Presentation Speech by Professor Bertil Näslund of the Royal Swedish Academy of Sciences
Translation of the Swedish text
Your Majesties, Your Royal Highness, Ladies and Gentlemen,
A market economy is a gigantic system which communicates information about the production costs of enterprises and consumer preferences. Sometimes, however, information is unevenly distributed among decision-makers. A bank which lends money to a customer usually knows less than the borrower about his future income. An insurance company often has less knowledge than the policyholder when determining whether damage is due to a lack of proper care for insured property or whether it is caused by an external event.
In many instances, incomplete and asymmetric information has fundamental effects on the market system since an informational advantage can be exploited strategically.
Modern economic research is to a large extent devoted to analyses of how contracts and institutions can be designed to reduce the negative social effects of asymmetric information. This research has given us a better understanding of how insurance markets, credit markets, auctions, wage systems, tax systems etc. operate.
This year’s prizewinners have laid a methodological foundation for analyzing these seemingly quite disparate areas. They have solved important problems where asymmetric information plays a large role and have thereby developed methods with very general applications.
Many economic transactions take place through sealed bids. For strategic reasons, the bidder may be tempted to submit a bid which does not correspond to his true willingness to pay, for example by stating a bid which is lower than the price he is willing to pay. By doing so, he hopes to make a favorable deal. It can be shown that such strategic behavior often leads to social costs.
William Vickrey showed that if the highest bidder does not have to pay the price he bids – but the price stated in the next highest bid – then he has a private interest in revealing his true willingness to pay. At the same time, the price paid reflects the social opportunity cost of the item being auctioned. This contributes to social efficiency.
Vickrey’s contributions in this area have had important practical consequences, for example regarding the design of auctions of government securities, air traffic concessions, and band spectrum licenses.
Asymmetric information is also important in the design of income tax systems. In 1945, Vickrey showed how a tax system could be designed to take into consideration not only goals for the distribution of income after tax, such as equality, but also the fact that taxes should not distort economic behavior. Vickrey formulated the income tax problem mathematically in a way that specifically considered asymmetric information – namely that the government does not know the productivity of individuals and that it is the individual who decides his own work effort, while taking such factors as the tax rate into account. Vickrey was very close to a solution, but he was unable to master its mathematical complications.
It was James Mirrlees who, 26 years later, solved the income tax problem in a way which has become a paradigm for a broad class of economic problems where asymmetric information plays a large role. Mirrlees reformulated the problem in a way which made it possible to arrive at a solution. He established a principle whereby individuals are motivated to act in accordance with their true preferences.
Mirrlees has also made an important contribution to the analysis of two-party negotiations. One example is a situation where the holder of an insurance policy (the agent) knows more than the insurance company (the principal) about whether damage is due to improper care of insured property or is caused by external events (such as bad weather or theft). Many economic interactions take this form. Shareholders, for instance, do not always know if profit or loss in a company depends on actions taken by the management or on external circumstances.
In the mid-1970s, Mirrlees was able to show how contracts can be designed in such a way that the preferences of the principal are also taken into account by the agent. The solution that Mirrlees developed for this problem has had applications in many different areas.
James Mirrlees and William Vickrey have made fundamental contributions to the economic theory of incentives under asymmetric information.
William Vickrey died only a few days after the announcement that he was one of the recipients of this year’s prize in Economic Sciences. In accordance with the wishes of his widow, Cecile Vickrey, the prize will be received by his longtime friend and colleague Lowell Harriss.
Dear Professor Mirrlees,
It is an honor and a privilege for me to convey to you, on behalf of the Royal Swedish Academy of Sciences, our warmest congratulations. I now ask you to receive the Prize from his Majesty the King.
Dear Professor Harriss,
I now ask you to receive the Prize, on behalf of Mrs Vickrey, from His Majesty the King.