Chinese / English
Home >> Great Minds China Forum >>  2nd Great Minds China Forum >>  Mechanism Design Theory and Its Significance to China's Reform, Development and GovernanceMechanism Design Theory and Its Significance to China's Reform, Development and Governance
Tian Guoqiang :Mechanism Design Theory and Its Significance to China’s Reform, D

Tian Guoqiang:

Good afternoon, everyone.


Firstly, I would like to congratulate Professor Qian Yingyi and Professor Xu Chenggang on winning the first China Economics Award as well as their supervisor Professor Maskin for cultivating such excellent economists for China. I really admire them. Why? As China’s reform proceeds, we need scholars doing thoughtful academic work with an academic mind. They did very well. This was represented in their speech in the morning. We should give credit to their teachers. They used incentive mechanism theory to research the basic question in the development of China’s reform and made great achievement. My speech today is about the significance of mechanism design theory and its application in China’s Reform as well as its significance to the development and management of China’s reform.


From this year’s China Economics Award and the research on mechanism theory that the two winners conducted, we can find a trend. Just like the two gurus who won this year’s Nobel Economics Prize for their research on complete contracting theory and incomplete contracting theory. In fact, in the last decades, there were five Nobel Economics Prize were given to 9 persons who researched incentive mechanism and related areas. In addition, there were 24 to 25 economists being awarded Nobel Economics Prize for the similar research. Therefore, we can see the importance of this theory which influences almost all the subjects.


Today I want to talk about four aspects. Firstly, what is the core topic and contribution of mechanism design theory? Secondly, the importance and the Chinese value of mechanism design theory. We are discussing what to do next. What is the key for Chinese economic development being successful? Thirdly, to view the factors of the successful reform in China from the perspective of mechanism design. Fourthly, how to reform in order to restructure the system scientifically and effectively? What I am going to discuss today is closely related to two of my books. In my book Advanced Microeconomics, I introduced the rigor of mechanism design theory and its ideas.


Firstly, what is the core topic and contribution of mechanism design theory?


In 2007, Royal Swedish Academy of Sciences highly praised mechanism design theory when presenting the Nobel Economics Prize and regarded it as “The core of economics and political science in the same era” “Greatly enlarges our understanding toward optimal mechanism by personal incentive and personal information” “Enables us to distinguish situation that may influence the effective operation of the market and allows economists, governments and enterprises to set effective trading mechanism, regulation framework and voting procedure, which outperforms the market theory proposed by Adam Smith”. I believe such evaluations are accurate and proper.


Why mechanism design theory is highly praised by the Nobel Economics Prize? Economic issues are hard to solve for two major objective facts. One fact is that individuals either at national, enterprise, family or personal level are profit-driven in most cases. The other fact is the information asymmetry among economic men. It’s easy for them to disguise which increase the difficulty in understanding and solving problems. Sometimes, the effect of applied system could be counteracted. Therefore, how to deal with these major objective facts and what economic system should we apply become the key issues and topics of all areas of economics.


My tutor, Professor Hurwicz, the founder of mechanism design theory, began with information and incentive as the key, focused on the most fundamental issue in system and regulation design, provided a general complete analysis framework for different resource allocation mechanisms or systems. Simply put, what mechanism design theory discusses is under the circumstances of information asymmetry caused by self-interest and private information, is it possible and how to design a mechanism, which means rules like method, laws, regulations for top level design of the country or the principle-agent relationship in a unit or family that allows individuals to seek for personal welfare, benefits or effectiveness subjectively while also generating the objective results of achieving the goals for the society, community, reformer or designer? In addition, if possible, guarantee the information cost to be the lowest.


Many domestic scholars tend to divide it according to the schools. I would like to discuss the relationships between incentive mechanism theory and the new classical economics, new institutional economics, Comparative Institutional Analysis, especially with the Austrian School. For example, domestic economists highly advocate Austrian School and deny New Classical School or other theories. Let’s see the relationships between them.

The comparison with new classical economics


The general equilibrium theory of New Classical School rigorously proves the invisible hand conclusion that drawn by Adam Smith. The free competition market system has optimality (the first theorem of welfare economics), uniqueness (Economic Nuclear Extreme Theorem), and impartiality (theorem of fairness) in resource allocation. Such system is also beneficial to the social stability (Economic Nuclear Theorem). In a complete market economy, this is not the concept of political economics and it is beneficial to the national unity. It can explain why Brexit somehow was not an economic nuclear. On one hand, Hurwicz upholds an attitude of protecting, expanding but not overthrowing toward New Classical Economics. He mildly responded to many critics of New Classical Economics and stressed the importance of New Classical Economics’ role of reference. The axiomatic logical deduction method summarized from the New Classical Economics emphasizes the scientific nature and rigor.


On the other hand, he pointed out the limitations of New Classical Economics when explaining practical issues and said that market sometimes failed to manage some economic issues. Therefore, replacement or supplement mechanism is needed. He then developed his theoretical framework of mechanism design. Hurwicz led a revolutionary academic innovation in modern economics that disruptively changed the way economists think about economic mechanism. This new research thinking does not take system or mechanism like complete competition and monopoly as given conditions to find out under what economic environment can resource optimal allocation or optimal decision can be achieved like New Classical Economics suggests. Instead, it conducts research with reverse thinking. It reverses the question and take economic environment as the given condition which is more realistic and research on how to create certain interactive rules (similar as mechanism) to achieve the goal based on rigorous methods. Many people think that mechanism design only considers the goal and ignores the process. This is wrong because it considers the executive power to a great extent.

The comparison with new institutional economics (NIE)


Hurwicz called institutions as the regulations about regulation, the cluster of a series of mechanism. He stresses the extreme importance of institution on economic development and rigorously defined institution using mathematical expression. He modeled institution, rigorously explained the preconditions and feasibility in different scenarios of Coase Theorem and tried to establish the communication platform between mechanism design theory and NIE. The common point of these two theories is that they both break the given traditional analysis route of New Classical Economics and include institution into the theoretical analysis framework and they are seen to be changeable, designable and customizable. There are two major differences between them. One is the normal form of research. Mechanism design theory adopts rigorous logical deduction method while NIE basically uses descriptive analysis. The other is the definition of institution. Economists of NIE like North defines institution as the “rules of the game” in a society while Hurwicz believes that institution is the rule of rule which limits the categories of institutions that can be accepted.

The comparison with Comparative Institutional Analysis (CIA)


Comparative Institutional Analysis (CIA) School is proposed by another student of Hurwicz, Professor Masahiko Aoki. Professor Qian Yingyi used to work with him in Stanford University and also participated in the discussion in this field. This School learns from the mechanism design theory and NIE and then gives its own explanation of the definition, changes and comparisons of the institutions. It basically discusses from the perspectives of information and incentive. CIA stresses the self-enforcement and self-sustainability, or incentive compatibility of the institution, which coincides with Hurwicz’s idea. The difference between them is that CIA takes given institutions as the research subjects and denies the perspective of mechanism design which Hurwicz disagrees with.

The comparison with the Austrian School


The economic thinking of Hurwicz and the Austrian School have much in common, like the acknowledgement of decentralized information and bounded rationality as well as the preferences for market mechanism and decentralized decision. However, there are also many differences between them. Hurwicz was frank about being influenced by Hayek, but mostly on the mind-set and philosophical level. The analysis tools and research methods that advocated by Hurwicz are of logical deduction style that promoted by the mainstream economics, not the descriptive methods based on individualism of the Austrian School. The biggest critic that Hurwicz has on the Austrian School is about not being rigorous. Austrian School fails to have clear definition on concept which resulted in ambiguous conclusions. It doesn’t clearly define the theoretical boundary and ignore the warning and critics raised by basic economic theory. Economics is a social subject with strong externality. Unlike doctors who would only kill some people if not being skillful enough, once wrong economic policy and institution are made, individuals or even the whole country will be at risk. Hurwicz proposes to use axiomatic logical deduction methods to improve the scientific nature, logic and rigor of economic research.


In addition, there are also differences in philosophical thinking and normal form between Hurwicz’s mechanism design theory and the Austrian School. Mechanism design theory is the “normal form of design” for normative design while the normal form of Mises-Hayek is the “Evolutionary Paradigm” of empirical analysis. These normal forms only partly explain the objective facts. Some of the institutions are evolutionary. Informal institutions like social customs are basically evolutionary while formal institutions are designed. For example, the design of constitution. The initial constitution of the America is not evolutionary but designed. It helps the America become the most powerful country in the world within only 200 years. That is a typical case of good market economy that generated by mechanism design. The selection of economic system like China chose planned economy upon its foundation and chose market economy after the Reform and Opening up, including set the guarantee of the fixing of farm output quotas for each household as an institution. Therefore, we should not be biased on “normal form of design” and “Evolutionary Paradigm”.

Secondly, the importance status and value for China of mechanism design theory.

Mechanism design theory is at the core of modern economics


As a general basic economic theory and analysis tool, mechanism design theory provides analysis framework and platform for the innovation and development of comparatively practical economic theory that based on it from the perspectives of information effectiveness and incentive compatibility. Over the last 50 years, theories that closely related to mechanism design theory or information economics, incentive theory, Principal-agent Theory, contract theory, incomplete contracting theory, experimental economics, behavioral economics and the currently popular market design theory of microeconomics which includes Auction Theory and Matching theory that analyzes how to effectively provide public goods and indivisible goods, etc. that developed from mechanism design theory are now the important and active research fields for modern economics. There were more 20 economists who studied in these fields won the Nobel Economics Prize and the number has been increasing in recent years. 5 out of 10 years’ Nobel Economic Prize were given to economists researched on mechanism design theory.

The spread of mechanism design theory in China and its value.

After reform and opening up, Chinese economy has been growing rapidly. Hurwicz was increasingly interested in China and its economic reform. He wrote to Hu Qiaomu, former Dean of Chinese Academy of Social Sciences on 10th June and 12th August in 1980 to express his interest in the state of Chinese economic reform and illustrated the theoretical and practical meaning of realizing the goals such as economic development efficiency and justice based on the mechanism design theory that he worked on. Between 7th June and 24th July, 1984, he visited and taught in China through Senior Scholars Exchange Program. After that, he visited China frequently and lectured in the Ford Class at Renmin University of China on Gregeory C Chow Project which plays a significant role in the spread and enlightenment of mechanism design theory in China. The 2007 Nobel Economics Prize provided a good opportunity for spreading this theory.


In the framework of mechanism design theory, the effectiveness of information, incentive compatibility and Pareto efficiency are the important standards for measuring a mechanism. Hurwicz (1972, 1973, 1979, 1986) proves the effectiveness of information utility of market mechanism. It means under the constraint of information asymmetry, as long as there is one or more people seeking for maximizing the personal interest, competitive market mechanism with clear property is the one that saves the most information and generates Pareto effective allocation. Similarly, in a New Classical Economic environment with exchanges only, Jordan (1982) further proves that competitive market mechanism is the only mechanism that can use the least information and generate effective resource allocation. However, pure exchange economy is detached from reality. Will we have similar conclusions in economic environment that involves production? My (2006) answer is yes and I rigorously proved them.

These conclusions are crucial to the marketization reform in China. China is comprehensively deepening the reform that aims at achieving the modernization of national governance system and management. It is a profound institutional reform and system transition in some way. Therefore, it will involve a series of different mechanism designs, including the national central top level mechanism design of the macro level as well as the mechanism design of semi and micro industrial organization level. How can we avoid the internal conflicts and potential incentive distortion between mechanisms when large mechanisms nest the smaller ones and old mechanisms accompanied by the new ones? This is the question that we should focus on at the next stage of reform.


Thirdly, to view the factors of China’s successful reform from the perspective of mechanism design.


Before we plan for the future, we need to learn from the past, to summarize the experience of being successful and the lessons of failure. Some scholars believe that the China’s rapid development over the last 30 years should be credited to the leading of government and saying that most of the government interventions were correct. However, I think we should distinguish what reform measures and government policy that enabled the China’s successful reform using scientific method of controlled experiment rather than comparing with other countries’ experiment as the initial conditions of countries were different. The core of science is to use controlled experiment which set other influencing factors as unchanged in order to find out the confirmed interactive relationship between two factors and confirm the differentiators. Due to the different initial conditions in countries, it is not desirable to compare with other countries.


China’s reform made great achievement because it basically abandoned planned economy, used different incentive mechanism and implemented decentralization reform of liberalization, marketization and privatization of economy progressively to greatly reduce the government intervention and promote the private economy development which resulted in the constant decrease in the proportion of state-own economy. According to the scientific method of controlled experiment, the new factors in addition to the fixed ones are free selection of economy to a great extent, reform on decentralization, introduction of competitive mechanism, adoption of different incentive mechanism, opening up, rapid development of private economy and adoption of progressive reform. The great achievement of China was achieved by the marketization reform of basic economic system.


These new factors are the scientific reasons for the differences between reform or not reform in China. To deepen the reform is to establish the marketization reform of modern market institution more thoroughly so that market can play a decisive role in the resource allocation as well as allowing the government to play a better not excessive role. However, there are many old factors like government’s important role is indispensable. We cannot simply say that it was because of government led or interventions that reform and opening up had great achievement. If we don’t use controlled experiment to analyze the reform in China, simply believe the old factors are important and then compare with other countries inappropriately, we might misunderstand the importance of deepening market reform, unable to distinguish the directional issue of where should reform go and conclude that the secret of China’s reform is to break the myth of liberalization, privatization and marketization of new liberalism. As we forget about the scientific method for comparing, when we talk about new factors, especially liberalization, privatization and marketization, we would think the existing factors are being ignored or denied. Thus, scholars like Lin Yifu would give tags like shock therapy, Washington Consensus or new liberalism to people who talk about new factors.


Thanks to these new factors, China’s system and mechanism reform goes toward the right direction toward having the right incentive. North highly praised Hurwicz’s research work on mechanism design. He said the reform in China does not involve private property, western legal system or competition but it involves incentive mechanism; Hurwicz’s work on incentive mechanism is significant. It is justified to say that the achievement made in China’s reform was mainly thank to having the right incentive while the specific issues we faced now are also due to the wrong incentive. To be specific, there are three kinds of incentive and they are all about people.


How to reform in order to restructure the system scientifically and effectively?


In the last part, I would like to discuss the basic methodology of China’s successful reform. Mechanism design theory has a significant guiding role in this aspect. To deepen the reform is to establish the marketization reform of modern market institution more thoroughly so that market can play a decisive role in the resource allocation as well as allowing the government to play a better but not excessive role. Reform means to design institution or mechanism. If we can design a good institution or mechanism, we can not only solve the practical issues we faced with in the current reform but also remove the obstacles on the road of deepening reform so that we won’t make detours and pay less.

The precondition of reform is to meet the requirement of participatory constraint and incentive compatibility.


In view of macro level, two basic objective facts of individual profit driven and information asymmetry, need to be understood in the next step of deepening reform in China. Under such precondition, if a reform or institution wants to achieve good result, it needs to satisfy two basic constraints of participatory constraint and incentive compatibility that set by mechanism design theory so that the public can benefit from the reform. Thus, an up-to-bottom reform consensus, potential energy and driving force can be formed. This is also the necessary condition of a successful reform that I mentioned in my book China’s Reform, History, Logics and Future.

Incentive compatibility requires the adopted reform measure and institution that can greatly arouse people’s enthusiasm for production and work and achieve the goal even if individuals are seeking for optimal profits. This is a necessary condition for improving efficiency. The individuals here can be local governments, government departments, industries, enterprises or normal people. This means we need to have right incentive for the government, enterprise and individual. Only by doing so can we smoothly promote the reform and achieve expected results.

Reform should rationally define the boundaries between government and market, government and society as the guide.


The 3rd Plenary Session of 18th CPC Central Committee mainly discussed reform and market. We must consider to define the boundaries between government and market as well as government and society. Only by doing so, can we sustain a harmonious society, sustainable economic development, the long term peace and stability of the country and the modernization of national governance system and power. We mentioned government, market and society, which one is the most important? This involves two issues. One is the definition of governance boundary. Under what kind of condition can the market play a good role? Under what condition can government play a good but not excessive role? The basic function of government is to safeguard national security, society stability, market sustainability, rigorous implementation as well as maintaining public service and narrowing the giant wealth gap, etc. The second is to prioritize. Market, society and government, which one is the key? The answer is institution. We need institution to define and understand their boundaries. We need government as the main body to understand the boundaries. Who can regulate the main body, or in other words, the positioning of the government? Rule of law. Does it mean rule by institutions or law? The main function of rule of law is to constrain the government behaviors and its arbitrarily intervention in economic activities. To limit government power is to protect market from being intervened by the visible hand, which include protecting the property, enforcing contract and law as well as safeguarding market competition.

Rule of law is the most crucial and the most fundamental part that laid the foundation for the basic institutional environment with strong externalities and decided the effectiveness of market incentive mechanism and the regulated social behavior. Rule of law doesn’t mean the more laws the better. If the supervision and implementation cost of the laws are very high or no one implements them, such laws should not exist. Democracy can restrict law-executors and prevent them from becoming law destroyers. Therefore, rule of law is safeguarded. That is the advantage of democracy. Democracy and rule of law are the basis and institutional safeguard for a harmonious society. To build a good system for rule of law, we need to fully respect the public opinion, which requires us to use democracy as the guarantee to make rational and effective laws and regulations. Even though democracy is not the necessary nor sufficient condition for economic development, it can guarantee the laws to be fair and rational.


What does democracy rely on? Democracy means decentralization. To be specific, decentralization includes the decentralization between government departments, between different level of governments, between government and people, among people, different groups, and different people. It prevents fortune and power to be centralized within a small amount of people or interest groups. Why do we need decentralization? This is due to information asymmetry and individual profit-driven. There is always information asymmetry in economic activities, we then need to decentralize decision-making. We need to adopt the indirect inductive incentive compatible mechanism to give people more freedom on economy. In addition, we need to arouse their enthusiasm due to individual profit driven. To view from the perspective of long period of stability and economic profound development, with modern state institution as a whole under the two major restrictions of individual profit driven and information asymmetry, an executable incentive compatible mechanism of decentralization, democracy and rule of law is formed. Establishing a market economy that ruled by law is critical to the current Chinese economic growth and prosperity.


To summarize, only by comprehensively managing from regulating, restricting and supervising the regulations, rule of law and decentralization of government power, rationally defining the governance boundaries of government and market, government and society can we solve the issue of efficiency and social justice and eliminate corruption and bribery as well as establishing the healthy relationship among government, market, society, enterprises and individuals. There should be positive interactions between them. Only by doing so can government constantly enhance the efficiency of market by enacting and implementing laws and regulations.

Thank you!


◆please indicate the source if authorized: National Economics Foundation

◆photo:National Economics Foundation