Fundamental Theory of Institutions: a Lecture in Honor of Leo Hurwicz

We follow Hurwicz in considering fundamental questions about social institutions. Hurwicz's concept of incentive compatibility may help clarify old debates about socialism, where such questions arose. Moral-hazard models show disadvantages of socialism, while adverse-selection models may delimit its advantages. We review Hurwicz's general theory of how institutions can be enforced in larger games, suggesting curb sets as an alternative enforcement theory that admits focal-point effects. Finally, we consider specific problems of leadership and trust in establishing sovereign political institutions, where high officials can be deterred from abuse of power only by promises of large future rewards, which a leader must be credibly committed to fulfill. "The economic problem of society is not merely a problem of how to allocate 'given' resources... It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. ...it is a problem of the utilization of knowledge not given to anyone in its totality. This character of the fundamental problem has, I am afraid, been rather obscured than illuminated by many of the recent refinements of economic theory, particularly by many of the uses made of mathematics." F. A. Hayek, "The Use of Knowledge in Society" (1945). Recognizing the need for a fundamental theory of institutions 1 The Hurwicz Lecture, presented at the North American Meetings of the Econometric Society, at the University of Minnesota, on June 22, 2006. In the early twentieth century, economic theorists from left and right (Barone 1908, Lange 1938; Mises 1920, Hayek 1935) argued whether socialist reform of economic institutions was possible without loss of economic efficiency. The inconclusive nature of their debate showed that