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Leonardo Felli
NAB.2.14
30 January 2014
Optimal Auction Design
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 2 / 40
Optimal Auction Design (contd)
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 3 / 40
Direct Mechanism
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 4 / 40
Direct Mechanism (contd)
I The second way the seller can use the revelation principle to
simplify his problem is to restrict attention to the direct
mechanisms in which it is a Bayesian Nash equilibrium for
each bidder to report the truth.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 5 / 40
The Revelation Mechanism
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 6 / 40
Revelation Principle (contd)
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 7 / 40
Example Auction
I Two bidders N = {1, 2};
I Action spaces:
A1 = {b1 0} A2 = {b2 0}
I Type spaces:
T1 = {0 v1 1} T2 = {0 v2 1}
1 = 1, 2 = 1
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 8 / 40
Example Auction (contd)
I Payoffs:
v1 b1 if b1 > b2
1
u1 (b1 , b2 ) = (v 1 b 1 ) if b1 = b2
2
0 if b1 < b2
and
v2 b2 if b2 > b1
1
u2 (b1 , b2 ) = (v 2 b 2 ) if b2 = b1
2
0 if b2 b1
b1 = b(v1 ), b2 = b(v2 )
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 9 / 40
Example Auction (contd)
Revelation principle tells us that we can re-write this game as a
direct mechanism with the following features.
A01 = T1 = {0 v1 1} A02 = T2 = {0 v2 1}
I Type spaces:
T1 = {0 v1 1} T2 = {0 v2 1}
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 10 / 40
Example Auction (contd)
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 11 / 40
Example Auction (contd)
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 12 / 40
Example Auction (contd)
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 13 / 40
Example Auction (contd)
1
I Neither player wants to deviate from the bids b1 = 2 v1 , and
b2 = 12 v2 .
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 14 / 40
Example Auction (contd)
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 15 / 40
Example Auction (contd)
I The mechanism designer can now make sure that the direct
mechanism is incentive compatible if he reinterprets each
player announcement in terms of a bid in the following way:
bi = (1/2) vi .
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 16 / 40
Example Auction (contd)
I and v2 = v2
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 17 / 40
Example Auction (contd)
I The direct mechanism that is optimal for the seller is the one
in which each player tells the truth.
1
bi (vi ) = vi
2
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 18 / 40
The Revelation Principle
= {N, Ai , Ti , i , ui }
d = {N, Ti , Ti , i , vi }
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 19 / 40
The Revelation Principle (contd)
vi (i , i | ti ) = ui [(si (i ), si (i )) | ti ]
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 20 / 40
The Revelation Principle (contd)
Eti ui [(si (i ), si
(ti )) | ti ]
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 21 / 40
Centralize the Mechanism
Definition
A communication mechanism is a game:
c = {N, Mi , Ti , i , ui (s(m) | ti )}
Y
where Mi is a message space for every player: M = Mi .
iN
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 22 / 40
Timing of Revelation Game
Assume that c has a BNE m (t) with allocation s(m (t)) and
assume that all agents participate in stage 2.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 23 / 40
Revelation Principle (Myerson 1979)
ti = ti , i N
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 24 / 40
Static Adverse Selection
I The seller does not know how much the buyer is willing to pay
for the commodity.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 25 / 40
Static Adverse Selection (contd)
U(q, T , i ) = i u(q) T
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 26 / 40
Static Adverse Selection (contd)
=T cq
I Assume that:
i {L , H } and = Pr{i = L }
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 27 / 40
First best:
i u 0 (qi ) = c, i {L, H}
and
Ti = i u(qi ), i {L, H}
(TL c qL ) + (1 ) (TH c qH
)
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 28 / 40
Second best:
I If the seller cannot observe the the buyers type then she has
to offer the same contract to both types.
I In other words the seller may offer to the agent (whatever his
type) a set of choices
(T (q), q)
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 29 / 40
Revelation Principle
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 30 / 40
The principals problem:
such that
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 31 / 40
The principals problem (contd)
L u(qL ) TL L u(qH ) TH
H u(qH ) TH 0
L u(qL ) TL 0
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 32 / 40
The principals problem (contd)
I The Principal maximizes her expected payoff:
(TL c qL ) + (1 )(TH c qH ).
I Subject to the individual rationality constraint (IR) that
guarantee that in equilibrium both types of agent want to
participate in the game:
H u(qH ) TH 0
L u(qL ) TL 0
I Subject to the incentive compatibility constraint (IC) that
guarantee that in equilibrium the agent will report the truth:
H u(qH ) TH H u(qL ) TL
L u(qL ) TL L u(qH ) TH
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 33 / 40
The Optimal Solution
Step 3: Solve the relaxed problem that ignores the (ICL ) constraint.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 34 / 40
The Optimal Solution (contd)
To select which constraint to omit consider the two (IC)
constraints at the first best optimum:
H u(qH ) TH = 0
and
H u(qL ) TL = (H L ) u(qL ) > 0
.
while
L u(qL ) TL = 0
and
L u(qH ) TH = (L H ) u(qH
)<0
.
Therefore the key (IC) constraint is the one of the H-type.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 35 / 40
Spence-Mirrlees Condition
The reason why the (IC) constraint of only one type of agent binds
is Spence-Mirrlees Single Crossing Condition:
U/q
= u 0 (q) > 0
U/T
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 36 / 40
The Optimal Solution (contd)
L u(qL ) TL 0
If (ICH ) does not bind then the principal can raise TH without
affecting (IRL ), while improving the maximand.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 37 / 40
The Optimal Solution (contd)
We get:
max [L u(qL ) c qL ] +
qi
+ (1 ) [H u(qH ) (H L ) u(qL ) c qH ]
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 38 / 40
The Optimal Solution (contd)
Case 1: [ L (1 ) (H L )] 0
[ L (1 ) (H L )] u 0 (qL ) c < 0
qL = 0, TL = 0
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 39 / 40
The Optimal Solution (contd)
In other words the principal decides not to serve the type L of the
agent.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 30 January 2014 40 / 40