Three US economists who established and developed theories governing how trade between two individuals or companies takes place and how it can be optimised have won the Nobel Prize in Economics.
The Royal Swedish Academy of Sciences announced yesterday that Leonid Hurwicz, Eric Maskin and Roger Myerson would share the 2007 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for "for having laid the foundations of mechanism design".
This toolkit for analysing market structures was initiated by Prof Hurwicz in the early 1960s and developed separately by professors Maskin and Myerson in the 1970s and 1980s. The economists will share the Skr10 million (€1 million) prize.
One problem that mechanism design theory can analyse occurs when buyers and sellers lie about their true motives and economics.
Prof Paul Klemperer of Oxford University, who has applied mechanism design theory widely, said: "Actions are the great triumph of it. Without the theory, we wouldn't be doing what we are now."
One of the difficulties in economics is that markets are remarkably efficient but they work best only under rather extreme assumptions. If information held by buyers or sellers is private - for example, how much someone is really willing to pay for something - trade can break down.
A company might say it is only willing to provide a service for $200 when, in fact, it would make a profit if it charged $150. Another might say it is only willing to buy at $100 when it would really pay up to $170.
In this example, trade is certainly possible between the range of $150 and $170, but the transaction might not occur because both the buyer and the seller have an incentive to misrepresent their true positions.
Prof Hurwicz, a Russian-born US citizen who is now 90, introduced to economics the important notion of "incentive compatibility" in 1972, which proved central to later developments, both theoretical and practical.
An important application is in economic regulation of industry, where companies have huge incentives not to reveal their private costs or information.
The theoretical work has led to more effective regulatory concepts, such as the design of auctions that give the parties an incentive to reveal their private information, enabling everyone to benefit.
Prof Myerson's 1981 paper "Optimal auction design" was a seminal work in this field.
