This award funds research in economic theory that develops methods for incorporating behavioral ideas about individual preferences into formal mechanism design models.

Mechanism design is a formal framework for analyzing the design and operation of social and economic institutions. It is a central tool in microeconomic theory applied in contexts as varied as organizational design, personnel management, auctions, matching markets etc. A cornerstone of mechanism design theory is the analysis of incentives and how institutions are designed to manage them.

Behavioral economics has identified a number of important deviations from standard theories of individual behavior and researchers have begun to revisit mechanism design problems in their presence. A theoretical hurdle exists because many of these theories give rise to preferences under which the standard tools for characterizing the constraints imposed by incentives no longer apply. In this project the PI is investigating a generalization of the classical revenue equivalence property and accompanying analytical techniques. Applying these techniques allows the PI and future researchers to study how behavioral assumptions alter the normative and positive theories of institution design.

An important behavioral finding is loss aversion. Losses relative to a reference level of consumption are amplified by comparison to gains. This is a finding that is documented at the level of individual behavior and the next step for research is to understand its impact on markets. In this project the PI reformulates a classical problem of monopoly price discrimination to investigate how a seller leverages a buyers' loss aversion in order to increase profits.

The methodology developed here can also be applied to develop new insights into the design of auctions, insurance, and other contracts. Finally, a related behavioral phenomenon, inequality aversion, lends itself to a similar analysis. Conflict resolution, contract settlement, and other bargaining protocols can be analyzed from mechanism design standpoint when the affected agents have preferences that respond to inequality.

Project Report

Economic analysis of institutions uses the methodology of mechanism design. This methodology has produced insights of great significance from auction design to matching to market design. These are contributions to practical real-world institutions coming out of a purely theoretical analysis. At the same time, economics as a discipline has sought to extend the domain of standard analysis to encompass theories of behavior informed by psychology research. Real-world agents interacting with real-world institutions inevitably exhibit such biases and these impact the way institutions perform. The research funded through this NSF proposal has sought to extend the classical mechanism design analysis to encompass models of decision-making from behavioral economics. The main contributions are extensions of classical methodology for characterizing feasible institutions to a broad class of preferences that represent behavioral agents. Building on these advances, the classical approach to the design of price-discriminating product lines has been extended to encompass consumer's who have the well-documented bias of loss aversion. In addition, this research has used classical mechanism design techniques coupled with behavioral models of the demand for information to break new ground in the economic analysis of entertainment. Entertainment is viewed as consumption of information and to structure entertainment is to structure the release of information to maximize consumption value.

National Science Foundation (NSF)
Division of Social and Economic Sciences (SES)
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Nancy A. Lutz
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Northwestern University at Chicago
United States
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