The Model of a Mechanism

A fundamental problem in economic theory is to explain how acceptable choices can be made by a group despite the fact that only a small portion of the information that may a priori seem relevant can be taken into account. This problem arises in many settings, ranging from the largest scale problems of macroeconomic systems to the smallest problems of coordination among individuals in an organization. A market economy, for instance, coordinates production by firms and purchases by consumers through prices and quantities. The enormous amount of information held by each firm concerning its production processes and the knowledge of each consumer concerning his own tastes are not communicated among the participants in a market. General equilibrium theory, however, explains a sense in which the production plan selected by each firm and the purchases of each consumer in a market equilibrium are optimal despite the fact that a vast amount of the information known by firms and consumers remains private. A similar phenomenon arises within organizations. Employees cannot communicate all that they know to their manager, and if they could, then the manager could not possibly absorb all of this information. Communication is instead typically limited to conversations and memos. Determining exactly what information should be transmitted to a manager in order to allow him to make good decisions is a fundamental problem in the design of organizations and in the theory of accounting. Firms successfully function, however, despite this limited communication among its layers of management.