Mechanism design can be thought of as reverse Game Theory. A lot of economic thought is devoted to understanding existing economic institutions and aims to understand and predict the outcomes that these institutions generate. Mechanism design is the reverse of this in that you start by identifying the desired outcome and then ask what institutions (mechanisms) could be designed to achieve that outcome.
Mechanism design works on the principle that the rules of the game can have profound impact on the way the actors in a game interact with each other.
The game (or mechanism) consists of a finite number of actors and a set of potential decisions. Actors have private information called signals or types that represent their preferences. A common assumption is a probability distribution of types across actors in the mechanism. A decision rule then maps types to the actors decisions.
An actors utility is then a function of their reported type, their actual type, and the output of the decision rule. Transfer functions use a transferable good to capture the externalities that an actors decisions impose on others. Social choice functions map reported types to outcomes and have different monetary and non-monetary components.
The mechanism designer can choose the mechanism but not the actors or their types. When designing the mechanism there are a number of constraints that need to be considered:
- Incentive compatibility
- Individual rationality
- Budget balance
The mechanism designer often does not know in advance what outcomes are optimal. The mechanism is thus a way for the actors in the game to generate the information needed to identify what is the best outcome.
When developing a game, the mechanism designer must consider what tools are available to create the rules of the game and what incentives and punishments can be put into place. They should also consider what information they can learn from the game and how they may be able to improve the design of the game as it progresses and more information becomes available.