EC319 Economic Theory and Its Applications,
Part II: Lecture 4
Leonardo Felli
NAB.2.14
6 February 2014
Static Adverse Selection
Recall:
I A seller is trying to price a commodity, choose (T (q), q), for a
buyer that has private information on his valuation i for it
i {L , H } and = Pr{i = L }
I The Revelation Principle allows the seller (the principal) to
focus exclusively on direct revelation mechanisms.
I These mechanisms ask the buyer (the agent) to report his
private information to the principal.
I Moreover they are such that in equilibrium the agent decides
to participate and reports the truth about i .
I We showed that:
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 2 / 36
The Principals Problem:
By revelation principle the principals problem identifies the direct
mechanism (Ti , qi ) = (T (q(i )), q(i )), i {L, H}:
max (TL c qL ) + (1 )(TH c qH )
Ti ,qi
s.t. H u(qH ) TH H u(qL ) TL
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 6 February 2014 3 / 36
The Relaxed Problem
I The solution to the Principals problem is the same as the
solution to the following relaxed problem:
max (TL c qL ) + (1 )(TH c qH )
Ti ,qi
s.t. H u(qH ) TH H u(qL ) TL
L u(qL ) TL 0
I This problem can be re-written as:
max [L u(qL ) c qL ] +
qi
+ (1 ) [H u(qH ) (H L ) u(qL ) c qH ]
I We distinguished two cases.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 4 / 36
The Optimal Solution (contd)
Case 1: [ L (1 ) (H L )] 0
In this case the principal decides not to serve the type L of the
agent:
qL = 0, TL = 0
The principal then serves only the type H of the agent:
qH = qH , TH = TH
The (ICL ) constraint we omitted is satisfied:
L u(qH ) TH < 0
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 5 / 36
The Optimal Solution (contd)
Case 2: [ L (1 ) (H L )] > 0
In this case the slope of the maximand with respect to qL is not
necessarily negative for every qL 0.
Therefore the principal decides to serve both types of agent.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 6 / 36
The Optimal Solution (contd)
In this case the optimal contract (qi , Ti ) is such that:
I efficiency at the top: = q
qH H
H u 0 (qH
)=c
I inefficiency at the bottom: qL < qL
0 L
L u (qL ) = c >c
L (1 ) (H L )
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 7 / 36
The Optimal Solution (contd)
I inefficient premium to the top type: TH < TH
TH = H u(qH
) (H L ) u(qL )
I efficient transfer for the bottom type: TL < TL
TL = L u(qL )
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 8 / 36
The Optimal Solution (contd)
Notice that from the first two conditions we obtain
qL < qH
We therefore obtain that the (ICL ) constraint is satisfied
L u(qL ) TL L u(qH
) TH
from H > L and
H [u(qH ) u(qL )] = TH TL
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 9 / 36
The Optimal Solution: Interpretation
I The result obtained can be re-interpreted in terms of the
taxation principle.
I The principal offers a menu of (two) two-part tariff contracts:
{(qH , TH ), (qL , TL )}
I These contracts are such that the L-type agent self-selects in
choosing the contract (qL , TL ),
I While the H-type agent self-selects in choosing the contract
, T ).
(qH H
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 10 / 36
Quantity Discounts
I This re-interpretation corresponds to a realistic indirect
mechanism.
I An alternative indirect mechanism that is quite frequently
observed in real life is the following:
I The good is offered at the price TL ,
I If the consumer is willing to buy any quantity in excess of qL
then he is offered a discount in the amount of (TH TL ),
I the balk quantities offered are either qL or qH .
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 11 / 36
Optimal Auction Design
I Armed with the Revelation Principle we now go back to the
optimal auction design problem.
I Consider the case where there are only two bidders, i {1, 2}.
I Each bidder i has private information on his valuation vi for
the auctioned good.
I Assume that
v i {vL , vH }, 0 < vL < vH
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 12 / 36
Independent Private Value Optimal Auction
I Let
Pr{v i = vH } =
I We assume first that the valuations vi are i.i.d. In other
words, we consider an independent private value auction.
I Clearly:
vH vL
vH 2 (1 )
vL (1 ) (1 )2
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 13 / 36
Independent Private Value Optimal Auction (contd)
I The total ex-ante surplus present among the bidders is:
2
+ 2 (1 ) vH + (1 )2 vL
I Both buyers are ex-ante identical. We therefore restrict
attention to symmetric optimal auctions.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 14 / 36
Independent Private Value Optimal Auction (contd)
The direct revelation mechanism associated with a symmetric
auction is
(k,j , tk,j )
where:
I k,j = the probability that the buyer announcing vk gets the
good;
I tkj = the transfer from the buyer to the seller contingent on
the announcement (vk , vj ) (not the delivery of the good).
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 15 / 36
Restrictions on the Direct Revelation Mechanism
Feasibility constraints:
2 HH 1, 2 LL 1, LH + HL 1
the seller is offering only one indivisible unit of the good.
Individual rationality (IR) constraints that guarantees both types of
bidders want to participate in the direct revelation mechanism
(HH vH tHH ) + (1 ) (HL vH tHL ) 0
(LH vL tLH ) + (1 ) (LL vL tLL ) 0
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 16 / 36
Restrictions on the Direct Revelation Mechanism (contd)
Incentive compatibility (IC) constraints that guarantee both types
of bidders in equilibrium report the truth
(HH vH tHH ) + (1 ) (HL vH tHL )
(LH vH tLH ) + (1 ) (LL vH tLL )
(LH vL tLH ) + (1 ) (LL vL tLL )
(HH vL tHH ) + (1 ) (HL vL tHL )
Since all parties are risk neutral we can only solve for the expected
transfers from the buyer to the seller:
tL = tLH + (1 ) tLL , tH = tHH + (1 ) tHL
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 17 / 36
The IPV Auctioneers Problem
The sellers problem can now be simplified by dropping the (IRH )
and the (ICL ) constraints.
The auctioneers relaxed problem is then:
max 2 [ tH + (1 ) tL ]
k,j ,tk
s.t. ( HH + (1 ) HL ) vH tH
( LH + (1 ) LL ) vH tL
( LH + (1 ) LL ) vL tL 0
2 HH 1, 2 LL 1, LH + HL 1
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 18 / 36
Binding Constraints
Notice first that the (ICH ) is binding:
I the (ICH ) is monotonic decreasing in tH while the objective
function is monotonic increasing in tH .
Notice second that the (IRL ) is binding:
I if we substitute the binding (ICH ) in the objective function we
get that this is monotonic increasing in tL while the (IRL ) is
monotonic decreasing in tL .
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 19 / 36
The IPV Auctioneers Problem (contd)
Therefore substituting the (IRL ) in the objective function the
auctioneers problem becomes:
max 2 ( HH + (1 ) HL ) vH
k,j
( LH + (1 ) LL )(vH vL ) +
+ 2 (1 ) ( LH + (1 ) LL ) vL
s.t. 2 HH 1, 2 LL 1, LH + HL 1
This is a linear programming problem.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 20 / 36
The IPV Optimal Auction
Consider first the coefficient of HH :
2 2 vH > 0
since
2HH 1
then the probability HH is set to its highest value
1
HH =
2
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 21 / 36
The Optimal Auction (contd)
The coefficient of HL is:
2 (1 ) vH > 0
and it is always bigger than the coefficient of LH hence from the
constraint LH + HL 1 we have:
HL = 1, LH = 0
Finally the coefficient of LL : is
2 (1 )(vH vL ) + (1 )2 vL
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 22 / 36
The Optimal Auction (contd)
We can now distinguish two cases:
I The first the case is defined by
(1 ) vL (vH vL )
I from the constraint 2 LL 1 we then conclude that
1
LL =
2
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 23 / 36
The IPV Optimal Auction (contd)
I In this case the optimal auction implies:
1 1
HH = , HL = 1, LH = 0 LL =
2 2
I That is, if both bidders announce vH then each one gets the
good with probability one half.
I If only one bidder announces vH then this bidder receives the
good.
I If both bidders announce vL then each one gets the good with
probability one half.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 24 / 36
The IPV Optimal Auction (contd)
I In this case the sellers expected profits are:
vH + (1 ) vL
I The rents left to the high value bidder are:
(1 )(vH vL ) > 0
I Therefore the total surplus generated is the efficient one:
2
+ 2(1 ) vH + (1 )2 vL
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 25 / 36
The IPV Optimal Auction (contd)
I The second case is instead characterized by
(1 ) vL < (vH vL )
I the coefficient of LL is then strictly negative,
I it is then optimal for the auctioneer to set:
LL = 0
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 26 / 36
The IPV Optimal Auction (contd)
I In this case the optimal auction implies:
1
HH = , HL = 1, LH = 0 LL = 0
2
I That is, if both bidders announce vH then each one gets the
good with probability one half.
I If only one bidder announces vH then this bidder receives the
good.
I If both bidders announce vL then the good is not allocated to
anybody.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 27 / 36
The IPV Optimal Auction (contd)
I In this case the sellers expected profit is:
2
+ 2 (1 ) vH
I This is also the total surplus that is clearly lower than the
efficient surplus.
I The inefficiency associated with the optimal mechanism is
measured by the resources waisted:
(1 )2 vL > 0
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 28 / 36
Correlated Values Optimal Auction
Consider now an environment such that:
Pr{v 1 = vk , v 2 = vj } = k,j
In other words:
vH vL
vH HH HL
vL LH LL
Where we assume that:
HH LL HL LH 6= 0
The total surplus is then:
LL vL + (1 LL ) vH
The optimal auction is dramatically different.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 29 / 36
The CV Optimal Auction (contd)
Theorem (Cremer and McLean 1988)
The seller can extract all the surplus from the buyer:
LL vL + (1 LL ) vH
Proof: Consider a general contract that specifies:
I a payment wkj from buyer 1 when his value is vk and buyer
2s value is vj ; (wjk then specifies the payment from buyer 2);
I an efficient allocation of the good kj :
1
HH = LL = , HL = 1, LH = 0
2
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 30 / 36
The CV Optimal Auction (contd)
This contract extract all the surplus if it is incentive compatible:
v
L
LL wLL LH wLH
2
v
L
LL (vL wHL ) + LH wHH
2
v
H
HH wHH HL (vH wHL )
2
v
H
HH wLH + HL wLL
2
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 31 / 36
and the buyers (IR) constraints are binding for all types:
v
L
LL wLL LH wLH = 0
2
v
H
HH wHH HL (vH wHL ) = 0
2
We can now find wkj such that these four conditions are satisfied.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 32 / 36
The CV Optimal Auction (contd)
Rewrite the (IR) constraints as:
LL vL
wLH = wLL
LH 2
HH vH
wHL = vH + wHH
HL 2
Define now
HH LL
= 6= 1
HL LH
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 33 / 36
Using these equations and the fact that each buyers surplus is 0
the (IC) constraints become:
LH
0 (vL vH ) LL (vH vL ) + LH ( 1) wHH
2
HL
0 (vH vL ) + HL ( 1)wLL
2
If 6= 1 then the latter two inequalities can be satisfied.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 34 / 36
The CV Optimal Auction (contd)
In particular:
I If > 1 then one needs to set wHH and wLL low enough.
I The H buyer is deterred from misreporting by imposing a low
enough wLL and by (IRL ) a high enough wLH .
I Notice that in this case (ICH ) is easier to meet: if a buyers
type is vH the probability that the other buyer is vH as well is
higher than the probability that is vL and hence paying wLH is
more likely than wLL .
I A similar argument applies to the buyer whose type is vL .
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 35 / 36
The CV Optimal Auction (contd)
Of course if < 1 then the same outcome can be accomplished by
setting wHH and wLL high enough.
In other words, the idea is to set the high payments in the states of
nature that are less likely under truth-telling than under deviation
from truth-telling.
Notice that the following assumptions are critical:
I the buyers are risk neutral,
I the buyers are not resource constrained.
Indeed, payments vary a lot as 1.
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 6 February 2014 36 / 36
