Mechanism design, along with incentive compatibility, is one of the key ideas for which the 2007 Nobel Prize in Economic Sciences was awarded.
The key idea of mechanism design is identifying goals first and then attempting to design a system that achieves those goals. In other words, at the beginning of the process, the goals are given, and the ideal mechanism is the unknown. This contrasts with “positive” or predictive economics, which studies the actual or likely outcomes of a given system. In that case, the system is the given, and the outcomes are the unknowns.
Eric Maskin, in his lecture, “An Introduction to Mechanism Design” (Warwick Economics Summit 2014) uses the simple example of a parent wanting to divide a cake between two children. The goal is to divide the cake in such a way that both children are happy. The mechanism could be that one child cuts the cake while the other has first choice of the pieces. The goal of making a “fair division” is known in advance. The mechanism is designed specifically to achieve that goal.
This mechanism is incentive compatible because it allows both children to achieve their goal, defined as getting at least half the cake.
This approach is sometimes referred to as the “engineering” part of economics.
Wikipedia, for instance, defines mechanism design as “a field in economics and game theory that takes an engineering approach to designing economic mechanisms or incentives, toward desired objectives, in strategic settings, where players act rationally.”
Mechanism design is also called “reverse game theory” because it takes the desired objectives as the given data, while the mechanism or “game” which will best achieve those objectives is the unknown in the equation.
Maskin notes in his lecture that the predictive approach constitutes “on the order of 90%” of the study of economics, though mechanism design is growing as a percentage of the total.
Mechanism design “has broad applications, from economics and politics (markets, auctions, voting procedures) to networked-systems (internet interdomain routing, sponsored search auctions).” (Wikipedia)
At least partially, in its infancy, mechanism design was an outgrowth of discussions of the relative merits of socialism, communism and capitalism. It also represented an attempt to provide a scientific basis for addressing the “socialist calculation debate“, by providing a theoretical framework for considering systems other than capital markets for allocating the means of production, and a mathematically rigorous approach to asking how a given arrangement might compare to capitalism in terms of efficiency and productivity.
As the Nobel Prize site explains, “[i]n 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.” (See the article from which this quote is taken for a brief, non-mathematical explanation of mechanism design.)