21st April, 2015

Optimal Auction Design

Abhishek Lal
Electrical Engineering Undergraduate
Indian Institute of Technology Delhi
New Delhi, India
ee1120432@ee.iitd.ac.in

Ritesh Baldva
Computer Science Undergraduate
Indian Institute of Technology Delhi
New Delhi, India
cs5120711@cse.iitd.ac.in

Abstract The design of auctions has brought economic theory and practice together. Indeed this is an area
where microeconomic theory and game theory has had its largest direct impact. This is in part because it
focuses on settings where people interact according to very clearly delineated rules. In problem of auction
design, the strategic interactions of the participants are relatively easy to model, and the seller has the sole
goal of maximizing his/her revenue. The idea is to design a game where Nash Equilibrium exists which
provides the seller the highest utility. We will derive such optimal auctions in this paper for a variety of auction
design problems.

1. Introduction. The auction literature focuses on the fact that objects are exchanged
for some transferrable good that in practice is generally money. So the literature is
varied, but again one closely driven by application. The major strands encompass
questions on how to allocate goods to a set of individuals who have private values of
these objects, developing theoretical predictions about workings of specific and
observed auctions and finally designing different auctions for a variety of applications.
The seminal paper in the theoretical literature is Vickreys (1961) article, in
which he provides some of the first formal analyses of a series of observed auction
formats. We study the auctions as non-cooperative games with imperfect information.
These auctions are discussed in the context of a model with independent private values.
To analyze the performance of different kinds of auctions, we follow Myerson[1] which
extends on Vickreys article, and study the game of auction.
The structure of the paper is as follows. We first, formulate the auction as a
Bayesian game and define the assumptions and notations that are used across the paper.
Then the idea of feasibility is discussed, which describes conditions, which should be
satisfied before the seller decides to auction an object. Then we extend the idea of
efficiency, to prove that given certain conditions, any auction mechanism also has the
same expected revenue to the seller. This is illustrated with a graphical proof, and some
examples too. Based on these concepts, we come up with solution of optimal auctions
problem and discuss the problems that are present with them too. Follow-ups are
included which discuss the need for assumptions. A few concluding lines on the current
problems faced in auction design and existence of multiple units version of auctions,
whereby the seller has to sell not only, say one widget but multiple units of that widget.
2. Definitions and assumptions. First we formulate the auction problem, which we
intend to discuss. The description is more or less the same as described by Myerson. We
assume that the seller has only one object to sell, which is assumed to be indivisible. But
there are n bidders, or buyers, namely 1, 2, 3, . . . , n. Assume that N denotes this set of
bidders, resulting in
= { 1, , }
We also use i and j to represent typical bidders from the set N. It is assumed that the
after the auction only one of the bidders get the object.
The seller is faced with the problem that before auction he does not know how
much the bidders are willing to pay for the object. Thus for each bidder i, we define ti

which is bidder is value estimate for the object. This dictates the maximum value that
bidder i would be willing to pay for the object given his current information.
The uncertainty of the seller regarding value estimate of bidder is described
using a continuous probability distribution over a finite interval. Let [ai, bi] be that
interval where ai describes the lowest possible value, which I might assign to the object,
and bi describes the highest possible value, which i might assign to the object. Then let
us assume that denotes the probability density function for is value estimate ti. We also
assume certain basic conditions, namely, - < ai < bi < ; fi(ti)>0 , for all ti belongs to
[ai,bi]; and fi(.) is a continuous function on [ai,bi]. Fi [ai, bi] [0,1] will denote the
cumulative distribution function corresponding to the density f(.), so that

( ) = ( )

Thus Fi (ti ) is the sellers assessment of the probability that bidder i has a value estimate
of ti or less.
We will let T denote the set of all possible combinations of bidders values
estimates; that is,
= [1 , 1 ] [ , ]
For any bidder i, we let T-i denote the set of all possible combinations of value estimates;
that is,
= [ , ]

We will assume that the value estimates of the n bidders are stochastically independent
random variables. Thus, the joint density function on T for the vector t = (t1, , tn) of
individual value estimates is
() = ( )

Of course, bidder i considers his own value estimate to be a known quantity, not
a random variable. However, we assume that bidder i assesses the probability
distribution for the other bidders value estimates in the same ways as the seller does.
That is, both the seller and the bidder i assess the joint density function on Ti for the
vector t i = (t1 , t i1 , t i+1 , t n ) of values for all bidders other than i to be
( ) = ( )

The sellers personal estimate for the object, if he were to keep it and not sell it
to any of the n bidders, will be denoted by t0. We assume that seller has no private
information about the object, so that all bidders know t0.
There are two general reasons why one bidders value estimates ay be unknown
to the seller and the other bidders. First, the bidders personal preferences might be
unknown to the other agents (for example, if the object is a painting, the others might
not know how much really enjoys looking at the painting). Second, the bidder might
have some special information about the intrinsic quality of the object (he might know if

the painting is an old master or a copy). We may refer to these two factors as preference
uncertainty and quality uncertainty. This distinction is very important. If there are only
preference uncertainties, then informing bidder i about bidder js value estimate should
not cause i to revise his valuation. (This does not mean that I might not revise his
bidding strategy in an auction if he knew js value estimate; this earns only that is
honest preference for having money versus having the object should not change.)
However, is there are quality uncertainties, then bidder i might tend to revise his
valuation of the object after learning about other bidders value estimates. That is, if i
learned that tj was very low, suggesting that j had received discouraging information
about the quality of the object, then i might honestly revise downward his assessment of
how much he should be willing to pay for the object.
We assume that there exist n revision effect functions ej : [ai , bi ] R such that, if
another bidder i learned that tj was js value estimate for the object, then i would revise
his own valuation by ej(tj). Thus, if bidder i learned that t = (t1 , . . t n ) was the vector of
value estimates initially held by the n bidders, then i would revise his own valuation of
the object to
() = + ( )

Similarly, we shall assume that the seller would reassess his personal valuation
of the object to
0 () = 0 + ( )

If he learned that t was the vector of value estimates initially held by the bidders. In the
case of pure preference uncertainty, we would simply have ej (t j ) 0 .
3. Feasible auction mechanisms. Given the above description of the game, we now
turn to the problem the seller faces. He has to select an auction mechanism, which
maximizes his/her expected utility. We consider here a special class of auction
mechanism, namely the Direct Revelation Mechanism.
In direct revelation mechanism all the bidders simultaneously and confidentially
announce its valuation to the seller. The seller decides who gets the object based on
valuations & the amount they must pay. It is described by a pair of outcome functions (p,
x).Expected utility from the auction for the seller and the buyer can be defined as
follows,
(, , ) = ( () () ()) ( )

0 (, ) = (0 ()(1 ()) + ())()

Now for an auction to be feasible three conditions need to be imposed on p & x.

Since there is only one indivisible object to allocate and it is possible that none of the
bidders may get that object,

 () 1 () 0 ,

And the seller cannot force a bidder to participate in an auction. He must provide some
incentive to the bidder to participate by guaranteeing that the bidders expected utility
is at-least zero. This condition is also called the individual rationality condition.
(, , ) 0 , [ , ]
Seller must also ensure that the bidder cannot gain anything from lying. This condition
is called the incentive compatibility condition, i.e
(, , ) ( () ( , ) ( , )) ( )

Now the above conditions can be re stated as follows.

Lemma1. (p, x) is feasible if and only if the following conditions hold:
If then (, ) (, )

, , [ , ] ,

Where Q i (p, t i ) is the conditional probability that bidder i will get the object from the
auction mechanism (p, x) given that his value estimate is ti.

(, , ) = (, , ) + (, )

, [ , ]

(, , ) 0

And

() 1 () 0 ,

See Myerson for proof. The above lemma is just equivalently re stating the incentive
compatibility and individual rationality conditions. Note that seller has to make the
auction feasible for the buyer or the bidder. Now we shall prove that for symmetric two
bidders, the first price auction is not feasible, the second price auction is feasible and the
all pay auction is not feasible. And lets assume symmetric estimate intervals for
valuations of the object for both players namely [a,b] .
Consider a two player first price auction, where the utility received by the
players is as follows,
1
1 = { 1
0

1 > 2

Then the expected utility for the players can be written as,
= 0

(1 1 )
[1 2 ]2
( )

 (
1

1 ) 2
( )

(1 1 )(1 )
( )

which implies that if s1 < t1 then utility for the bidder becomes positive when he
lies (placing bid at a lower valuation or s1). Thus, this cant be a feasible mechanism for
auction.
Now lets look at the two-player second price auction. Calculating the difference in
utilities for the cases when a player i tells the truth(he places bid at his valuation) and
when he tells lie (places bid at a lower valuation),

(1 2 )
[(1 2 ) (1 2 )]2
( )

Solving the above case for s1 < t1 ,

=

1
1
(1 2 )2
( ) 1

2
= [1 2 2 2]

(1 1 )2
=
2( )
which is always greater than zero. Similarly for s1 > t1 , we can work out that the
integral comes out to be the same. This means that truth telling is always a strictly
dominating strategy in the second price auction for the bidder. Thus this mechanism is
always feasible.
Moving to the for the all-pay auction, again calculate the difference in utilities in truth
telling and lie-telling cases, we see that the condition reduces to a condition on s1 , the
value told by the player 1,
= 0

1
=
{(1 1 )[1 2 ] 1 [2 1 ]2
( )

1
[ (1 1 )2 1 2 ]
( )
1

[(1 1 )(1 1 ) 1 ( 1 )]
( )

which reduces to an infeasible condition since there exists a value of s 1 and t1 for
which U1 (p, x, s1 ) > 0 .

4. Revenue Equivalence. The general dilemma of an auctioneer is to find a mechanism

which maximizes its expected utility. The Revenue Equivalence Theorem answers to
this query. The theorem states, Assume that each of n risk-neutral agents has an
independent private valuation for a single good at auction, each drawn from cumulative
distribution F. Then any two auction mechanisms in which in equilibrium, the good is
always allocated in the same way and any agent with valuation 0 has an expected utility
of 0; both yield the same expected revenue and both result in any bidder with valuation
v making the same expected payment.
It means that as long as two mechanisms allocate in the same way and as long as they
charge an agent with the lowest possible valuation the same amount zero. Then the rest
of their payment functions have to be the same as well. So, you can't get extra money out
of agents without changing the allocation function or the payment of the lowest valued
agent.
Now we will prove revenue equivalence using a stronger theorem, namely the BayesNash Equilibrium Characterization. The theorem states When values are drawn from
a continuous joint distribution F and agents are risk neutral, a strategy profile s is in
BayesNash equilibrium only if for all i, ( , ) is monotone non-decreasing in t i and

( , ) = () () 0 ( , ) + ( , 0) where ( , 0) = 0.
The proof proceeds in three parts:
1. s is a BayesNash equilibrium if the characterization holds and s is onto;
2. s is a BayesNash equilibrium only if monotonicity holds; and
3. s is a BayesNash equilibrium only if the payment identity holds.
We consider the special case where the support of each agents distribution is [0, ).
For the first part, if i deviates from s and takes action si, rather than ti, i gets utility
( | ) = () ( , ) ( , )
Now, since strategy s is in equilibrium if for all i and all ti & si,
( | ) ( | )
Consider some arbitrary, monotonic allocation rule,

Figure 1 : p(t-i,ti) vs ti

is surplus for playing as type ti & si. Consider the first term in the above equation, it
represents the area in the given curve where the valuation of the player is vi(ti). Now
even if the player lies about his bid his actual valuation does not change and surplus for
the player I can be seen as the difference in areas in the two graphs.

Figure 2 : Shaded area is equivalent to pi(t)vi(t)

i,si)

Figure 3 : Shaded area is equivalent to pi(t)vi(t-

The second term in the above equation represents the area shaded in the curves below.
The area of the curve is taken along the probability axis and it is taken till the point of
intersection of the curve with the rectangle formed.

Figure 4 : Shaded area is equivalent to xi(t-i,ti)

Figure 5 : Shaded area is equivalent to xi(t-i,si)

Now the utility is just the difference in areas for the corresponding above figures.

Figure 6 : Shaded area is equivalent to Ui(p,x,ti)

Figure 7 : Shaded area is equivalent to Ui(p,x,si)

Here we can see that if the player places a bid lower than his valuation, his utility is less
as compared to when he places his bid at true value. Note that here we have considered
the case where his bid is less, but even in the case where he places bid greater than his
valuation, his utility will not increase. So even in that case he does not have any
incentive to place his bid greater than his valuation.

Figure 6 : Shaded area is equivalent to Ui(p,x,ti)-Ui(p,x,si)

For the second part of the proof using idea of the equilibrium strategy, we can write
that
(utility for the equilibrium strategy is greater than any other strategy)
( , ) ( , ) ( , ) ( , ) ( , ) ( , )
Now consider two values z1 and z2. Substitute ( , ) = 1 and ( , ) = 2 and other
time vice versa, we will get two inequalities
(1 ) (1 ) (1 ) (2 ) (2 ) (2 )
(2 ) (2 ) (2 ) (1 ) (1 ) (1 )
And adding those equations will result in
( (2 ) (1 ))(1 (1 ) 1 (2 )) 0
From which we can see that if (2 ) (1 ) > 0 then other part also has to be at least
zero which proves the monotonicity of the ( , ) function.
For the third part, we again use the idea of equilibrium strategy and solving for
(1 ) (2 ) we get the following inequality:
(2 )( (2 ) 1 (1 )) (1 ) (2 ) (1 )( (2 ) 1 (1 ))
Thus we now have an upper bound and lower bound on the difference in expected
payments for types 1 and 2 . We can even visualize this difference on the graph.

Where d is the value (2 ) (1 ) and note that if we make d tend to zero both the
right and left hand side of the inequality will get converted to an integral.

And the only payment rule that satisfies these upper and lower bounds for all pair of
types 1 and 2 has payment difference exactly equal to the area to the left of the
allocation rule (2 ) 1 (1 ). The payment identity follows by taking ti = 0 and ti + d
= vi.
From the above discussion we can see that if two mechanisms follow the same
allocation rule, they need to have(essentially) the same payment rule too. This leads to
the corollary of Revenue Equivalence, i.e, all efficient auctions yield the same revenue in
equilibrium. But the above derivation also makes an assumption of risk neutrality
among the players whereby they dont change their belief dynamically to suit the
desired outcome.
5 Optimal Auctions. Up till now we have only considered the utility of bidders. In
optimal auction design we focus on maximizing sellers revenue. The auction mechanism
may not remain efficient (good always goes to the bidder with highest valuation). Thus

the auction that maximizes the sellers expected revenue subject to individual
rationality and Bayesian incentive compatibility for the buyers is an optimal
auction.
Consider 2 bidders whose valuation is uniformly distributed on [0,1]. A
reserve price R is set such that no sale if both bids below R; sale at price R if one bid
above reserve and other below; sale at second highest bid if both bids above reserve.
Now the main objective is to find the value of R for which expected utility of seller is
maximized. Truth telling is still a dominant strategy. Both players bidding below R
occurs with a probability R2 and revenue in this case is 0. If one player bids below R and
the other above it the revenue earned is R with a probability of such event 2(1 ).
Both players bidding above R occurs with a probability (1 )2 the expected revenue is
1+2
[ | ] = 3
1 + 2
= 2(1 ) 2 + (1 )2
3
1 + 4 2 3 3
=
3
1
5
At maxima, = and =
2
12
The tradeoff of such a design is that it loses sales when both the bids are below 0
which occurs with probability 0.25. The advantage is that when one player bids low and
the other high, the price of good is increased and this event occurs with a probability 0.5.
6 Myersons Optimal Auctions. Let us define bidders virtual valuation as
1 ( )
( ) = ( ) . According to Myersons Optimal Auction Theorem, The optimal

(single good) auction in terms of a direct mechanism: the good is sold to the
= arg max ( ) , as long as > ( ( ) = 0). If good is sold the

winning agent i is charged the smallest valuation that he could have declared

while still remaining the winner: inf{ | ( ) > 0 , ( ) ( )}.

Thus this mechanism is not efficient as the good may not always be sold to the
bidder with highest valuation. Truth telling is still a dominant strategy. This works
because reserve prices act as competitors and virtual valuations can increase the impact
of weaker bidders bids.
7. Conclusions and Remarks. The analysis presented in this paper takes a new look at
the proofs presented in the actual paper by Myerson. But the actual problem still
remains, since auction design is concerned with decision making under uncertainty. The
seller must choose the auction mechanism carefully. Moreover single good auctions
comprise very little space in the literature of auction theory. The real world now deals
with even more complex kind of auctions, like the multi-unit auctions, sponsored search
auctions and combinatorial auctions, etc. The idea of indivisible good many times never
holds true, like in the auction of spectrum frequencies, etc.
8. References.

(i) Optimal Auction Design, by Roger. G Myerson, Mathematics of Operations Research, Volume 6 ,
February 1981.
(ii) Yale Game Theory Lectures : oyc.yale.edu/economics/econ-159
(iii) Stanford Game Theory Lectures: online.stanford.edu/gametheory-wi13
(iv) A Course in Game Theory by Osborne and Rubenstein.