OTTAWA -- When Alex Tabarrok explains the ideas that won three Americans the Nobel prize for economics, he points to the proverbial pie that has to be divided between two people.
"The first person cuts it in half. The second person gets to choose the piece," says the economics professor at George Mason University in Virginia.
It's the only way the first person will have the incentive to cut the pieces evenly, and the second person will trust the first person to do so, Mr. Tabarrok says.
The basic idea of setting up rules and incentives to divide limited resources fairly and honestly is what lies behind the "mechanism design theory" that won Leonid Hurwicz, Eric Maskin and Roger Myerson the 2007 Nobel Prize in Economics yesterday.
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They're not household names, but they use household concepts to guide decision makers through everything from implementing tax policy and holding telecommunications spectrum auctions to designing executive compensation packages and setting up successful commission regimes.
The theory helps the Department of Finance decide how taxation should be tweaked to achieve social policy goals. And it's helping the Department of Industry design a long-awaited auction of airwaves to the telecommunications sector.
Thirty years ago, the government would have decided directly which company gets what part of the spectrum, said Finn Poschmann, director of research at the C.D. Howe Institute. Now, under the influence of mechanism design theory, the government takes great pains in devising rules, which it then uses to auction off the spectrum in a way that best benefits companies, the government and the public.
Of course none of these examples is as simple as a pie divided in two, Mr. Tabarrok notes, but mechanism design theory is flexible enough to set up incentives and rules that allow the division of a proverbial pizza, where some people want only the crust, others don't like pepperoni, and others like pineapple and olives.
The theory sets up incentives for participants to be transparent with their information, and gives decision makers processes and procedures that will lead to outcomes that are best for the common good.
The premise, at its most basic, has been around forever, but Mr. Hurwicz took the concept in 1960, expanded it and made it applicable to governments, organizations and companies making decisions on how to distribute resources.
Mr. Maskin and Mr. Myerson took his theories, pushed them further and applied them in practical situations in the late 1970s.
Nowadays, aspects of mechanism design theory are so pervasive that most tax experts and economists are well versed in them, sometimes without realizing.
"It's part of what economists do every day," said Craig Brett, the chair of Canadian public policy at Mount Alison University.
"It's not all the rage, it's just ingrained," he said. "You'd be hard-pressed to find a microeconomic practice that does not build on mechanism design theory."
But while applications of mechanism design theory in some cases seem like plain old common sense, and in other cases have been well established for decades, the theory is still cutting edge in the field of executive compensation.
Marc Hodak has set up a Manhattan consulting business based mainly on applying mechanism design theory to a company's business plans. But when it comes to compensation, it's only the most daring 5 to 10 per cent of firms that embrace the theory, he says.
Instead, "sandbagging" is the norm, he says. It's in the best interest of managers to set the bar low for the coming year, so they can surpass their targets and earn healthy bonuses, Mr. Hodak points out.
Using the theory, Mr. Hodak sets up compensation schemes that reward managers for being realistic. The company and the managers benefit when the goals are met, and sandbagging is eliminated.
He uses a similar approach to help large companies decide whether they should invest in new technology. If the head of a company asks managers whether they need the new gear, they will all say yes, and not be straightforward about how useful it would be. But with the right incentives for managers to be forthright, the company will get a good return on its investment.
The challenge is in setting up the right rules.
"I'm creating a situation where the managers are truthful and the company gains, and then the managers will be personally rewarded," Mr. Hodak explained.
The same approach can help companies decide how to make sure commissions reflect the effort of individuals, added Ben Hermalin, chairman of economics at the University of California, Berkeley.
Salespeople will know which territories are easy and which are difficult for making sales, but managers may not know, and may end up designing commission schemes with perverse results, he said.
But with the right incentives for salespeople to be honest and forthcoming, the salespeople will all have to work equally hard for their money.
"It's about how to impose contracts when they know more than you do," he explained. "If you tell me what you want to accomplish, [mechanism design theory] can tell me how to do it."
Similarly, by using auctions to sell off public goods, carefully designed rules and incentives force buyers to be forthright about how they value something, Mr. Hermalin explained.
Mr. Hurwicz, at \, is the oldest recipient of a Nobel prize. He was born in Moscow in 1917, and became a U.S. citizen. He joined the University of Minnesota in 1951.
His co-winners are also both American. Mr. Maskin was born in 1950, earned his doctorate in advanced mathematics at Harvard in 1976, and is currently a professor at Princeton. Mr. Myerson was born in 1951, and graduated with Mr. Maskin from Harvard in 1976. He is a professor at the University of Chicago.
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Nobel facts
Winner Eric Maskin lives in the Princeton, N.J., home once occupied by Albert Einstein. Like all the professors who have lived there, Mr. Maskin agreed not to put up any kind of plaque identifying it as Einstein's home. But on Halloween, Maskin dances around the rule, if only to dress up as the fuzzy-haired physicist.
The University of Chicago, once the academic home of free-market advocates such as Milton Friedman, claims ties to 24 Nobel Prize winners in economics - more than a third of the 62 individuals so honoured since the first Nobel in the field was given in 1969.
The last non-American to win the prize was Canadian Robert A. Mundell in 1999.
Nobel prizes have been given out since 1901 after being established in the will of Alfred Nobel, the Swedish inventor of dynamite, who died in 1896.
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