One of the simplest and yet most central insights of information economics is that, independent of the classical technological constraints, transactions costs, trading frictions, etc.,  standing in the way of efficient employment of resources is an informational constraint.  How do you find out what the efficient allocation is and implement it when the answer depends on the preferences of individuals?  Any institution, whether or not it is a market, is implicitly a channel for individuals to communicate their preferences and a rule which determines an allocation based on those preferences. Understanding this connection, individuals cannot be expected to faithfully communicate their true preferences unless the rule gives them adequate incentive.

As we saw last time there typically does not exist any rule which does this and at the same time produces an efficient allocation.  This result is deeper than “market failure” because it has nothing to do with markets per se. It applies to markets as well as any other idealized institution we could dream up.

So how are we to judge the efficiency of markets when we know that they didnt have any chance of being efficient in the first place?  That is the topic of this lecture.

Let’s refer to the efficient allocation rule as the first-best. In the language of mechanism design the first-best is typically not feasible because it is not incentive-compatible. Given this, we can ask what is the closest we can get to the first best using a mechanism that is incentive compatible (and budget-balanced.)  That is a well-posed constrained optimization problem and the solution to that problem we call the second best.

Information economics tells us we should measure existing institutions relative to the second best.  In this lecture I demonstrate how to use the properties of incentive-compatibility and budget balance to characterize the second-best mechanism in the public goods problem we have been looking at.  (Previously the espresso machine problem.)

I am particularly proud of these notes because as you will see this is a complete characterization of second-best mechanisms (remember: dominant strategies)for public goods entirely based on a graphical argument.  And the characterization is especially nice:  any second-best mechanism reduces to a simple rule where the contributors are assigned ex ante a share of the cost and asked whether they are willing to contribute their share.  Production of the public good requires unanimity.

For example, the very simple mechanism we started with, in which two roomates share the cost of an espresso machine equally, is the unique symmetric second-best mechanism.  We argued at the beginning that this mechanism is inefficient and now we see that the inefficiency is inevitable and there is no way to improve upon it.

Here are the notes.