Mechanism design – a commonly used framework for auctions, reverse auctions as well as governing behaviour

By Jovina Ang

SMU Office of Research & Tech Transfer – Assume you are a potential buyer for a house that is valued at $2 million. At the auction, you meet three other potential buyers who are keen to put in bids for the house.

A house auction is a simple form of a mechanism design where potential buyers submit bids to buy the property which is sold to the highest bidder.

Because it is a silent auction, you will not know the value of the highest bid until the auction is closed. Should you be the highest bidder, you will soon find out that you have become the proud owner.

As this example shows, input or bids from agents or buyers are needed for mechanism design to work. In this case, the mechanism responds with an outcome that awards the house to the highest bidder.

Thus, the idea behind a mechanism design is to create a mechanism or a process that produces a desired outcome.

Outcomes need not be in monetary terms. A mechanism design can also work to drive outcomes that serve a social cause or enhances psychological needs such as happiness.

In speaking to the Office of Research & Tech Transfer, SMU Assistant Professor of Economics Li Jiangtao said: “The use of mechanism design is widespread. Governments and leaders across the world have relied on mechanism design to develop better systems of allocation of resources. They have also used it to drive efficient labour markets and even allocate school places in an equitable way. In Singapore, the mechanism design has been used successfully for COE (certificate of entitlement) bidding to limit the number of cars on the road.”

“The application of mechanism design can be seen in the work context. For instance, CEOs have used key performance indicators (KPIs) as the guiding principles to drive team and individual performance to achieve a set of outcomes such as profit and loss, customer satisfaction, employee satisfaction and operational efficiency.”

“While many positive outcomes have resulted from the application of mechanism design, this framework is not without criticisms,” he added.

“In delving into the body of work on mechanism design, there appear to be two apparent research flaws. First, a lot of research on mechanism design has assumed that the agents participating in the process can think and act rationally. Second, it assumes that the mechanism operates in a utopian state where detailed environmental factors are available for creating an efficient mechanism design,” he elaborated.

 “As you know, nothing in the real-world works in this way. There’s information asymmetry. Human beings are emotional beings. You cannot assume humans would always think and act rationally. There also exist many external factors that can come from the ‘left field’, e.g., COVID-19 which nearly caused the healthcare system across the world to ‘collapse’ within weeks of the onset of the pandemic.”

“I was so stoked when I found out that we were awarded the MOE Academic Research Fund Tier 2 research grant. I have set my eyes on furthering this important work for quite some time already”, he continued.

The research

The research is comprised of three separate studies, for which Professor Li will be collaborating with researchers specialising in micro-economics.

The first study is an experiment to test the efficacy of mechanism design in situations where people behave irrationally. Most of the research will be conducted at the top three universities in Singapore, with universities in Hong Kong lined up as a back-up plan. For this study, Professor Li will be partnering with Assistant Professor Piotr Dworczak of Northwestern University and Associate Professor Wooyoung Lim at the Hong Kong University of Science and Technology.

The second and third studies will comprise of detailed mathematical analyses to simulate the impact of less than adequate environmental factors – politics, economic, social, technological, legal – on the efficacy of mechanism design.

Specifically, Study 2, which Professor Li will be collaborating with Chinese University of Hong Kong Assistant Professor Wei He on, will focus on assessing the impact of limited statistical information about the environmental factors.

Last but not least, Professor Li will work with SMU PhD student Kexin Wang on Study 3, which deals with the impact of misspecification or incorrect environmental factors on the mechanism.

Back to Research@SMU November 2022 Issue