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John Harsanyi and the Economics of Information
GAMES AND ECONOMIC BEHAVIOR ARTICLE NO.
14, 296–298 (1996)
0054
John Harsanyi and the Economics of Information∗
A half-century ago, Friedrich von Hayek (a 1974 Nobelist) offered a new perspective on markets, prices, and the invisible hand. In his view, the fundamental process of a market economy is price formation. He interprets prices resulting from competing bids and offers as summaries of information dispersed among traders. It is essential, but nonetheless amazing, that markets distill the welter of disparate information into terms of trade relevant for productive and allocative efficiency. A quarter-centery later, the developers of the Economics of Information discovered that market imperfections attributable to informational asymmetries can cause serious inefficiencies such as adverse selection, wasteful signaling, absent markets or incomplete contracts. Initially, the main analytical tool was price theory, but more recently it has been game theory. In particular, it is the flavor of game theory that originates in the work of our honoree. John Harsanyi recast game theory in ways so fundamental that today some here may not recognize the extent of his influence. Doctoral students are immersed in his concepts and terminology, but rarely does one learn about Harsanyi’s intellectual struggle. In part this is because his great ideas have been simple ideas—ones that distill clarifying concepts from perplexing dilemmas. Afterwards, it is hard to appreciate why the dilemma appeared intractable. A good way to celebrate his contributions is to recount some of these ideas that are now familiar. The first, of course, is Harsanyi’s vigorous development of a new explanatory hypothesis in Economics. This is the hypothesis that differences among agents’ information have major effects on strategic behaviors. His idea that information is part of an agent’s endowment or production is fundamental to studies of the Economics of Information. His work provides a causal model of “divergent expectations” that has become the standard analytical framework for analyses of incentives and strategic behavior. Nowadays it is standard practice to envision economic agents as characterized by their “types.” Models of screening, signaling, and reputation are cast in terms of these privately known parameters. For econometricians, such models introduce substantially new interpretations ∗ Presented on January 6, 1996, at a luncheon honoring the 1994 Nobel Laureates, at the American Economics Association annual meetings in San Francisco.
296 0899-8256/96 $18.00 Copyright © 1996 by Academic Press, Inc. All rights of reproduction in any form reserved.
REVIEWS AND COMMENTS
297
of the sources of heterogeneity and stochastic variations in observable data. For theorists, Harsanyi’s insights reveal an entirely new class of constraints on economic systems, namely “incentive compatibility” constraints. These constraints are centerpieces of theories of “mechanism design” that focus on the construction of procedural rules for auctions and other organized markets. Harsanyi himself has been a chief protagonist in extending this perspective into the realm of philosophy, where he has argued that Rule Utilitarianism is the proper approach to the design of general social systems. Perhaps the most remarkable aspect of this perspective is the recognition that counterfactual events affect behavior; that is, what one agent knows to be false, others may think likely, and therefore it is relevant even to the one agent who knows it is false. Example: “For me to predict your behavior, I need to estimate your prediction of what I would do in circumstances I know to be false but that you think are likely.” This is evidently true in parlor games such as poker; that it is equally true in economic contexts was implicit in von Neumann and Morgenstern’s formulation of extensive-form games, but it was John Harsanyi who developed its practical ramifications. A second major contribution is Harsanyi’s steady search for wider applications of game theory as a methodological tool in Economics. A basic tenet of his research program is that Economics should be grounded in a theory of multiperson decisions. His extension of single-person decision theory in the Bayesian framework led first to the concept of “types” as a consistent way to describe the hierarchy of “one’s beliefs about others’ beliefs.” Its subsequent development led next to recognition of the implicit assumptions about common knowledge that pervade economic models. These extensions have been fundamental to the progress of game theory, for from common knowledge of rationality and the game one can deduce the main properties of Nash equilibria. A further emphasis in Harsanyi’s work has had profound implications for economic modeling. His early and vigorous insistence on the dynamics of strategic interactions brought to light the importance of issues of timing, commitment, and credibility. Harsanyi’s focus on game theory stemmed initially from his interest in developing better methods for the analysis of imperfect competition—and, more generally, interactions in political and social situations. His program is a great success. Nowadays, models of imperfectly competitive markets are typically formulated as dynamic games with incomplete information, following the schema of Harsanyi’s classic articles of 1967–1968. These methodological innovations were essential precursors of the formal development of game-theoretic models of several important phenomena, such as rational expectations, correlated equilibria, and learning and reputational effects. A third major contribution is John Harsanyi’s early and steadfast insistence on the importance of equilibrium refinements—and on the necessity of a systematic development. I first met John 32 years ago when he presented an initial formulation to Jascha Marschak’s colloquium at UCLA. That work material-
298
REVIEWS AND COMMENTS
ized 15 years later in his monumental book, and further, in the 1988 book coauthored with Reinhard Selten, on their general theory of equilibrium selection. Over a quarter-century, his collaboration with Reinhard Selten has produced some of the most important advances in game theory. The building blocks of an axiomatic theory now include such criteria as admissibility, intertemporal consistency (backward induction), and invariance. Their development in terms of perfection, risk-dominance (and payoff-dominance), and other selections from the Nash equilibrium correspondence have become standard tools, especially for the analysis of dynamic games in extensive form. In his review of von Neumann and Morgenstern’s book, Jacob Marschak expressed his view that 10 such contributions would assure the progress of economic science. Today, the probability is even larger that Marshack’s prediction will come true. The 1994 Nobel Laureates devised new tools for the analysis of strategic behavior that enabled advances in our understanding of imperfect competition and, in particular, the roles of dynamic interactions and informational disparities. Robert Wilson† Graduate School of Business Stanford University Stanford, California 94305-5015 † [email protected]
14, 296–298 (1996)
0054
John Harsanyi and the Economics of Information∗
A half-century ago, Friedrich von Hayek (a 1974 Nobelist) offered a new perspective on markets, prices, and the invisible hand. In his view, the fundamental process of a market economy is price formation. He interprets prices resulting from competing bids and offers as summaries of information dispersed among traders. It is essential, but nonetheless amazing, that markets distill the welter of disparate information into terms of trade relevant for productive and allocative efficiency. A quarter-centery later, the developers of the Economics of Information discovered that market imperfections attributable to informational asymmetries can cause serious inefficiencies such as adverse selection, wasteful signaling, absent markets or incomplete contracts. Initially, the main analytical tool was price theory, but more recently it has been game theory. In particular, it is the flavor of game theory that originates in the work of our honoree. John Harsanyi recast game theory in ways so fundamental that today some here may not recognize the extent of his influence. Doctoral students are immersed in his concepts and terminology, but rarely does one learn about Harsanyi’s intellectual struggle. In part this is because his great ideas have been simple ideas—ones that distill clarifying concepts from perplexing dilemmas. Afterwards, it is hard to appreciate why the dilemma appeared intractable. A good way to celebrate his contributions is to recount some of these ideas that are now familiar. The first, of course, is Harsanyi’s vigorous development of a new explanatory hypothesis in Economics. This is the hypothesis that differences among agents’ information have major effects on strategic behaviors. His idea that information is part of an agent’s endowment or production is fundamental to studies of the Economics of Information. His work provides a causal model of “divergent expectations” that has become the standard analytical framework for analyses of incentives and strategic behavior. Nowadays it is standard practice to envision economic agents as characterized by their “types.” Models of screening, signaling, and reputation are cast in terms of these privately known parameters. For econometricians, such models introduce substantially new interpretations ∗ Presented on January 6, 1996, at a luncheon honoring the 1994 Nobel Laureates, at the American Economics Association annual meetings in San Francisco.
296 0899-8256/96 $18.00 Copyright © 1996 by Academic Press, Inc. All rights of reproduction in any form reserved.
REVIEWS AND COMMENTS
297
of the sources of heterogeneity and stochastic variations in observable data. For theorists, Harsanyi’s insights reveal an entirely new class of constraints on economic systems, namely “incentive compatibility” constraints. These constraints are centerpieces of theories of “mechanism design” that focus on the construction of procedural rules for auctions and other organized markets. Harsanyi himself has been a chief protagonist in extending this perspective into the realm of philosophy, where he has argued that Rule Utilitarianism is the proper approach to the design of general social systems. Perhaps the most remarkable aspect of this perspective is the recognition that counterfactual events affect behavior; that is, what one agent knows to be false, others may think likely, and therefore it is relevant even to the one agent who knows it is false. Example: “For me to predict your behavior, I need to estimate your prediction of what I would do in circumstances I know to be false but that you think are likely.” This is evidently true in parlor games such as poker; that it is equally true in economic contexts was implicit in von Neumann and Morgenstern’s formulation of extensive-form games, but it was John Harsanyi who developed its practical ramifications. A second major contribution is Harsanyi’s steady search for wider applications of game theory as a methodological tool in Economics. A basic tenet of his research program is that Economics should be grounded in a theory of multiperson decisions. His extension of single-person decision theory in the Bayesian framework led first to the concept of “types” as a consistent way to describe the hierarchy of “one’s beliefs about others’ beliefs.” Its subsequent development led next to recognition of the implicit assumptions about common knowledge that pervade economic models. These extensions have been fundamental to the progress of game theory, for from common knowledge of rationality and the game one can deduce the main properties of Nash equilibria. A further emphasis in Harsanyi’s work has had profound implications for economic modeling. His early and vigorous insistence on the dynamics of strategic interactions brought to light the importance of issues of timing, commitment, and credibility. Harsanyi’s focus on game theory stemmed initially from his interest in developing better methods for the analysis of imperfect competition—and, more generally, interactions in political and social situations. His program is a great success. Nowadays, models of imperfectly competitive markets are typically formulated as dynamic games with incomplete information, following the schema of Harsanyi’s classic articles of 1967–1968. These methodological innovations were essential precursors of the formal development of game-theoretic models of several important phenomena, such as rational expectations, correlated equilibria, and learning and reputational effects. A third major contribution is John Harsanyi’s early and steadfast insistence on the importance of equilibrium refinements—and on the necessity of a systematic development. I first met John 32 years ago when he presented an initial formulation to Jascha Marschak’s colloquium at UCLA. That work material-
298
REVIEWS AND COMMENTS
ized 15 years later in his monumental book, and further, in the 1988 book coauthored with Reinhard Selten, on their general theory of equilibrium selection. Over a quarter-century, his collaboration with Reinhard Selten has produced some of the most important advances in game theory. The building blocks of an axiomatic theory now include such criteria as admissibility, intertemporal consistency (backward induction), and invariance. Their development in terms of perfection, risk-dominance (and payoff-dominance), and other selections from the Nash equilibrium correspondence have become standard tools, especially for the analysis of dynamic games in extensive form. In his review of von Neumann and Morgenstern’s book, Jacob Marschak expressed his view that 10 such contributions would assure the progress of economic science. Today, the probability is even larger that Marshack’s prediction will come true. The 1994 Nobel Laureates devised new tools for the analysis of strategic behavior that enabled advances in our understanding of imperfect competition and, in particular, the roles of dynamic interactions and informational disparities. Robert Wilson† Graduate School of Business Stanford University Stanford, California 94305-5015 † [email protected]