10 - Transaction costs and incentive theory

Summary

Introduction

Over the last twenty-five years, incentive theory has been used as a powerful tool to describe how resources can be allocated in a world of decentralized information. The key achievement of incentive theory is that it provides a full characterization of the set of implementable allocations when resources within an organization must be allocated under informational constraints. The basic tool to obtain such a characterization is the Revelation Principle which has been demonstrated independently by several authors.

The Revelation Principle stipulates that any contractual outcome achieved by an organization where information is decentralized among its members can equivalently be implemented with a simple direct mechanism where privately informed agents send messages on their own piece of information to a mediator who, in turn, recommends plans of actions to those agents. Moreover, the agents' messages are truthful in equilibrium, i.e. the mechanism must satisfy a number of incentive compatibility constraints. If the mechanism must be voluntarily accepted by the agents, some participation constraints must also be satisfied. These two sets of constraints completely characterize the set of feasible allocations under asymmetric information.

Once this first step of the analysis is completed, one can stipulate an objective function for the organization and proceed to further optimization. This optimization leads to an interesting trade-off between the achievement of allocative efficiency as Coasian bargaining would permit under complete information and the cost of insuring incentive compatibility. Under asymmetric information, conceding informational rents to privately informed agents must be done at the minimal cost and this has allocative consequences.