2007 Nobel Prize in Economics ~ Mechanism Design, or Why Technocratic Dreams of Dispensing with Politics Don't Work
Here is the problem. Markets work well (read produce efficient outcomes) only when all participants are parametric. That means that no participant has undue influence over the terms of market exchange. Unfortunately, most of life is strategic, meaning that what is best for any given individual depends on what she expects relevant others to do. Others therefore have influence, whether intentionally or otherwise, over her decisions. So, markets are useful institutional tools only in a quite restricted range of social life. They are very useful in that restricted domain. But they may wreak havoc in domains of interaction where the basic assumption of parametric action does not hold.
I cannot offer the whole argument here*, but it runs roughly like this. In situations of strategic interdependence such as decisions on whether to provide a public good (where, due to strategic interdependencies, markets are not going to function well), a mechanism is an institution designed to mitigate the effects of that interdependence. So, mechanism design models will postulate an impartial mediator who can determine the actual cost of providing the good and elicit honest information from members of the group facing the decision about the level at which they individually value the public good. Such an arrangement is termed incentive compatible.
In some instances honesty then becomes a dominant strategy for all members of the group - except the mediator. This means all members of the group will be best off telling the truth regardless of what other members of the group do when the mediator asks them how much they value the public good. Unfortunately, since the total amount members of the group reveal to the mediator will not be budget balancing (there will always be a deficit or a surplus), she will have an incentive to overstate the cost of the good and pocket the surplus. This obviously is not efficient. Moreover, because the task of monitoring the mediator is itself a public good the group faces a regress.
In other instances honesty will be a (weaker) Nash equilibrium strategy for everyone, including the mediator. This means honesty will be the best policy for each individual given what she expects all relevant others to do. Unfortunately, as is typically the case in such circumstances, there will be multiple equilibrium outcomes and hence another decision problem since those outcomes will distribute benefits and costs to various individuals differentially. Hence again the group faces a regress.
So, in either instance there is a residual political problem - how to monitor the mediator or how to select one among the available, but distributionally non-equivalent equilibrium outcomes. Technocrats weep - there is not a market-mimicking way to elicit honest information about provision public goods that can eliminate politics. We thus face the task of making politics more attractive - hence the importance of democratic theory.**
* So here are two citations for the curious. Neither paper is technical despite the fact that work in mechanism design enters mathematical hyperspace very quickly. Only one of the citations is directly self-promoting!
Gary Miller & Thomas Hammond. 1994."Why Politics is More Fundamental Than Economics" Journal of Theoretical Politics Vol. 6, No. 1, pages 5-26.
Jack Knight & James Johnson. 1999. "Inquiry into Democracy: What Might a Pragmatist Make of Rational Choice Theories?" American Journal of Political Science 43: 566-589.
** Since this will seem a leap, you might have a look at this second, self-promoting reference:
Jack Knight & James Johnson. 2007. "The Priority of Democracy: A Pragmatist Approach to Political-Economic Institutions and the Burden of Justification," American Political Science Review 101:47-61.