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Monday, December 14, 2009

Leonid Hurwicz : Oldest Economist to Get Nobel

Leonid Hurwicz

It is a matter of commonsense that economic transactions take place in markets. What is, however, not that commonly known is about the economic transactions that take place within firms and a host of other institutional arrangements, but are mostly guided by the market prices. Some of these markets are highly regulated by governments, while some others are free from such governmental interventions. And, often markets are held as efficient ‘allocation mechanisms’, for they stay focused on the problems relating to incentives and private information.

However, in the early 20th century, there emerged a new concept called ‘socialism’ that triggered a bitter argument among the economists as to whether socialist reform of economic institutions was possible without loss of economic efficiency. Von Mises and Hayek argued that “A centrally-planned economy was doomed to collapse: because every individual knew his own needs and capabilities best, government planners could never hope to piece it all together and make sensible decisions.” But economists like Oskar Lange and Abba Lerner disagreed with them arguing that a centralized planning, if conceived and executed well, can even surpass the performance of the competitive market.

Their arguments, however, remained inconclusive, for the then existing framework of economic analysis was felt inadequate to formally prove any side of argument as right. To measure the efficiency levels of these two distinctly different forms of economic architecture, a new and more general theoretical framework was felt essential. Hayek also argued that any model attempting to evaluate these two economic organizations must first recognize that economic institutions of all kinds essentially serve as a means to transmit the widely dispersed information about the desires and resources of different individuals of the society. But the economists of those days have, in the words of Hayek, ignored the importance of communication in market systems. It is of course a different matter that the subsequent corpus of research findings under the economic theory of competitive markets and the bitter failure of socialist economies have made many to conclude that Von Mises and Hayek were right but what then Hayek looked for was a new mathematical model that could capture the importance of communication in market systems and permit a generalized comparison of the two systems.

In the words of Hayek, as published in his famous 1945 paper The Use of Knowledge in Society, “The economic problem of society is not merely a problem of how to allocate ‘given’ resources.... It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. is a problem of the utilization of knowledge not given to anyone in its totality. This character of the fundamental problem has, I am afraid, been rather obscured than illuminated by many of the recent refinements of economic theory, particularly by many of the uses made of mathematics.” It was this challenge of Hayek that Leonid Hurwicz—who was born in Moscow on August 21, 1917 to Polish-Jewish refugee parents; obtained a law degree from Warsaw University in 1938; studied at London School of Economics with Von Hayek and Nicolas Kaldor, and with Von Mises at Geneva’s Graduate Institute of International studies; moved to the US in 1940; worked at Harvard, MIT as a research assistant to Paul Samuelson, Chicago’s Institute of Meteorology, Cowles Commission for Research in Economics; and finally settled at the University of Minnesota—took up.

In the process, Leonid Hurwicz— against the normal practice of economists to predict the likely outcome from institutions such as markets, regulations and taxes—came up with a theory of Mechanism Design that can tell us if we could design an institution that is capable of delivering the desired outcome, a sort of ‘reverse engineering’ in economics. This can be best illustrated with the example of a mother’s dilemma: How to divide the single dosa that she cooked between her two sons? She first thought of dividing the dosa into two equal pieces and keep it ready for her sons—Ram and Prasad—returning from school. But she wondered: What if, one of them thinks that the other got a bigger piece? It may even generate envy between them. To obviate this, she then came up with a new model: asking Ram to cut the dosa into two pieces while granting the right to pick a piece of his choice to Prasad, leaving the other piece to Ram. This mechanism, she thought, would induce Ram to cut the dosa into two equal halves, so that no matter which piece Prasad chose, he could be happy with the left-out piece. Prasad also would be happy because since he had the right to choose his pick. Thus, warmth—the desired outcome—is ensured between them. Here, the designer—mother—is not having enough advance information as to which outcome will achieve her goal and hence she has to proceed indirectly, i.e., through the mechanism of divide-and-choose model which in itself generates the information needed. On the other hand, the designer’s goal hardly matters to the participants, Ram and Prasad, for they are only concerned about getting as much dosa as possible.

His Mechanism Design theory, thus, provides a coherent framework to analyze ‘allocation mechanisms’ and particularly, the complexities of ‘incentives’ and ‘private information’ associated with it. In his seminal work of 1960 and 1972, Leonid Hurwicz defined mechanism as a communication system in which participants send messages to each other or to a message center where a pre-specified rule assigns an outcome for every received message. E-bay auctioning is a best illustration of this. He opined that it is useful to look at any economic institution in this way. Importantly, he argued that the path to the most efficient and satisfactory economic outcome in any system is to design mechanisms which induces everybody to do the best for themselves by sharing truthfully whatever private information they have, which idea he named as ‘incentive compatibility’. Leo is the first to conceptualize the abstractions such as ‘mechanisms’, their role in information-generation, and ‘incentive compatibility’ by offering clear definitions in his pioneering papers of 1960 and 1972.

Coming back to Hayek’s challenge, Hurwicz argued that the failure of the central planning model was more due to lack of incentive for people to share their information with the government truthfully so as to permit rational economic calculation for the alternate uses of scarce resources. However, by giving unambiguous definitions to concepts such as ‘centralization’ and ‘decentralization’ and with his ultimate theory of mechanism design, Hurwicz created a broad consensus that Von Mises and Von Hayek were right in their assessment that free markets are ‘efficient allocators’ subject to: one, there are large numbers of economic agents on the buying and selling sides of the market; two, there are no significant ‘externalities’ of consumption or production; and three, there is no asymmetry of information about the good. Thus, his highly abstract and mathematical work “allows us to distinguish situations in which markets work well from those in which they do not. In the same vein, alternative mechanisms can also be devised for improving the outcome of pure market whenever any of the three conditions prescribed above is missing. It has helped economists identify efficient trading mechanisms, regulation schemes and voting procedures.” His work also had a big effect on the way people look at development problems in poor countries.

It is essentially for inventing this pioneering economic theory—Mechanism Design Theory—that Leonid Hurwicz received Nobel Prize in Economics in the year 2007 at the age of 90 along with two others—Roger Myerson and Eric S Maskin. Hurwicz was so humble that when the President of University of Minnesota, Robert Bruininks spoke to him—knowing that he had won the Nobel—it is said that he underplayed it in his own characteristic way, saying that he was surprised by the award, deeply appreciative of the recognition of the work, and felt that he largely received this recognition because he outlived his contemporaries. Hurwicz was a polymath—he was knowledgeable about such diverse matters as the dialects of Tamil, archaeology, biochemistry and music, and also served as a member of the National Science Foundation Commission on Weather Modification established under Lyndon B Jonson. And, as Kenneth Arrow, his collaborator, once observed, he stands out for his intellectual caution, rigor and depth of his understanding of a problem. In 1990, he was awarded the National Medal of Science by President Bush—one of the only six economists honored with this medal.

Leonid Hurwicz, Regents Professor of Emeritus of Economics at the University of Minnesota, Minneapolis—an antithesis of ‘publish or perish’ mentality but took delight in teaching graduate students, which he did till 2006—died at the age of 90, on June 24, 2008 leaving behind his wife Evelyn Jensen whom he married in 1944, and their two sons and two daughters.

- GRK Murty


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