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James Mirrlees' Contributions to the Theory of Information And James Mirrlees' Contributions to the Theory of Information and Incentives Author(s): Avinash Dixit and Timothy Besley Source: The Scandinavian Journal of Economics, Vol. 99, No. 2 (Jun., 1997), pp. 207-235 Published by: Blackwell Publishing on behalf of The Scandinavian Journal of Economics Stable URL: http://www.jstor.org/stable/3440553 . Accessed: 09/03/2011 03:25 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at . http://www.jstor.org/action/showPublisher?publisherCode=black. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. Blackwell Publishing and The Scandinavian Journal of Economics are collaborating with JSTOR to digitize, preserve and extend access to The Scandinavian Journal of Economics. http://www.jstor.org Scand.J. of Economics99(2), 207-235, 1997 James Mirrlees' Contributions to the Theory of Information and Incentives* Avinash Dixit PrincetonUniversity, Princeton, NJ 08544-1021,USA and TimothyBesley London School of Economics,London WC2A 2AE, England I. Introduction The theory of informationand incentives has revolutionizedeconomics. We now understandhow markets and other modes of private economic transaction,as well as public policy, are affected when different partici- pants have differentinformation, or when the actions of some participants are not observable to others. Mirrlees has made pathbreakingcontribu- tions - arguablythe two most importantcontributions - to the develop- ment of these ideas and methods of analysis. His Review of Economic Studiesarticle [1971c]on optimal nonlinearincome taxationintroduced a technique that evolved into the "revelationprinciple", which fully charac- terizes all policies that are "incentivecompatible", or feasible under infor- mation asymmetry. This technique is now the workhorse model for numerous applications.His Bell Journalof Economics article [1976a] on hierarchiesand organizations,and some of his importantunpublished (yet widely circulated)papers referred to below, played a similar role for the theoryof the design of incentivesto induce effort. He identifiedthe precise way in which observableoutcomes convey probabilisticinformation about the underlyingunobservable action, and therebyclarified how rewardsor punishmentsbased on outcomes can serve as incentivesto action. Mirrlees developed these ideas in the context of specific applications. However, they are truly fundamentalto economic theory, and they have profoundlyinfluenced subsequent thinking and researchon the design of * We are very gratefulto Peter Diamond, Oliver Hart, Bengt Holmstrom,Kevin Roberts, RobertWilson, and last and most important,Richard Zeckhauser, for theirvery detailed and helpful commentson the preliminaryversion, given under extremetime pressure. Dates in bracketsrefer to publicationsby Mirrlees discussed in this paper (see Biblio- graphy) and dates in parentheses to works by other authors listed at the end of this article. Biographicalnote: James A. Mirrleeswas bornin 1936in Minnigaff,Scotland. He received his M.S. in Mathematics in Edinburghin 1957, and his Ph.D. from the University of Cambridgein 1963. He was Edgeworth Professor of Economics at Oxford University between 1969 and 1995, and currentlyholds the professorshipof PoliticalEconomy at the Universityof Cambridge. ? The editors of the ScandinavianJournal of Economics1997. Publishedby BlackwellPublishers, 108 Cowley Road, OxfordOX4 1JF, UK and 350 Main Street, Maiden, MA 02148, USA. 208 A. Dixit and T.Besley incentives in numerous contexts. Robert Wilson has expressed this eloquently:1"For twenty years the general theory of taxation has been founded substantiallyon the seminal contributionby James Mirrlees.It is also the foundation for related topics that have become mature fields of study: the theory of regulation, price discriminationof various forms, nonlinear pricing and Ramsey pricing generally, contracting (labor contracts,principal-agent relationships,procurement, risk-sharing). Like the implicationsof Einstein'stheory of relativityfor physics,the methodo- logical implications of Mirrlees' formulation and analysis infuse every topic in microeconomictheory where incentives and/or private informa- tion are relevant." Mirrlees is also known to a broader spectrumof the economics profes- sion for his contributionsto the theory of public finance, and to develop- ment economics.In the formerarea, in collaborationwith Peter Diamond, he offered a thorough and definitive treatment of optimal commodity taxation. This both formalized and extended previous work by Frank Ramsey and Paul Samuelson. The Diamond-Mirrlees [1971a,b] papers also spurred a great deal of subsequent work, with the germs of ideas developed later by many others found within them. Most importantly,they proved that even in the absence of personalized lump-sumtransfers, it is generallydesirable to main efficiencyin produc- tion. Any necessarydistortions should take the form of taxes or subsidies levied at the final stage of sales to consumers. In particular,for a small country that does not have any monopoly power in internationaltrade, world prices constitute the correct social opportunitycosts. This formed the basis of Mirrlees' work with Ian Little in development economics, whichhas had a majorpractical influence on the way in whichinternational development agencies conduct cost benefit analyses. This essay focuses on Mirrlees'work on informationand incentives.We begin with a brief review of the issues, and the limitationsof traditional economic theory in confrontingthem. We keep this part very non-techni- cal and elementary, so that the general reader can obtain an adequate knowledge of the issues. We then discuss Mirrlees' pioneering articles, explainhow they evolved into the general methods of solution of problems of the design of incentives,and give a brief summaryof later developments of the theory and its applications.Here we sketch a few technical details. We then briefly discuss Mirrlees'other contributions. II. An Overview of Information Economics It has long been recognized that the participantsin the numerous trans- actions that go on in any complex economy have diverse information ' Privatecommunication. ? The editors of the Scandinavian Journal of Economics 1997. James Mirrleesand the theoryof informationand incentives 209 pertaining to these transactionsand their effects. Managersknow more about a firm'sproduction than do shareholders;workers know more about their own abilities than do employers;taxpayers know more about their actual and potential income than does the government'srevenue service. Traditionaleconomic theory argued that the price system automatically fully aggregates this dispersed information.The reasoning is as follows. Each producer or worker uses his information to calculate the action (supply or demand) that is most profitableor beneficial to himself, and these decisionscollectively determine the marketprices. Therefore market pricesshould reflect all the privateinformation as it pertainsto the scarcity of various goods and services. However, this analysisapplies only to marketswith a large number of participantswhere the buyer and seller do not care about each other's identities. Many real-life transactionsare not "arm's-length"or "anony- mous" in this sense, and thereforethey have featuresthat orthodoxtheory cannot explain. Bilateralbargaining offers the most obvious example;the informationa seller has about the quality of his product matters to the potentialbuyer, who has to decide whetherto concludea deal, and if so, on what terms. Similarly,an employer tryingto secure more or better effort from a particularworker or groups of workersis not dealing in an anony- mous labormarket. And likewise,a bankthat lends to a companyfaces the risk of default from that particularcompany, not from an anonymous capital market.Some of these relationshipsmay be competitiveex ante:an employermay choose from amongseveral job applicantsand a workermay choose among several jobs; there are many potential borrowers and lenders in the capital market. But once a deal is struck,the relationship becomes bilateral and non-anonymous;therefore the parties must take into account this future fixity and its implications,even while they are consideringthe choice from among numerouspotential partners.2 When private information bears on transactionsthat are not anony- mous, each participanthas the opportunityand the natural incentive to manipulate his information to his own advantage.A job applicant may overstatehis abilityor qualifications,and an intense workerwhen the boss is present may slack off in his absence.An insuranceapplicant
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