Decentralization, Hierarchies and Incentives: A Mechanism Design Perspective

A classic topic in economic theory is the organization of economic activity. While the roots of this topic go back to discussions of the appropriate role of the state in a market economy by the Mercantilists and Adam Smith’sWealth of Nations, it became the central issue in the 1930’s debates concerning the possibility of efficient resource allocation in a socialist economy. In this debate it was recognized that information relevant to efficient resource allocation is dispersed throughout agents in an economy. A decentralized market economy distributes decision making authority to individual agents, who are motivated by their self interest and are coordinated by market prices. This was contrasted with a socialist economy where decision making authority is vested in a central planner, on the basis of information communicated by individual agents. Hurwicz (1972a, 1972b, 1973, 1984) has provided excellent surveys of this early literature, and its subsequent offshoots culminating in the contemporary theory of mechanism design. The comparative performance of these specific decentralized and centralized resource allocation systems were sought to be compared, on the basis of the extent of communication and information processing they entail, and the incentives of individual agents they give rise to. Arguments pertaining to the superiority of the decentralized market-based system relied on the fact that their communications requirements are minimal (represented by the dimensionality of the message space for communication), the fact that it distributes tasks of information processing across agents in the economy, and is consistent with self-interested behavior of agents. On the other hand a centralized system may be better equipped to combat weaknesses of the decentralized system in dealing with problems of externalities, public goods, increasing returns, and distributional equity.