The seminal work of Leonid Hurwicz (1960,1972) marks the birth of mechanism design theory. In Hurwicz’s formulation, a mechanism is a communication system in which participants exchange messages with each other, messages that jointly determine the outcome. These messages may contain private information, such as an individual’s (true or pretended) willingness to pay for a public good. The mechanism is like a machine that compiles and processes the received messages, thereby aggregating (true or false) private information provided by many agents. Each agent strives to maximize his or her expected payoff (utility or profit), and may decide to withhold disadvantageous information or send false information (hoping to pay less for a public good, say). This leads to the notion of “implementing” outcomes as equilibria of message games, where the mechanism defines the “rules” of the message game. The comparison of alternative mechanisms is then cast as a comparison of the equilibria of the associated message games…
Hurwicz’s (1972) notion of incentive-compatibility can now be expressed as follows: the mechanism is incentive-compatible if it is a dominant strategy for each participant to report his private information truthfully.
In other words, no incentive scheme, no matter how clever, can get people to tell the truth. Grove, Clarke, Tideman, and Tullock lurk in the hallways. Note that a second price auction (let everyone bid and the winner pays the price of the next highest bid) fails in terms of Paretian optimality. The government takes the second price bid from the winner, but what should it do with the money? Either the government wastes resources by destroying wealth, or it redistributes that wealth in some way but then the resulting redistribution in turn feeds back into bids and we can no longer derive truth-telling as optimal (but is this really a practical problem?; my fear is that the entire incentive-compatibility literature has never gotten at the real reason why we don’t run the entire economy as a second-price auction.)
Here is Roger Myerson’s very nice piece on Hurwicz. Myerson ties Hurwicz to the socialist calculation debate of Mises and Hayek and also to the later work of Jean Tirole. It is sometimes said that moral hazard problems favor capitalism, adverse selection problems favor socialism.
Hurwicz also wrote a very important paper with Kenneth Arrow on the stability of general equilibrium theory, as well as other notable theory pieces, not all on mechanism design. Here is a list of major works, some of the early ones have pdfs attached.