Tyler Cowen explores economic ideas that should be popularized.  Let me take this opportunity to help popularize what I think is one of the pillars of economic theory and the fruit of the information economics/game theory era.

When we notice that markets or other institutions are inefficient, we need to ask compared to what?  What is the best we could possibly hope for even if we could design markets from scratch?  Myerson and Satterthwaite give the definitive answer:  even the best of all possible market designs must be inefficient:  it must leave some potential gains from trade unrealized.

If markets were perfectly efficient, whenever individual A values a good more than individual B it should be sold from B to A at a price that they find mutually agreeable.  There are many possible prices, but how do they decide on one?  The Myerson-Satterthwaite theorem says that, no matter how clever you are in designing the rules of negotiation, inevitably it will sometimes fail to converge on such a price.

The problem is one of information.  If B is going to be induced to sell to A, the price must be high enough to make B willing to part with the good.  And the more B values the good, the higher the price it must be.  That principle, which is required for market efficiency, creates an incentive problem which makes efficiency impossible.  Because now B has an incentive to hold out for a higher price by acting as if he is unwilling to part with the good.  And sometimes that price is more than A is willing to pay.

From Myerson-Satterthwaite we know what the right benchmark is for markets:  we should expect no more from them than what is consistent with these informational constraints.  It is a fundamental change in the way we think about markets and it is now part of the basic language of economics.  Indeed, in my undergraduate intermediate microeconomics course I give  simple proof of a dominant-strategy version of Myerson-Satterthwaite, you can find it here.

(Myerson won the Nobel prize jointly with Maskin and Hurwicz.  There should be a second Nobel for Myerson and Satterthwaite.)

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