8 October 1996
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,
(deceased October 10, 1996)
for their fundamental contributions to the economic theory of incentives under asymmetric information.
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 borrowers’ 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.
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.
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.
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.
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
Cambridge CB3 9DD
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 was Professor Emeritus at Columbia University.