation and fee schedules. If not, then the designer must use Myerson ironing.
Myerson ironing
In some applications the designer may solve the firstorder conditions for the price and allocation schedules yet find they are not monotonic. For example, in the quasilinear setting this often happens when the hazard ratio is itself not monotone. By the SpenceMirrlees condition the optimal price and allocation schedules must be monotonic, so the designer must eliminate any interval over which the schedule changes direction by flattening it.
Intuitively, what is going on is the designer finds it optimal to bunch certain types together and give them the same contract. Normally the designer motivates higher types to distinguish themselves by giving them a better deal. If there are insufficiently few higher types on the margin the designer does not find it worthwhile to grant lower types a concession (called their information rent) in order to charge higher types a typespecific contract.
Consider a monopolist principal selling to agents with quasilinear utility, the example above. Suppose the allocation schedule
satisfying the firstorder conditions has a single interior peak at
and a single interior trough at
, illustrated at right.
 Following Myerson (1981) flatten it by choosing satisfying
 where is the inverse function of x mapping to and is the inverse function of x mapping to . That is, returns a before the interior peak and returns a after the interior trough.
 If the nonmonotonic region of borders the edge of the type space, simply set the appropriate function (or both) to the boundary type. If there are multiple regions, see a textbook for an iterative procedure; it may be that more than one troughs should be ironed together.
Proof
The proof uses the theory of optimal control. It considers the set of intervals
in the nonmonotonic region of
over which it might flatten the schedule. It then writes a Hamiltonian to obtain necessary conditions for a
within the intervals
 that does satisfy monotonicity
 for which the monotonicity constraint is not binding on the boundaries of the interval
Condition two ensures that the
satisfying the optimal control problem reconnects to the schedule in the original problem at the interval boundaries (no jumps). Any
satisfying the necessary conditions must be flat because it must be monotonic and yet reconnect at the boundaries.
As before maximize the principal's expected payoff, but this time subject to the monotonicity constraint
and use a Hamiltonian to do it, with shadow price
where
is a state variable and
the control. As usual in optimal control the costate evolution equation must satisfy
Taking advantage of condition 2, note the monotonicity constraint is not binding at the boundaries of the
interval,
meaning the costate variable condition can be integrated and also equals 0
The average distortion of the principal's surplus must be 0. To flatten the schedule, find an
such that its inverse image maps to a
interval satisfying the condition above.
See also
 Algorithmic mechanism design
Algorithmic mechanism design lies at the intersection of economic game theory and computer science.Noam Nisan and Amir Ronen, from the Hebrew University of Jerusalem, first coined "Algorithmic mechanism design" in a research paper published in 2001....
 Contract theory
In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of asymmetric information. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as Law and economics...
 Implementation theory
Implementation theory is an area of game theory closely related to mechanism design where an attempt is made to add into a game a mechanism such that the equilibrium of the game conforms to some concept of social optimality ....
 Incentive compatibility
In mechanism design, a process is said to be incentivecompatible if all of the participants fare best when they truthfully reveal any private information asked for by the mechanism. As an illustration, voting systems which create incentives to vote dishonestly lack the property of incentive...
 Revelation principle
The revelation principle of economics can be stated as, "To any Bayesian Nash equilibrium of a game of incomplete information, there exists a payoffequivalent revelation mechanism that has an equilibrium where the players truthfully report their types."...
 Smart market
A "smart market" is a periodic auction which is cleared by the operations research technique of mathematical optimization, such as linear programming. The smart market is operated by a market manager. Trades are not bilateral, between pairs of people, but rather to or from a pool...
 Metagame