Nobel prize in economy 1996
From nobelsrv@www.nobel.ki.seTue Oct 8 15:19:09 1996
Date: Tue, 8 Oct 1996 12:56:56 +0100
From: Nobel Foundation WWW Server
Kungl. Vetenskapsakademien
The Royal Swedish Academy of Sciences
Box 50005, S-104 05 Stockholm, Sweden. Ph: +46 8 673 95 00,
fax: +46 8 15 56 70, e-mail: rsas@kansli.kva.se
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
for their fundamental contributions to the economic theory of
incentives under asymmetric information.
[Professor Vickrey died three days later at the age
of 82. (je)]
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 lenders' 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 is currently Professor
Emeritus at Columbia University.
Professor William Vickrey
Department of Economics
Columbia University
New York NY 10027
USA
-------
Edited by the webmaster of The Nobel Foundation