The theory of mechanism design can be thought of as the “engineering” side of economic theory. Much theoretical work, of course, focuses on existing economic institutions. The theorist wants to explain or forecast the economic or social outcomes that these institutions generate. But in mechanism design theory the direction of inquiry is reversed. We begin by identifying our desired outcome or social goal. We then ask whether or not an appropriate institution (mechanism) could be designed to attain that goal. If the answer is yes, then we want to know what form that mechanism might take. In this paper, I offer a brief introduction to the part of mechanism design called implementation theory, which, given a social goal, characterizes when we can design a mechanism whose predicted outcomes (i.e., the set of equilibrium outcomes) coincide with the desirable outcomes, according to that goal. I try to keep technicalities to a minimum, and usually confine them to footnotes.

The soft budget constraint is a syndrome that was identified and studied by Janos Kornai in his analysis of centrally planned economies ( see, Kornai, 1980 ) . The syndrome is said to arise when a seemingly unprofitable enterprise is bailed out by the government or the enterprise’s creditors. In other words, the enterprise is not held to a fixed budget, but finds its budget constraint ‘‘softened’’ by the infusion of additional credit when it is on the verge of failure. Kornai viewed the soft budget constraint as a crucial ingredient for explaining the salient features of socialist economic performance, in particular, the pervasiveness of shortages. One interesting puzzle is why centrally planned economies have been particularly susceptible to the influence of the soft budget constraint; the capitalist world is hardly immune, as the recent financial crisis in Asia attests, but on the whole it has proved less vulnerable. Indeed, the very origin of the soft budget constraint and the mechanism by which it gives rise to shortages and other undesirable effects are also obviously important questions. Although Kornai’s work has long been well known and appreciated, answers to these associated theoretical questions have been hazarded only recently. In Maskin ( 1996 ) , I surveyed some of the initial efforts in this direction, including Mathias Dewatripont and Maskin (1995), which argues that centralization of credit can give rise to soft budget constraints because it facilitates the refinancing of

When economists contemplate the invisible hand at work, they generally think of competitive markets. But there are some circumstances in which markets are not supposed to operate well (i.e., in which the invisible hand is thought to falter). A leading cause of market failure, many argue, is the presence of significant externalities. With such externalities, the first welfare theorem does not apply, and so competitive equilibrium-if it exists at all-is not typically Pareto optimal. In the tradition of A. C. Pigou (1932), the typical response to this lack of optimality is for the government to step in and introduce corrective policy, usually in the form of taxes or subsidies. There is, of course, a strong antiPigouvian tradition, as well. Specifically, proponents of the Coase theorem (Ronald Coase, 1960) have contended that, despite externalities, unrestrained bargaining and contracting ought to be sufficient to generate an efficient outcome. (Indeed Coase's own celebrated example was a case of externalities.) Thus, even if formal markets themselves fail, the invisible hand nevertheless succeeds, and outside intervention or design is not required. Recently, Joseph Farrell (1987) argued that, even when free bargaining is permitted, the laissez-faire conclusion inherent in the Coase theorem may founder if agents have incomplete information about one another's relevant characteristics. I shall show, however, that the problem that Farrell identified is due only to monopoly power and is not peculiar to externalities. Indeed, in this paper, I shall take a modified Coasian stance. I shall attempt to show that, in spite of externalities and incomplete information, private contractual agreements suffice to achieve efficiency, as long as no agent is big enough to have significant market power. This conclusion must be qualified, however, with the proviso that, if the externality is (i.e., no one can be excluded from its effects), the government must intervene to prevent free-riding on the agreements. Intervention, in this case, amounts to establishing the right of an agent providing a positive external effect to collect a fee for increasing the effect from all who enjoy it, even if they are not parties to a contract with the provider. Symmetrically, providers of a negative externality can collect a fee for diminishing the effect from all their victims. In either case, however, the fee is set endogenously, that is, it is determined by the contractual arrangements rather than by the government. This result for nonexcludable externalities (which include pure public goods) provides support for a fairly laissez-faire stance toward externalities but turns on an important assumption, namely, that parties always write contracts so as to maximize their social surplus (subject to incentive and individual-rationality constraints). I will return to this assumption in the final section.