Optimizing Social Institutions
In the mid 20th century, economists found themselves in need of a new theoretical framework with which to tackle the comparison of fundamentally different types of economic organization, such as capitalist and socialist institutions. Discussions between the likes of Oskar Lange and Friedrich von Hayek led to the development of the idea that economic institutions could be viewed as communication mechanisms, and set the stage for Leonid Hurwicz to formulate a general mathematical framework for analyzing institutions implementing collective decision making. His 'Mechanism design theory', first introduced in 1960, has developed into a powerful and widely-applied tool.
Whether one considers auctions, elections or the taxes we pay, our lives are governed by mechanisms which make collective decisions while attempting to take account of individual preferences. Such mechanisms are designed to deliver the greatest social good despite that fact that individual participants may act for their own gain, rather than for the general well-being of society. Studying such mechanisms is the goal of mechanism design theory, and mechanism design can be described as the art of producing institutions that align individual incentives with overall social goals.
Mechanism design theory is a branch of game theory (which psychologists refer to as the theory of social situations), and extends the application of game theory to ask about the consequence of applying different types of rules to a given problem. As a method of demonstrating which mechanism, out of all conceivable allocation mechanisms, gives the optimal result, mechanism design theory can be applied to problems as diverse as the auctioning of radio frequencies to mobile phone companies to the building of social welfare systems. Mechanism design theory lies at the heart of many organizations whose operation we now take for granted.
Often, when asked if the charge that modern economics, with so much emphasis on mathematical reasoning and theoretical rigor, is out of touch with reality and no longer of much use, I will counter with a huge list of examples where modern economic research is being used in real life (because this charge is completely baseless and totally absurd). Mechanism design is a very good place to start. For example, this work laid the foundation for auction theory that has been used by the FCC in its spectrum auctions - work in which all of us benefit as the government maximized revenues. And by the way, Milgrom and Wilson, the pioneers of auction theory are pretty good Nobel bets for the near future.