Roger B. Myerson Prize Lecture

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diation plan would first compute the dishonest reports that everyone would 

have sent in the given equilibrium, then it would compute the behavior 

that the given mechanism would have indicated for each individual based 

on these reports, then it would compute the disobedient action that each 

individual would have actually chosen in the given equilibrium, and finally 

it would confidentially recommend to each individual that he should choose 

this computed action. If any individual had any incentive to be dishonest 

or disobedient to the mediator under this plan, then he would have had 

an incentive also to be dishonest or disobedient to himself under his given 

equilibrium strategy in the given mechanism. But in a rational equilibrium, 

nobody can gain by lying to himself or disobeying his own optimal strategy. 

See Myerson 1982.)

In sections 3 to 5 below, we consider three examples to illustrate the power 

of mechanism-design theory. First we consider an example of trading in a 

simple pure-exchange economy, where one seller and one potential buyer 

are bargaining over the sale of one unique object. This example involves 

adverse-selection problems, and it illustrates how individuals’ incentives to 

bargain for a better price can prevent allocatively efficient trading. Second, 

we consider a simple production example, involving moral hazard in man-

agement. This example illustrates how incentives for good management 

may require that managers must have a valuable stake in their enterprise. 

Third, we consider an example that introduces politics into a productive 

economy, involving moral hazard in the government. This example shows 

how unrestrained power of government over the economy can be inefficient, 

as capital investors require credible political guarantees against the govern-

ment’s temptation to expropriate them. The latter two moral-hazard models 

here may particularly illustrate the kinds of theoretical frameworks that can 

be used to exhibit practical disadvantages of socialism, which Hayek sought 

to show. 

3. A SIMPLE BILATERAL TRADING EXAMPLE  

WITH ADVERSE SELECTION

For our first example of mechanism-design theory, let us consider the sim-

plest possible economic transaction: the sale of one single object by one 

seller who faces one potential buyer. In this example, each individual knows 

his or her own private value of the object. The object may be worth either $0 

or $80 to the seller, and it may be worth either $100 or $20 to the buyer. For 

each trader, we may say that the type that is willing to trade at more prices is 

“weak,” and the other type is “strong”. So the seller’s type is weak when his 

value of the object is $0, but he is strong when his value is $80. The buyer’s 

type is weak when her value is $100, but she is a strong when her value is 

$20. Each trader thinks that that the other trader is equally likely to be weak 

or strong in this sense; that is, each type of each trader has independent 

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probability 0.5. (This discrete example is from Myerson 1991. Myerson and 

Satterthwaite 1983 derive stronger results for models where each trader has a 

continuum of possible types.)

Let us consider this trading situation from the perspective of a mediator 

who is assisting the two individuals to negotiate this transaction. Trade would 

be mutually beneficial unless both individuals are strong, but the range of 

mutually acceptable prices will depend on how much the object is actually 

worth to each trader, which each knows privately. So the mediator should ask 

the traders to reveal this information and should formulate a plan of how 

the terms of trade may depend on what they report. Based on the reported 

information, the mediator could either recommend that the object should 

be traded for some specified price, or the mediator could recommend that 

they should not trade at all. (For simplicity, let us assume that, whatever the 

mediator recommends, the buyer and seller will accept and implement the 

mediator’s recommendation, as long as neither one is made worse off by the 

trade.

2

) Such a mediation plan is, in our theoretical terminology, a mechanism 

for coordinating the given economic agents. 

3.1 Failure of incentive compatibility in the simple split-the-difference plan

Figure 2 shows one natural mediation plan, where the mediator recommends 

trade whenever the buyer’s value of the object is more than the seller’s value, 

and the recommended price is always half way between their two values. This 

mechanism may be called the simple split-the-difference plan. 

[strong]

[weak]

Seller’s value

$20

$100

[strong]  $80

0,  *

1, $90

[weak]  $0

1, $10

1, $50

 P(trade), E(price if trade)

Buyer’s value

Figure 2. Split-the-difference mediation plan. 

The four cells in Figure 2 correspond to the four possible combinations 

of the traders’ types. In each cell, the first number listed is the conditional 

probability of the buyer getting the object if the individuals’ reported types 

are as in this cell. The second number in each cell is the expected price that 

the buyer will pay if they trade when their reported types are as in this cell. 

(In a cell where the probability of trade is 0, we do not need to specify any 

price-if-trade because we know that they would not trade if that cell occurred, 

and so an asterisk is indicated instead.)

The simple split-the-difference mediation plan might seem a fair way to 

achieve mutually beneficial trades with probability 3/4. But we are allowing 

2  

In a more advanced treatment, we could justify this assumption by arguing that, if either 

individual announced any other offer after they hear mediator’s recommendation, then this 

offer would be taken as evidence that this individual was weak and would soon make a more 

generous offer that concedes all his or her gains from trade. See Myerson (1991).

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