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Microeconomic Theory

Guoqiang TIAN

Department of Economics

Texas A&M University

College Station, Texas 77843

(gtian@tamu.edu)

January, 2004

Contents

1 Overview of Economics 1

1.1 Nature and Role of Modern Economics . . . . . . . . . . . . . . . . . . . . 1

1.1.1 Modern Economics and Economic Theory . . . . . . . . . . . . . . 1

1.1.2 The Standard Analytical Framework of Modern Economics . . . . . 2

1.1.3 Key Assumptions Commonly Used or Preferred in Modern Economics 4

1.1.4 Roles of Mathematics in Modern Economics . . . . . . . . . . . . . 5

1.1.5 Conversion between Economic and Mathematical Languages . . . . 5

1.1.6 Limitation and Extension of an Economic Theory . . . . . . . . . . 6

1.1.7 Distinguish Necessary and Suﬃcient Conditions for Statements . . . 7

1.2 Partial Equilibrium Model for Competitive Markets . . . . . . . . . . . . . 8

1.2.1 Assumptions on Competitive Market . . . . . . . . . . . . . . . . . 8

1.2.2 The Role of Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

1.2.3 The Competitive Firm’s Proﬁt Maximization Problem . . . . . . . 9

1.2.4 Partial Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . 11

1.2.5 Entry and Long-Run Equilibrium . . . . . . . . . . . . . . . . . . . 12

I General Equilibrium Theory and Social Welfare 14

2 Positive Theory of Equilibrium: Existence, Uniqueness, and Stability 16

2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

2.2 The Structure of General Equilibrium Model . . . . . . . . . . . . . . . . . 18

2.2.1 Economic Environments . . . . . . . . . . . . . . . . . . . . . . . . 18

2.2.2 Institutional Arrangement: the Private Market Mechanism . . . . . 20

2.2.3 Individual Behavior Assumptions: . . . . . . . . . . . . . . . . . . . 20

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2.2.4 Competitive Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . 21

2.3 Some Examples of GE Models: Graphical Treatment . . . . . . . . . . . . 22

2.3.1 Pure Exchange Economies . . . . . . . . . . . . . . . . . . . . . . . 23

2.3.2 The One-Consumer and One Producer Economy . . . . . . . . . . . 28

2.4 The Existence of Competitive Equilibrium . . . . . . . . . . . . . . . . . . 31

2.4.1 Fixed Point Theorems, KKM Lemma, Maximum Theorem, and

Separating Hyperplane Theorem . . . . . . . . . . . . . . . . . . . . 31

2.4.2 The Existence of CE for Aggregate Excess Demand Functions . . . 36

2.4.3 The Existence of CE for Aggregate Excess Demand Correspondences 47

2.4.4 The Existence of CE for General Production Economies . . . . . . . 48

2.5 The Uniqueness of Competitive Equilibria . . . . . . . . . . . . . . . . . . 49

2.6 Stability of Competitive Equilibrium . . . . . . . . . . . . . . . . . . . . . 50

2.7 Abstract Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

2.7.1 Equilibrium in Abstract Economy . . . . . . . . . . . . . . . . . . . 58

2.7.2 The Existence of Equilibrium for General Preferences . . . . . . . . 59

3 Normative Theory of Equilibrium: Its Welfare Properties 65

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

3.2 Pareto Eﬃciency of Allocation . . . . . . . . . . . . . . . . . . . . . . . . . 66

3.3 The First Fundamental Theorem of Welfare Economics . . . . . . . . . . . 71

3.4 Calculations of Pareto Optimum by First-Order Conditions . . . . . . . . . 74

3.4.1 Exchange Economies . . . . . . . . . . . . . . . . . . . . . . . . . . 74

3.4.2 Production Economies . . . . . . . . . . . . . . . . . . . . . . . . . 75

3.5 The Second Fundamental Theorem of Welfare Economics . . . . . . . . . . 76

3.6 Pareto Optimality and Social Welfare Maximization . . . . . . . . . . . . . 81

3.6.1 Social Welfare Maximization for Exchange Economies . . . . . . . . 82

3.6.2 Welfare Maximization in Production Economy . . . . . . . . . . . . 83

3.7 Political Overtones . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

4 Economic Core, Fair Allocations, and Social Choice Theory 87

4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87

4.2 The Core of Exchange Economies . . . . . . . . . . . . . . . . . . . . . . . 88

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4.3 Fairness of Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92

4.4 Social Choice Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

4.4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

4.4.2 Basic Settings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

4.4.3 Arrow’s Impossibility Theorem . . . . . . . . . . . . . . . . . . . . 100

4.4.4 Some Positive Result: Restricted Domain . . . . . . . . . . . . . . . 101

4.4.5 Gibbard-Satterthwaite Impossibility Theorem . . . . . . . . . . . . 103

II Externalities and Public Goods 105

5 Externalities 108

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

5.2 Consumption Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . 109

5.3 Production Externality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

5.4 Solutions to Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

5.4.1 Pigovian Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

5.4.2 Coase Voluntary Negotiation . . . . . . . . . . . . . . . . . . . . . . 114

5.4.3 Missing Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

5.4.4 The Compensation Mechanism . . . . . . . . . . . . . . . . . . . . 116

6 Public Goods 121

6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

6.2 Notations and Basic Settings . . . . . . . . . . . . . . . . . . . . . . . . . . 121

6.3 Discrete Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

6.3.1 Eﬃcient Provision of Public Goods . . . . . . . . . . . . . . . . . . 123

6.3.2 Free-Rider Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

6.3.3 Voting for a Discrete Public Good . . . . . . . . . . . . . . . . . . . 125

6.4 Continuous Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

6.4.1 Eﬃcient Provision of Public Goods . . . . . . . . . . . . . . . . . . 126

6.4.2 Lindahl Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . 128

6.4.3 Free-Rider Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

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III Incentives, Information, and Mechanism Design 135

7 Principal-Agent Model: Hidden Information 139

7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

7.2 The Basic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140

7.2.1 Economic Environment (Technology, Preferences, and Information) 140

7.2.2 Contracting Variables: Outcomes . . . . . . . . . . . . . . . . . . . 141

7.2.3 Timing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

7.3 The Complete Information Optimal Contract(Benchmark Case) . . . . . . 142

7.3.1 First-Best Production Levels . . . . . . . . . . . . . . . . . . . . . . 142

7.3.2 Implementation of the First-Best . . . . . . . . . . . . . . . . . . . 142

7.3.3 A Graphical Representation of the Complete Information Optimal

Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144

7.4 Incentive Feasible Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . 145

7.4.1 Incentive Compatibility and Participation . . . . . . . . . . . . . . 145

7.4.2 Special Cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

7.4.3 Monotonicity Constraints . . . . . . . . . . . . . . . . . . . . . . . 146

7.5 Information Rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

7.6 The Optimization Program of the Principal . . . . . . . . . . . . . . . . . 147

7.7 The Rent Extraction-Eﬃciency Trade-Oﬀ . . . . . . . . . . . . . . . . . . . 148

7.7.1 The Optimal Contract Under Asymmetric Information . . . . . . . 148

7.7.2 A Graphical Representation of the Second-Best Outcome . . . . . . 150

7.7.3 Shutdown Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

7.8 The Theory of the Firm Under Asymmetric Information . . . . . . . . . . 152

7.9 Asymmetric Information and Marginal Cost Pricing . . . . . . . . . . . . . 153

7.10 The Revelation Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

7.11 A More General Utility Function for the Agent . . . . . . . . . . . . . . . . 155

7.11.1 The Optimal Contract . . . . . . . . . . . . . . . . . . . . . . . . . 155

7.11.2 More than Two Goods . . . . . . . . . . . . . . . . . . . . . . . . . 157

7.12 Ex Ante versus Ex Post Participation Constraints . . . . . . . . . . . . . . 158

7.12.1 Risk Neutrality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

7.12.2 Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

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7.13 Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164

7.13.1 Renegotiating a Contract . . . . . . . . . . . . . . . . . . . . . . . . 164

7.13.2 Reneging on a Contract . . . . . . . . . . . . . . . . . . . . . . . . 165

7.14 Informative Signals to Improve Contracting . . . . . . . . . . . . . . . . . 165

7.14.1 Ex Post Veriﬁable Signal . . . . . . . . . . . . . . . . . . . . . . . . 165

7.14.2 Ex Ante Nonveriﬁable Signal . . . . . . . . . . . . . . . . . . . . . . 166

7.15 Contract Theory at Work . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

7.15.1 Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

7.15.2 Nonlinear Pricing by a Monopoly . . . . . . . . . . . . . . . . . . . 168

7.15.3 Quality and Price Discrimination . . . . . . . . . . . . . . . . . . . 169

7.15.4 Financial Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . 170

7.15.5 Labor Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171

7.16 The Optimal Contract with a Continuum of Types . . . . . . . . . . . . . 172

7.17 Further Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

8 Moral Hazard: The Basic Trade-Oﬀs 179

8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

8.2 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180

8.2.1 Eﬀort and Production . . . . . . . . . . . . . . . . . . . . . . . . . 180

8.2.2 Incentive Feasible Contracts . . . . . . . . . . . . . . . . . . . . . . 181

8.2.3 The Complete Information Optimal Contract . . . . . . . . . . . . 182

8.3 Risk Neutrality and First-Best Implementation . . . . . . . . . . . . . . . . 183

8.4 The Trade-Oﬀ Between Limited Liability Rent Extraction and Eﬃciency . 185

8.5 The Trade-Oﬀ Between Insurance and Eﬃciency . . . . . . . . . . . . . . . 186

8.5.1 Optimal Transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187

8.5.2 The Optimal Second-Best Eﬀort . . . . . . . . . . . . . . . . . . . . 188

8.6 More than Two Levels of Performance . . . . . . . . . . . . . . . . . . . . 189

8.6.1 Limited Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190

8.6.2 Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191

8.7 Contract Theory at Work . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

8.7.1 Eﬃciency Wage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

8.7.2 Sharecropping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

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8.7.3 Wholesale Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . 195

8.7.4 Financial Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . 196

8.8 A Continuum of Performances . . . . . . . . . . . . . . . . . . . . . . . . . 198

8.9 Further Extension . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199

9 General Mechanism Design 202

9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202

9.2 Basic Settings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

9.2.1 Economic Environments . . . . . . . . . . . . . . . . . . . . . . . . 204

9.2.2 Social Goal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

9.2.3 Economic Mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . 205

9.2.4 Solution Concept of Self-Interested Behavior . . . . . . . . . . . . . 207

9.2.5 Implementation and Incentive Compatibility . . . . . . . . . . . . . 207

9.3 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208

9.4 Dominant Strategy and Truthful Revelation Mechanism . . . . . . . . . . . 210

9.5 Gibbard-Satterthwaite Impossibility Theorem . . . . . . . . . . . . . . . . 213

9.6 Hurwicz Impossibility Theorem . . . . . . . . . . . . . . . . . . . . . . . . 213

9.7 Groves-Clarke-Vickrey Mechanism . . . . . . . . . . . . . . . . . . . . . . . 216

9.7.1 Groves-Clark Mechanism for Discrete Public Good . . . . . . . . . 216

9.7.2 The Groves-Clark-Vickery Mechanism with Continuous Public Goods220

9.8 Nash Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224

9.8.1 Nash Equilibrium and General Mechanism Design . . . . . . . . . . 224

9.8.2 Characterization of Nash Implementation . . . . . . . . . . . . . . . 226

9.9 Better Mechanism Design . . . . . . . . . . . . . . . . . . . . . . . . . . . 232

9.9.1 Groves-Ledyard Mechanism . . . . . . . . . . . . . . . . . . . . . . 232

9.9.2 Walker’s Mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . 234

9.9.3 Tian’s Mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236

9.10 Incomplete Information and Bayesian Nash Implementation . . . . . . . . 238

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Chapter 1

Overview of Economics

We ﬁrst set out some basic terminologies, methodologies, and assumptions used in modern

economics in general and this course in particular.

1.1 Nature and Role of Modern Economics

1.1.1 Modern Economics and Economic Theory

• What is economics about?

Economics is a social science that studies economic phenomena and the economic behavior

of individuals, ﬁrms, government, and other economic units as well as how they make

choices so that limited resources are allocated among competing uses.

Because resources are limited, but people’s desires are unlimited, we need economics

to study this fundamental conﬂict.

• Four basic questions must be answered by any economic insti-

tution:

(1) What goods and services should be produced and in what quantity?

(2) How should the product be produced?

(3) For whom should it be produced and how should it be distributed?

(4) Who makes the decision?

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The answers depend on the use of economic institution. There are two basic economic

institutions that have been used in reality:

(1) Market economic institution: Most decisions on economic activities are

made by individuals, it is mainly a decentralized decision system.

(2) Planning economic institution: Most decisions on economic activities are

made by government, it is mainly a centralized decision system.

• What is Modern Economics?

The market economy has been proved to be only economic institution so far that can

keep an economy with sustainable development, and therefore modern economics mainly

studies various economic phenomena and behavior under market economic environment

by using an analytical approach.

• What is Economic Theory?

Every economic theory that can be considered as an axiomatic approach consists of

a set of presumptions and conditions, basic framework, and conclusions that are derived

from the assumptions and the framework.

In discussing and applying an economic theory to argue some claims, one should pay

attention to the assumptions of the economic theory and the applicable range (boundary

and limitation) of the theory.

• Microeconomic theory

Microeconomic theory aims to model economic activity as an interaction of individual

economic agents pursuing their private interests.

1.1.2 The Standard Analytical Framework of Modern Economics

Modern economics developed in last ﬁfty years stands for an analytical method or frame-

work for studying economic behavior and phenomena. As a theoretical analytical frame-

work of modern economics, it consists of three aspects: perspective, reference system

2

(benchmark), and analytical tools. To have a good training in economic theory, one

needs to start from these three aspects. To understand various economic theories and

arguments, it is also important for people to understand these three aspects:

(1) Perspective: modern economics provides various perspectives or angles of

looking at economic issues starting from reality. An economic phenomenon

or issue may be very complicated and aﬀected by many factors. The per-

spective approach can grasp the most essential factors of the issue and

take our attention to most key and core characteristics of an issue so that

it can avoid those unimportant details. This should be done by making

some key and basic assumptions about preferences, technologies, and en-

dowments. From these basic assumptions, one studies eﬀects of various

economic mechanisms (institutions) on behavior of agents and economic

units, and takes “equilibrium,” “eﬃciency”, “information”, and “incen-

tives” as focus points. That is, economists study how individuals interact

under the drive of self-interested motion of individuals with a given mech-

anism, reach some equilibria, and evaluate the status at equilibrium. Ana-

lyzing economic problem using such a perspective has not only consistence

in methodology, but also get surprising (but logic consistent) conclusions.

(2) Reference Systems (Benchmark): modern economics provides various ref-

erence systems. For instance, the general equilibrium theory we will study

in this course is such a reference system. Other example includes Coase

Theorem in property rights theory and economic law, Modigliani-Miller

Theorem in corporate ﬁnance theory. The importance of a reference sys-

tem does not relay on whether or not it describes the real world correctly

or precisely, but gives a criterion of understanding the real world. Un-

derstanding such a role of reference system is useful to clarify two mis-

understandings: One is that some people may over-evaluate a theoretical

result in a reference system. They do not know in most situations that

a theory does not exactly coincide with the reality, but it only provides

a benchmark to see how far a reality is from the ideal status given by a

reference system. The other misunderstanding is that some people may

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under-evaluate a theoretical result in the reference system and think it is

not useful because of unrealistic assumptions. They do not know the value

of a theoretical result is not that it can directly explain the world, but that

it provides a benchmark for developing new theories to explain the world.

In fact, the establishment of a reference system is extremely important for

any subject, including economics. Everyone could talk something about an

economic issue from realty, but the main diﬀerence is that a person with

systematic training in modern economics have a few reference systems in

her mind while a person without a training in modern economics does not

so he cannot grasp an essential part of the issue and cannot provide deep

analysis and insights.

(3) Analytical Tools: modern economics provides various powerful analyti-

cal tools that are actually given by geometrical or mathematical models.

Advantages of such tools can help us to analyze complicated economic be-

havior and phenomena through a simple diagram or mathematical struc-

ture in a model. Examples include (1) the demand-supply curve model,

(2) Samuelson’s overlapping generation model, and (3) the principal-agent

model.

1.1.3 Key Assumptions Commonly Used or Preferred in Mod-

ern Economics

Economists usually make some of the following key assumptions and conditions when they

study economic problems:

(1) Individuals are (bounded) rational: self-interested behavior assumption;

(2) Scarcity of Resources: Individuals confront scarce resources;

(3) Economic freedom: voluntary cooperation and voluntary exchange;

(4) Decentralized decision makings: One prefers to use the way of decentralized

decision marking because most economic information is incomplete to the

decision marker;

4

(5) Incentive compatibility of parties: the system or economic mechanism

should solve the problem of interest conﬂicts between individuals or eco-

nomic units;

(6) Well-deﬁned property rights;

(7) Equity in opportunity;

(8) Allocative eﬃciency of resources;

Relaxing any of these assumptions may result in diﬀerent conclusions.

1.1.4 Roles of Mathematics in Modern Economics

Mathematics has become an important tool used in modern economics. Almost every

ﬁeld in modern economics more or less uses mathematics and statistics. Mathematical

approach is an approach to economic analysis in which the economists make use of math-

ematical symbols in the statement of a problem and also draw upon known mathematical

theorems to aid in reasoning. It is not hard to understand why mathematical approach

has become a dominant approach because the establishment of a reference system and

the development of analytical tools need mathematics. Advantages of using mathemat-

ics is that (1) the “language” used is more accurate and precise and the descriptions of

assumptions are more clear using mathematics, (2) the logic of analysis is more rigorous

and it clearly clariﬁes the boundary and limitation of a statement, (3) it can give a new

result that may not be easily obtained through the observation, and (4) it can reduce

unnecessary debates and improve or extend existing results.

It should be remarked that, although mathematics is of critical importance in modern

economics, economics is not mathematics, rather economics uses mathematics as a tool

to model and analyze various economic problems.

1.1.5 Conversion between Economic and Mathematical Languages

A product in economics science is an economic conclusion. The production of an eco-

nomic conclusion usually takes three stages: Stage 1 (non-mathematical language stage).

Produce preliminary outputs –propose economic ideas, intuitions, and conjectures. (2)

Stage 2 (mathematical language stage). Produce intermediate outputs – give a formal and

5

rigorous result through mathematical modeling. Stage 3 (non-technical language stage).

Produce ﬁnal outputs – conclusions, insights, and statements that can be understood by

non-specialists.

1.1.6 Limitation and Extension of an Economic Theory

When making an economic conclusion and discussing an economic problem, it is very

important to notice the boundary, limitation, and applicable range of an economic theory.

Every theory is based on some imposed assumptions, and thus it only relatively correct

and has its limitation and boundary of suitability. No theory is universe (absolute).

One example is the assumption of perfect competition. In reality, no competition is

perfect. Real world markets seldom achieve this ideal. The question is then not whether

any particular market is perfectly competitive – almost no market is. The appropriate

question is to what degree models of perfect competition can generate insights about real-

world market. We think this assumption is approximately correct under some situations.

Just like frictionless models in physics such as in free falling body movement (no air

resistance), ideal gas (molecules do not collide), ideal ﬂuid, can describe some important

phenomena in the physical world, the frictionless models of perfect competition generates

useful insights in the economic world.

It is often heard that some people claims they topple an existing theory or conclusion,

or they say some theory or conclusions have been overthrown when some conditions or

assumptions behind the theory or conclusions are criticized. This is usually not a correct

way to say it. We can always criticize any existing theory because no assumption can

coincides fully with reality or cover everything. So, as long as there is no logic errors

or inconsistency in theory, we cannot say the theory is wrong, although we may criticize

that it is too limited or not realistic. What we need to do is to weaken or relax those

assumptions, and obtain new theories based on old theories. However, we cannot say this

new theory topples the old one, but it may be more appropriate to say that the new theory

extends the old theory to cover more general situation or deal with a diﬀerent economic

environments.

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1.1.7 Distinguish Necessary and Suﬃcient Conditions for State-

ments

In discussing an economic issue, it is very important to distinguish: (1) two types of

statements: positive analysis and normative analysis, and (2) two types of conditions:

necessary and suﬃcient conditions for a statement to be true.

Some people often confuse the distinction between necessary condition and suﬃcient

condition when they give their claims, and get wrong conclusions. For instance, it is often

heard that the market institution should not used by giving examples that some countries

are market economies but are still poor. The reason they get the wrong conclusion that

the market mechanism should not be used is because they did not realize the adoption

of a market mechanism is just a necessary condition for a country to be rich, but is not

a suﬃcient condition. Becoming a rich country also depends on other factors such as

political system, social infrastructures, and culture. So far, no example of a country can

be found that it is rich in a long run, but is not a market economy.

7

1.2 Partial Equilibrium Model for Competitive Mar-

kets

The consumer theory and producer theory study maximizing behavior of consumers and

producers by taking market prices as given. We begin our study of how the competitive

market prices are determined by the actions of the individual agents.

1.2.1 Assumptions on Competitive Market

The competitive markets is based on the following assumptions:

(1) Large number of buyers and sellers — price-taking behavior

(2) Unrestricted mobility of resources among industries: no artiﬁcial barrier

or impediment to entry or to exit from market.

(3) Homogeneous product: All the ﬁrms in an industry produce an identical

production in the consumers’ eyes.

(4) Passion of all relevant information (all relevant information are common

knowledge): Firms and consumers have all the information necessary to

make the correct economic decisions.

1.2.2 The Role of Prices

The key insight of Adam Smith’s Wealth of Nations is simple: if an exchange between

two parties is voluntary, it will not take place unless both believe they will beneﬁt from

it. How is this also true for any number of parties and for production case? The price

system is the mechanism that performs this task very well without central direction.

Prices perform three functions in organizing economic activities in a free market econ-

omy:

(1)They transmit information about production and consumption. The price

system transmit only the important information and only to the people

who need to know. Thus, it transmits information in an eﬃciently way.

8

(2) They provide right incentives. One of the beauties of a free price system is

that the prices that bring the information also provide an incentive to react

on the information not only about the demand for output but also about

the most eﬃcient way to produce a product. They provides incentives to

adopt those methods of production that are least costly and thereby use

available resources for the most highly valued purposes.

(3) They determine the distribution of income. They determine who gets

how much of the product. In general, one cannot use prices to transmit

information and provide an incentive to act that information without using

prices to aﬀect the distribution of income. If what a person gets does not

depend on the price he receives for the services of this resources, what

incentive does he have to seek out information on prices or to act on the

basis of that information?

1.2.3 The Competitive Firm’s Proﬁt Maximization Problem

Since the competitive ﬁrm must take the market price as given, its proﬁt maximization

problem is simple. The ﬁrm only needs to choose output level y so as to solve

max

y

py −c(y) (1.1)

where y is the output produced by the ﬁrm, p is the price of the product, and c(y) is the

cost function of production.

The ﬁrst-order condition (in short, FOC) for interior solution gives:

p = c

t

(y) ≡ MC(y). (1.2)

The ﬁrst order condition becomes a suﬃcient condition if the second-order condition (in

short, SOC) is satisﬁed

c

tt

(y) > 0. (1.3)

By p = c

t

(y(p)), we have

1 = c

tt

(y(p))y

t

(p) (1.4)

and thus

y

t

(p) > 0, (1.5)

9

which means the law of supply holds.

For the short-run (in short, SR) case,

c(y) = c

v

(y) + F (1.6)

The ﬁrm should produce if

py(p) −c

v

(y) −F −F, (1.7)

and thus we have

p

c

v

(y(p))

y(p)

≡ AV C. (1.8)

That is, the necessary condition for the ﬁrm to produce a positive amount of output is

that the price is greater than or equal to the average variable cost.

Figure 1.1: Firm’s supply curve, and AC, AVC, and MC Curves

The industry supply function is simply the sum of all individuals’ supply functions so

that it is given by

ˆ y(p) =

J

¸

j=1

y

j

(p) (1.9)

where y

i

(p) is the supply function of ﬁrm j for j = 1, . . . , J. Since each ﬁrm chooses a level

of output where price equals marginal cost, each ﬁrm that produces a positive amount

of output must have the same marginal cost. The industry supply function measures the

relationship between industry output and the common cost of producing this output.

10

The aggregate (industry) demand function measures the total output demanded at

any price which is given by

ˆ x(p) =

n

¸

i=1

x

i

(p) (1.10)

where x

i

(p) is the demand function of consumer i for 1 = 1, . . . , n.

1.2.4 Partial Market Equilibrium

A partial equilibrium price p

∗

is a price where the aggregate quantity demanded equals

the aggregate quantity supplied. That is, it is the solution of the following equation:

n

¸

i=1

x

i

(p) =

J

¸

j=1

y

j

(p) (1.11)

Example 1.2.1 ˆ x(p) = a −bp and c(y) = y

2

+ 1. Since MC(y) = 2y, we have

y =

p

2

(1.12)

and thus the industry supply function is

ˆ y(p) =

Jp

2

(1.13)

Setting a −bp =

Jp

2

, we have

p

∗

=

a

b +J/2

. (1.14)

Now for general case of D(p) and S(p), what happens about the equilibrium price if

the number of ﬁrms increases? From

D(p(J)) = Jy(p(J))

we have

D

t

(p(J))p

t

(J) = y(p) + Jy

t

(p(J))p

t

(J)

and thus

p

t

(J) =

y(p)

X

t

(p) −Jy

t

(p)

< 0,

which means the equilibrium price decreases when the number of ﬁrms increases.

11

1.2.5 Entry and Long-Run Equilibrium

In the model of entry or exit, the equilibrium number of ﬁrms is the largest number of

ﬁrms that can break even so the price must be chosen to minimum price.

Example 1.2.2 c(y) = y

2

+ 1. The break-even level of output can be found by setting

AC(y) = MC(y)

so that y = 1, and p = MC(y) = 2.

Suppose the demand is linear: X(p) = a −bp. Then, the equilibrium price will be the

smallest p

∗

that satisﬁes the conditions

p

∗

=

a

b + J/2

2.

As J increases, the equilibrium price must be closer and closer to 2.

Reference

Arrow, K and G. Debreu, “Existence of Equilibrium for a Competitive Economy,” Econo-

metrica, 1954, 22.

Coase, R., “The Problem of Social Cost,” Journal of Law and Economics, 3 (1960), 1-44.

Fridman, M. and R. Frideman, Free to Choose, HBJ, New York, 1980.

Debreu, G. (1959), Theory of Value, (Wiley, New York).

Mas Colell, A., M. D. Whinston, and J. Green, Microeconomic Theory, Oxford University

Press, 1995, Chapter 10.

Modigliani, F., and M. Miller, “The Cost of Capital, Corporation Finance and the Theory

of Investment,” American Economic Review, 48 (1958), 261-297.

Jehle, G. A., and P. Reny, Advanced Microeconomic Theory, Addison-Wesley, 1998,

Chapter 6.

Samuelson, P., “An Exact Consumption-Loan Model of Interest with or without the

Social Contrivance of Money,” Journal of Political Economy, 66 (1958), 467-482.

12

Tian, G., Market Economics for Masses, (with Fan Zhang), in A Series of Market Eco-

nomics, Vol. 1, Ed. by G. Tian, Shanghai People’s Publishing House and Hong

Kong’s Intelligent Book Ltd, 1993 (in Chinese), Chapters 1-2.

Varian, H.R., Microeconomic Analysis, W.W. Norton and Company, Third Edition,

1992, Chapter 13.

13

Part I

General Equilibrium Theory and

Social Welfare

14

Part I is devoted to an examination of competitive market economies from a general

equilibrium perspective at which all prices are variable and equilibrium requires that all

markets clear.

The content of Part I is organized into three chapters. Chapters 2 and 3 constitute

the heart of the general equilibrium theory. Chapter 2 presents the form structure of the

equilibrium model, introduces the notion of competitive equilibrium (or called Walrasian

equilibrium). The emphasis is on positive properties of the competitive equilibrium. We

will discuss the existence, uniqueness, and stability of a competitive equilibrium. We will

also discuss a more general setting of equilibrium analysis, namely the abstract economy

which includes the general equilibrium model as a special case. Chapter 3 discusses the

normative properties of the competitive equilibrium by introducing the notion of Pareto

eﬃciency. We examine the relationship between the competitive equilibrium and Pareto

optimality. The core is concerned with the proof of the two fundamental theorems of wel-

fare economics. Chapter 4 explores extensions of the basic analysis presented in Chapters

2 and 3. Chapter 4 covers a number of topics whose origins lie in normative theory. We

will study the important core equivalence theorem that takes the idea of Walrasian equi-

libria as the limit of noncooperative equilibria as markets grow large, fairness of allocation,

and social choice theory.

15

Chapter 2

Positive Theory of Equilibrium:

Existence, Uniqueness, and Stability

2.1 Introduction

The general equilibrium theory considers equilibrium in many markets simultaneously,

unlike partial equilibrium theory which considers only one market at a time. Interaction

between markets may result in a conclusion that is not obtained in a partial equilibrium

framework.

A General Equilibrium is deﬁned as a state where the aggregate demand will not

excess the aggregate supply for all markets. Thus, equilibrium prices are endogenously

determined.

The general equilibrium approach has two central features:

(1) It views the economy as a closed and inter-related system in which we

must simultaneously determine the equilibrium values of all variables of

interests (consider all markets together).

(2) It aims at reducing the set of variables taken as exogenous to a small

number of physical realities.

From a positive viewpoint, the general equilibrium theory is a theory of the determination

of equilibrium prices and quantities in a system of perfectly competitive markets. It is

often called the Walrasian theory of market from L. Walras (1874).

16

It is to predict the ﬁnal consumption and production in the market mechanism.

The general equilibrium theory consists of four components:

1. Economic institutional environment (the fundamentals of the economy):

economy that consists of consumption space, preferences, endowments of

consumers, and production possibility sets of producers.

2. Economic institutional arrangement: It is the price mechanism in which a

price is quoted for every commodity.

3. The behavior assumptions: price taking behavior for consumers and ﬁrms,

utility maximization and proﬁt maximization.

4. Predicting outcomes: equilibrium analysis: positive analysis such as exis-

tence, uniqueness, and stability, and normative analysis such as allocative

eﬃciency of general equilibrium.

Questions to be answered in the general equilibrium theory.

A. The existence and determination of a general equilibrium: What kinds

of restrictions on economic environments (consumption sets, endowments,

preferences, production sets) would guarantee the existence of a general

equilibrium.

B. Uniqueness of a general equilibrium: What kinds of restrictions on economic

environments would guarantee a general equilibrium to be unique?

C. Stability of a general equilibrium: What kinds of restrictions economic

environments would guarantee us to ﬁnd a general equilibrium by changing

prices, especially rasing the price if excess demand prevails and lowering it

if excess supply prevails?

D. Welfare properties of a general equilibrium: What kinds of restrictions on

consumption sets, endowments, preferences, production sets would ensure

a general equilibrium to be social optimal – Pareto eﬃcient?

17

2.2 The Structure of General Equilibrium Model

Throughout this notes, subscripts are used to index consumers or ﬁrms, and superscripts

are used to index goods unless otherwise stated. By an agent, we will mean either a

consumer or a producer. As usual, vector inequalities, , ≥, and >, are deﬁned as

follows: Let a, b ∈ R

m

. Then a b means a

s

b

s

for all s = 1, . . . , m; a ≥ b means a b

but a = b; a > b means a

s

> b

s

for all s = 1, . . . , m.

2.2.1 Economic Environments

The fundamentals of the economy are economic institutional environments that are ex-

ogenously given and characterized by the following terms:

n: the number of consumers

N: the set of agents

J: the number of producers (ﬁrms)

L: the number of (private) goods

X

i

∈ '

L

: the consumption space of consumer i, which speciﬁes the bound-

ary of consumptions, collection of all individually feasible consumptions of

consumer i. Some components of an element may be negative such as a

labor supply;

i

: preferences ordering (or u

i

if a utility function exists) of i;

Remark:

i

is a preference ordering if it is reﬂexive (x

i

i

x

i

), transitive

(x

i

i

x

t

i

and x

t

i

i

x

tt

i

implies x

i

i

x

tt

i

), and complete (for any pair x

i

and x

t

i

, either x

i

i

x

t

i

or x

t

i

i

x

i

). Notice that it can be represented by a

utility function if

i

are continuous. The existence of general equilibrium

can be obtained even when preferences are weakened to be non-complete

or non-transitive.

w

i

∈ X

i

: endowment of consumer i.

e

i

= (X

i

,

i

, w

i

): the characteristic of consumer i.

18

Y

j

: production possibility set of ﬁrm j = 1, 2, . . . , J, which is the characteristic

of producer j.

y

j

∈ Y

j

: a production plan, y

l

j

> 0 means y

l

j

is output and y

l

j

< 0 means y

l

j

is

input. Most elements of y

j

for a ﬁrm are zero.

Recall there can be three types of returns about production scales: non-

increasing returns to scale (i.e., y

j

∈ Y

j

implies that αy

j

∈ Y

j

for all

α ∈ [0, 1]), non-decreasing (i.e., y

j

∈ Y

j

implies that αy

j

∈ Y

j

for all

α 1) returns to scale, and constant returns to scale i.e., y

j

∈ Y

j

implies

that αy

j

∈ Y

j

for all α 0). In other words, decreasing returns to scale

implies any feasible input-output vector can be scaled down; increasing

returns to scale implies any feasible input-output vector can be scaled up,

constant returns to scale implies the production set is the conjunction of

increasing returns and decreasing returns. Geometrically, it is a cone.

Figure 2.1: Various Returns to Scale: IRS, DRS, and CRS

e = (¦X

i

, , w

i

¦, ¦Y

j

¦): an economy, or called an economic environment.

X = X

1

X

2

. . . X

n

: consumption space.

Y = Y

1

Y

2

. . . Y

J

: production space.

19

2.2.2 Institutional Arrangement: the Private Market Mecha-

nism

p = (p

1

, p

2

, . . . , p

L

) ∈ '

L

+

: a price vector;

px

i

: the expenditure of consumer i for i = 1, . . . , n;

py

j

: the proﬁt of ﬁrm J for j = 1, . . . , J;

pw

i

: the value of endowment of consumer i for i = 1, . . . , n;

θ

ij

∈ '

+

: the proﬁt share of consumer i from ﬁrm j, which speciﬁes ownership

(property rights) structures, so that

¸

n

i=1

θ

ij

= 1 for j = 1, 2, . . . , J, and

i = 1, . . . , n;

¸

J

j=1

θ

ij

py

j

= the total proﬁt dividend received by consumer i for i = 1, . . . , n.

For i = 1, 2, . . . , n, consumer i’s budget constraint is given by

px

i

pw

i

+

J

¸

j=1

θ

ij

py

j

(2.1)

and the budget set is given by

B

i

(p) = ¦x

i

∈ X

i

: px

i

pw

i

+

J

¸

j=1

θ

ij

py

j

¦. (2.2)

A private ownership economy then is referred to

e = (e

1

, e

2

, . . . , e

n

, ¦Y

j

¦

n

j=1

, ¦θ

ij

¦). (2.3)

The set of all such private ownership economies are denoted by E.

2.2.3 Individual Behavior Assumptions:

(1) Perfect Competitive Markets: Every player is a price-taker.

(2) Utility maximization: Every consumer maximizes his preferences subject

to B

i

(p). That is,

max

x

i

u

i

(x

i

) (2.4)

s.t.

px

i

pw

i

+

J

¸

j=1

θ

ij

py

j

(2.5)

20

(3) Proﬁt maximization: Every ﬁrm maximizes its proﬁt in Y

j

. That is,

max

y

j

∈Y

j

py

j

(2.6)

for j = 1, . . . , J.

2.2.4 Competitive Equilibrium

Before deﬁning the notion of competitive equilibrium, we ﬁrst give some notions on alloca-

tions which identify the set of possible outcomes in economy e. For notational convenience,

“ˆ a” will be used throughout the notes to denote the sum of vectors a

i

, i.e., ˆ a :=

¸

a

l

.

Allocation:

An allocation (x, y) is a speciﬁcation of consumption vector x = (x

1

, . . . , x

n

) and

production vector y = (y

1

, . . . , y

J

).

An allocation (x, y) is individually feasible if x

i

∈ X

i

for all i ∈ N, y

j

∈ Y

j

for all

j = 1, . . . , J.

An allocation is weakly balanced

ˆ x ˆ y + ˆ w (2.7)

or speciﬁcally

n

¸

i=1

x

i

J

¸

j=1

y

j

+

n

¸

i=1

w

i

(2.8)

When inequality holds with equality, the allocation is called balanced or attainable.

An allocation (x, y) is feasible if it is both individually feasible and (weakly) balanced.

Thus, an economic allocation is feasible if the total amount of each good consumed does

not exceed the total amount available from both the initial endowment and production.

Denote by A = ¦(x, y) ∈ X Y : ˆ x ˆ y + ˆ w¦ by the set of all feasible allocations.

Aggregation:

ˆ x =

¸

n

i=1

x

i

: aggregation of consumption;

ˆ y =

¸

J

j=1

y

j

: aggregation of production;

ˆ w =

¸

n

i=1

w

i

: aggregation of endowments;

Now we deﬁne the notion of competitive equilibrium.

Deﬁnition 2.2.1 (Competitive Equilibrium or also called Walrasian Equilibrium)

Given a private ownership economy, e = (e

1

, . . . , e

n

, ¦Y

j

¦, ¦θ

ij

¦), an allocation (x, y) ∈

21

X Y and a price vector p ∈ '

L

+

consist of a competitive equilibrium if the following

conditions are satisﬁed

(i) Utility maximization: x

i

i

x

t

i

for all x

t

i

∈ B

i

(p) and x

i

∈ B

i

(p) for

i = 1, . . . , n.

(ii) Proﬁt maximization: py

j

py

t

j

for y

t

j

∈ Y

j

.

(iii) Market Clear Condition: ˆ x ˆ w + ˆ y.

Denote

x

i

(p) = ¦x

i

∈ B

i

(p) : x

i

∈ B

i

(p) and x

i

i

x

t

i

for all x

t

i

∈ B

i

(p)¦: the demand

correspondence of consumer i under utility maximization; it is called the

demand function of consumer i if it is a single-valued function.

y

j

(p) = ¦y

j

∈ Y

j

: py

j

py

t

j

for all y

t

j

∈ Y

j

¦: the supply correspondence of

the ﬁrm j; it is called the supply function of ﬁrm j if it is a single-valued

function.

ˆ x(p) =

¸

n

i=1

x

i

(p) : the aggregate demand correspondence.

ˆ y(p) =

¸

J

j=1

y

j

(p) : the aggregate supply correspondence.

ˆ z(p) = ˆ x(p) − ˆ w − ˆ y(p) : aggregate excess demand correspondence.

An equivalent deﬁnition of competitive equilibrium then is that a price vector p

∗

∈ '

L

+

is a competitive equilibrium price if there exists ˆ z ∈ ˆ z(p

∗

) such that ˆ z 0.

If ˆ z(p) is a single-valued, ˆ z(p

∗

) 0 is a competitive equilibrium.

2.3 Some Examples of GE Models: Graphical Treat-

ment

In most economies, there are three types of economic activities: production, consumption,

and exchanges. Before formally stating the existence results on competitive equilibrium,

we will ﬁrst give two simple examples of general equilibrium models: exchange economies

and a production economy with only one consumer and one ﬁrm. These examples intro-

duce some of the questions, concepts, and common techniques that will occupy us for the

rest of this part.

22

2.3.1 Pure Exchange Economies

A pure exchange economy is an economy in which there is no production. This is a

special case of general economy. In this case, economic activities only consist of trading

and consumption.

The aggregate excess demand correspondence becomes ˆ z(p) = ˆ x(p) − ˆ w so that we can

deﬁne the individual excess demand by z

i

(p) = x

i

(p) −w

i

for this special case.

The simplest exchange economy with the possibility of mutual beneﬁt exchange is the

exchange economy with two commodities and two consumers. As it turns out, this case

is amenable to analysis by an extremely handy graphical device known as the Edgeworth

box.

• Edgeworth Box:

Consider an exchange economy with two goods (x

1

, x

2

) and two persons. The total

endowment is ˆ w = w

1

+ w

2

. For example, if w

1

= (1, 2), w

2

= (3, 1), then the total

endowment is: ˆ w = (4, 3). Note that the point, denoted by w in the Edgeworth Box, can

be used to represent the initial endowments of two persons.

Figure 2.2: Edgeworth Box in which w

1

= (1, 2) and w

2

= (3, 1)

Advantage of the Edgeworth Box is that it gives all the possible (balanced) trading

points. That is,

x

1

+ x

2

= w

1

+ w

2

(2.9)

23

for all points x = (x

1

, x

2

) in the box, where x

1

= (x

1

1

, x

2

1

) and x

2

= (x

1

2

, x

2

2

). Thus, every

point in the Edgeworth Box stands for an attainable allocation so that x

1

+x

2

= w

1

+w

2

.

The shaded lens (portion) of the box in the above ﬁgure represents all the trading

points that make both persons better oﬀ. Beyond the box, any point is not feasible.

Which point in the Edgeworth Box can be a competitive equilibrium?

Figure 2.3: In the Edgeworth Box, the point CE is a competitive equilibrium.

In the box, one person’s budget line is also the budget line of the other person. They

share the same budget line in the box.

Figure 2.4 below shows the market adjustment process to a competitive equilibrium.

Originally, at price p, both persons want more good 2. This implies that the price of good

1, p

1

, is too high so that consumers do not consume the total amounts of the good so that

there is a surplus for x

1

and there is an excess demand for x

2

, that is, x

1

1

+x

1

2

< w

1

1

+w

1

2

and x

2

1

+ x

2

2

> w

2

1

+ w

2

2

. Thus, the market will adjust itself by decreasing p

1

to p

1t

. As a

result, the budget line will become ﬂatter and ﬂatter till it reaches the equilibrium where

the aggregate demand equals the aggregate supply. In this interior equilibrium case, two

indiﬀerence curves are tangent each other at a point that is on the budget line so that

the marginal rates of substitutions for the two persons are the same that is equal to the

price ratio.

24

Figure 2.4: This ﬁgure shows the market adjustment process

What happens when indiﬀerence curves are linear?

Figure 2.5: A competitive equilibrium may still exist even if two persons’ indiﬀerence

curves do not intersect.

In this case, there is no tangent point as long as the slopes of the indiﬀerence curves

of the two persons are not the same. Even so, there still exists a competitive equilibrium

although the marginal rates of substitutions for the two persons are not the same.

25

Oﬀer Curve: the locus of the optimal consumptions for the two goods when price

varies. Note that, it consists of tangent points of the indiﬀerence curves and budget lines

when price varies.

The oﬀer curves of two persons are given in the following ﬁgure:

Figure 2.6: The CE is characterized by the intersection of two persons’ oﬀer curves.

The intersection of the two oﬀer curves of the consumers can be used to check if there

is a competitive equilibrium. By the above diagram, one can see that the one intersection

of two consumers’ oﬀer curves is always given at the endowment w. If there is another

intersection of two consumers’ oﬀer curves rather than the one at the endowment w, the

intersection point must be the competitive equilibrium.

To enhance the understanding about the competitive equilibrium, you try to draw the

competitive equilibrium in the following situations:

1. There are many equilibrium prices.

2. One person’s preference is such that two goods are perfect substitutes (i.e.,

indiﬀerence curves are linear).

3. Preferences of one person are the Leontief-type (perfect complement)

4. One person’s preferences are non-convex.

26

5. One person’s preferences are “thick”.

6. One person’s preferences are convex, but has a satiation point.

Note that a preference relation

i

is convex if x

i

x

t

implies tx + (1 −t)x

t

i

x

t

for

all t ∈ [0, 1] and all x, x

t

∈ X

i

. A preference relation

i

has a satiation point x if x

i

x

t

all x

t

∈ X

i

.

Cases in which there may be no Walrasian Equilibria:

Case 1. Indiﬀerence curves (IC) are not convex. If the two oﬀer curves may not be

intersected except for at the endowment points, then there may not exist a competitive

equilibrium. This may be true when preferences are not convex.

Figure 2.7: A CE may not exist if indiﬀerence curves are not convex. In that case, two

persons’ oﬀer curves do not intersect.

Case 2. The initial endowment may not be an interior point of the consumption

space. Consider an exchange economy in which one person’s indiﬀerence curves put no

values on one commodity, say, when Person 2’s indiﬀerence curves are vertical lines so

that u

2

(x

1

2

, x

2

2

) = x

1

2

. Person 1’s utility function is regular one, say, which is given by

the Cobb-Douglas utility function. The initial endowments are given by w

1

= (0, 1) and

w

2

= (1, 0). There may not be a competitive equilibrium. Why?

27

If p

1

/p

2

> 0, then

x

1

2

= 1

x

1

1

> 0

(2.10)

so that x

1

1

(p) + x

1

2

(p) > 1 = ˆ w

1

. Thus, there is no competitive equilibrium.

If p

1

/p

2

= 0, then x

1

2

= ∞and thus there is not competitive equilibrium. A competitive

equilibrium implies that x

1

1

(p) +x

1

2

(p) ˆ w

1

. However, in both sub-cases, we have x

1

1

(p) +

x

1

2

(p) > ˆ w

1

which violates the feasibility conditions.

Figure 2.8: A CE may not exist if an endowment is on the boundary.

2.3.2 The One-Consumer and One Producer Economy

Now we introduce the possibility of production. To do so, in the simplest-possible setting

in which there are only two price-taking economic agents.

Two agents: one producer so that J = 1 and one consumer so that n = 1.

Two goods: labor (leisure) and the consumption good produced by the ﬁrm.

w = (

¯

L, 0): the endowment.

L: the total units of leisure time.

28

f(z): the production function that is strictly increasing, concave, and diﬀer-

entiable, where z is labor input. To have an interior solution, we assume

f satisﬁes the Inada condition f

t

(0) = +∞ and lim

z→0

f

t

(z)z = 0.

(p, w): the price vector of the consumption good and labor.

θ = 1: single person economy.

u(x

1

, x

2

): is the utility function which is strictly quasi-concave, increasing,

and diﬀerentiable. To have an interior solution, we assume u satisﬁes the

Inada condition

∂u

∂x

i

(0) = +∞ and lim

x

i

→0

∂u

∂x

i

x

i

= 0.

The ﬁrm’s problem is to choose the labor z so as to solve

max

z0

pf(z) −wz (2.11)

FOC:

pf

t

(z) = w

⇒ f

t

(z) = w/p

(MRTS

z,q

= Price ratio)

which means the marginal rate of technique substitution of labor for the consumption

good q equals the price ratio of the labor input and the consumption good output.

Let

q(p, w) = the proﬁt maximizing output for the consumption good.

z(p, w) = the proﬁt maximizing input for the labor.

π(p, w) = the proﬁt maximizing function.

The consumer’s problem is to choose the leisure time and the consumption for the good

so as to solve

max

x

1

,x

2

u(x

1

, x

2

)

s.t. px

2

w(L −x

1

) + π(p, w)

where x

1

is the leisure and x

2

is the consumption of good.

(FOC:)

∂u

∂x

1

∂u

∂x

2

=

w

p

(2.12)

29

which means the marginal rate of substitution of the leisure consumption for the con-

sumption good q equals the price ratio of the leisure and the consumption good, i.e.,

MRS

x

1

x

2 = w/p.

By (2.11) and (2.12)

MRS

x

1

x

2 =

w

p

= MRTS

z,q

(2.13)

Figure 2.9: Figures for the producer’s problem, the consumer problem and the CE.

30

A competitive equilibrium for this economy involves a price vector (p

∗

, w

∗

) at which

x

2

(p

∗

, w

∗

) = q(p

∗

, w

∗

);

x

1

(p

∗

, w

∗

) + z(p

∗

, w

∗

) = L

That is, the aggregate demand for the two goods equals the aggregate supply for the

two goods. Figure 2.9 shows the problems of ﬁrm and consumer, and the competitive

equilibrium, respectively.

2.4 The Existence of Competitive Equilibrium

In this section we will examine the existence of competitive equilibrium for the three

cases: (1) the single-valued aggregate excess demand function; (2) the aggregate excess

demand correspondence; (3) a general class of private ownership production economies.

The ﬁrst two cases are based on excess demand instead of underlying preference orderings

and consumption and production sets. There are many ways to prove the existence of

general equilibrium. For instance, one can use the Brouwer ﬁxed point theorem approach,

KKM lemma approach, and abstract economy approach to show the existence of compet-

itive equilibrium for these three cases. Before giving the existence result on competitive

equilibrium, we ﬁrst provide some notation, deﬁnitions and mathematics results used in

this section.

2.4.1 Fixed Point Theorems, KKM Lemma, Maximum Theo-

rem, and Separating Hyperplane Theorem

This subsection gives various deﬁnitions on continuity of functions and correspondences,

ﬁxed point theorems, KKM lemma, maximum theorem, and Separating Hyperplane The-

orem which will be used to prove the existence of competitive equilibrium for various

economic environments.

Let X and Y be two topological spaces, and let 2

Y

be the collection of all subsets

of Y . Although most the results given in this subsection is held for general topological

vector spaces, for simplicity, we will restrict X and Y to subsets of Euclidian spaces.

31

Deﬁnition 2.4.1 A function f : X →R is said to be continuous if at point x

0

∈ X,

lim

x→x

0

f(x) = f(x

0

),

or equivalently, for any > 0, there is a δ > 0 such that for any x ∈ X satisfying

[x −x

0

[ < δ, we have

[f(x) −f(x

0

)[ <

A function f : X → R is said to be continuous on X if f is continuous at every point

x ∈ X.

The so-called upper semi-continuity and lower semi-continuity continuities are weaker

than continuity. Even weak conditions on continuity are transfer continuity which char-

acterize many optimization problems and can be found in Tian (1992, 1993, 1994) and

Tian and Zhou (1995), and Zhou and Tian (1992).

Deﬁnition 2.4.2 A function f : X →R is said to be upper semi-continuous if at point

x

0

∈ X, we have

limsup

x→x

0

f(x) f(x

0

),

or equivalently,

F(x

0

) ≡ ¦x ∈ X : f(x) f(x

0

)¦ is a closed subset of X

or equivalently, for any > 0, there is a δ > 0 such that for any x ∈ X satisfying

[x −x

0

[ < δ, we have

f(x) < f(x

0

) +

A function f : X → R is said to be upper semi-continuous on X if f is upper semi-

continuous at every point x ∈ X.

Deﬁnition 2.4.3 A function f : X →R is said to be lower semi-continuous on X if −f

is upper semi-continuous.

It is clear that a function f : X → R is continuous on X if and only if it is both

upper and lower semi-continuous.

To show the existence of a competitive equilibrium for the continuous aggregate excess

demand function, we may use the following ﬁxed-point theorem. The generalization of

32

Brouwer’s ﬁxed theorem can be found in Tian (1991) that gives necessary and suﬃcient

conditions for a function to have a ﬁxed point.

Theorem 2.4.1 (Brouwer’s Fixed Theorem) Let X be a non-empty, compact, and

convex subset of R

m

. If a function f : X → X is continuous on X, then f has a ﬁxed

point, i.e., there is a point x

∗

∈ X such that f(x

∗

) = x

∗

.

Figure 2.10: Fixed points are given by the intersections of the 45

0

line and the curve of

the function.

Example 2.4.1 f : [0, 1] → [0, 1] is continuous, then f has a ﬁxed point (x). To see this,

let

g(x) = f(x) −x.

Then, we have

g(0) = f(0) 0

g(1) = f(1) −1 0.

From the mean-value theorem, there is a point x

∗

∈ [0, 1] such that g(x

∗

) = f(x

∗

) −

x

∗

= 0.

When the aggregate excess demand correspondence is not a single-valued function or is

not a continuous function, we need the ﬁxed point theorem for correspondence or KKM

lemma to prove the existence of competitive equilibrium.

Deﬁnition 2.4.4 A correspondence F : X → 2

Y

is upper hemi-continuous if the set

¦x ∈ X : F(x) ⊂ V ¦ is open in X for every open set subset V of Y .

We also use F : X →→ Y to denote the mapping F : X → 2

Y

in this lecture notes.

33

Deﬁnition 2.4.5 A correspondence F : X → 2

Y

is said to be lower hemi-continuous at

x if for any ¦x

k

¦ with x

k

→ x and y ∈ F(x), then there is a sequence ¦y

k

¦ with y

k

→ y

and y

n

∈ F(x

k

). F is said to be lower hemi-continuous on X if F is lower hemi-continuous

for all x ∈ X or equivalently, if the set ¦x ∈ X : F(x) ∩ V = ∅¦ is open in X for every

open set subset V of Y .

Deﬁnition 2.4.6 A correspondence F : X → 2

Y

is said to be continuous if it is both

upper hemi-continuous and lower hemi-continuous.

Remark 2.4.1 As with upper (lower) hemi-continuous correspondence, if f() is a func-

tion then the concept of upper (lower) hemi-continuity as a correspondence and of conti-

nuity as a function coincide.

Deﬁnition 2.4.7 A correspondence F : X → 2

Y

is said to be closed at x if for any ¦x

k

¦

with x

k

→ x and ¦y

k

¦ with y

k

→ y and y

n

∈ F(x

k

) implies y ∈ F(x). F is said to be

closed if F is closed for all x ∈ X or equivalently

Gr(F) = ¦(x, y) ∈ X Y : y ∈ F(x)¦ is closed.

Remark 2.4.2 If Y is compact and F is closed, then F is upper hemi-continuous.

Deﬁnition 2.4.8 A correspondence F : X → 2

Y

said to be open if ifs graph

Gr(F) = ¦(x, y) ∈ X Y : y ∈ F(x)¦ is open.

Deﬁnition 2.4.9 A correspondence F : X → 2

Y

said to have upper open sections if F(x)

is open for all x ∈ X.

A correspondence F : X → 2

Y

said to have lower open sections if its inverse set

F

−1

(y) = ¦x ∈ X : y ∈ F(x)¦ is open.

Remark 2.4.3 If a correspondence F : X → 2

Y

has an open graph, then it has upper

and lower open sections. If a correspondence F : X → 2

Y

has lower open sections, then

it must be lower hemi-continuous.

Theorem 2.4.2 (Kakutani’s Fixed Point Theorem) Let X be a non-empty, com-

pact, and convex subset of R

m

. If a correspondence F : X → 2

X

is a upper hemi-

continuous correspondence with non-empty compact and convex values on X, then F has

a ﬁxed point, i.e., there is a point x

∗

∈ X such that x

∗

∈ F(x

∗

).

34

The Knaster-Kuratowski-Mazurkiewicz (KKM) lemma is quite basic and in some ways

more useful than Brouwer’s ﬁxed point theorem. The following is a generalized version of

KKM lemma due to Ky Fan (1984).

Theorem 2.4.3 (FKKM Theorem) Let Y be a convex set and ∅ ⊂ X ⊂ Y . Suppose

F : X → 2

Y

is a correspondence such that

(1) F(x) is closed for all x ∈ X;

(2) F(x

0

) is compact for some x

0

∈ X;

(3) F is FS-convex, i.e, for any x

1

, . . . , x

m

∈ X and its convex combination

x

λ

=

¸

m

i=1

λ

i

x

i

, we have x

λ

∈ ∪

m

i=1

F(x

i

).

Then ∩

x∈X

F(x) = ∅.

Here, The term FS is for Fan (1984) and Sonnenschein (1971), who introduced the notion

of FS-convexity.

Theorem 2.4.4 (Berg’s Maximum Theorem) Suppose f(x, a) is a continuous func-

tion mapping from A to X, and the constraint set F : A →→ X is a continuous cor-

respondence with non-empty compact-valued values. Then, the optimal valued function

(also called marginal function):

M(a) = max

x∈F(a)

f(x, a)

is a continuous function, and the optimal solution:

φ(a) = arg max

x∈F(a)

f(x, a)

is a upper hemi-continuous correspondence.

The various characterization results on Kakutani’s Fixed Point Theorem, KKM Lemma,

and Maximum Theorem can be found in Tian (1991, 1992, 1994) and Tian and Zhou

(1992).

Theorem 2.4.5 (Separating Hyperplane Theorem) Suppose that A, B ⊂ R

m

are

convex and A ∩ B = ∅. Then, there is a vector p ∈ R

m

with p = 0, and a value c ∈ R

such that

px c py ∀x ∈ A & y ∈ B.

35

Furthermore, suppose that B ⊂ R

m

is convex and closed, A ⊂ R

m

is convex and compact,

and A ∩ B = ∅. Then, there is a vector p ∈ R

m

with p = 0, and a value c ∈ R such that

px < c < py ∀x ∈ A & y ∈ B.

2.4.2 The Existence of CE for Aggregate Excess Demand Func-

tions

The simplest case for the existence of a competitive equilibrium is the one when the

aggregate excess demand correspondence is a single-valued function. Assume the following

properties on the aggregate excess demand correspondence ˆ z(p).

Function: ˆ z(p) is a function. It is so if preference orderings are strictly convex.

Continuity: ˆ z(p) is continuous. Note that if x

i

(p) and y

j

(p) are continuous,

ˆ z(p) is also continuous.

Walras’ Law: for all p 0,

p ˆ z(p) = 0. (2.14)

Homogeneity of ˆ z(p): it is homogeneous of degree 0 in price ˆ x(λp) = ˆ z(p) for any

λ > 0. From this property, we can normalize prices.

Because of homogeneity, for example, we can normalize a price vector as follows:

(1) p

tl

= p

l

/p

1

l = 1, 2, . . . , L

(2) p

tl

= p

l

/

¸

L

l=1

p

l

.

Thus, without loss of generality, we can restrict our attention to the unit simplex:

S

L−1

= ¦p ∈ '

L

+

:

L

¸

l=1

p

l

= 1¦. (2.15)

Then, we have the following theorem on the existence of competitive equilibrium.

Theorem 2.4.6 (The Existence Theorem I)) For a private ownership economy e =

(¦X

i

, w

i

,

i

¦ , ¦Y

j

¦, ¦θ

ij

; ¦), if ˆ z(p) is a continuous function and satisﬁes Walras’ Law,

then there exists a competitive equilibrium, that is, there is p

∗

∈ '

L

+

such that

ˆ z(p

∗

) 0 (2.16)

36

Proof: Deﬁne a continuous function g : S

L−1

→ S

L−1

by

g

l

(p) =

p

l

+ max¦0, ˆ z

l

(p)¦

1 +

¸

L

k=1

max¦0, ˆ z

k

(p)¦

(2.17)

for l = 1, 2, . . . , L.

First note that g is a continuous function since max¦f(x), h(x)¦ is continuous when

f(x) and h(x) are continuous.

By Brouwer’s ﬁxed point theorem, there exists a price vector p

∗

such that g(p

∗

) = p

∗

,

i.e.,

p

∗l

=

p

∗l

+ max¦0, ˆ z

l

(p

∗

)¦

1 +

¸

L

k=1

max¦0, ˆ z

k

(p

∗

)¦

l = 1, 2, . . . , L. (2.18)

We want to show p

∗

is in fact a competitive equilibrium price vector.

Cross multiplying 1 +

¸

L

k=1

max¦0, ˆ z

k

(p

∗

) on both sides of (2.18), we have

p

∗l

L

¸

k=1

max¦0, ˆ z

k

(p

∗

)¦ = max¦0, ˆ z

l

(p

∗

)¦. (2.19)

Then, multiplying the above equation by ˆ z

l

(p

∗

) and making summation, we have

¸

L

¸

l=1

p

∗l

ˆ z

l

(p

∗

)

¸¸

L

¸

l=1

max¦0, ˆ z

l

(p

∗

)¦

¸

=

L

¸

l=1

ˆ z

l

(p

∗

) max¦0, ˆ z

l

(p

∗

)¦. (2.20)

Then, by Walras’ Law, we have

L

¸

l=1

ˆ z

l

(p

∗

) max¦0, ˆ z

l

(p

∗

)¦ = 0. (2.21)

Therefore, each term of the summations is either zero or (ˆ z

l

(p

∗

))

2

> 0. Thus, to have

the summation to be zero, we must have each term to be zero. That is, ˆ z

l

(P

∗

) 0 for

l = 1, . . . , L. The proof is completed.

Remark 2.4.4 By Walras’ Law, if p > 0, and if (L −1) markets are in the equilibrium,

the L-th market is also in the equilibrium.

Remark 2.4.5 Do not confuse a aggregate excess demand function with Walras’ Law.

Even though Walras’ Law holds, we may not have ˆ z(p) 0 for all p. Also, if ˆ z(p

∗

) = 0

for some p

∗

, i.e., p

∗

is a competitive equilibrium price vector, the Walras’ Law may not

hold unless some types of monotonicity are imposed.

37

Fact 1: (free goods). Under Walras’ Law, if p

∗

is a competitive equilibrium price

vector and ˆ z

l

(p

∗

) < 0, then p

∗l

= 0.

Proof. Suppose not. Then p

∗l

> 0. Thus, p

∗l

ˆ z

l

(p

∗

) < 0, and so p

∗

ˆ z(p

∗

) < 0, contra-

dicting Walras’ Law.

Desirable goods: if p

l

= 0, ˆ z

l

(p

∗

) > 0.

Fact 2: (Equality of demand and supply). If all goods are desirable and p

∗

is a

competitive equilibrium price vector, then ˆ z(p

∗

) = 0.

Proof. Suppose not. We have ˆ z

l

(p

∗

) < 0 for some l. Then, by Fact 1, we have p

∗l

= 0.

Since good l is desirable, we must have ˆ z

l

(p

∗l

) > 0, a contradiction.

From the above theorem, Walras’ Law is important to prove the existence of a com-

petitive equilibrium. Under which conditions, is Walras’ Law held?

• Conditions for Walras’ Law to be true

When each consumer’s budget constraint holds with equality:

px

i

= pw

i

+

J

¸

j=1

θ

ij

py

j

for all i, we have

n

¸

i=1

px

i

(p) =

n

¸

i=1

pw

i

+

n

¸

i=1

J

¸

j=1

θ

ij

py

j

=

n

¸

i=1

pw

i

+

J

¸

j=1

py

j

which implies that

¸

n

¸

i=1

x

i

(p) −

n

¸

i=1

w

i

−

J

¸

j=1

py

j

¸

= 0 (2.22)

so that

p ˆ z = 0 (Walras

t

Law) (2.23)

Thus, as long as the budget line holds with equality, Walras’ Law must hold.

The above existence theorem on competitive equilibrium is based on the assumptions

that the aggregate excess demand correspondence is single-valued and satisﬁes the Wal-

ras’s Law. The questions are under what conditions on economic environments a budget

38

constraint holds with equality, and the aggregate excess demand correspondence is single-

valued or convex-valued? The following various types of monotonicities and convexities

of preferences with the ﬁrst one strongest and the last one weakest may be used to answer

these questions.

• Types of monotonicity conditions

(1) Strict monotonicity: For any two consumption market bundles (x ≥ x

t

)

with x = x

t

implies x ~

i

x

t

.

(2) Monotonicity: if x > x

t

implies that x ~

i

x

t

.

(3) Local non-satiation: For any point x and any neighborhood, N(x), there

is x

t

∈ N(x) such that x

t

~

i

x.

(4) Non-satiation: For any x, there exists x

t

such that x

t

~

i

x.

• Types of convexities

(i) Strict convexity: For any x and x

t

with x

i

x

t

and x = x

t

, x

λ

≡ λx+(1 −

λ)x

t

~

i

x

t

for λ ∈ (0, 1).

Figure 2.11: Strict convex indiﬀerence curves.

(ii) Convexity: If x ~

i

x

t

, then x

λ

= λx + (1 −λ)x

t

~

i

x

t

for λ ∈ (0, 1).

39

Figure 2.12: Linear indiﬀerence curves are convex, but not strict convex.

(iii) Weak convexity: If x

i

x

t

, then x

λ

i

x

t

.

Figure 2.13: “Thick” indiﬀerence curves are weakly convex, but not convex.

Each of the above condition implies the next one, the converse may not be true by

examining thick indiﬀerence curves and linear indiﬀerence curves, strictly convex indiﬀer-

ence curves as showed in the above ﬁgures:

Remark 2.4.6 Monotonicity of preferences can be interpreted as individuals’ desires for

goods: the more, the better. Local non-satiation means individuals’ desires are unlimited.

40

Remark 2.4.7 The convexity of preferences implies that people want to diversify their

consumptions, and thus, convexity can be viewed as the formal expression of basic measure

of economic markets for diversiﬁcation. Note that the strict convexity of ~

i

implies the

conventional diminishing marginal rates of substitution (MRS), and weak convexity of

i

is equivalent to the quasi-concavity of utility function u

i

. Also notice that the continuity of

i

is a suﬃcient condition for the continuous utility representations, that is, it guarantees

the existence of continuous utility function u

i

().

Remark 2.4.8 Under the convexity of preferences,

i

, non-satiation implies local non-

satiation. Why? The proof is lest to readers.

Now we are ready to answer under which conditions Walras’s Law holds, a demand

correspondence can be function, and convex-valued. The following propositions answer

the questions.

Proposition 2.4.1 Under local no-satiation assumption, we have the budget constraint

holds with equality, and thus the Walras’s Law holds.

Proposition 2.4.2 Under the strict convexity of

i

, x

i

(p) becomes a (single-valued) func-

tion.

Proposition 2.4.3 Under the weak convexity of preferences, demand correspondence

x

i

(p) is convex-valued.

Strict convexity of production set: if y

1

j

∈ Y

j

and y

2

j

∈ Y

j

, then the convex combination

λy

1

j

+ (1 −λ)y

2

j

∈ intY

j

for all 0 < λ < 1, where intY

j

denotes the interior points of Y

j

.

The proof of the following proposition is based on the maximum theorem.

Proposition 2.4.4 If Y

j

is compact (i.e., closed and bounded) and strictly convex, then

the supply correspondence y

j

(p) is a well deﬁned single-valued and continuous function.

Proof: By the maximum theorem, we know that y

j

(p) is a non-empty valued upper

hemi-continuous correspondence by the compactness of y

j

(by noting that 0 ∈ Y

j

) for all

p ∈ R

L

+

.

Now we show it is single-valued. Suppose not. y

1

j

and y

2

j

are two proﬁt maximizing

production plans for p ∈ '

L

+

, and thus py

1

j

= py

2

j

. Then, by the strict convexity of Y

j

, we

41

have λy

1

j

+ (1 − λ)y

2

j

∈ intY

j

for all 0 < λ < 1. Therefore, there exists some t > 1 such

that

t[λy

1

j

+ (1 −λ)y

2

j

] ∈ intY

j

. (2.24)

Then t[λpy

1

j

+ (1 − λ)py

2

j

] = tpy

1

j

> py

1

j

which contradicts the fact that y

1

j

is a proﬁt

maximizing production plan.

So y

j

(p) is a single-valued function. Thus, by the upper hemi-continuity of y

j

(p), we

know it is a single-valued and continuous function.

Proposition 2.4.5 If

i

is continuous, strictly convex, locally non-satiated, and w

i

> 0,

then x

i

(p) is a continuous single-valued function and satisﬁes the budget constraint with

equality. As such the Walras’s Law is satisﬁed.

Proof. First note that, since w

i

> 0, one can show that the budget constrained set B

i

(p)

is a continuous correspondence with non-empty and compact values and

i

is continuous.

Then, by the maximum theorem, we know the demand correspondence x

i

(p) is upper

hemi-continuous. Furthermore, by the strict convexity of preferences, it is single-valued

and continuous. Finally, by local non-satiation, we know the budget constraint holds with

equality, and thus Walras’s Law is satisﬁed.

Note that there’s no utility function representation when preferences are lexicographic.

Then, from the above propositions, we can have the following existence theorem that

provides suﬃcient conditions directly based on the fundamentals of the economy by ap-

plying the Existence Theorem I above.

Theorem 2.4.7 For a private ownership economy e = (¦X

i

, w

i

,

i

¦ , ¦Y

j

¦, ¦θ

ij

; ¦, there

exists a competitive equilibrium if the following conditions hold

(i) X

i

∈ '

L

+

;

(ii)

i

are continuous, strictly convex (which guarantee the demand function

is single valued) and locally non-satiated (which guarantees Walras’ Law

holds);

(iii) w

i

> 0;

(iv) Y

j

are compact, strictly convex, 0 ∈ Y

j

j = 1, 2, . . . , J.

42

Note that

i

are continuous if the upper contour set U

w

(x

i

) ≡ ¦x

t

i

∈ X

i

and x

t

i

i

x

i

¦

and the lower contour set L

w

(x

i

) ≡ ¦x

t

i

∈ X

i

and x

t

i

i

x

i

¦ are closed.

Figure 2.14: The upper contour set U

w

(x

i

) is given by all points above the indiﬀerence

curve, and the lower contour set L

w

(x

i

) is given by all points below the indiﬀerence

curve in the ﬁgure.

Proof: By the assumption imposed, we know that x

i

(p) and y

j

(p) are continuous

single-valued. Thus the aggregate excess demand function is a continuous function and

satisﬁes Walras’ Law, and therefore, there is a competitive equilibrium.

The above results require the aggregate excess demand function is continuous. By

using the KKM lemma, we can prove the existence of competitive equilibrium by only

assuming the aggregate excess demand function is lower hemi-continuous.

Theorem 2.4.8 (The Existence Theorem I

t

) For a private ownership economy e =

(¦X

i

, w

i

,

i

¦ , ¦Y

j

¦, ¦θ

ij

¦), if the aggregate excess demand function ˆ z(p) is a lower semi-

continuous correspondence and satisﬁes Walras’ Law, then there exists a competitive equi-

librium, that is, there is p

∗

∈ S

L−1

such that

ˆ z(p)

∗

0. (2.25)

Proof. Deﬁne a correspondence F : S → 2

S

by,

F(q) = ¦p ∈ S : qˆ z(p) 0¦ for all q ∈ S.

43

Since p 0 and ˆ z() is lower semi-continuous, the function deﬁned by φ(q, p) ≡ qˆ z(p) =

¸

L

l=1

q

l

ˆ z

l

(p) is lower semi-continuous in p. Hence, the set F(q) is closed for all q ∈

S. We now prove F is FS-convex. Suppose, by way of contradiction, that there some

q

1

, . . . , q

m

∈ S and some convex combination q

λ

=

¸

m

t=1

λ

t

q

t

such that q

λ

∈ ∪

m

t=1

F(q

t

).

Then, q

λ

∈ F(q

t

) for all t = 1, . . . , m. Thus,

¸

m

t=1

λ

t

q

t

ˆ z(q

λ

) = q

λ

ˆ z(q

λ

) > 0 which

contradicts the fact that ˆ z satisﬁes Walras’ Law. So F must be FS-convex. Therefore, by

KKM lemma, we have

∩

q∈S

F(q) = ∅.

Then there exists a p

∗

∈ S such that p

∗

∈ ∩

q∈S

F(q), i.e., p

∗

∈ F(q) for all q ∈ S.

Thus, qˆ z(p

∗

) 0 for all q ∈ S. Now let q

1

= (1, 0, . . . , 0), q

2

= (0, 1, 0, . . . , 0), and

q

n

= (0, . . . , 0, 1). Then q

t

∈ S and thus q

t

ˆ z(p

∗

) = ˆ z

t

(p

∗

) 0 for all t = 1, . . . , L. Thus

we have ˆ z(p

∗

) 0, which means p

∗

is a competitive equilibrium price vector. The proof

is completed.

Examples of Computing CE

Example 2.4.2 Consider an exchange economy with two consumers and two goods with

w

1

= (1, 0) w

2

= (0, 1)

u

1

(x

1

) = (x

1

1

)

a

(x

2

1

)

1−a

0 < a < 1

u

2

(x

2

) = (x

1

2

)

b

(x

2

2

)

1−b

0 < b < 1

(2.26)

Let p =

p

2

p

1

Consumer 1’s problem is to solve

max

x

1

u

1

(x

1

) (2.27)

subject to

x

1

+ px

2

= 1 (2.28)

Since utility functions are Cobb-Douglas types of functions, the solution is then given

by

x

1

(p) =

a

1

= a (2.29)

x

2

1

(p) =

1 −a

p

. (2.30)

44

Consumer 2’s problem is to solve

max

x

2

u

2

(x

2

) (2.31)

subject to

x

1

2

+ px

2

2

= p. (2.32)

The solution is given by

x

1

2

(p) =

b p

1

= b p (2.33)

x

2

2

(p) =

(1 −b)p

p

= (1 −b). (2.34)

Then, by the market clearing condition,

x

1

1

(p) + x

1

2

(p) = 1 ⇒ a + bp = 1 (2.35)

and thus the competitive equilibrium is given by

p =

p

2

p

1

=

1 −a

b

. (2.36)

This is true because, by Walras’s Law, for L = 2, it is enough to show only one market

clearing.

Remark 2.4.9 Since the Cobb-Douglas utility function is widely used as an example of

utility functions that have nice properties such as strict monotonicity on R

L

++

, continuity,

and strict quasi-concavity, it is very useful to remember the functional form of the demand

function derived from the Cobb-Douglas utility functions. It may be remarked that we

can easily derive the demand function for the general function: u

i

(x

2

) = (x

1

1

)

α

(x

2

1

)

β

α >

0, β > 0 by the a suitable monotonic transformation. Indeed, by invariant to monotonic

transformation of utility function, we can rewrite the utility function as

[(x

1

1

)

α

(x

2

1

)

β

]

1

α+β

= (x

1

1

)

α

α+p

(x

2

1

)

β

α+β

(2.37)

so that we have

x

1

1

(p) =

α

α+β

I

p

1

(2.38)

and

x

2

1

(p) =

β

α+β

I

p

2

(2.39)

when the budget line is given by

p

1

x

1

1

+ p

2

x

2

1

= I. (2.40)

45

Example 2.4.3

n = 2 L = 2

w

1

= (1, 0) w

2

= (0, 1)

u

1

(x

1

) = (x

1

1

)

a

(x

2

1

)

1−a

0 < a < 1

u

2

(x

2

) = min¦x

1

2

, bx

2

2

¦ with b > 0

(2.41)

For consumer 1, we have already obtained

x

1

1

(p) = a, x

2

1

=

(1 −a)

p

. (2.42)

For Consumer 2, his problem is to solve:

max

x

2

u

2

(x

2

) (2.43)

s.t.

x

1

2

+ px

2

2

= p. (2.44)

At the optimal consumption, we have

x

1

2

= bx

2

2

. (2.45)

By substituting the solution into the budget equation, we have bx

2

2

+ px

2

2

= p and thus

x

2

2

(p) =

p

b+p

and x

1

2

(p) =

bp

b+p

.

Then, by x

1

1

(p) + x

1

2

(p) = 1, we have

a +

bp

b + p

= 1 (2.46)

or

(1 −a)(b + p) = bp (2.47)

so that

(a + b −1)p = b(1 −a) (2.48)

Thus,

p

∗

=

b(1 −a)

a +b −1

.

To make p

∗

be a competitive equilibrium price, we need to assume a + b > 1.

46

2.4.3 The Existence of CE for Aggregate Excess Demand Cor-

respondences

When preferences and/or production sets are not strictly convex, the demand correspon-

dence and/or supply correspondence may not be single-valued, and thus the aggregate

excess demand correspondence may not be single-valued. As a result, one cannot use the

above existence results to argue the existence of competitive equilibrium. Nevertheless,

by using the KKM lemma, we can still prove the existence of competitive equilibrium

when the aggregate excess demand correspondence satisﬁes certain conditions.

Theorem 2.4.9 (The Existence Theorem II)) For a private ownership economy e =

(¦X

i

, w

i

,

i

¦ , ¦Y

j

¦, ¦θ

ij

¦), if ˆ z(p) is an non-empty convex and compact-valued upper hemi-

continuous correspondence and satisﬁes Walras’ Law, then there exists a competitive equi-

librium, that is, there is a price vector r

∗

∈ S such that

ˆ z(p)

∗

∩ ¦−'

L

¦ = ∅. (2.49)

Proof. Deﬁne a correspondence F : S → 2

S

by,

F(q) = ¦p ∈ S : qˆ z 0 for some ˆ z ∈ ˆ z(p)¦.

Since ˆ z() is upper semi-continuous, F(q) is closed for each q ∈ S. We now prove F is

FS-convex. Suppose, by way of contradiction, that there are some q

1

, . . . , q

m

∈ S and

some convex combination q

λ

=

¸

m

t=1

λ

t

q

t

such that q

λ

∈ ∪

m

t=1

F(q

t

). Then, q

λ

∈ F(q

t

)

for all t = 1, . . . , m. Thus, for all ˆ z ∈ ˆ z(p), we have q

λ

ˆ z > 0 for t = 1, . . . , m. Thus,

¸

m

t=1

λ

t

q

t

ˆ z = q

λ

ˆ z > 0 which contradicts the fact that ˆ z satisﬁes Walras’ Law. So F must

be FS-convex. Therefore, by KKM lemma, we have

∩

q∈S

F(q) = ∅.

Then there exists a p

∗

∈ S such that p

∗

∈ ∩

q∈S

F(q), i.e., p

∗

∈ F(q) for all q ∈ S.

Thus, for each q ∈ S, there is ˆ z ∈ ˆ z(p

∗

) such that

qˆ z 0.

We now prove ˆ z(p

∗

) ∩ ¦−'

L

+

¦ = 0. Suppose not. Since ˆ z(p

∗

) is convex and compact

and −'

L

+

is convex and closed, by the Separating Hyperplane theorem, there exists some

47

c ∈ '

L

such that

q (−'

L

+

) < c < qˆ z(p

∗

)

Since (−'

L

+

) is a cone, we must have c > 0 and q (−'

L

+

) 0. Thus, q ∈ '

L

+

and

qˆ z(p

∗

) > 0 for all q, a contradiction. The proof is completed.

Remark 2.4.10 The last part of the proof can be also shown by applying the following

result: Let K be a compact convex set. Then K ∩ ¦−'

L

+

¦ = ∅ if and only if for any

p ∈ '

L

+

, there exists z ∈ K such that pz 0. The proof of this result can be found, for

example, in the book of K. Border (1985, p. 13).

Similarly, we have the following existence theorem that provides suﬃcient conditions

directly based on economic environments by applying the Existence Theorem II above.

Theorem 2.4.10 For a private ownership economy e = (¦X

i

, w

i

,

i

¦), ¦Y

j

¦, ¦θ

ij

¦, there

exists a competitive equilibrium if the following conditions hold

(i) X

i

∈ '

L

+

;

(ii)

i

are continuous, weakly convex and locally non-satiated;

(iii) w

i

> 0;

(iv) Y

j

are compact, convex, and 0 ∈ Y ; j = 1, 2, . . . , J.

2.4.4 The Existence of CE for General Production Economies

For a general private ownership production economy,

e = (¦X

i

,

i

, w

i

¦, ¦Y

j

¦, ¦θ

ij

¦) (2.50)

recall that a competitive equilibrium consists of a feasible allocation (x

∗

y

∗

) and a price

vector p

∗

∈ R

L

+

such that

(i) x

∗

i

∈ D

i

(p

∗

) ≡ x

i

(p

∗

) (utility maximization, i = 1, 2, . . . n)

(ii) y

∗

i

∈ S

i

(p

∗

) ≡ y

i

(p

∗

) (proﬁt maximization, j = 1, 2, . . . J)

We now state the following existence theorem for general production economies without

proof. Since the proof is very complicated, we refer readers to the proof that can be found

in Debreu (1959) who used the existence theorem on equilibrium of the abstract economy

on Section 2.7.

48

Theorem 2.4.11 (Existence Theorem III, Debreu, 1959) A competitive equilibrium

for the private-ownership economy e exists if the following conditions are satisﬁed:

(1) X

i

is closed, convex and bounded from below;

(2)

i

are non-satiated;

(3)

i

are continuous;

(4)

i

are convex;

(5) w

i

∈ intX

i

;

(6) 0 ∈ Y

j

(possibility of inaction);

(7) Y

j

are closed and convex (continuity and no IRS)

(8) Y

j

∩ ¦−Y

j

¦ = ¦0¦ (Irreversibility)

(9) ¦−'

L

+

¦ ⊆ Y

j

(free disposal)

2.5 The Uniqueness of Competitive Equilibria

We can easily give examples in which there are multiple competitive equilibrium price

vectors. When is there only one normalized price vector that clears all markets?

The free goods case is not of great interest here, so we will rule it out by means of

the desirability assumption so that every equilibrium price of each good must be strictly

positive. We want to also assume the continuous diﬀerentiability of the aggregate excess

demand function. The reason is fairly clear; if indiﬀerence curves have kinks in them, we

can ﬁnd whole ranges of prices that are market equilibria. Not only are the equilibria not

unique, they are not even locally unique.

Thus, we answer this question for only considering the case of p

∗

> 0 and ˆ z(p) is

diﬀerentiable.

Theorem 2.5.1 If all goods are desirable and gross substitute for all prices (i.e.,

∂z

h

(p)

∂p

l

>

0 for l = h), then if p

∗

is a competitive equilibrium price vector and Walras’ Law holds,

it is the unique competitive equilibrium price vector.

Proof: By the desirability, p

∗

> 0. Suppose p is another competitive equilibrium price

vector that is not proportional to p

∗

. Let m = max

p

l

p

∗l

=

p

k

p

∗k

for some k. By homogeneity

49

and the deﬁnition of competitive equilibrium, we know that ˆ z(p

∗

) = ˆ z(mp

∗

) = 0. We

know that m =

p

k

p

∗k

p

l

p

∗l

for all l = 1, . . . , L and m >

p

h

p

∗h

for some h. Then we have

mp

∗l

p

l

for all l and mp

∗h

> p

h

for some h. Thus, when the price of good k is ﬁxed,

the prices of the other goods are down. We must have the demand for good k down by

the gross substitutes. Hence, we have ˆ z

k

(p) < 0, a contradiction.

2.6 Stability of Competitive Equilibrium

The concept of competitive equilibrium is a stationary concept. But, it has given no

guarantee that the economy will actually operate at the equilibrium point. What forces

exist that might tend to move prices to a market-clearing price? This is a topic about the

stability on the price adjustment mechanism in a competitive equilibrium.

A paradoxical relationship between the idea of competition and price adjustment is

that: If all agents take prices as given, how can prices move? Who is left to adjust prices?

To solve this paradox, one introduces a “Walrasian auctioneer” whose sole function is

to seek for the market clearing prices. The Walrasian auctioneer is supposed to call the

prices and change the price mechanically responding to the aggregate excess demand till

the market clears. Such a process is called Tˆatonnement adjustment process.

Tˆatonnement Adjustment Process is deﬁned, according to the laws of demand

and supply, by

dp

l

dt

= G

l

(ˆ z(p)) l = 1, . . . , L (2.51)

where G

l

is a sign-preserving function of ˆ z(p), i.e., G

l

(x) > 0 if x > 0, G

l

(x) = 0 if

x = 0, and G

l

(x) < 0 if x < 0. The above equation implies that when the aggregate

excess demand is positive, we have a shortage and thus price should go up by the laws of

demand and supply.

As a special case of G

l

, G

l

can be an identical mapping such that

˙ p

l

= ˆ z

l

(p) (2.52)

˙ p = ˆ z(p). (2.53)

50

Under Walras’ Law,

d

dt

(p

t

p) =

d

dt

¸

L

¸

l=1

(p

l

)

2

¸

= 2

L

¸

l=1

(p

l

)

dp

l

dt

= 2p

t

˙ p = pˆ z(p) = 0

which means that the sum of squares of the prices remain constant as the price adjusts.

This is another price normalization. The path of the prices are restricted on the surface

of a k-dimensional sphere.

Examples of price dynamics in ﬁgures: The ﬁrst and third ﬁgures show a stable equi-

librium, the second and fourth ﬁgures show a unique unstable equilibrium.

Figure 2.15: The ﬁrst and third ﬁgures show the CEs are stable, and the second and

fourth show they are not stable.

51

Deﬁnition 2.6.1 An equilibrium price p

∗

is globally stable if

(i) p

∗

is the unique competitive equilibrium,

(ii) for all p

o

there exists a unique price path p = φ(t, p

0

) for 0 t < ∞ such

that lim

t→∞

φ(t, p

o

) = p

∗

.

Deﬁnition 2.6.2 An equilibrium price p

∗

is locally stable if there is δ > 0 and a unique

price path p = φ(t, p

0

) such that lim

t→∞

φ(t, p

o

) = p

∗

whenever [p −p

0

[ < δ.

The local stability of a competitive equilibrium can be easily obtained from the stan-

dard result on the local stability of a diﬀerentiate equation.

Theorem 2.6.1 A competitive equilibrium price p

∗

is locally stable if the Jacobean matrix

deﬁned by

A =

¸

∂ˆ z

l

(p

∗

)

∂p

k

**has all negative characteristic roots.
**

The global stability result can be obtained by Liaponov Theorem.

Liaponov’s function: For a diﬀerentiate equation system ˙ x = f(x) with x

∗

= 0, a

function V is said to be a Liaponov’s function if

(1) there is a unique x

∗

such that V (x

∗

) = 0;

(2) V (x) > 0 for all x = x

∗

;

(3)

dV (x)

dt

< 0.

Theorem 2.6.2 (Liaponov’s Theorem) If there exists a Liaponov’s function for ˙ x =

f(x), the unique stationary point x

∗

is globally stable.

Debreu (1974) has shown essentially that any continuous function which satisﬁes the

Walras’ Law is an aggregate demand function for some economy. Thus, utility maximiza-

tion places no restriction on aggregate behavior. Thus, to get global stability, one has to

make some special assumptions.

The Weak Axiom of Revealed Preference (WARP) of the aggregate demand

function: If pˆ z(p) pˆ z(p

t

), then p

t

ˆ z(p) > p

t

ˆ z(p

t

) for all p, p

t

∈ '

L

+

.

52

Figure 2.16: The ﬁgure shows an aggregate demand function satisﬁes WARP.

WARP implies that, if ˆ z(p

t

) could have been bought at p where ˆ z(p) was bought, then

at price p

t

, ˆ z(p) is outside the budget constraint.

The WARP is a weak restriction than the continuous concave utility function. How-

ever, the restriction on the aggregate excess is not as weak as it may been seen. Even

though two individuals satisfy the individual WARP, the aggregate demand function may

not satisfy the aggregate WARP as shown in the following ﬁgures.

Figure 2.17: Both individual demand functions satisfy WARP.

53

Even if the individual demand functions satisfy WARP, it does not necessarily satisfy

the WARP in aggregate.

Figure 2.18: The aggregate excess demand function does not satisfy WARP.

Lemma 2.6.1 Under the assumptions of Walras’ Law and WARP, we have p

∗

ˆ z(p) > 0

for all p = kp

∗

where p

∗

is a competitive equilibrium.

Proof: Suppose p

∗

is a competitive equilibrium.

ˆ z(p

∗

) 0 (2.54)

Also, by Walras’ Law pˆ z(p) = 0. So we have pˆ z(p) pˆ z(p

∗

). Then, by WARP, p

∗

ˆ z(p) >

p

∗

ˆ z(p

∗

) = 0 ⇒ p

∗

ˆ z(p) > 0 for all p = kp

∗

.

Lemma 2.6.2 Under the assumptions of Walras’ Law and WARP in aggregate, the com-

petitive equilibrium is unique.

Proof: By Lemma 2.6.1, for any p = kp

∗

, p

∗

ˆ z(p) > 0 which means at least for some l,

ˆ z

l

> 0.

Lemma 2.6.3 Under the assumptions of Walras’ Law and gross substitute, we have

p

∗

ˆ z(p) > 0 for all p = kp

∗

where p

∗

> 0 is a competitive equilibrium.

54

Proof. The proof of this lemma is complicated. We illustrate the proof only for the case

of two commodities by aid of the ﬁgure. The general proof of this lemma can be seen in

Arrow and Hahn, 1971, p. 224.

Figure 2.19: An illustration of the proof of Lemma 2.6.3.

Let p

∗

be an equilibrium price vector and x

∗

= x(p

∗

). Let p = αp

∗

for any α > 0.

Then we know p is not an equilibrium price vector by the uniqueness of the competitive

equilibrium under the gross substitutability. Since pˆ x(p) = pˆ x(p

∗

) by Walras’ Law, then

x(p) is on the line AB which passes through the point x

∗

and whose slope is given by

p. Let CD be the line which passes through the point x

∗

and whose shope is p

∗

. We

assume that p

∗1

/p

∗2

> p

1

/p

2

without loss of generality. Then p

∗1

/p

1

> p

∗2

/p

2

≡ µ. Thus,

p

∗1

> µp

1

and p

∗2

= µp

2

. Therefore, we have x

2

(p

∗

) > x

2

(µp) by the gross substitutability.

But Walras’ Law implies that µpˆ x(µp) = µpˆ x(p

∗

) so that we must have x

1

(µp) > x

1

(p

∗

).

Using the homogeneity assumption, we get x

1

(p) = x

1

(µp) > x

1

(p

∗

) = x

∗1

and x

2

(p) =

x

2

(µp) < x

2

(p

∗

) = x

∗2

. Hence the point x(p) must lie to the right of the point x

∗

in

the ﬁgure. Now draw a line parallel to CD passing through the point x(p). We see that

p

∗

ˆ x(p) > p

∗

ˆ x

∗

and thus p

∗

ˆ z(p) > 0. The proof is completed.

Now we are ready to prove the following theorem on the global stability of a compet-

itive equilibrium.

55

Theorem 2.6.3 (Arrow-Block-Hurwicz) Under the assumptions of Walras’ Law, if

ˆ z(p) satisﬁes either gross substitutability, or WARP, then the competitive equilibrium price

is globally stable.

Proof: Deﬁne a Liaponov’s function by

V (p) =

L

¸

l=1

(p

l

(t) −p

∗l

)

2

= (p −p

∗

) (p −p

∗

) (2.55)

By the assumption, the competitive equilibrium price p

∗

is unique. Also, since

dV

dt

= 2

L

¸

l=1

(p(t)

l

−p

∗l

)

dp

l

(t)

dt

= 2

L

¸

l=1

(p

l

(t)

−p

∗l

)ˆ z

l

(p)

= 2[pˆ z(p) −p

∗

ˆ z(p)]

= −2p

∗

ˆ z(p) < 0

by Walras’ Law and Lemma 2.6.1-2.6.3 for p = kp

∗

, we know ˙ p = ˆ z(p) is globally stable

by Leaponov’s theorem.

The above theorem establishes the global stability of a competitive equilibrium under

Walras’ Law, homogeneity, and gross substitutability/WARP. It is natural to ask how far

we can relax these assumptions, in particular gross substitutability. Since many goods

in reality are complementary goods, can the global stability of a competitive equilibrium

also hold for complementary goods? Scarf (1961) has constructed examples that show

that a competitive equilibrium may not be globally stable.

Example 2.6.1 (Scarf ’s Counterexample on Global Instability) Consider a pure

exchange economy with three consumers and three commodities (n=3, L=3). Suppose

consumers’ endowments are given by w

1

= (1, 0, 0), w

2

= (0, 1, 0) w

3

= (0, 0, 1) and their

utility functions are given by

u

1

(x

1

) = min¦x

1

1

, x

2

1

¦

u

2

(x

2

) = min¦x

2

2

, x

3

2

¦

u

3

(x

3

) = min¦x

1

3

, x

3

3

¦

56

so that they have L-shaped indiﬀerence curves. Then, the aggregate excess demand

function is given by

ˆ z

1

(p) = −

p

2

p

1

+ p

2

+

p

3

p

1

+ p

3

(2.56)

ˆ z

2

(p) = −

p

3

p

2

+ p

3

+

p

1

p

1

+ p

2

(2.57)

ˆ z

3

(p) = −

p

1

p

1

+ p

3

+

p

2

p

2

+ p

3

. (2.58)

Then, the dynamic adjustment equation is given by

˙ p = ˆ z(p).

We know that |p(t)| = constant for all t by Walras’ Law. Now we want to show that

¸

3

l=1

p

l

(t) = constant for all t. Indeed,

d

dt

(

3

¸

l=1

p(t)) = ˙ p

1

p

2

p

3

+ ˙ p

2

p

1

p

3

+ ˙ p

3

p

1

p

2

= ˆ z

1

p

2

p

3

+ ˆ z

2

p

1

p

3

+ ˆ z

3

p

1

p

2

= 0.

Now, we show that the dynamic process is not globally stable. First choose the initial

prices p

l

(0) such that

¸

3

l=1

[p

l

(0)]

2

= 3 and

¸

3

l=1

p

l

(0) = 1. Then,

¸

3

l=1

[p

l

(t)]

2

= 3 and

¸

3

l=1

p

l

(t) = 1 for all t. Since

¸

3

l=1

[p

l

(t)]

2

= 3, the only possible equilibrium prices are

p

∗1

= p

∗2

= p

∗3

= 1, the solution of the above system of diﬀerential equations cannot

converge to the equilibrium price p

∗

= (1, 1, 1).

In this example, we may note the following facts. (i) there is no substitution eﬀect, (ii)

the indiﬀerence curve is not strictly convex, and (iii) the diﬀerence curve has a kink and

hence is not diﬀerentiable. Scarf (1961) also provided the examples of instabiity in which

the substitution eﬀect is present for the case of Giﬀen’s goods. Thus, Scarf’s examples

indicate that instability may occur in a wide variety of cases.

2.7 Abstract Economy

The abstract economy deﬁned by Debreu (Econometrica, 1952) generalizes the notion

of N-person Nash noncooperative game in that a player’s strategy set depends on the

strategy choices of all the other players and can be used to prove the existence of compet-

itive equilibrium since the market mechanism can be regarded as an abstract economy as

57

shown by Arrow and Debreu (Econometrica 1954). Debreu (1952) proved the existence

of equilibrium in abstract economies with ﬁnitely many agents and ﬁnite dimensional

strategy spaces by assuming the existence of continuous utility functions. Since Debreu’s

seminal work on abstract economies, many existence results have been given in the litera-

ture. Shafer and Sonnenschein (J. of Mathematical Economics, 1975) extended Debreu’s

results to abstract economies without ordered preferences.

2.7.1 Equilibrium in Abstract Economy

Let N be the set of agents which is any countable or uncountable set. Each agent i

chooses a strategy x

i

in a set X

i

of R

L

. Denote by X the (Cartesian) product

¸

j∈N

X

j

and X

−i

the product

¸

j∈N\|i¦

X

j

. Denote by x and x

−i

an element of X and X

−i

. Each

agent i has a payoﬀ (utility) function u

i

: X → R. Note that agent i’s utility is not

only dependent on his own choice, but also dependent on the choice of the others. Given

x

−i

(the strategies of others), the choice of the i-th agent is restricted to a non-empty,

convex and compact set F

i

(x

−i

) ⊂ X

i

, the feasible strategy set; the i-th agent chooses

x

i

∈ F

i

(x

−i

) so as to maximize u

i

(x

−i

, x

i

) over F

i

(x

−i

).

An abstract economy (or called generalized game) Γ = (X

i

, F

i

, u

i

)

i∈N

is deﬁned as a

family of ordered triples (X

i

, F

i

, P

i

).

Deﬁnition 2.7.1 A vector x

∗

∈ X is said to be an equilibrium of an abstract economy if

∀i ∈ N

(i) x

∗

i

∈ F

i

(x

∗

−i

) and

(ii) x

∗

i

maximizes u

i

(x

∗

−i

, x

i

) over F

i

(x

∗

−i

).

If F

i

(x

−i

) ≡ X

i

, ∀i ∈ N, the abstract economy reduces to the conventional game

Γ = (X

i

, u

i

) and the equilibrium is called a Nash equilibrium.

Theorem 2.7.1 (Arrow-Debreu) Let X be a non-empty compact convex subset of R

nL

.

Suppose that

i) the correspondence F: X → 2

X

is a continuous correspondence with non-

empty compact and convex values,

ii) u

i

: X X →R is continuous,

58

iii) u

i

: X X →R is either quasi-concave in x

i

or it has a unique maximum

on F

i

(x

−i

) for all x

−i

∈ X

−i

.

Then Γ has an equilibrium.

Proof. For each i ∈ N, deﬁne the maximizing correspondence

M

i

(x

−i

) = ¦x

i

∈ F

i

(x

−i

) : u

i

(x

−i

, x

i

) u

i

(x

−i

, z

i

), ∀z

i

∈ F

i

(x

−i

)¦.

Then, the correspondence M

i

: X

−i

→ 2

X

i

is non-empty and convex-valued because u

i

is

continuous in x and quasi-concave in x

i

and F

i

(x

−i

) is non-empty convex compact-valued.

Also, by the Maximum Theorem, M

i

is an upper hemi-continuous correspondence with

compact-valued. Therefore the correspondence

M(x) =

¸

i∈N

M

i

(x

−i

)

is an upper hemi-continuous correspondence with non-empty convex compact-values.

Thus, by Kakutani’s Fixed Point Theorem, there exists x

∗

∈ X such that x

∗

∈ M(x

∗

)

and x

∗

is an equilibrium in the generalized game. Q.E.D

A competitive market mechanism can be regarded as an abstract economy. For sim-

plicity, consider an exchange economy e = (X

i

, u

i

, w

i

)

i∈N

. Deﬁne an abstract economy

Γ = (Z, F

i

, u

i

)

i∈N+1

as follows. Let

Z

i

= X

i

i = 1, . . . , n

Z

n+1

= ∆

L−1

F

i

(x

i

, p) = ¦x

i

∈ X

i

: px

i

pw

i

¦ i = 1, . . . , n

F

n+1

= ∆

L−1

u

n+1

(p, x) =

n

¸

i=1

p(x

i

−w

i

) (2.59)

Then, we verify that the economy e has a competitive equilibrium if the abstract

economy deﬁned above has an equilibrium by noting that

¸

n

i=1

x

i

¸

n

i=1

w

i

at the

equilibrium of the abstract equilibrium.

2.7.2 The Existence of Equilibrium for General Preferences

The above theorem on the existence of an equilibrium in abstract economy has assumed

the preference relation is an ordering and can be represented by a utility function. In

59

this subsection, we consider the existence of equilibrium in an abstract economy where

individuals’ preferences may be non total or not-transitive. Deﬁne agent i’s preference

correspondence P

i

: X → 2

X

i

by

P

i

(x) = ¦y

i

∈ X

i

: (y

i

, x

−i

) ~

i

(x

i

, x

−i

)¦

We call Γ = (X

i

, F

i

, P

i

)

i∈N

an abstract economy.

A generalized game (or an abstract economy) Γ = (X

i

, F

i

, P

i

)

i∈N

is deﬁned as a family

of ordered triples (X

i

, F

i

, P

i

). An equilibrium for Γ is an x

∗

∈ X such that x

∗

∈ F(x

∗

)

and P

i

(x

∗

) ∩ F

i

(x

∗

) = ∅ for each i ∈ N.

Shafer and Sonnenschein (1975) proved the following theorem that generalizes the

above theorem to an abstract economy with non-complete/non-transitive preferences.

Theorem 2.7.2 (Shafer-Sonnenschein ) Let Γ = (X

i

, F

i

, P

i

)

i∈N

be an abstract econ-

omy satisfying the following conditions for each i ∈ N:

(i) X

i

is a non-empty, compact, and convex subset in R

l

i

,

(ii) F

i

: X → 2

X

i

is a continuous correspondence with non-empty, compact,

and convex values,

(iii) P

i

has open graph,

(iv) x

i

∈ con P

i

(x) for all x ∈ Z.

Then Γ has an equilibrium.

This theorem requires the preferences have open graph. Tian (International Journal of

Game Theory, 1992) proved the following theorem that is more general and generalizes

the results of Debreu (1952), Shafer and Sonnenschein (1975) by relaxing the openness of

graphs or lower sections of preference correspondences. Before proceeding to the theorem,

we state some technical lemmas which were due to Micheal (1956, Propositions 2.5, 2.6

and Theorem 3.1

ttt

).

Lemma 2.7.1 Let X ⊂ R

M

and Y ⊂ R

K

be two convex subsets and φ : X → 2

Y

,

ψ : X → 2

Y

be correspondences such that

60

(i) φ is lower hemi-continuous, convex valued, and has open upper sections,

(ii) ψ is lower hemi-continuous,

(iii) for all x ∈ X, φ(x) ∩ ψ(x) = ∅.

Then the correspondence θ : X → 2

Y

deﬁned by θ(x) = φ(x) ∩ ψ(x) is lower hemi-

continuous.

Lemma 2.7.2 Let X ⊂ R

M

and Y ⊂ R

K

be two convex subsets, and let φ : X → 2

Y

be

lower hemi-continuous. Then the correspondence ψ : X → 2

Y

deﬁned by ψ(x) = conφ(x)

is lower hemi-continuous.

Lemma 2.7.3 Let X ⊂ R

M

and Y ⊂ R

K

be two convex subsets. Suppose F : X → 2

Y

is

a lower hemi-continuous correspondence with non-empty and convex values. Then there

exists a continuous function f : X → Y such that f(x) ∈ F(x) for all x ∈ X.

Theorem 2.7.3 (Tian) Let Γ = (X

i

, F

i

, P

i

)

i∈N

be a generalized game satisfying for each

i ∈ N:

(i) X

i

is a non-empty, compact, and convex subset in R

l

i

,

(ii) F

i

is a continuous correspondence, and F

i

(x) is non-empty, compact, and

convex for all x ∈ X,

(iii) P

i

is lower hemi-continuous and has open upper sections,

(iv) x

i

∈ con P

i

(x) for all x ∈ F.

Then Γ has an equilibrium.

Proof. For each i ∈ N, deﬁne a correspondence A

i

: X → 2

X

i

by A

i

(x) = F

i

(x)∩conP

i

(x).

Let U

i

= ¦x ∈ X : A

i

(x) = ∅¦. Since F

i

and P

i

are lower hemi-continuous in X, so are

they in U

i

. Then, by Lemma 2.7.2, conP

i

is lower hemi-continuous in U

i

. Also since

P

i

has open upper sections in X, so does conP

i

in X and thus conP

i

in U

i

. Further,

F

i

(x) ∩ conP

i

(x) = ∅ for all x ∈ U

i

. Hence, by Lemma 2.7.1, the correspondence A

i

[U

i

:

U

i

→ 2

X

i

is lower hemi-continuous in U

i

and for all x ∈ U

i

, F(x) is non-empty and convex.

Also X

i

is ﬁnite dimensional. Hence, by Lemma 2.7.3, there exists a continuous function

61

f

i

: U

i

→ X

i

such that f

i

(x) ∈ A

i

(x) for all x ∈ U

i

. Note that U

i

is open since A

i

is lower

hemi-continuous. Deﬁne a correspondence G

i

: X → 2

X

i

by

G

i

(x) =

¦f

i

(x)¦ if x ∈ U

i

F

i

(x) otherwise

. (2.60)

Then G

i

is upper hemi-continuous. Thus the correspondence G : X → 2

X

deﬁned by

G(x) =

¸

i∈N

G

i

(x) is upper hemi-continuous and for all x ∈ X, G(x) is non-empty,

closed, and convex. Hence, by Kakutani’s Fixed Point Theorem, there exists a point

x

∗

∈ X such that x

∗

∈ G(x

∗

). Note that for each i ∈ N, if x

∗

∈ U

i

, then x

∗

i

= f

i

(x

∗

) ∈

A(x

∗

) ⊂ conP

i

(x

∗

), a contradiction to (iv). Hence, x

∗

∈ U

i

and thus for all i ∈ N,

x

∗

i

∈ F

i

(x

∗

) and F

i

(x

∗

) ∩ conP

i

(x

∗

) = ∅ which implies F

i

(x

∗

) ∩ P

i

(x

∗

) = ∅. Thus Γ has

an equilibrium.

Note that a correspondence P has open graph implies that it has upper and lower open

sections; a correspondence P has lower open sections implies P is lower hemi-continuous.

Thus, the above theorem is indeed weaker.

Reference

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rium, II,” Econometrica, 27 (1959), 82-109.

Arrow, K and G. Debreu, “Existence of Equilibrium for a Competitive Economy,” Econo-

metrica, 1954, 22.

Arrow, K., and L. Hurwicz, “On the Stability of the Competitve Equilibrium, I,” Econo-

metrica, 26 (1958), 522-552.

Arrow, K. J. and Hahn, F. H. (1971), General Competitive Analysis, (San Francisco,

Holden Day).

Baye, M. J. Zhou, and Tian, G. “Characterizations of the Existence of Equilibria in

Games with Discontinuous and Nonquasiconcave Payoﬀs,” Review of Economic

Studies, 60 (1993), 935-948.

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Border, K. C., Fixed Point Theorems with Appplications to Economics and Game The-

ory, Cambridge: Cambridge University Press, 1985.

Debreu, G., “A Social equilibrium existence theorem,” Proceedings of the National

Academy of Sciences of the U. S. A. 38 (1952) 386 393.

Debreu, G., Theory of Value, (Wiley, New York), 1959.

Debreu, G. “Excess Demand Functions,” Journal of Mathematical Economics, 1 (1974),

15-22.

Jehle, G. A., and P. Reny, Advanced Microeconomic Theory, Addison-Wesley, 1998,

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Fan, K., “Some Properties of Convex Sets Related to Fixed Point Theorem,” Mathe-

matics Annuls, 266 (1984), 519-537.

Luenberger, D. Microeconomic Theory, McGraw-Hill, Inc, 1995, Chapter 7.

Mas-Colell, A., M. D. Whinston, and J. Green, Microeconomic Theory, Oxford Univer-

sity Press, 1995, Chapters 15, 17.

Michael, E., “Continuous selections I,” Annals of Mathematics 63 (1956), 361 382.

Scarf, H., “Some Examples of Global Instability of the Competitive Equilibrium,” Inter-

national Economic Review, 1 (1960), 157-172.

Shafer, W. and H. Sonnenschein, Equilibrium in abstract economies without ordered

preferences, Journal of Mathematical Economics 2 (1975) 345 348.

Sonnenschein, H., Demand Theory without Transitive Preferences, with Application to

the Theory of Competitive Equilibrium, Preferences, Utility, and Demand, Edited.

by J. S. Chipman, L. Hurwicz, M. K. Richter, and H. Sonnenschein, Harcourt Brace

Jovanovich, New York, New York, 1971.

Takayama, A. Mathematical Economics, the second edition, Cambridge: Cambridge

University Press, 1985, Chapters 1-3.

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Tian, G., “Fixed Points Theorems for Mappings with Non-Compact and Non-Convex

Domains,” Journal of Mathematical Analysis and Applications, 158 (1991), pp.

161-167.

Tian, G. “On the Existence of Equilibria in Generalized Games,” International Journal

of Game Theory, 20 (1992), pp.247-254.

Tian, G.“Generalizations of the FKKM Theorem and Ky-Fan Minimax Inequality, with

Applications to Maximal Elements, Price Equilibrium, and Complementarity,” Jour-

nal of Mathematical Analysis and Applications, 170 (1992), pp. 457-471.

Tian, G. “Existence of Equilibrium in Abstract Economies with Discontinuous Payoﬀs

and Non-Compact Choice Spaces,” Journal of Mathematical Economics, 21 (1992),

pp. 379-388.

Tian, G. “Necessary and Suﬃcient Conditions for Maximization of a Class of Preference

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Tian, G. and J. Zhou, “Transfer Method for Characterizing the Existence of Maximal

Elements of Binary Relations on Compact or Noncompact Sets,” SIAM Journal on

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64

Chapter 3

Normative Theory of Equilibrium:

Its Welfare Properties

3.1 Introduction

In the preceding chapter, we studied the conditions which would guarantee the existence,

uniqueness, and stability of competitive equilibrium. In this chapter, we will study the

welfare properties of competitive equilibrium.

Economists are interested not only in describing the world of the market economy, but

also in evaluating it. Does a competitive market do a “good” job in allocating resources?

Adam Smith’s “invisible hand” says that market economy is eﬃcient. Then in what sense

and under what conditions is a market eﬃcient? The concept of eﬃciency is related to

a concern with the well-being of those in the economy. The normative analysis can not

only help us understand what advantage the market mechanism has, it can also help us

to evaluate an economic system used in the real world, as well as help us understand why

China and East European countries want to change their economic institutions.

The term of economic eﬃciency consists of three requirements:

(1) Exchange eﬃciency: goods are traded eﬃciently so that no further mutual

beneﬁcial trade can be obtained.

(2) Production eﬃciency: there is no waste of resources in producing goods.

(3) Product mix eﬃciency, i.e., the mix of goods produced by the economy

65

reﬂects the preferences of those in the economy.

3.2 Pareto Eﬃciency of Allocation

When economists talk about the eﬃciency of allocation resources, it means Pareto eﬃ-

ciency. It provides a minimum criterion for eﬃciency of using resources.

Under the market institution, we want to know what is the relationship between

a market equilibrium and Pareto eﬃciency. There are two basic questions: (1) If a

market (not necessarily competitive) equilibrium exists, is it Pareto eﬃcient? (2) Can any

Pareto eﬃcient allocation be obtained through the market mechanism by redistributing

endowments?

The concept of Pareto eﬃciency is not just to study the eﬃciency of a market economy,

but it also can be used to study the eﬃciency of any economic system.

Deﬁnition 3.2.1 (Pareto Eﬃciency, also called Pareto Optimality) : An alloca-

tion is Pareto eﬃcient or Pareto optimal (in short, P.O) if it is feasible and there is no

other feasible allocation such that one person would be better oﬀ and all other persons

are not worse oﬀ.

More precisely, for exchange economies, a feasible allocation x is P.O. if there is no other

allocation x

t

such that

(i)

¸

n

i=1

x

t

i

¸

n

i=1

w

i

(ii) x

t

i

i

x

i

for all i and x

t

k

~

k

x

k

for some k = 1, . . . , n.

For production economy, (x, y) is Pareto optimal if and only if:

(1) ˆ x ˆ y + ˆ w

(2) there is no feasible allocation (x

t

, y

t

) s.t.

x

t

i

x

i

for all i

x

t

k

~

k

x

k

for some k

A weaker concept about economic eﬃciency is the so-called weak Pareto eﬃciency.

66

Deﬁnition 3.2.2 (Weak Pareto Eﬃciency) An allocation is weakly Pareto eﬃcient if

it is feasible and there is no other feasible allocation such that all persons are better oﬀ.

Remark 3.2.1 Some textbooks such as Varian (1992) has used weak Pareto optimality

as the deﬁnition of Pareto optimality. Under which conditions are they equivalent? It is

clear that Pareto eﬃciency implies weak Pareto eﬃciency. But the converse may not be

true. However, under the continuity and strict monotonicity of preferences, the converse

is true.

Proposition 3.2.1 Under the continuity and strict monotonicity of preferences, weak

Pareto eﬃciency implies Pareto eﬃciency.

Proof. Suppose x is weakly Pareto eﬃcient but not Pareto eﬃcient. Then, there exists a

feasible allocation x

t

such that x

t

i

i

x

i

for all i and x

t

k

~

k

x

k

for some k.

Deﬁne x as follows

x

k

= (1 −θ)x

t

k

x

i

= x

t

i

+

θ

n −1

x

t

k

for i = k

Then we have

x

k

+

¸

i,=k

x

i

= (1 −θ)x

t

k

+

¸

i,=k

(x

t

i

+

θ

n −1

x

t

k

) =

n

¸

i=1

x

t

i

(3.1)

which means x is feasible. Furthermore, by the continuity of preferences, x

k

= (1−θ)x

t

k

~

x

k

when θ is suﬃciently close to zero, and ¯ x

i

~

i

x

i

for all i = k by the strict monotonicity

of preferences. This contradicts the fact that x is weakly Pareto optimal. Thus, we must

have every weak Pareto eﬃcient allocation is Pareto eﬃcient under the monotonicity and

continuity of preferences.

Remark 3.2.2 The trick of taking a little from one person and then equally distribute

it to the others will make every one better oﬀ is a useful one. We will use the same trick

to prove the second theorem of welfare economics.

Remark 3.2.3 The above proposition also depends on an implicit assumption that the

goods under consideration are all private goods. Tian (Economics Letters, 1988) showed,

67

by example that, if goods are public goods, we may not have such equivalence between

Pareto eﬃciency and weak Pareto eﬃciency under the monotonicity and continuity of

preferences.

The set of Pareto eﬃcient allocations can be shown with the Edgeworth Box. Every

point in the Edgeworth Box is attainable. A is the starting point. Is “A” a weak Pareto

optimal? No. The point C, for example in the shaded area is better oﬀ to both persons.

Is the point “B” a Pareto optimal? YES. Actually, all tangent points are Pareto eﬃcient

points where there are no incentives for any agent to trade. The locus of all Pareto eﬃcient

is called the contract curve.

Figure 3.1: The set of Pareto eﬃcient allocations is given by the contract curve.

Remark 3.2.4 Equity and Pareto eﬃciency are two diﬀerent concepts. The points like

O

A

or O

B

are Pareto optimal points, but these are extremely unequal. To make an

allocation be relatively equitable and also eﬃcient, government needs to implement some

institutional arrangements such as tax, subsidy to balance between equity and eﬃciency,

but this is a value judgement and policy issue.

We will show that, when Pareto eﬃcient points are given by tangent points of two

68

persons’ indiﬀerence curves, it should satisfy the following conditions:

MRS

A

x

1

x

2 = MRS

B

x

1

x

2

x

A

+x

B

= ˆ w.

When indiﬀerence curves of two agents are never tangent, we have the following cases.

Case 1. For linear indiﬀerence curves with positive slope, indiﬀerence curves of agents

may not be tangent. How can we ﬁnd the set of Pareto eﬃcient allocations in this case?

We can do it by comparing the steepness of indiﬀerence curves.

Figure 3.2: The set of Pareto eﬃcient allocations is given by the upper and left edges of

the box when indiﬀerence curves are linear.

MRS

A

x

1

x

2 < MRS

B

x

1

x

2 (3.2)

In this case, when indiﬀerence curves for B is given, say, by Line AA, then K is a Pareto

eﬃcient point. When indiﬀerent curves for A is given, say, by Line BB, then P is a Pareto

eﬃcient point. Contract curve is then given by the upper and left edge of the box.

Case 2. Suppose that indiﬀerence curves are given by

u

A

(x

A

) = x

2

A

and

u

B

(x

B

) = x

1

B

69

Figure 3.3: The only Pareto eﬃcient allocation point is given by the upper and left

corner of the box when individuals only care about one commodity.

Then, only Pareto eﬃcient is the right upper corner point. But the set of weakly Pareto

eﬃcient is given by the upper and left edge of the box. Notice that utility functions in this

example are continuous and monotonic, but a weak Pareto eﬃcient allocation may not

be Pareto eﬃcient. This example shows that the strict monotonicity cannot be replaced

by the monotonicity for the equivalence of Pareto eﬃciency and weak eﬃciency.

Case 3. Now suppose that indiﬀerence curves are perfect complementary. Then, utility

functions are given by

u

A

(x

A

) = min¦ax

1

A

, bx

2

A

¦

and

u

B

(x

B

) = min¦cx

1

B

, dx

2

B

¦

A special case is the one where a = b = c = d = 1.

70

Figure 3.4: The ﬁrst ﬁgure shows that the contract curve may be the “thick” when

indiﬀerence curves are perfect complementary. The second ﬁgure shows that a weak

Pareo eﬃcient allocation may not Pareto eﬃcient when indiﬀerence curves are “thick.”

Then, the set of Pareto optimal allocations is the area given by points between two

45

0

lines.

Case 4. One person’s indiﬀerence curves are “thick.” In this case, an weak Pareto

eﬃcient allocation may not be Pareto eﬃcient.

3.3 The First Fundamental Theorem of Welfare Eco-

nomics

There is a well-known theorem, in fact, one of the most important theorems in economics,

which characterizes a desirable nature of the competitive market institution. It claims

that every competitive equilibrium allocation is Pareto eﬃcient. A remarkable part of

this theorem is that the theorem requires few assumptions, much fewer than those for

71

the existence of competitive equilibrium. Some implicit assumptions in this section are

that preferences are orderings, goods are divisible, and there are no public goods, or

externalities.

Theorem 3.3.1 (The First Fundamental Theorem of Welfare Economics) If (x, y, p)

is a competitive equilibrium, then x is weakly Pareto eﬃcient, and further under local non-

satiation, it is Pareto eﬃcient.

Proof: Suppose (x, y) is not weakly Pareto optimal, then there exists another feasible

allocation (x

t

, y

t

) such that x

t

i

~

i

x

i

for all i. Thus, we must have px

t

i

> px

i

+

¸

J

j=1

θ

ij

py

j

for all i. Therefore, by summation, we have

n

¸

i=1

px

t

i

>

n

¸

i=1

pw

i

+

J

¸

j=1

py

j

.

Since py

j

py

t

j

for all y

t

j

∈ Y

j

by proﬁt maximization, we have

n

¸

i=1

px

t

i

>

n

¸

i=1

pw

i

+

J

¸

j=1

py

t

j

. (3.3)

or

p[

n

¸

i=1

x

t

i

−

n

¸

i=1

w

i

−

J

¸

j=1

y

t

j

] > 0, (3.4)

which contradicts the fact that (x

t

, y

t

) is feasible.

To show Pareto eﬃciency, suppose (x, y) is not Pareto optimal. Then there exists

another feasible allocation (x

t

, y

t

) such that x

t

i

i

x

i

for all i and x

t

k

~

k

x

k

for some k .

Thus we have, by local non-saltation,

px

t

i

pw

i

+

J

¸

j=1

θ

ij

py

j

∀i

and by x

t

k

~

k

x

k

,

px

t

k

> pw

k

+

J

¸

j=1

θ

kj

py

j

and thus

n

¸

i=1

px

t

i

>

n

¸

i=1

pw

i

+

J

¸

j=1

py

j

n

¸

i=1

pw

i

+

J

¸

j=1

py

t

j

. (3.5)

Again, it contradicts the fact that (x

t

, y

t

) is feasible.

72

Remark 3.3.1 If the local non-satiation condition is not satisﬁed, a competitive equi-

librium allocation x may not be Pareto optimal, say, for the case of thick indiﬀerence

curves.

Figure 3.5: A CE allocation may not be Pareto eﬃcient when the local non-satiation

condition is not satisﬁed.

Remark 3.3.2 Note that neither convexity of preferences nor convexity of production

set is assumed in the theorem. The conditions required for Pareto eﬃciency of com-

petitive equilibrium is much weaker than the conditions for the existence of competitive

equilibrium.

Remark 3.3.3 If goods are indivisible, then a competitive equilibrium allocation x may

not be Pareto optimal.

Figure 3.6: A CE allocation may not be Pareto eﬃcient when goods are indivisible.

73

The point x is a competitive equilibrium allocation, but not Pareto optimal since x

t

is

preferred by person 1. Hence, the divisibility condition cannot be dropped for the First

Fundamental Theorem of Welfare Theorem to be true.

3.4 Calculations of Pareto Optimum by First-Order

Conditions

The ﬁrst-order conditions for Pareto eﬃciency are a bit harder to formulate. However,

the following trick is very useful.

3.4.1 Exchange Economies

Proposition 3.4.1 A feasible allocation x

∗

is Pareto eﬃcient if and only if x

∗

solves the

following problem for all i = 1, 2, . . . , n

max

x

i

u

i

(x

i

)

s.t.

¸

x

k

¸

w

k

u

k

(x

k

) u

k

(x

∗

k

) for k = i

Proof. Suppose x

∗

solves all maximizing problems but x

∗

is not Pareto eﬃcient. This

means that there is some allocation x

t

where one consumer is better oﬀ, and the others are

not worse oﬀ. But, then x

∗

does not solve one of the maximizing problems, a contradiction.

Conversely, suppose x

∗

is Pareto eﬃcient, but it does not solve one of the problems.

Instead, let x

t

solve that particular problem. Then x

t

makes one of the agents better

oﬀ without hurting any of the other agents, which contradicts the assumption that x

∗

is

Pareto eﬃcient. The proof is completed.

If utility functions u

i

(x

i

) are diﬀerentiable and x

∗

is an interior solution, then we can

deﬁne the Lagrangian function to get the optimal solution to the above problem:

L = u

i

(x

i

) + q( ˆ w − ˆ x) +

¸

k,=i

t

k

[u

k

(x

k

) −u

k

(x

∗

k

)]

74

The ﬁrst order conditions are then given by

∂L

∂x

l

i

=

∂u

i

(x

i

)

∂x

l

i

−q

l

= 0 l = 1, 2, . . . , L, i = 1, . . . , n, (3.6)

∂L

∂x

l

k

= t

k

∂u

k

(x

k

)

∂x

l

k

−q

l

= 0 l = 1, 2, . . . , L; k = L (3.7)

By (3.6)

∂u

i

(x

i

)

∂x

l

i

∂u

i

(x

i

)

∂x

h

i

=

q

l

q

h

= MRS

x

l

i

,x

h

i

(3.8)

By (3.7)

∂u

k

(x

k

)

∂x

l

k

∂u

k

(x

k

)

∂x

h

k

=

q

l

q

h

(3.9)

Thus, we have

MRS

x

l

1

,x

h

1

= = MRS

x

n

n

,x

h

n

l = 1, 2, . . . , L; h = 1, 2, . . . , L. (3.10)

which are the necessary conditions for the interior solutions to be Pareto eﬃcient, which

means that the MRS of any two goods are all equal for all agents. They become suﬃcient

conditions when utility functions u

i

(x

i

) are diﬀerentiable and quasi-concave.

3.4.2 Production Economies

For simplicity, we assume there is only one ﬁrm. Let T(y) 0 be the transformation

frontier. Similarly, we can prove the following proposition.

Proposition 3.4.2 A feasible allocation (x

∗

, y

∗

) is Pareto eﬃcient if and only if (x

∗

, y

∗

)

solves the following problem for all i = 1, 2, . . . , n

max

x

i

u

i

(x

i

)

s.t.

¸

k∈N

x

k

=

¸

k∈N

w

k

+ y

u

k

(x

k

) u

k

(x

∗

k

) for k = i

T(y) 0.

If utility functions u

i

(x

i

) are diﬀerentiable and x

∗

is an interior solution, then we can

deﬁne the Lagrangian function to get the ﬁrst order conditions:

L = u

i

(x

i

) + λT( ˆ w − ˆ x) +

¸

k,=i

t

k

[u

k

(x

k

) −u

k

(x

∗

k

)]

75

FOC:

∂L

∂x

l

i

=

∂u

i

(x

i

)

∂x

l

i

−λ

l

∂T(y)

∂x

l

i

= 0 l = 1, 2, . . . , L, i = 1, . . . , n, (3.11)

∂L

∂x

l

k

= t

k

∂u

k

(x

k

)

∂x

l

k

−λ

l

∂T(y)

∂x

l

i

= 0 l = 1, 2, . . . , L; k = L . (3.12)

By (3.11)

∂u

i

(x

i

)

∂x

l

i

∂u

i

(x

i

)

∂x

h

i

=

∂T(y)

∂y

l

∂T(y)

∂y

h

. (3.13)

By (3.12)

∂u

k

(x

k

)

∂x

l

k

∂u

k

(x

k

)

∂x

h

k

=

∂T(y)

∂y

l

∂T(y)

∂y

h

. (3.14)

Thus, we have

MRS

x

l

1

,x

h

1

= = MRS

x

l

n

,x

h

n

= MRTS

y

l

,y

h l = 1, 2, . . . , L; h = 1, 2, . . . , L (3.15)

which are the necessary condition for the interior solutions to be Pareto eﬃcient, which

means that the MRS of any two goods for all agents equals the MRTS. They become

suﬃcient conditions when utility functions u

i

(x

i

) are diﬀerentiable and quasi-concave and

the production functions are concave.

3.5 The Second Fundamental Theorem of Welfare

Economics

Now we can assert a converse of the First Fundamental Theorem of Welfare Economics.

The Second Fundamental Theorem of Welfare Economics gives conditions under which a

Pareto optimum allocation can be “supported” by a competitive equilibrium if we allow

some redistribution of endowments. It tells us, under its assumptions, including essential

condition of convexity of preferences and production sets, that any desired Pareto optimal

allocation can be achieved as a market-based equilibrium with transfers.

We ﬁrst deﬁne the competitive equilibrium with transfer payments (also called an

equilibrium relative to a price system), that is, a competitive equilibrium is established

after transferring some of initial endowments between agents.

76

Deﬁnition 3.5.1 (Competitive Equilibrium with Transfer Payments) For an econ-

omy, e = (e

1

, . . . , e

n

, ¦Y

j

¦), (x, y, p) ∈ X Y R

L

+

is a competitive equilibrium with

transfer payment if

(i) x

i

i

x

t

i

for all x

t

i

∈ ¦x

t

i

∈ X

i

: px

t

i

px

i

¦ for i = 1, . . . , n.

(ii) py

j

py

t

j

for y

t

j

∈ Y

j

.

(iii) ˆ x ˆ w + ˆ y (feasibility condition).

Remark 3.5.1 An equilibrium with transfer payments is diﬀerent from a competitive

equilibrium with respect to a budget constrained utility maximization that uses a value

calculated from the initial endowment. An equilibrium with transfer payments is deﬁned

without reference to the distribution of initial endowment, given the total amount.

The following theorem which is called the Second Fundamental Theorem of Welfare

Economics shows that every Pareto eﬃcient allocation can be supported by a competitive

equilibrium through a redistribution of endowments so that one does not need to seek

any alternative economic institution to reach Pareto eﬃcient allocations. This is one of

the most important theorems in modern economics, and the theorem is also one of the

theorems in microeconomic theory that is hardest to be proved.

Theorem 3.5.1 (The Second Fundamental Theorem of Welfare Economics) Suppose

(x

∗

, y

∗

) with x

∗

> 0 is Pareto optimal, suppose

i

are continuous, convex and strictly

monotonic, and suppose that Y

j

are closed and convex. Then, there is a price vector

p ≥ 0 such that (x

∗

, y

∗

, p) is a competitive equilibrium with transfer payments, i.e.,

(1) if x

t

i

~

i

x

∗

i

, then px

t

i

> px

∗

i

for i = 1, . . . , n.

(2) py

∗

j

py

t

j

for all y

t

j

∈ Y

j

and j = 1, . . . , J.

Proof: Let

P(x

∗

i

) = ¦x

i

∈ X

i

: x

i

~

i

x

∗

i

¦ (3.16)

be the strict upper contour set and let

P(x

∗

) =

n

¸

i=1

P(x

∗

i

). (3.17)

By the convexity of

i

, we know that P(x

∗

i

) and thus P(x

∗

) are convex.

77

Figure 3.7: P(x

∗

i

) is the set of all points strictly above the indiﬀerence curve through x

∗

i

.

Let W = ¦ ˆ w¦ +

¸

J

j=1

Y

j

which is closed and convex. Then W ∩ P(x

∗

) = ∅ by Pareto

optimality of (x

∗

, y

∗

), and thus, by the Separating Hyperplane Theorem in last chapter,

there is a p = 0 such that

pˆ z pˆ σ for all ˆ z ∈ P(x

∗

) and ˆ σ ∈ W (3.18)

Now we show that p is a competitive equilibrium price vector by the following four steps.

1. p 0

To see this, let e

l

= (0, . . . , 1, 0, . . . , 0) with the l-th component one and other places

zero. Let

ˆ z = ˆ σ + e

l

for some ˆ σ ∈ W.

Then ˆ z = ˆ σ + e

l

∈ P(x

∗

) by strict monotonicity and redistribution of e

l

. Thus, we

have by (3.18).

p(ˆ σ + e

l

) pˆ σ (3.19)

and thus

pe

l

0 (3.20)

which means

p

l

0 for l = 2, 3, . . . , L. (3.21)

78

2. py

∗

j

py

j

for all y

j

∈ Y

j

, j = 1, . . . , J.

Since ˆ x

∗

= ˆ y

∗

+ ˆ w by noting (x

∗

, y

∗

) is a Pareto eﬃcient allocation and preference

orderings are strictly monotonic, we have pˆ x

∗

= p( ˆ w + ˆ y

∗

). Thus, by pˆ z p( ˆ w + ˆ y)

in (3.18) and p ˆ w = pˆ y

∗

−pˆ x

∗

, we have

p(ˆ z − ˆ x

∗

) p(ˆ y − ˆ y

∗

).

Letting ˆ z → x

∗

, we have

p(ˆ y − ˆ y

∗

) 0.

Letting y

k

= y

∗

k

for k = j, we have from the above equation,

py

∗

j

py

j

∀y

j

∈ Y

j

.

3. If x

i

~

i

x

∗

i

, then

px

i

px

∗

i

. (3.22)

To see this, let

x

t

i

= (1 −θ)x

i

0 < θ < 1

x

t

k

= x

∗

k

+

θ

n −1

x

i

for k = i

Then, by the continuity of

i

and the strict monotonicity of

k

, we have x

t

i

~

i

x

∗

i

for all i ∈ N, and thus

x

t

∈ P(x

∗

) (3.23)

if θ is suﬃciently small. By (3.18), we have

p(x

t

i

+

¸

k,=i

x

t

k

) = p[(1 −θ)x

i

+

¸

k,=i

(x

∗

k

+

θ

n −1

x

i

)] p

n

¸

k=1

x

∗

k

(3.24)

and thus we have

px

i

px

∗

i

(3.25)

4. If x

i

~

i

x

∗

i

, we must have px

i

> px

∗

i

. To show this, suppose by way of contradiction,

that

px

i

= px

∗

i

(3.26)

Since x

i

~

i

x

∗

i

, then λx

i

~

i

x

∗

i

for λ suﬃciently close to one by the continuity of

preferences for 0 < λ < 1. By step 3, we know λpx

i

px

∗

i

= px

i

so that λ 1 by

px

i

= px

∗

i

> 0, which contradicts the fact that λ < 1.

79

**For exchange economies, the competitive equilibrium with transfers is the same as a
**

regular competitive equilibrium with w

i

= x

∗

i

. As a corollary, we have

Corollary 3.5.1 Suppose x

∗

> 0 is Pareto optimal, suppose

i

are continuous, convex

and strictly monotonic. Then, x

∗

is a competitive equilibrium for the initial endowment

w

i

= x

∗

i

.

Remark 3.5.2 If

i

can be represented by a concave and diﬀerentiable utility function,

then the proof of the Second Fundamental Theorem of Welfare Economics can be much

simpler. A suﬃcient condition for concavity is that the Hessian matrix is negative deﬁnite.

Also note that monotonic transformation does not change preferences so that we may be

able to transform a quasi-concave utility function to a concave utility function as follows,

for example

u(x, y) = xywhich is quasi-concave

⇔ u

1

2

(x, y) = x

1

2

y

1

2

which is concave after monotonic transformation.

Diﬀerentiation Version of the Second Fundamental Theorem of Welfare

Economics for Exchange Economies

Proof: If x

∗

> 0 is Pareto Optimal, then we have

Du

i

(x

i

) = q/t

i

i = 1, 2, . . . , n. (3.27)

We want to show q is a competitive equilibrium price vector. To do so, we only need to

show that each consumer maximizes his utility s.t. B(p) = ¦x

i

∈ X

i

: px

i

px

∗

i

). Indeed,

by concavity of u

i

u

i

(x

i

) u(x

∗

i

) + Du

i

(x

∗

i

) (x

i

−x

∗

i

)

= u(x

∗

i

) + q(x

i

−x

∗

i

)/t

i

u(x

∗

i

)

80

Figure 3.8: Concave funtion

The reason the inequality holds for a concave function is because that, from Figure

3.8, we have

u(x) −u(x

∗

)

x −x

∗

u

t

(x

∗

). (3.28)

Thus, we have u

i

(x

i

) u(x

∗

i

) + Du

i

(x

∗

i

) (x

i

−x

∗

i

).

3.6 Pareto Optimality and Social Welfare Maximiza-

tion

Pareto eﬃciency is only concerned with eﬃciency of allocations and has nothing to say

about distribution of welfare. Even if we agree with Pareto optimality, we still do not

know which one we should be at. One way to solve the problem is to assume the existence

of a social welfare function.

Deﬁne a social welfare function W : X → ' by W(u

1

(x

1

), . . . , u

n

(x

n

)) where we

assume that W() is monotone increasing.

Example 3.6.1 (The Utilitarian Social Welfare Function) W(u

1

, . . . , u

n

) =

¸

n

t=1

a

i

u

i

(x

i

)

with

¸

a

i

= 1, a

i

0. Under a utilitarian rule, social states are ranked according to the

linear sum of utilities. The utilitarian form is by far the most common and widely applied

social welfare function in economics.

Example 3.6.2 (The Rawlsian Social Welfare Function) W() = min¦u

1

(x

1

), u

2

(x

2

), . . . , u

n

(x

n

)¦.

So the utility function is not strictly monotonic increasing. The Rawlsian form gives prior-

81

ity to the interests of the worst oﬀ members, and it is used in the ethical system proposed

by Rawls (1971).

3.6.1 Social Welfare Maximization for Exchange Economies

We suppose that a society should operate at a point that maximizes social welfare; that

is, we should choose an allocation x

∗

such that x

∗

solves

max W(u

1

(x

1

), . . . , u

n

(x

n

))

subject to

n

¸

i=1

x

i

n

¸

i=1

w

i

.

How do the allocations that maximize this welfare function compare to Pareto eﬃcient

allocations? The following is a trivial consequence if the strict monotonicity assumption

is imposed.

Proposition 3.6.1 Under strict monotonicity of preferences, if x

∗

maximizes a social

welfare function, then x

∗

must be Pareto Optimal.

Proof: If x

∗

is not Pareto Optimal, then there is another feasible allocation x

t

such that

u

i

(x

t

i

) u

i

(x

i

) for all i and u

k

(x

t

k

) > u

k

(x

k

) for some k. Then, by strict monotonicity of

preferences, we have W(u

1

(x

t

1

), . . . , u

n

(x

t

n

)) > W(u

1

(x

i

), . . . , u

n

(x

n

)) and thus it does not

maximizes the social welfare function.

Thus, every social welfare maximum is Pareto eﬃcient. Is the converse necessarily

true? By the Second Fundamental Theorem of Welfare Economics, we know that every

Pareto eﬃcient allocation is a competitive equilibrium allocation by redistributing endow-

ments. This gives us a further implication of competitive prices, which are the multipliers

for the welfare maximization. Thus, the competitive prices really measure the (marginal)

social value of a good. Now we state the following proposition that shows every Pareto

eﬃcient allocation is a social welfare maximum for the social welfare function with a

suitable weighted sum of utilities.

Proposition 3.6.2 Let x

∗

> 0 be a Pareto optimal allocation. Suppose u

i

is concave,

diﬀerentiable and strictly monotonic. Then, there exists some choice of weights a

∗

i

such

82

that x

∗

maximizes the welfare functions

W(u

1

, . . . , u

n

) =

n

¸

i=1

a

i

u

i

(x

i

) (3.29)

Furthermore, a

∗

i

=

1

λ

i

with λ

i

=

∂V

i

(p,I

i

)

∂I

i

where V

i

() is the indirect utility function of consumer i.

Proof: Since x

∗

is Pareto optimal, it is a competitive equilibrium allocation with

w

i

= x

∗

i

by the second theorem of welfare economies. So we have

D

i

u

i

(x

∗

i

) = λp (3.30)

by the ﬁrst order condition, where p is a competitive equilibrium price vector.

Now for the welfare maximization problem

max

n

¸

i=1

a

i

u

i

(x

i

)

s.t.

¸

x

i

¸

x

∗

i

since u

i

is concave, x

∗

solves the problem if the ﬁrst order condition

a

i

∂u

i

(x

i

)

∂x

i

= q i = 1, . . . , n (3.31)

is satisﬁed for some q. Thus, if we let p = q, then a

∗

i

=

1

λ

i

. We know x

∗

also maximizes

the welfare function

¸

n

t=1

a

∗

i

u

i

(x

t

i

).

Thus, the price is the Lagrangian multiples of the welfare maximization, and this

measures the marginal social value of goods.

3.6.2 Welfare Maximization in Production Economy

Deﬁne a choice set by the transformation function

T(ˆ x) = 0 with ˆ x =

n

¸

t=1

x

i

. (3.32)

The social welfare maximization problem for the production economy is

max W(u

1

(x

1

), u

2

(x

2

), . . . , u

n

(u

n

)) (3.33)

83

subject to

T(ˆ x) = 0.

Deﬁne the Lagrangian function

L = W(u

1

(x

1

), . . . , u

n

(u

n

)) −λT(ˆ x). (3.34)

The ﬁrst order condition is then given by

W

t

()

∂u

i

(x

i

)

∂x

l

i

−λ

∂T(ˆ x)

∂x

l

i

= 0, (3.35)

and thus

∂u

i

(x

i

)

∂x

l

i

∂u

i

(x

i

)

∂x

k

i

=

∂T(ˆ x)

∂x

2

∂T(ˆ x)

∂x

l

i

(3.36)

That is,

MRS

x

l

i

,x

k

i

= MRTS

x

l

,x

k. (3.37)

The conditions characterizing welfare maximization require that the marginal rate of

substitution between each pair of commodities must be equal to the marginal rate of

transformation between the two commodities for all agents.

Figure 3.9: Welfare maximization

3.7 Political Overtones

1. By the First Fundamental Theorem of Welfare Economics, implication is that what the

government should do is to secure the competitive environment in an economy and give

84

people full economic freedom. So there should be no subsidizing, no price ﬂoor, no price

ceiling, stop a rent control, no regulations, lift the tax and the import-export barriers.

2. Even if we want to reach a preferred Pareto optimal outcome which may be diﬀerent

from a competitive equilibrium from a given endowment, you might do so by adjusting the

initial endowment but not disturbing prices, imposing taxes or regulations. This is, if a

derived Pareto optimal is not “fair”, all the government has to do is to make a lump-sum

transfer payments to the poor ﬁrst, keeping the competitive environments intact. We

can adjust initial endowments to obtain a desired competitive equilibrium by the Second

Fundamental Theorem of Welfare Economics.

3. Of course, when we reach the above conclusions, you should note that there are

conditions on the results. In many cases, we have market failures, in the sense that either

a competitive equilibrium does not exist or a competitive equilibrium may not be Pareto

optimal so that the First or Second Fundamental Theorem of Welfare Economics cannot

be applied.

The conditions for the existence of a competitive equilibrium are: (i) convexity (di-

versiﬁcation of consumption and no IRS), (ii) monotonicity (self-interest), and (iii) con-

tinuity, (iv) divisibility, (v) perfect competion, (vi) complete information, etc. If these

conditions are not satisﬁed, we may not obtain the existence of a competitive equilibrium.

The conditions for the First Fundamental Theorem of Welfare Economics are: (i) local

non-satiation (unlimited desirability), (ii) divisibility, (iii) no externalities, (iv) perfect

competion, (v) complete information etc. If these conditions are not satisﬁed, we may

not guarantee that every competitive equilibrium allocation is Pareto eﬃcient. The con-

ditions for the Second Fundamental Theorem of Welfare Economics are: (i) the convexity

of preferences and production sets, (ii) monotonicity (self-interest), and (iii) continuity,

(iv) divisibility, (v) perfect competion, (vi) complete information, etc. If these conditions

are not satisﬁed, we may not guarantee every Pareto eﬃcient allocation can be supported

by a competitive equilibrium with transfers.

Thus, as a general notice, before making an economic statement, one should pay atten-

tion to the assumptions which are implicit and/or explicit involved. As for a conclusion

from the general equilibrium theory, one should notice conditions such as divisibility, no

externalities, no increasing returns to scale, perfect competition, complete information.

85

If these assumptions are relaxed, a competitive equilibrium may not exist or may not be

Pareto eﬃcient, or a Pareto eﬃcient allocation may not be supported by a competitive

equilibrium with transfer payments. Only in this case of a market failure, we may adopt

another economic institution. We will discuss the market failure and how to solve the

market failure problem in Part II and Part III.

Reference

Arrow, K and G. Debreu, “Existence of Equilibrium for a Competitive Economy,” Econo-

metrica, 1954, 22.

Arrow, K. J. and Hahn, F. H. (1971), General Competitive Analysis, (San Francisco,

Holden Day).

Debreu, G. (1959), Theory of Value, (Wiley, New York).

Jehle, G. A., and P. Reny, Advanced Microeconomic Theory, Addison-Wesley, 1998,

Chapter 7.

Luenberger, D. Microeconomic Theory, McGraw-Hill, Inc, 1995, Chapters 6, 10.

Mas-Colell, A., M. D. Whinston, and J. Green, Microeconomic Theory, Oxford Univer-

sity Press, 1995, Chapters 10, 16.

Rawls, J., A Theory of Justice, Cambridge: Harvard University Press, 1971.

Takayama, A. Mathematical Economics, the second edition, Cambridge: Cambridge

University Press, 1985, Chapters 1-3.

Tian, G., “On the Constrained Walrasian and Lindahl Correspondences,” Economics

Letters, 26 (1988), pp. 299-303.

Varian, H.R., Microeconomic Analysis, W.W. Norton and Company, Third Edition,

1992, Chapters 17-18.

86

Chapter 4

Economic Core, Fair Allocations,

and Social Choice Theory

4.1 Introduction

In this chapter we brieﬂy discuss some topics in the framework of general equilibrium

theory, namely economic core, fair allocations, and social choice theory. Theory of core

is important because it gives an insight into how a competitive equilibrium is achieved

as a result of individual strategic behavior instead of results of an auctioneer and the

Walrasian tˆatonnement mechanism.

We have also seen that Pareto optimality may be too weak a criterion to be meaningful.

It does not address any question about income distribution and equity of allocations.

Fairness is a notion to overcome this diﬃculty. This is one way to restrict a set of Pareto

optimum.

In a slightly diﬀerent framework, suppose that a society is deciding the social priority

among ﬁnite alternatives. Alternatives may be diﬀerent from Pareto optimal allocations.

Let us think of a social “rule” to construct the social ordering (social welfare function)

from many individual orderings of diﬀerent alternatives. The question is: Is it possible

to construct a rule satisfying several desirable properties? Both “fairness” and “social

welfare function” address a question of social justice.

87

4.2 The Core of Exchange Economies

The use of a competitive (market) system is just one way to allocate resources. What

if we use some other social institution? Would we still end up with an allocation that

was “close” to a competitive equilibrium allocation? The answer will be that, if we allow

agents to form coalitions, the resulting allocation can only be a competitive equilibrium

allocation when the economy becomes large. Such an allocation is called a core allocation

and was originally considered by Edgeworth (1881).

The core is a concept in which every individual and every group agree to accept an

allocation instead of moving away from the social coalition.

There is some reason to think that the core is a meaningful political concept. If a

group of people ﬁnd themselves able, using their own resources to achieve a better life, it

is not unreasonable to suppose that they will try to enforce this threat against the rest of

community. They may ﬁnd themselves frustrated if the rest of the community resorts to

violence or force to prevent them from withdrawing.

The theory of the core is distinguished by its parsimony. Its conceptual apparatus

does not appeal to any speciﬁc trading mechanism nor does it assume any particular

institutional setup. Informally, notion of competition that the theory explores is one

in which traders are well informed of the economic characteristics of other traders, and

in which the members of any group of traders can bind themselves to any mutually

advantageous agreement.

For simplicity, we consider exchange economies. We say two agents are of the same

type if they have the same preferences and endowments.

The r-replication of the original economy: There are r times as many agents of each

type in the original economy.

A coalition is a group of agents, and thus it is a subset of n agents.

Deﬁnition 4.2.1 (Blocking Coalition) A group of agents S (a coalition) is said to

block (improve upon) a given allocation x if there is some allocation x

t

such that

(1) it is feasible for S, ie.,

¸

i∈S

x

t

i

¸

i∈S

w

i

,

(2) x

t

i

i

x

i

for all i ∈ S and x

t

k

~

k

x

k

for some k ∈ S .

88

Deﬁnition 4.2.2 (Core) A feasible allocation x is said to be in the core of an economy

if it cannot be improved upon for any coalition.

Remark 4.2.1 Every core allocation is Pareto optimal (coalition by whole people).

Deﬁnition 4.2.3 (Individual Rationality) An allocation x is individually rational if

x

i

i

w

i

for all i = 1, 2, . . . , n.

The individual rationality condition is also called the participation condition which means

that a person will not participate the economic activity if he is worse oﬀ than at the initial

endowment.

Remark 4.2.2 Every core allocation must be individually rational.

Remark 4.2.3 When n = 2, an allocation is in the core if and only if it is Pareto optimal

and individually rational.

Figure 4.1: The set of core allocations are simply given by the set of Pareto eﬃcient and

individually rational allocations when n = 2.

Remark 4.2.4 Even though a Pareto optimal allocation is independent of individual

endowments, a core allocation depends on individual endowments.

What is the relationship between core allocations and competitive equilibrium alloca-

tions?

89

Theorem 4.2.1 Under local non-satiation, if (x, p) is a competitive equilibrium, then x

is a core allocation.

Proof: Suppose x is not a core allocation. Then there is a coalition S and a feasible

allocation x

t

such that

¸

i∈S

x

t

i

¸

i∈S

w

i

(4.1)

and x

t

i

i

x

i

for all i ∈ S, x

t

k

~

k

x

k

for some k ∈ S. Then, by local non-satiation, we have

px

t

i

px

i

for all i ∈ S and

px

t

k

> px

k

for some k

Therefore, we have

¸

i∈S

px

t

i

>

¸

i∈S

px

i

=

¸

i∈S

w

i

(4.2)

a contradiction. Therefore, the competitive equilibrium must be a core allocation.

The following proposition is a converse of the above proposition and shows that any

allocation that is not a market equilibrium allocation must eventually not be in the r-

core of the economy. This means that core allocations in large economies look just like

Walrasian equilibria.

Theorem 4.2.2 (Shrinking Core Theorem) Suppose

i

are strictly convex, strongly

monotonic, and continuous. Suppose x

∗

is a unique competitive equilibrium allocation.

Then, if y is not a competitive equilibrium, there is some replication V such that y is not

in the V -core.

90

Figure 4.2: The shrinking core. A point like y will eventually not be in the core.

Proof: We want to show that there is a coalition such that the point y can be improved

upon for V -replication. Since y is not a competitive equilibrium, the line segment through

y and w must cut at least one agent’s, say agent A’s, indiﬀerence curve through y. Then,

by strict convexity and continuity of

i

, there are integers V and T with 0 < T < V such

that

g

A

≡

T

V

w

A

+ (1 −

T

V

)y

A

~

A

y

A

.

Form a coalition consisting of V consumers of type A and V − T consumers of type

B. Consider the allocation x = (g

A

, . . . g

A

, y

B

, . . . y

B

)(in which there are V Type A and

V −T Type B). We want to show x is feasible for this coalition.

V g

A

+ (V −T)y

B

= V

¸

T

V

w

A

+

1 −

T

V

+ (V −T)y

B

= Tw

A

+ (V −T)y

A

+ (V −T)y

B

= Tw

A

+ (V −T)(y

A

+y

B

)

= Tw

A

+ (V −T)(w

A

+w

B

)

= V w

A

+ (V −T)w

B

by noting y

A

+ y

B

= w

A

+ w

B

. Thus, x is feasible in the coalition and g

A

~

A

y

A

for

all agents in type A and y

B

∼

B

y

B

for all agents in type B which means y is not in the

V -core for the V -replication of the economy. The proof is completed.

91

Remark 4.2.5 The shrinking core theorem then shows that the only allocations that are

in the core of a large economy are market equilibrium allocations, and thus Walrasian

equilibria are robust: even very weak equilibrium concepts, like that of core, tend to yield

allocations that are close to Walrasian equilibria for larger economies. Thus, this theorem

shows the essential importance of competition and fully economic freedom.

Remark 4.2.6 Many of the restrictive assumptions in this proposition can be relaxed

such as strict monotonicity, convexity, uniqueness of competitive equilibrium, and two

types of agents.

From the above discussion, we have the following limit theorem.

Theorem 4.2.3 (Limit Theorem on the Core) Under the strict convexity, strict mono-

tonicity and continuity, the core of a replicated two person economy shrinks when the

number of agents for each type increases, and the core coincides with the competitive

equilibrium allocation if the number of agents goes to inﬁnity.

This result means that any allocation which is not a competitive equilibrium allocation

is not in the core for some r-replication.

4.3 Fairness of Allocation

Pareto eﬃciency gives a criterion of how the goods are allocated eﬃciently, but it may be

too weak a criterion to be meaningful. It does not address any questions about income

distribution, and does not give any “equity” implication. Fairness is a notion that may

overcome this diﬃculty. This is one way to restrict the whole set of Pareto eﬃcient

outcomes to a small set of Pareto eﬃcient outcomes that satisfy the other properties.

What is the equitable allocation?

How can we deﬁne the notion of equitable allocation?

Deﬁnition 4.3.1 (Envy) An agent i is said to envy agent k if agent i prefers agent k’s

consumption. i.e., x

k

~

i

x

i

.

Deﬁnition 4.3.2 An allocation x is equitable if no one envies anyone else, i.e., for each

i ∈ N, x

i

i

x

k

for all k ∈ N.

92

Deﬁnition 4.3.3 (Fairness) An allocation x is said to be fair if it is both Pareto optimal

and equitable.

Figure 4.3: A fair allocation.

Remark 4.3.1 By the deﬁnition, a set of fair allocations is a subset of that of Pareto

eﬃcient allocations. Therefore, fairness restricts the size of Pareto optimal allocations.

The following strict fairness concept is due to Lin Zhou (JET, 1992, 57: 158-175).

An agent i envies a coalition S (i / ∈ S) at an allocation x if ¯ x

S

~

i

x

i

, where ¯ x

S

=

1

[S[

¸

j∈S

x

j

.

Deﬁnition 4.3.4 An allocation x is strictly equitable or strictly envy-free if no one envies

any other coalitions.

Deﬁnition 4.3.5 (Strict Fairness) An allocation x is said to be strictly fair if it is both

Pareto optimal and strictly equitable.

Remark 4.3.2 A set of strictly fair allocation S are a subset of Pareto optimal alloca-

tions.

Remark 4.3.3 For a two person exchange economy, if x is Pareto optimal, it is impossible

for two persons to envy each other.

93

Remark 4.3.4 It is clear every strictly fair allocation is a fair allocation, but the converse

may not be true. However, when n = 2, a fair allocation is a strictly fair allocation.

The following ﬁgure shows that x is Pareto eﬃcient, but not equitable.

Figure 4.4: x is Pareto eﬃcient, but not equitable.

The ﬁgure below shows that x is equitable, but it is not Pareto eﬃcient.

Figure 4.5: x is equitable, but not Pareto eﬃcient.

How to test a fair allocation?

Graphical Procedure for Testing Fairness:

Let us restrict an economy to a two-person economy. An easy way for agent A to

compare his own allocation x

A

with agent B’s allocation x

B

in the Edgeworth Box is to

ﬁnd a point symmetric of x

A

against th center of the Box. That is, draw a line from x

A

to the center of the box and extrapolate it to the other side by the same length to ﬁnd

94

x

t

A

, and then make the comparison. If the indiﬀerence curve through x

A

cuts “below” x

t

A

,

then A envies B. Then we have the following way to test whether an allocation is a fair

allocation:

Step 1: Is it Pareto optimality? If the answer is “yes”, go to step 2; if no,

stop.

Step 2: Construct a reﬂection point (x

B

, x

A

). (Note that

x

A

+x

B

2

is the

center of the Edgeworth box.)

Step 3: Compare x

B

with x

A

for person A to see if x

B

~

A

x

A

and compare

x

A

with x

B

for person B to see if x

A

~

B

x

B

. If the answer is “no” for both

persons, it is a fair allocation.

Figure 4.6: How to test a fair allocation.

We have given some desirable property of “fair” allocation. A question is whether it

exists at all. The following theorem provides one suﬃcient condition to guarantee the

existence of fairness.

Theorem 4.3.1 Let (x

∗

, p

∗

) be a competitive equilibrium. Under local non-satiation, if

all individuals’ income is the same, i.e., p

∗

w

1

= p

∗

w

2

= . . . = p

∗

w

n

, then x

∗

is a strictly

fair allocation.

95

Proof: By local non-satiation, x

∗

is Pareto optimal by the First Fundamental Theorem

of Welfare Economics. We only need to show x

∗

is strictly equitable. Suppose not. There

is i and a coalition S with i ∈ S such that

x

∗

S

≡

1

[S[

¸

k∈S

x

∗

k

~

i

x

∗

i

(4.3)

Then, we have p

∗

x

∗

S

> p

∗

x

∗

i

= p

∗

w

i

. But this contradicts the fact that

p

∗

x

∗

S

=

1

[S[

¸

k∈S

p

∗

x

∗

k

=

1

[S[

¸

k∈S

p

∗

w

k

= p

∗

w

i

(4.4)

by noting that p

∗

w

1

= p

∗

w

2

= . . . = p

∗

w

n

. Therefore, it must be a strictly fair allocation.

Deﬁnition 4.3.6 An allocation x ∈ '

nL

+

is an equal income Walrasian allocation if there

exists a price vector such that

(1) px

i

pw, where w =

1

n

¸

n

k=1

w

k

: average endowment.

(2) x

t

i

~

i

x

i

implies px

t

i

> px

i

(3)

¸

x

i

¸

w

i

Notice that every equal Walrasian allocation x is a competitive equilibrium allocation

with w

i

= w for all i.

Corollary 4.3.1 Under local non-satiation, every equal income Walrasian allocation is

strictly fair allocation.

Remark 4.3.5 An “equal” division of resource itself does not give “fairness,” but trading

from “equal” position will result in “fair” allocation. This “divide-and-choose” recom-

mendation implies that if the center of the box is chosen as the initial endowment point,

the competitive equilibrium allocation is fair. A political implication of this remark is

straightforward. Consumption of equal bundle is not Pareto optimum, if preferences are

diﬀerent. However, an equal division of endowment plus competitive markets result in

fair allocations.

Remark 4.3.6 A competitive equilibrium from an equitable (but not “equal” division)

endowment is not necessarily fair.

96

Remark 4.3.7 Fair allocation are deﬁned without reference to initial endowment. Since

we are dealing with optimality concepts, initial endowments can be redistributed among

agents in a society.

In general, there is no relationship between core and fair allocations. However, when

the social endowments are divided equally among two persons, we have the following

theorem.

Theorem 4.3.2 In a two-person exchange economy, if

i

are convex, and if the total

endowments are equally divided among individuals, then the set of core allocations is a

subset of (strictly) fair allocation.

Proof: We know that a core allocation x is Pareto optimal. We only need to show that x

is equitable. Since x is a core allocation, then x is individually rational (everyone prefers

initial endowments). If x is not equitable, there is some agent i, say, agent A, such that

x

B

~

A

x

A

A

w

A

=

1

2

(w

A

+ w

B

)

=

1

2

(x

A

+ x

B

)

by noting that w

A

= w

B

and x is feasible. Thus, x

A

A

1

2

(x

A

+ x

B

). But, on the other

hand, since

A

is convex, x

B

~

A

x

A

implies that

1

2

(x

A

+ x

B

) ~

A

x

A

, a contradiction.

4.4 Social Choice Theory

4.4.1 Introduction

In this section, we present a vary brief summary and introduction of social choice theory.

We analyze the extent to which individual preferences can be aggregated into social pref-

erences, or more directly into social decisions, in a “satisfactory” manner (in a manner

compatible with the fulﬁlment of a variety of desirable conditions.

As was shown in the discussion of “fairness,” it is diﬃcult to come up with a criterion

(or a constitution) that determines that society’s choice. Social choice theory aims at

constructing such a rule which could be allied with not only Pareto eﬃcient allocations,

but also any alternative that a society faces. We will give some fundamental results of

97

social choice theory: Arrow Impossibility Theorem, which states there does not exist any

non-dictatorial social welfare function satisfying a number of “reasonable” assumptions.

Gibbard-Satterthwaite theorem states that no social choice mechanism exists which is

non-dictatorial and can never be advantageously manipulated by some agents.

4.4.2 Basic Settings

N = ¦1, 2, ...n¦ : the set of individuals;

X = ¦x

1

, x

2

, ...x

m

¦ : (m 3): the set of alternatives (outcomes);

P

i

= (or ~

i

) : strict preference orderings of agent i;

¸

(X) = the class of allowed individual orderings;

P = (P

1

, P

2

, ..., P

n

) : a preference ordering proﬁle;

[

¸

(X)]

n

: the set of all proﬁles of individuals orderings;

S(X) : the class of allowed social orderings.

Arrow’s social welfare function:

F : [

¸

(X)]

n

→ S(X) (4.5)

which is a mapping from individual ordering proﬁles to social orderings.

Gibbard-Satterthwaite’s social choice function (SCF) is a mapping from individual

preference orderings to the alternatives

f : [

¸

(X)]

n

→ X (4.6)

Note that even though individuals’ preference orderings are transitive, a social prefer-

ence ordering may not be transitive. To see this, consider the following example.

Example 4.4.1 (The Condorect Paradox) Suppose a social choice is determined by

the majority voting rule. Does this determine a social welfare function? The answer is in

general no by the well-known Condorect paradox. Consider a society with three agents

and three alternatives: x, y, z. Suppose each person’s preference is given by

x ~

1

y ~

1

z (by person 1)

y ~

2

z ~

2

x (by person 2)

98

z ~

3

x ~

3

y (by person 3)

By the majority rule,

For x and y, xFy (by social preference)

For y and z, yFz (by social preference)

For x and z, zFx (by social preference)

Then, pairwise majority voting tells us that x must be socially preferred to y, y must

be socially preferred to z, and z must be socially preferred to x. This cyclic pattern means

that social preference is not transitive.

The number of preference proﬁles can increase very rapidly with increase of number

of alternatives.

Example 4.4.2 X = ¦x, y, z¦, n = 3

x ~ y ~ z

x ~ z ~ y

y ~ x ~ z

y ~ z ~ x

z ~ x ~ y

z ~ y ~ x

Thus, there are six possible individual orderings, i.e., [

¸

(X)[ = 6, and therefore there

are [

¸

(X)[

3

= 6

3

= 216 possible combinations of 3-individual preference orderings on

three alternatives. The social welfare function is a mapping from each of these 216 entries

(cases) to one particular social ordering (among six possible social orderings of three

alternatives). The social choice function is a mapping from each of these 216 cases to one

particular choice (among three alternatives). A question we will investigate is what kinds

of desirable conditions should be imposed on these social welfare or choice functions.

You may think of a hypothetical case that you are sending a letter of listing your

preference orderings, P

i

, on announced national projects (alternatives), such as reducing

deﬁcits, expanding the medical program, reducing society security program, increasing

national defence budget, to your Congressional representative. The Congress convenes

with a hug stake of letters P and try to come up with national priorities F(P). You want

the Congress to make a certain rule (the Constitution) to form national priorities out of

individual preference orderings. This is a question addressed in social choice theory.

99

4.4.3 Arrow’s Impossibility Theorem

Deﬁnition 4.4.1 Unrestricted Domain (UD): A class of allowed individual orderings

¸

(X) consists of all possible orderings deﬁned on X.

Deﬁnition 4.4.2 Pareto Principle (P): if for x, y ∈ X, xP

i

y for all i ∈ N, then xF(P)y

(social preferences).

Deﬁnition 4.4.3 Independence of Irrelevant Alternatives (IIA): For x, y, ∈ X, P, P

t

∈

[Σ(X)]

n

“xP

i

y if and only if xP

t

i

y for all i ∈ N” implies that xF(P)y if and only if

xF(P

t

)y.

Remark 4.4.1 IIA means that the ranking between x and y for any agent is equivalent

in terms of P and P

t

implies that the social ranking between x and y by F(P) and F(P

t

)

is the same. IN other words, if two diﬀerent preference proﬁles that are the same on x

and y, the social order must also the same on x and y.

Remark 4.4.2 By IIA, any change in preference ordering other than the ordering of x

and y should not aﬀect social ordering between x and y.

Example 4.4.3 Suppose x P

i

y P

i

z and x P

t

i

z P

t

i

y.

By IIA, if xF(P)y, then xF(P

t

)y.

Deﬁnition 4.4.4 (Dictator) There is some agent i ∈ N such that F(P) = P

i

for all

P ∈ [Σ(X)]

n

, and agent i is called a dictator.

Theorem 4.4.1 (Arrow’s Impossibilities Theorem) Any social welfare function that

satisﬁes m 3, UD, P, IIA conditions is dictatorial.

The proof of Arrow’s Impossibility Theorem is very complicated, and the readers who

are interested in the proof are referred to Mas-Colell, Whinston, and Green (1995).

The impact of the Arrow possibility theorem has been quite substantial. Obviously,

Arrow’s impossibility result is a disappointment. The most pessimistic reaction to it is

to conclude that there is just no acceptable way to aggregate individual preferences, and

hence no theoretical basis for treating welfare issues. A more moderate reaction, however,

is to examine each of the assumptions of the theorem to see which might be given up.

Conditions imposed on social welfare functions may be too restrictive. Indeed, when some

conditions are relaxed, then the results could be positive, e.g., UD is usually relaxed.

100

4.4.4 Some Positive Result: Restricted Domain

When some of the assumptions imposed in Arrow’s impossibility theorem is removed, the

result may be positive. For instance, if alternatives have certain characteristics which

could be placed in a spectrum, preferences may show some patterns and may not exhaust

all possibilities orderings on X, thus violating (UD). In the following, we consider the case

of restricted domain. A famous example is a class of “single-peaked” preferences. We

show that under the assumption of single-peaked preferences, non-dictatorial aggregation

is possible.

Deﬁnition 4.4.5 A binary relation ≥ on X is a linear order if ≥ is reﬂexive (x ≥ x),

transitive (x ≥ y ≥ z implies x ≥ z), and total (for distinct x, y ∈ X, either x ≥ y or

y ≥ x, but not both).

Example: X = ' and x y.

Deﬁnition 4.4.6

i

is said to be single-peaked with respect to the linear order ≥ on X,

if there is an alternative x ∈ X such that

i

is increasing with respect to ≥ on the lower

contour set L(x) = ¦y ∈ X : y ≤ x¦ and decreasing with respect to ≥ on the upper

contour set U(x) = ¦y ∈ X : y ≥ x¦. That is,

(1) x ≥ z > y implies z ~

i

y

(2) y > z ≥ x implies z ~

i

y

In words, there is an alternative that represents a peak of satisfaction and, moreover,

satisfaction increases as we approach this peak so that, in particular, there cannot be any

other peak of satisfaction.

101

Figure 4.7: u in the left ﬁgure is single-peaked, u in the right ﬁgure is not single-peaked.

Given a proﬁle of preference (

1

, . . . ,

n

), let x

i

be the maximal alternative for

i

(we will say that x

i

is “individual i’s peak”).

Deﬁnition 4.4.7 Agent h ∈ N is a median agent for the proﬁle (

1

, . . . ,

n

) if #¦i ∈

N : x

i

≥ x

h

¦ ≥

I

2

and #¦i ∈ N : x

h

≥ x

i

¦ ≥

I

2

.

Figure 4.8: Five Agents who have single-peaked preferences.

Proposition 4.4.1 Suppose that ≥ is a linear order on X,

i

is single-peaked. Let h ∈ N

be a median agent, then the majority rule

˜

F() is aggregatable:

x

h

˜

F()y∀y ∈ X.

102

That is, the peak x

h

of the median agent is socially optimal ( cannot be defeated by any

other alternative) by majority voting. Any alternative having this property is called a

Condorect winner. Therefore, a Condorect winner exists whenever the preferences of all

agents are single-peaked with respect to the same linear order.

Proof. Take any y ∈ X and suppose that x

h

> y (the argument is the same for

y > x

h

). We need to show that

#¦i ∈ N : x

h

~

i

y¦ ≥ #¦i ∈ N : y ~

i

x

h

¦.

Consider the set of agents S ⊂ N that have peaks larger than or equal to x

h

, that is,

S = ¦i ∈ N : x

i

≥ x

h

¦. Then x

i

≥ x

h

> y for every i ∈ S. Hence, by single-peakness of

i

with respect to ≥, we get x

h

~

i

y for every i ∈ S. On the other hand, because agent

h is a median agent, we have that #S ≥ n/2 and so #¦i ∈ N : y ~

i

x

h

¦ #(N ` S)

n/2 #S #¦i ∈ N : x

h

~

i

y¦.

4.4.5 Gibbard-Satterthwaite Impossibility Theorem

Deﬁnition 4.4.8 A social choice function (SCF) is manipulable at P ∈ [Σ(X)]

n

if there

exists P

t

i

∈ Σ(X) such that

f(P

−i

, P

t

i

) P

i

f(P

−i

, P

i

) (4.7)

where P

−i

= (P

1

, . . . , P

i−1

, P

i+1

, . . . , P

n

).

Deﬁnition 4.4.9 A SCF is strongly individually incentive compatible (SIIC) if there

exists no preference ordering proﬁle at which it is manipulable. In other words, the truth

telling is a dominant strategy equilibrium:

f(P

t

−i

, P

i

)P

i

f(P

t

i

, P

t

i

) for all P

t

∈ [Σ(X)]

n

(4.8)

Deﬁnition 4.4.10 A SCF is dictatorial if there exists an agent whose optimal choice is

the social optimal.

Theorem 4.4.2 (Gibbard-Satterthwaite Theorem) If X has at least 3 alternatives,

a SCF which is SIIC and UD is dictatorial.

Again, the proof of Gibbard-Satterthwaite’s Impossibility Theorem is very compli-

cated, and the readers who are interested in the proof are referred to Mas-Colell, Whin-

ston, and Green (1995).

103

Reference

Arrow, K and G. Debreu, “Existence of Equilibrium for a Competitive Economy,” Econo-

metrica, 1954, 22.

Arrow, K. J. and Hahn, F. H. (1971), General Competitive Analysis, (San Francisco,

Holden Day).

Debreu, G., Theory of Value, (Wiley, New York), 1959.

Debreu, G. and H. Scarf, “A Limit Theorem on the Core of an Economy,” International

Economic Review, 4 (1963), 235-246.

Gibbard, A., “Manipulation of Voting Schemes,” Econometrica, 41 (1973), 587-601.

Jehle, G. A., and P. Reny, Advanced Microeconomic Theory, Addison-Wesley, 1998,

Chapters 7-8.

Luenberger, D. Microeconomic Theory, McGraw-Hill, Inc, 1995, Chapter 10.

Mas-Colell, A., M. D. Whinston, and J. Green, Microeconomic Theory, Oxford Univer-

sity Press, 1995, Chapters 18.

Rawls, J., A Theory of Justice, Cambridge: Harvard University Press, 1971.

Satterthwaite, M. A., “Strategy-Proofness and Arrow’s Existence and Correspondences

for Voting Procedures and Social Welfare Functions,” Journal of Economic Theory,

10 (1975), 187-217.

Tian, G., “On the Constrained Walrasian and Lindahl Correspondences,” Economics

Letters, 26 (1988), pp. 299-303.

Varian, H.R., Microeconomic Analysis, W.W. Norton and Company, Third Edition,

1992, Chapters 21.

Zhou, L., “Strictly Fair Allocations in Large Exchange Economies,” Journal of Economic

Theory, 57 (1992), 158-175

104

Part II

Externalities and Public Goods

105

In Chapters 2 and 3, we have introduced the notions of competitive equilibrium and

Pareto optimality, respectively. The concept of competitive equilibrium provides us with

an appropriate notion of market equilibrium for competitive market economies. The

concept of Pareto optimality oﬀers a minimal and uncontroversial test that any social

optimal economic outcome should pass since it is a formulation of the idea that there

is further improvement in society, and it conveniently separates the issue of economic

eﬃciency from more controversial (and political) questions regarding the ideal distribution

of well-being across individuals.

The important results and insights we obtained in these chapters are the First and

Second Fundamental Theorems of Welfare Economics. The ﬁrst welfare theorem provides

a set of conditions under which we can be assured that a market economy will achieve

a Pareto optimal; it is, in a sense, the formal expression of Adam Smith’s claim about

the “invisible hand” of the market. The second welfare theorem goes even further. It

states that under the same set of conditions as the ﬁrst welfare theorem plus convexity

and continuity conditions, all Pareto optimal outcomes can in principle be implemented

through the market mechanism by appropriately redistributing wealth and then “letting

the market work.”

Thus, in an important sense, the general equilibrium theory establishes the perfectly

competitive case as a benchmark for thinking about outcomes in market economies. In

particular, any ineﬃciency that arise in a market economy, and hence any role for Pareto-

improving market intervention, must be traceable to a violation of at least one of these

assumptions of the ﬁrst welfare theorem. The remainder of this course, can be viewed as

a development of this theme, and will study a number of ways in which actual markets

may depart from this perfectly competitive ideal and where, as a result, market equilibria

fail to be Pareto optimal, a situation known market failure.

In the current part, we will study externalities and public goods in Chapter 5 and

Chapter 6, respectively. In both cases, the actions of one agent directly aﬀect the utility

or production of other agents in the economy. We will see these nonmarketed “goods”

or “bads” lead to a non-Pareto optimal outcome in general; thus a market failure. It

turns out that private markets are often not a very good mechanism in the presence of

externalities and public goods. We will consider situations of incomplete information

106

which also result in non-Pareto optimal outcomes in general in Part III.

107

Chapter 5

Externalities

5.1 Introduction

In this chapter we deal with the case of externalities so that a market equilibrium may

lead to non-Pareto eﬃcient allocations in general, and thus there is a market failure. The

reason is that there are things that people care about are not priced. Externality can

happen in both cases of consumption and production.

Consumption Externality:

u

i

(x

i

) : without preference externality

u

i

(x

1

, ..., x

n

) : with preference externality

in which other individuals’s consumption enters the person’s utility function.

Example 5.1.1 (i) One person’s quiet environment is disturbed by another

person’s local stereo.

(ii) Mr. A hates Mr. D smoking next to him.

(ii) Mr. A’s satisfaction decreases as Mr. C’s consumption level increases,

because Mr. A envies Mr. C’s lifestyle.

Production Externality:

A ﬁrm’s production includes arguments other than its own inputs.

108

For example, downstream ﬁshing is adversely aﬀected by pollutants emitted from an

upstream chemical plant.

This leads to an examination of various suggestions for alternative ways to allocate

resources that may lead to eﬃcient outcomes. Achieving an eﬃcient allocation in the

presence of externalities essentially involves making sure that agents face the correct

prices for their actions. Ways of solving externality problem include taxation, regulation,

property rights, merges, etc.

5.2 Consumption Externalities

When there are no consumption externalities, agent i’s utility function is a function of

only his own consumption:

u

i

(x

i

) (5.1)

In this case, the ﬁrst order conditions for the competitive equilibrium are given by

MRS

A

xy

= MRS

B

xy

=

p

x

p

y

and the ﬁrst order conditions for Pareto eﬃciency are given by:

MRS

A

xy

= MRS

B

xy

.

So, every competitive equilibrium implies Pareto eﬃciency if utility functions are quasi-

concave.

The main purpose of this section is to show that a competitive equilibrium allocation

is not in general Pareto eﬃcient when there exists an externality in consumption. We

show this by examining that the ﬁrst order conditions for a competitive equilibrium is

not in general the same as the ﬁrst order conditions for Pareto eﬃcient allocations in the

presence of consumption externalities.

Consider the following simple two-person and two-good exchange economy.

u

A

(x

A

, x

B

, y

A

) (5.2)

u

B

(x

A

, x

B

, y

B

) (5.3)

109

which are assumed to be strictly increasing, quasi-concave, and satisﬁes the Inada condi-

tion

∂u

∂x

i

(0) = +∞ and lim

x

i

→0

∂u

∂x

i

x

i

= 0 so it results in interior solutions. Here good x

results in consumption externalities.

The ﬁrst order conditions for the competitive equilibrium are the same as before:

MRS

A

xy

=

p

x

p

y

= MRS

B

xy

.

To ﬁnd the ﬁrst order conditions for Pareto eﬃcient allocations, we now solve the

following problem

max

(x,y)

a

A

u

A

(x

A

, x

B

, y

A

) + a

B

u

B

(x

A

, x

B

, y

B

) (5.4)

s.t. x

A

+ x

B

= ˆ w

x

(5.5)

y

A

+ y

B

= ˆ w

y

(5.6)

Deﬁne

L = a

A

u

A

(x

A

, x

B

, y

B

) + a

B

u

B

(x

A

, x

B

, y

B

) + λ( ˆ w

x

−x

A

−x

B

) + µ( ˆ w

y

−y

A

−y

B

) (5.7)

The ﬁrst order conditions for interior solutions are:

x

A

: a

A

∂u

A

∂x

A

+ a

B

∂u

B

∂x

A

−λ = 0 (5.8)

x

B

: a

A

∂u

B

∂x

A

+ a

B

∂u

B

∂x

B

−λ = 0 (5.9)

y

A

: a

A

∂u

A

∂y

A

−µ = 0 (5.10)

y

B

: a

B

∂u

B

∂x

B

−µ = 0 (5.11)

Substituting (5.10) and (5.11) into (5.8) and (5.9), we have

∂u

A

∂x

A

∂u

A

∂y

A

+

∂u

B

∂x

A

∂u

B

∂y

B

=

λ

µ

(5.12)

∂u

A

∂x

B

∂u

A

∂y

A

+

∂u

B

∂x

B

∂u

B

∂y

B

=

λ

µ

(5.13)

and thus

∂u

A

∂x

A

∂u

A

∂y

A

+

∂u

B

∂x

A

∂u

B

∂y

B

=

∂u

A

∂x

B

∂u

A

∂y

A

+

∂u

B

∂x

B

∂u

B

∂y

B

(5.14)

That is,

MRS

A

x

A

y

A

−MRS

A

x

B

y

A

= MRS

B

x

B

y

B

−MRS

B

x

A

y

B

. (5.15)

110

which is diﬀerent from the ﬁrst order conditions for competitive equilibrium: MRS

A

x

B

y

A

=

MRS

B

x

B

y

B

. So the competitive equilibrium allocations may not be Pareto optimal because

the ﬁrst order conditions’ for competitive equilibrium and Pareto optimality are not the

same.

5.3 Production Externality

We now show that allocation of resources may not be eﬃcient also for the case of exter-

nality in production. To show this, consider a simple economy with two ﬁrms. Firm 1

produces an output x which will be sold in a competitive market. However, production

of x imposes an externality cost denoted by e(x) to ﬁrm 2, which is assumed to be convex

and strictly increasing.

Let y be the output produced by ﬁrm 2, which is sold in competitive market.

Let c

x

(x) and c

y

(y) be the cost functions of ﬁrms 1 and 2 which are both convex and

strictly increasing.

The proﬁts of the two ﬁrms:

π

1

= p

x

x −c

x

(x) (5.16)

π

2

= p

y

y −c

y

(y) −e(x) (5.17)

where p

x

and p

y

are the prices of x and y, respectively. Then, by the ﬁrst order conditions,

we have for positive amounts of outputs:

p

x

= c

t

x

(x) (5.18)

p

y

= c

t

y

(y) (5.19)

However, the proﬁt maximizing output x

c

from the ﬁrst order condition is too large from

a social point of view. The ﬁrst ﬁrm only takes account of the private cost – the cost

that is imposed on itself– but it ignores the social cost – the private cost plus the cost it

imposes on the other ﬁrm.

What’s the social eﬃcient output?

The social proﬁt, π

1

+π

2

is not maximized at x

c

and y

c

which satisfy (5.18) and (5.19).

If the two ﬁrms merged so as to internalize the externality

max

x,y

p

x

x + p

y

y −c

x

(x) −e(x) −c

y

(y) (5.20)

111

which gives the ﬁrst order conditions:

p

x

= c

t

x

(x

∗

) + e

t

(x

∗

)

p

y

= c

t

y

(y

∗

)

where x

∗

is an eﬃcient amount of output; it is characterized by price being equal to the

social cost. Thus, production of x

∗

is less than the competitive output in the externality

case by the convexity of e(x) and c

x

(x).

Figure 5.1: The eﬃcient output x

∗

is less than the competitive output x

c

.

5.4 Solutions to Externalities

From the above discussion, we know that a competitive market in general may not result

in Pareto eﬃcient outcome, and one needs to seek some other alternative mechanisms to

solve the market failure problem. In this section, we now introduce some remedies to this

market failure of externality such as:

1. Pigovian taxes

2. Voluntary negotiation (Coase Approach)

3. Compensatory tax/subsidy

112

4. Creating a missing markets with property rights

5. Direct intervention

6. Merges

7. Incentives mechanism design

Any of the above solution may result in Pareto eﬃcient outcomes, but may lead to diﬀerent

income distributions. Also, it is important to know what kind of information are required

to implement a solution listed above.

Most of the above proposed solutions need to make the following assumptions:

1. The source and degree of the externality is identiﬁable.

2. The recipients of the externality is identiﬁable.

3. The causal relationship of the externality can be established objectively.

4. The cost of preventing (by diﬀerent methods) an externality are perfectly

known to everyone.

5. The cost of implementing taxes and subsides is negligible.

6. The cost of voluntary negotiation is negligible.

5.4.1 Pigovian Tax

Set a tax rate, t, such that t = e

t

(x

∗

). This tax rate to ﬁrm 1 would internalize the

externality.

π

1

= p

x

x −c

x

(x) −t x (5.21)

The ﬁrst order condition is:

p

x

= c

t

x

(x) + t = c

t

x

(x) + e

t

(x

∗

), (5.22)

which is the same as the one for social optimality. That is, when ﬁrm 1 faces the wrong

price of its action, and a correction tax t = e

t

(x

∗

) should be imposed that will lead to

a social optimal outcome that is less that of competitive equilibrium outcome. Such

correction taxes are called Pigovian taxes.

The problem with this solution is that it requires that the taxing authority knows the

externality cost e(x). But, how does the authority know the externality and how do they

113

estimate the value of externality in real world? If the authority knows this information, it

might as well just tell the ﬁrm how much to produce in the ﬁrst place. So, in most case,

it will not work well.

5.4.2 Coase Voluntary Negotiation

Coase made an observation that in the presence of externalities, the victim has an incentive

to pay the ﬁrm to stop the production if the victim can compensate the ﬁrm by paying

p

x

−c

t

x

(x

∗

).

Remark 5.4.1 Both the Pigovian tax solution and the Coase voluntary negotiation is

equivalent in the sense that it achieves Pareto eﬃcient allocation. But, they are diﬀerent

in resulting the income distribution.

Property Rights Responses

To solve the externality problem, Nobel laureate Ronald Coase in a famous article in

1960 argues that government should simply rearrange property rights with appropriately

designed property rights. Market then could take care of externalities without direct

government intervention.

Example 5.4.1 Two ﬁrms: One is chemical factory that discharges chemicals into a river

and the other is the ﬁsherman. Suppose the river can produce a value of $50,000. If the

chemicals pollute the river, the ﬁsh cannot be eaten. How does one solve the externality?

Coase’s method states that as long as the property rights of the river are clearly assigned,

it results in eﬃcient outcomes. That is, the government should give the ownership of the

lake either to the chemical ﬁrm or to the ﬁsherman, then it will yield an eﬃcient output.

To see this, assume that:

The cost of the ﬁlter is denoted by c

f

.

Case 1: The lake is given to the factory.

i) c

f

< $50, 000. The ﬁsherman is willing to buy a ﬁlter for the factory. The

ﬁsherman will pay for the ﬁlter so that the chemical cannot pollute the

lake.

ii) c

f

> $50, 000 – The chemical is discharged into the lake. The ﬁsherman

does not want to install any ﬁlter.

114

Case 2: The lake is given to the ﬁsherman, and the ﬁrm’s net product revenue is grater

than c

f

.

i) c

f

< $50, 000 – The factory buys the ﬁlter so that the chemical cannot

pollute the lake.

ii) c

f

> $50, 000 – The ﬁrm pays $50,000 to the ﬁsherman then the chemical

is discharged into the lake.

More generally, let b(y) be the beneﬁt that the polluter draws from a level of pollutant

production y and c(y) the cost thus imposed on the pollutee. When b is concave and c

increasing and convex, the optimal pollution level is given

b

t

(y

∗

) = c

t

(y

∗

).

Suppose that the status quo y

0

corresponds to a situation where b

t

(y

0

) < c

t

(y

0

), and thus

the pollution level is too high. Then the polluter and the pollutee have an interest in

negotiating. Let be a small positive number, and assume that the polluter proposes

to lower the pollution level to (y

0

− ) against a payment of t, where t is comprised

between b

t

(y

0

) and c

t

(y

0

). Since t > b

t

(y

0

), this oﬀer raises the polluter’s proﬁt; and it is

equally beneﬁcial for the pollutee, since t < c

t

(y

0

). Therefore, the two parties will agree

to move to a slightly lower pollution level. The reasoning does not stop here: so long

as b

t

(y

o

) < c

t

(y

0

), it is possible to lower the pollution level against a well-chosen transfer

from pollutee to polluter. The end result is the optimal pollution level. A very similar

argument applies in the case where b

t

(y

0

) > c

t

(y

0

).

The formal statement of Coase Theorem thus can be set forth as follows:

Theorem 5.4.1 (Coase Theorem) When the transaction cost is negligible and there is

no income eﬀect, no matter how the property rights are assigned, the resulting outcomes

are eﬃcient.

The problem of this Coase theorem is that, costs of negotiation and organization, in

general, are not negligible, and the income eﬀect may not be zero. In fact, Hurwicz (Japan

and the World Economy 7, 1995, pp. 49-74) has proved that, even when the transition

cost is zero, absence of income eﬀects is not only suﬃcient (which is well known) but also

necessary for Coase Theorem to be true. Thus, a privatization is optimal only in case of

zero transaction cost and no income eﬀect.

115

5.4.3 Missing Market

We can regard externality as a lack of a market for an “externality.” For the above

example in Pigovian taxes, a missing market is a market for pollution. Adding a market

for ﬁrm 2 to express its demand for pollution - or for a reduction of pollution - will provide

a mechanism for eﬃcient allocations. By adding this market, ﬁrm 1 can decide how much

pollution it wants to sell, and ﬁrm 2 can decide how much pollution it wants to buy.

Let r be the price of pollution.

x

1

= the units of pollution that ﬁrm 1 wants to sell;

x

2

= the units of pollution for ﬁrm 2 wants to buy.

Normalize the output of ﬁrm 1 to x

1

.

The proﬁt maximization problems become:

π

1

= p

x

x

1

+ rx

1

−c

1

(x

1

)

π

2

= p

y

y −rx

2

−e

2

(x

2

) −c

y

(y)

The ﬁrst order conditions are:

p

x

+ r = c

t

1

(x

1

) for Firm 1

p

y

= c

t

y

(y) for Firm 2

−r = e

t

(x

2

) for Firm 2.

At the market equilibrium, x

∗

1

= x

∗

2

= x

∗

, we have

p

x

= c

t

1

(x

∗

) + e

t

(x

∗

) (5.23)

which results in a social optimal outcome.

5.4.4 The Compensation Mechanism

The Pigovian taxes were not adequate in general to solve externalities due to the informa-

tion problem: the tax authority cannot know the cost imposed by the externality. How

can one solve this incomplete information problem?

116

Varian (AER 1994) proposed an incentive mechanism which encourages the ﬁrms to

correctly reveal the costs they impose on the other. Here, we discuss this mechanism. In

brief, a mechanism consists of a message space and an outcome function (rules of game).

We will introduce in detail the mechanism design theory in Part III.

Strategy Space (Message Space): M = M

1

M

2

with M

1

= ¦(t

1

, x

1

)¦, where t

1

is

interpreted as a Pigovian tax proposed by ﬁrm 1 and x

1

is the proposed level of output by

ﬁrm 1, and t

2

is interpreted as a Pigovian tax proposed by ﬁrm 2 and y

2

is the proposed

level of output by ﬁrm 2.

The mechanism has two stages:

Stage 1: (Announcement stage): Firms 1 and 2 name Pigovian tax rates, t

i

, i = 1, 2,

which may or may not be the eﬃcient level of such a tax rate.

Stage 2: (Choice stage): If ﬁrm 1 produces x units of pollution, ﬁrm 1 must pay t

2

x

to ﬁrm 2. Thus, each ﬁrm takes the tax rate as given. Firm 2 receives t

1

x units as

compensation. Each ﬁrm pays a penalty, (t

1

−t

2

)

2

, if they announce diﬀerent tax rates.

Thus, the payoﬀs of two ﬁrms are:

π

∗

1

= max

x

p

x

x −c

x

(x) −t

2

x −(t

1

−t

2

)

2

π

∗

2

= max

y

p

y

y −c

y

(y) + t

1

x −e(x) −(t

1

−t

2

)

2

.

Because this is a two-stage game, we may use the subgame perfect equilibrium, i.e., an

equilibrium in which each ﬁrm takes into account the repercussions of its ﬁrst-stage choice

on the outcomes in the second stage. As usual, we solve this game by looking at stage 2

ﬁrst.

At stage 2, ﬁrm 1 will choose x(t

2

) to satisfy the ﬁrst order condition:

p

x

−c

t

x

(x) −t

2

= 0 (5.24)

Note that, by the convexity of c

x

, i.e., c

tt

x

(x) > 0, we have

x

t

(t

2

) = −

1

c

tt

x

(x)

< 0. (5.25)

Firm 2 will choose y to satisfy p

y

= c

t

y

(y).

Stage 1: Each ﬁrm will choose the tax rate t

1

and t

2

to maximize their payoﬀs.

For Firm 1,

max

t

1

p

x

x −c

x

(x) −t

2

x(t

2

) −(t

1

−t

2

)

2

(5.26)

117

which gives us the ﬁrst order condition:

2(t

1

−t

2

) = 0

so the optimal solution is

t

∗

1

= t

2

. (5.27)

For Firm 2,

max

t

2

p

y

y −c

y

(y) + t

1

x(t

2

) −e(x(t

2

)) −(t

1

−t

2

)

2

(5.28)

so that the ﬁrst order condition is

t

1

x

t

(t

2

) −e

t

(x(t

2

))x

t

(t

2

) + 2(t

1

−t

2

) = 0

and thus

[t

1

−e

t

(x(t

2

))]x

t

(t

2

) + 2(t

1

−t

2

) = 0. (5.29)

By (5.25),(5.27) and (5.29), we have

t

∗

= e

t

(x(t

∗

)) with t

∗

= t

∗

1

= t

∗

2

. (5.30)

Substituting the equilibrium tax rate, t

∗

= e

t

(x(t

∗

)), into (??) we have

p

x

= c

t

x

(x

∗

) + e

t

(x

∗

) (5.31)

which is the condition for social eﬃciency of production.

Remark 5.4.2 This mechanism works by setting opposing incentives for two agents.

Firm 1 always has an incentive to match the announcement of ﬁrm 2. But consider ﬁrm

2’s incentive. If ﬁrm 2 thinks that ﬁrm 1 will propose a large compensation rate t

1

for

him, he wants ﬁrm 1 to be taxed as little as possible so that ﬁrm 1 will produce as much

as possible. On the other hand, if ﬁrm 2 thinks ﬁrm 1 will propose a small t

1

, it wants

ﬁrm 1 to be taxed as much as possible. Thus, the only point where ﬁrm 2 is indiﬀerent

about the level of production of ﬁrm 1 is where ﬁrm 2 is exactly compensated for the cost

of the externality.

In general, the individual’s objective is diﬀerent from the social goal. However, we may

be able to construct an appropriated mechanism so that the individual’s proﬁt maximizing

118

goal is consistent with the social goal such as eﬃcient allocations. Tian (2003a) also gave

the solution to the consumption externalities by giving the incentive mechanism that

results in Pareto eﬃcient allocations. Tian (2003b) study the informational eﬃciency

problem of the mechanisms that results in Pareto eﬃcient allocations for consumption

externalities.

Reference

Aivazian, V. A., and J. L. Callen, “The Coase Theorem and the Empty Core,” Journal

of Law and Economics, 24 (1981), 175-181.

Chipman, J. S., “A Close Look to the Coase Theorem,” in The Economists’ Vision:

Essays in Modern Economic Perspectives, eds. by James and Buchanan and Bettina

Monissen, Frankfur/Mmain: Campus Verlag, 1998, 131-162.

Coase, R., “The Problem of Social Cost,” Journal of Law and Economics, 3 (1960), 1

44.

Hurwicz, L., “What is the Coase Theorem,” Japan and the World Economy, 7 (1995),

49-74.

Laﬀont, J.-J., Fundamentals of Public Economics, Cambridge, MIT Press, 1988.

Luenberger, D. Microeconomic Theory, McGraw-Hill, Inc, 1995, Chapter 9.

Mas-Colell, A., M. D. Whinston, and J. Green, Microeconomic, Oxford University Press,

1995, Chapter 11.

Pigou, A., A study of Public Finance, New York: Macmillan, 1928.

Salanie, B., Microeconomics of Market Failures, MIT Press, 2000, Chapter 6.

Tian, G. “Property Rights and the Nature of Chinese Collective Enterprises,” Journal

of Comparative Economics, 28 (2000), 247-268.

Tian, G. “A Theory of Ownership Arrangements and Smooth Transition To A Free

Market Economy,” Journal of Institutional and Theoretical Economics, 157 (2001),

119

380-412. (The Chinese version published in China Economic Quarterly, 1 (2001),

45-70.)

Tian, G., “A Solution to the Problem of Consumption Externalities,” Journal of Math-

ematical Economics, 2003, in press.

Tian, G., “A Unique Informationally Eﬃcient Allocation Mechanism in Economies with

Consumption Externalities,” International Economic Review, 2004, in press.

Varian, H.R., Microeconomic Analysis, W.W. Norton and Company, Third Edition,

1992, Chapters 24.

Varian, “A Solution to the Problem of Externalities when Agents Are Well Informed,”

American Economic Review, 84 (1994), 1278 1293.

120

Chapter 6

Public Goods

6.1 Introduction

A public good is a special case of externalities. A pure public good is a good in which

consuming one unit of the good by an individual in no way prevents others from consuming

the same unit of the good. Thus, the good is nonexcludable and non-rival.

A good is excludable if people can be excluded from consuming it. A good is non-rival

if one person’s consumption does not reduce the amount available to other consumers.

Examples of Public Goods: street lights, policemen, ﬁre protection, highway system,

national defence, ﬂood-control project, public television and radio broadcast, public parks,

and a public project.

Local Public Goods: when there is a location restriction for the service of a public

good.

Even if the competitive market is an eﬃcient social institution for allocating private

goods in an eﬃcient manner, it turns out that a private market is not a very good

mechanism for allocating public goods.

6.2 Notations and Basic Settings

In a general setting of public goods economy that includes consumers, producers, private

goods, and public goods.

Let

121

n: the number of consumers.

L: the number of private goods.

K: the number of public goods.

Z

i

⊆ '

L

+

'

K

+

: the consumption space of consumer i.

Z ⊆ '

nL

+

'

K

+

: consumption space.

x

i

∈ '

L

+

: a consumption of private goods by consumer i.

y ∈ '

K

+

: a consumption/production of public goods.

w

i

∈ '

L

+

: the initial endowment of private goods for consumer i. For simplicity,

it is assumed that there is no public goods endowment, but they can be

produced from private goods by a ﬁrm.

v ∈ '

L

+

: the private goods input. For simplicity, assume there is only one ﬁrm

to produce the public goods.

f: '

L

+

→ '

K

+

: production function with y = f(x).

θ

i

: the proﬁt share of consumer i from the production.

(x

i

, y) ∈ Z

i

.

(x, y) = (x

i

, ..., x

n

, y) ∈ Z: an allocation.

i

(or u

i

if exists) is a preference ordering.

e

i

= (Z

i

,

i

, w

i

, θ

i

): the characteristic of consumer i.

An allocation z ≡ (x, y) is feasible if

n

¸

i=1

x

i

+ v

n

¸

i=1

w

i

(6.1)

and

y = f(v) (6.2)

e = (e

1

, ..., e

n

, f): a public goods economy.

An allocation (x, y) is Pareto eﬃcient for a public goods economy e if it is feasible and

there is no other feasible allocation (x

t

, y

t

) such that (x

t

i

, y

t

)

i

(x

i

, y) for all consumers i

and (x

t

k

, y

t

) ~

k

(x

k

, y) for some k.

122

An allocation (x, y) is weakly Pareto eﬃcient for the public goods economy e if it is

feasible and there is no other feasible allocation (x

t

, y

t

) such that (x

t

i

, y

t

) ~

i

(x

i

, y) for all

consumers i.

Remark 6.2.1 Unlike private goods economies, even though under the assumptions of

continuity and strict monotonicity, a weakly Pareto eﬃcient allocation may not be Pareto

eﬃcient for the public goods economies. The following proposition is due to Tian (Eco-

nomics Letters, 1988).

Proposition 6.2.1 For the public goods economies, a weakly Pareto eﬃcient allocation

may not be Pareto eﬃcient even if preferences satisfy strict monotonicity and continuity.

Proof: The proof is by way of an example. Consider an economy with (n, L, K) =

(3, 1, 1), constant returns in producing y from x (the input-output coeﬃcient normalized to

one), and the following endowments and utility functions: w

1

= w

2

= w

3

= 1, u

1

(x

1

, y) =

x

1

+ y, and u

i

(x

i

, y) = x

i

+ 2y for i = 2, 3. Then z = (x, y) with x = (0.5, 0, 0) and

y = 2.5 is weakly Pareto eﬃcient but not Pareto eﬃcient because z

t

= (x

t

, y

t

) = (0, 0, 0, 3)

Pareto-dominates z by consumers 2 and 3.

However, under an additional condition of strict convexity, they are equivalent. The

proof is left to readers.

6.3 Discrete Public Goods

6.3.1 Eﬃcient Provision of Public Goods

For simplicity, consider a public good economy with n consumers and two goods: one

private good and one public good.

Let g

i

be the contribution made by consumer i, so that

x

i

+ g

i

= w

i

n

¸

i=1

g

i

= v

Assume u

i

(x

i

, y) is strictly monotonic increasing and continuous.

123

Let c be the cost of producing the public project so that the production technology is

given by

y =

1 if

¸

n

i=1

g

i

c

0 otherwise

.

We ﬁrst want to know under what conditions providing the public good will be Pareto

dominate to not producing it, i.e., there exists (g

1

, . . . , g

n

) such that

¸

n

i=1

g

i

c and

u

i

(w

i

−g

i

, 1) > u

i

(w

i

, 0) ∀i.

Let r

i

be the maximum willingness-to-pay (reservation price) of consumer i, i.e., r

i

must satisfy

u

i

(w

i

−r

i

, 1) = u

i

(w

i

, 0). (6.3)

If producing the public project Pareto dominates not producing the public project, we

have

u

i

(w

i

−g

i

, 1) > u

i

(w

i

, 0) = u

i

(w

i

−r

i

, 1) for all i (6.4)

By monotonicity of u

i

, we have

w

i

−g

i

> w

i

−r

i

for i (6.5)

Then, we have

r

i

> g

i

(6.6)

and thus

n

¸

i=1

r

i

>

n

¸

i=1

g

i

c (6.7)

That is, the sum of the willingness-to-pay for the public good must excess the cost of

providing it. This condition is necessary. In fact, this condition is also suﬃcient. In

summary, we have the following proposition.

Proposition 6.3.1 Providing the public good Pareto dominates not producing the good

if and only if

¸

n

i=1

r

i

>

¸

n

i=1

g

i

c.

6.3.2 Free-Rider Problem

How eﬀective is a private market at providing public goods? The answer as shown below

is that we cannot expect that purely independent decision will necessarily result in an

124

eﬃcient amount of the public good being produced. To see this, suppose

r

i

= 100 i = 1, 2

c = 150 (total cost)

g

i

=

**150/2 = 75 if both agents make contributions
**

150 if only agent i makes contribution

Each person decides independently whether or not to buy the public good. As a result,

each one has an incentive to be a free-rider on the other as shown the following payoﬀ

matrix.

buy doesn’t buy

buy (25, 25) (-50, 100)

doesn’t buy (100, -50) (0, 0)

Note that net payoﬀs are deﬁned by r

i

− g

i

. Thus, it is given by 100 - 150/2 = 25

when both consumers are willing to produce the public project, and 100-150 = -50 when

only one person wants to buy, but the other person does not.

This is the prisoner’s dilemma. The dominant strategy equilibrium in this game is

(doesn’t buy, doesn’t buy). Thus, no body wants to share the cost of producing the

public project, but wants to free-ride on the other consumer. As a result, the public

good is not provided at all even thought it would be eﬃcient to do so. Thus, voluntary

contribution in general does not result in the eﬃcient level of the public good.

6.3.3 Voting for a Discrete Public Good

The amount of a public good is often determined by a voting. Will this generally results

in an eﬃcient provision? The answer is no.

Voting does not result in eﬃcient provision. Consider the following example.

Example 6.3.1

c = 99

r

1

= 90, r

2

= 30, r

3

= 30

125

Clearly, r

1

+ r

2

+ r

3

> c. g

i

= 99/3 = 33. So the eﬃcient provision of the public good

should be yes. However, under the majority rule, only consumer 1 votes “yes” since she

receives a positive net beneﬁt if the good is provided. The 2nd and 3rd persons vote “no”

to produce public good, and therefore, the public good will not be provided so that we

have ineﬃcient provision of the public good. The problem with the majority rule is that it

only measures the net beneﬁt for the public good, whereas the eﬃcient condition requires

a comparison of willingness-to-pay.

6.4 Continuous Public Goods

6.4.1 Eﬃcient Provision of Public Goods

Again, for simplicity, we assume there is only one public good and one private good that

may be regarded as money, and y = f(v).

The welfare maximization approach shows that Pareto eﬃcient allocations can be

characterized by

max

(x,y)

n

¸

i=1

a

i

u

i

(x

i

, y)

s.t.

n

¸

i=1

x

i

+v

n

¸

i=1

w

i

y f(v)

Deﬁne the Lagrangian function:

L =

n

¸

i=1

a

i

u

i

(x

i

, y) + λ

n

¸

i=1

w

i

−

n

¸

i=1

x

i

−v

+ µ(f(v) −y). (6.8)

When u

i

is strictly quasi-concave and diﬀerentiable and f(v) is concave and diﬀerentiable,

the set of interior Pareto optimal allocations are characterized by the ﬁrst order condition:

∂L

∂x

i

= 0 : a

i

∂u

i

∂x

i

= λ (6.9)

∂L

∂v

= 0 : µf

t

(v) = λ (6.10)

∂L

∂y

= 0 :

n

¸

i=1

a

i

∂u

i

∂y

= µ. (6.11)

126

By (6.9) and (6.10)

a

i

µ

=

f

t

(v)

∂u

i

∂x

i

(6.12)

Substituting (6.12) into (6.11),

n

¸

i=1

∂u

i

∂y

∂u

i

∂x

i

=

1

f

t

(v)

. (6.13)

Thus, we obtain the well-known Lindahl-Samuelson condition.

In conclusion, the conditions for Pareto eﬃciency are given by

¸

n

i=1

MRS

i

yx

i

= MRTS

yv

¸

x

i

+ v

¸

n

i=1

w

i

y = f(v)

(6.14)

Example 6.4.1

u

i

= a

i

ln y + ln x

i

y = v

the Lindahl-Samuelson condition is

n

¸

i=1

∂u

i

∂y

∂u

i

∂x

i

= 1 (6.15)

and thus

n

¸

i=1

a

i

y

1

x

i

=

n

¸

i=1

a

i

x

i

y

= 1 ⇒

¸

a

i

x

i

= y (6.16)

which implies the level of the public good is not uniquely determined.

Thus, in general, the marginal willingness-to-pay for a public good depends on the amount

of private goods consumption, and therefor, the eﬃcient level of y depends on x

i

. However,

in the case of quasi-linear utility functions,

u

i

(x

i

, y) = x

i

+ u

i

(y) (6.17)

the Lindahl-Samuelson condition becomes

n

¸

i=1

u

t

i

(y) =

1

f

t

(v)

≡ c

t

(y) (6.18)

and thus y is uniquely determined.

127

Example 6.4.2

u

i

= a

i

ln y + x

i

y = v

the Lindahl-Samuelson condition is

n

¸

i=1

∂u

i

∂y

∂u

i

∂x

i

= 1 (6.19)

and thus

n

¸

i=1

a

i

y

=

n

¸

i=1

a

i

y

= 1 ⇒

¸

a

i

= y (6.20)

which implies the level of the public good is uniquely determined.

6.4.2 Lindahl Equilibrium

We have given the conditions for Pareto eﬃciency in the presence of public goods. The

next problem is how to achieve a Pareto eﬃcient allocation in a decentralized way. In

private-goods-only economies, any competitive equilibrium is Pareto optimal. However,

with public goods, a competitive mechanism does not help. For instance, if we tried the

competitive solution with a public good and two consumers, the utility maximization

would equalize the MRS and the relative price, e.g.,

MRS

A

yx

= MRS

B

yx

=

p

y

p

x

.

This is an immediate violation to the Samuelson-Lindahl optimal condition.

Lindahl suggested to use a tax method to provide a public good. Each person is signed

a speciﬁc “personalized price” for the public good. The Lindahl solution is a way to mimic

the competitive solution in the presence of public goods. Suppose we devise a mechanism

to allocate the production cost of a public good between consumers, then we can achieve

the Samuelson-Lindahl condition. To this end, we apply diﬀerent prices of a public good

to diﬀerent consumers. The idea of the Lindahl solution is that the consumption level of a

public goods is the same to all consumers, but the price of the public good is personalized

among consumers in the way that the price ratio of two goods for each person being equal

the marginal rates of substitutions of two goods.

128

To see this, consider a public goods economy e with x

i

∈ R

L

+

(private goods) and

y ∈ R

K

+

(public goods). For simplicity, we assume the CRS for y = f(v). A feasible

allocation

n

¸

i=1

x

i

+v

n

¸

i=1

w

i

(6.21)

Let q

i

∈ R

K

+

be the personalized price vector of consumer i for consuming the public

goods.

Let q =

¸

n

i=1

q

i

: the market price vector of y.

Let p ∈ R

L

+

be the price vector of private goods.

The proﬁt is deﬁned as π = qy −pv with y = f(v).

Remark 6.4.1 Because of CRS, the maximum proﬁt is zero at the Lindahl equilibrium.

Deﬁnition 6.4.1 (Lindahl Equilibrium) An allocation (x

∗

, y

∗

) ∈ R

nL+K

+

is a Lindahl

equilibrium allocation if it is feasible and there exists a price vector p

∗

∈ K

L

+

and person-

alized price vectors q

∗

i

∈ R

K

+

, one for each individual i, such that

(i) p

∗

x

∗

i

+ q

∗

i

y

∗

pw

i

;

(ii) (x

i

, y) ~

i

(x

∗

i

, y

∗

) implies p

∗

x

i

+ q

∗

i

y > p

∗

x

∗

i

+ q

∗

i

y

∗

;

(iii) q

∗

y

∗

−p

∗

i

v

∗

= 0,

where v

∗

=

¸

n

t=1

w

i

−

¸

n

i=1

x

∗

i

and

¸

n

t=1

q

∗

i

= q

∗

.

We call (x

∗

, y

∗

, p

∗

, q

∗

1

, . . . , q

∗

n

) a Lindahl equilibrium.

We may regard a Walrasian equilibrium as a special case of a Lindahl equilibrium when

there are no public goods. Similarly, we have the following First Fundamental Theorem

of Welfare Economics for public goods economies.

Theorem 6.4.1 : Every Lindahl allocation (x

∗

, y

∗

) with the price system (p

∗

, q

∗

i

, . . . , q

∗

n

)

is weakly Pareto eﬃcient, and further under local non-satiation, it is Pareto eﬃcient.

Proof: We only prove the second part. The ﬁrst part is the simple. Suppose not. There

exists another feasible allocation (x

i

, y) such that (x

i

, y)

i

(x

∗

i

, y

∗

) for all i and (x

j

, y) ~

j

(x

∗

j

, y

∗

) for some j. Then, by local-non-satiation of

i

, we have

p

∗

x

i

+ q

∗

i

y p

∗

w

i

for all i = 1, 2, . . . , n

p

∗

x

j

+ q

∗

j

y > p

∗

w

j

for some j.

129

Thus

n

¸

i=1

p

∗

x

i

+

n

¸

i=1

q

i

y >

n

¸

i=1

p

∗

w

i

(6.22)

So

p

∗

n

¸

i=1

x

i

+ q

∗

y >

n

¸

i=1

p

∗

w

i

or

p

∗

n

¸

i=1

x

i

+ pv >

n

¸

i=1

p

∗

w

i

by noting that q

∗

y −p

∗

v q

∗

y

∗

−p

∗

v

∗

= 0. Hence,

p

∗

¸

n

¸

i=1

(x

i

−w

i

) + v

¸

> 0

which contradicts the fact that (x, y) is feasible.

For a public economy with one private good and one public good y =

1

q

v, the deﬁnition

of Lindahl equilibrium becomes much simpler.

An allocation (x

∗

, y

∗

) is a Lindahl Allocation if (x

∗

, y

∗

) is feasible (i.e.,

¸

n

i=1

x

∗

i

+qy

∗

¸

w

i

) and there exists q

∗

i

, i = 1, . . . , n such that

(i) x

∗

i

+ q

i

y

∗

w

i

(ii) (x

i

, y) ~

i

(x

∗

i

, y

∗

) implies x

i

+ q

i

y > w

i

(iii)

¸

n

i=1

q

i

= q

In fact, the feasibility condition is automatically satisﬁed when the budget constraints

(i) is satisﬁed.

If (x

∗

, y

∗

) is an interior Lindahl equilibrium allocation, from the utility maximization,

we can have the ﬁrst order condition:

∂u

i

∂y

∂u

i

∂y

=

q

i

1

(6.23)

which means the Lindahl-Samuelson condition holds:

n

¸

i=1

MRS

yx

i

= q,

which is the necessary condition for Pareto eﬃciency.

130

Example 6.4.3

u

i

(x

i

, y) = x

α

i

i

y

(1−α

i

)

for 0 < α

i

< 1

y =

1

q

v

The budget constraint is:

x

i

+ q

i

y = w

i

.

The demand functions for x

i

and y

i

of each i are given by

x

i

= α

i

w

i

(6.24)

y

i

=

(1 −α

i

)w

i

q

i

(6.25)

Since y

1

= y

2

= . . . y

n

= y

∗

at the equilibrium, we have by (6.25)

q

i

y

∗

= (1 −α

i

)w

i

. (6.26)

Making summation, we have

qy

∗

=

n

¸

i=1

(1 −α

i

)w

i

.

Then, we have

y

∗

=

¸

n

i=1

(1 −α

i

)w

i

q

and thus, by (6.26), we have

q

i

=

(1 −α

i

)w

i

y

∗

=

q(1 −α

i

)w

i

¸

n

i=1

(1 −α

i

)w

i

. (6.27)

If we want to ﬁnd a Lindahl equilibrium, we must know the preferences or MRS of each

consumer.

But because of the free-rider problem, it is very diﬃcult for consumers to report their

preferences truthfully.

6.4.3 Free-Rider Problem

When the MRS is known, a Pareto eﬃcient allocation (x, y) can be determined from the

Lindahl-Samuelson condition or the Lindahl solution. After that, the contribution of each

consumer is given by g

i

= w

i

−x

i

. However, the society is hard to know the information

about MRS. Of course, a naive method is that we could ask each individual to reveal his

131

preferences, and thus determine the willingness-to-pay. However, since each consumer is

self-interested, each person wants to be a free-rider and thus is not willing to tell the true

MRS. If consumers realize that shares of the contribution for producing public goods (or

the personalized prices) depend on their answers, they have “incentives to cheat.” That

is, when the consumers are asked to report their utility functions or MRSs, they will have

incentives to report a smaller MRS so that they can pay less, and consume the public

good (free riders). This causes the major diﬃculty in the public economies.

To see this, notice that the social goal is to reach Pareto eﬃcient allocations for the

public goods economy, but from the personal interest, each person solves the following

problem:

max u

i

(x

i

, y) (6.28)

subject to

g

i

∈ (0, w

i

)

x

i

+ g

i

= w

i

y = f(g

i

+

n

¸

j,=i

g

j

).

That is, each consumer i takes others’ strategies g

−i

as given, and maximizes his payoﬀs.

From this problem, we can form a non-cooperative game:

Γ = (G

i

, φ

i

)

n

i=1

where G

i

= [0, w

i

] is the strategy space of consumer i and φ

i

: G

1

G

2

... G

n

→ R is

the payoﬀ function of i which is deﬁned by

φ

i

(g

i

, g

−i

) = u

i

[(w

i

−g

i

), f(g

i

+

n

¸

j,=i

g

i

)] (6.29)

Deﬁnition 6.4.2 For the game, Γ = (G

i

, φ

i

)

n

i=1

, the strategy g

∗

= (g

∗

1

, ..., g

∗

n

) is a Nash

Equilibrium if

φ

i

(g

∗

i

, g

∗

−i

) φ

i

(g

i

, g

∗

−i

) for all g

i

∈ G

i

and all i = 1, 2, ..., n,

g

∗

is a dominant strategy equilibrium if

φ

i

(g

∗

i

, g

−i

) φ

i

(g

i

, g

−i

) for all g ∈ G and all i = 1, 2, ...

132

Remark 6.4.2 Note that the diﬀerence between Nash equilibrium (NE) and dominant

strategy is that at NE, given best strategy of others, each consumer chooses his best

strategy while dominant strategy means that the strategy chosen by each consumer is

best regardless of others’ strategies. Thus, a dominant strategy equilibrium is clearly

a Nash equilibrium, but the converse may not be true. Only for a very special payoﬀ

functions, there is a dominant strategy while a Nash equilibrium exists for a continuous

and quasi-concave payoﬀ functions that are deﬁned on a compact set.

For Nash equilibrium, if u

i

and f are diﬀerentiable, then an interior solution g must

satisfy the ﬁrst order condition:

∂φ

i

(g

∗

)

∂g

i

= 0 for all i = 1, . . . , n. (6.30)

Thus, we have

∂φ

i

∂g

i

=

∂u

i

∂x

i

(−1) +

∂u

i

∂y

f

t

(g

∗

i

+

n

¸

j,=i

g

j

) = 0

So,

∂u

i

∂y

∂u

i

∂x

i

=

1

f

t

(g

∗

i

+

¸

j,=i

g

j

)

,

and thus

MRS

i

yx

i

= MRTS

yv

,

which does not satisfy the Lindahl-Samuelson condition. Thus, the Nash equilibrium in

general does not result in Pareto eﬃcient allocations. The above equation implies that

the low level of public good is produced rather than the Pareto eﬃcient level of the

public good. Therefore, Nash equilibrium allocations are in general not consistent with

Pareto eﬃcient allocations. How can one solve this free-ride problem? We will answer

this question in the mechanism design theory.

Reference

Foley, D., “Lindahl’s Solution and the Core of an Economy with Public Goods, Econo-

metrica 38 (1970), 66 72.

Laﬀont, J.-J., Fundamentals of Public Economics, Cambridge, MIT Press, 1988, Chapter

2.

133

Lindahl, E., “Die Gerechitgleit der Besteuring. Lund: Gleerup.[English tranlastion: Just

Taxation – a Positive Solution: In Classics in the Theory of Public Finance, edited

by R. A. Musgrave and A. T. Peacock. London: Macmillan, 1958].

Luenberger, D. Microeconomic Theory, McGraw-Hill, Inc, 1995, Chapter 9.

Mas-Colell, A., M. D. Whinston, and J. Green, Microeconomic, Oxford University Press,

1995, Chapter 11.

Milleron, J. C. “Theory of Value with Public Goods: a Survey Article,” Journal of

Economics Theory 5 (1972), 419 477.

Muench, T., “The Core and the Lindahl Equilibrium of an Economy with a Public Good,

Journal of Economics Theory 4 (1972), 241 255.

Pigou, A., A study of Public Finance, New York: Macmillan, 1928.

Salanie, B., Microeconomics of Market Failures, MIT Press, 2000, Chapter 5.

Roberts, D. J., “The Lindahl Solution for Economies with Public Goods, Journal of

Public Economics 3 (1974), 23 42.

Tian, G., “On the Constrained Walrasian and Lindahl Correspondences,” Economics

Letters 26 (1988), 299 303.

Tian, G. and Q. Li, “Ratio-Lindahl and Ratio Equilibria with Many Goods, Games and

Economic Behavior 7 (1994), 441 460.

Varian, H.R., Microeconomic Analysis, W.W. Norton and Company, Third Edition,

1992, Chapters 23.

Varian, “A Solution to the Problem of Externalities when Agents Are Well Informed,”

American Economic Review, 84 (1994), 1278 1293.

134

Part III

Incentives, Information, and

Mechanism Design

135

The notion of incentives is a basic and key concept in modern economics. To many

economists, economics is to a large extent a matter of incentives: incentives to work hard,

to produce good quality products, to study, to invest, to save, etc.

Until about 30 year ago, economics was mostly concerned with understanding the

theory of value in large economies. A central question asked in general equilibrium the-

ory was whether a certain mechanism (especially the competitive mechanism) generated

Pareto-eﬃcient allocations, and if so – for what categories of economic environments. In

a perfectly competitive market, the pressure of competitive markets solves the problem of

incentives for consumers and producers. The major project of understanding how prices

are formed in competitive markets can proceed without worrying about incentives.

The question was then reversed in the economics literature: instead of regarding mech-

anisms as given and seeking the class of environments for which they work, one seeks

mechanisms which will implement some desirable outcomes (especially those which result

in Pareto-eﬃcient and individually rational allocations) for a given class of environments

without destroying participants’ incentives, and which have a low cost of operation and

other desirable properties. In a sense, the theorists went back to basics.

The reverse question was stimulated by two major lines in the history of economics.

Within the capitalist/private-ownership economics literature, a stimulus arose from stud-

ies focusing upon the failure of the competitive market to function as a mechanism for

implementing eﬃcient allocations in many nonclassical economic environments such as

the presence of externalities, public goods, incomplete information, imperfect competi-

tion, increasing return to scale, etc. At the beginning of the seventies, works by Akerlof

(1970), Hurwicz (1972), Spence (1974), and Rothschild and Stiglitz (1976) showed in var-

ious ways that asymmetric information was posing a much greater challenge and could

not be satisfactorily imbedded in a proper generalization of the Arrow-Debreu theory.

A second stimulus arose from the socialist/state-ownership economics literature, as

evidenced in the “socialist controversy” — the debate between Mises-Hayek and Lange-

Lerner in twenties and thirties of the last century. The controversy was provoked by von

Mises’s skepticism as to even a theoretical feasibility of rational allocation under socialism.

The incentives structure and information structure are thus two basic features of any

economic system. The study of these two features is attributed to these two major lines,

136

culminating in the theory of mechanism design. The theory of economic mechanism

design which was originated by Hurwicz is very general. All economic mechanisms and

systems (including those known and unknown, private-ownership, state-ownership, and

mixed-ownership systems) can be studied with this theory.

At the micro level, the development of the theory of incentives has also been a major

advance in economics in the last thirty years. Before, by treating the ﬁrm as a black box

the theory remains silent on how the owners of ﬁrms succeed in aligning the objectives of its

various members, such as workers, supervisors, and managers, with proﬁt maximization.

When economists began to look more carefully at the ﬁrm, either in agricultural or

managerial economics, incentives became the central focus of their analysis. Indeed, dele-

gation of a task to an agent who has diﬀerent objectives than the principal who delegates

this task is problematic when information about the agent is imperfect. This problem is

the essence of incentive questions. Thus, conﬂicting objectives and decentralized

information are the two basic ingredients of incentive theory.

We will discover that, in general, these informational problems prevent society from

achieving the ﬁrst-best allocation of resources that could be possible in a world where all

information would be common knowledge. The additional costs that must be incurred

because of the strategic behavior of privately informed economic agents can be viewed

as one category of the transaction costs. Although they do not exhaust all possible

transaction costs, economists have been rather successful during the last thirty years in

modelling and analyzing these types of costs and providing a good understanding of the

limits set by these on the allocation of resources. This line of research also provides

a whole set of insights on how to begin to take into account agents’ responses to the

incentives provided by institutions.

We will brieﬂy present the incentive theory in three chapters. Chapters 7 and 8

consider the principal-agent model where the principal delegates an action to a single agent

with private information. This private information can be of two types: either the agent

can take an action unobserved by the principal, the case of moral hazard or hidden action;

or the agent has some private knowledge about his cost or valuation that is ignored by the

principal, the case of adverse selection or hidden knowledge. Incentive theory considers

when this private information is a problem for the principal, and what is the optimal way

137

for the principal to cope with it. The design of the principal’s optimal contract can

be regarded as a simple optimization problem. This simple focus will turn out

to be enough to highlight the various trade-oﬀs between allocative eﬃciency

and distribution of information rents arising under incomplete information.

The mere existence of informational constraints may generally prevent the principal from

achieving allocative eﬃciency. We will characterize the allocative distortions that the

principal ﬁnds desirable to implement in order to mitigate the impact of informational

constraints.

Chapter 9 will consider situations with one principal and many agents. Asymmetric

information may not only aﬀect the relationship between the principal and each of his

agents, but it may also plague the relationships between agents. Moreover, maintaining

the hypothesis that agents adopt an individualistic behavior, those organizational contexts

require a solution concept of equilibrium, which describes the strategic interaction between

agents under complete or incomplete information.

138

Chapter 7

Principal-Agent Model: Hidden

Information

7.1 Introduction

Incentive problems arise when a principal wants to delegate a task to an agent with private

information. The exact opportunity cost of this task, the precise technology used, and

how good the matching is between the agent’s intrinsic ability and this technology are all

examples of pieces of information that may become private knowledge of the agent. In

such cases, we will say that there is adverse selection.

Eexample

1. The landlord delegates the cultivation of his land to a tenant, who will be the only

one to observe the exact local weather conditions.

2. A client delegates his defense to an attorney who will be the only one to know the

diﬃculty of the case.

3. An investor delegates the management of his portfolio to a broker, who will privately

know the prospects of the possible investments.

4. A stockholder delegates the ﬁrm’s day-to-day decisions to a manager, who will be

the only one to know the business conditions.

5. An insurance company provides insurance to agents who privately know how good

a driver they are.

6. The Department of Defense procures a good from the military industry without

139

knowing its exact cost structure.

7. A regulatory agency contracts for service with a Public Utility without having

complete information about its technology.

The common aspect of all those contracting settings is that the information gap be-

tween the principal and the agent has some fundamental implications for the design of the

contract they sign. In order to reach an eﬃcient use of economic resources, some informa-

tion rent must be given up to the privately informed agent. At the optimal second-best

contract, the principal trades oﬀ his desire to reach allocative eﬃciency against the costly

information rent given up to the agent to induce information revelation. Implicit here is

the idea that there exists a legal framework for this contractual relationship. The contract

can be enforced by a benevolent court of law, the agent is bounded by the terms of the

contract.

The main objective of this chapter is to characterize the optimal rent extraction-

eﬃciency trade-oﬀ faced by the principal when designing his contractual oﬀer to the agent

under the set of incentive feasible constraints: incentive and participation constraints. In

general, incentive constraints are binding at the optimum, showing that adverse selection

clearly impedes the eﬃciency of trade. The main lessons of this optimization is that

the optimal second-best contract calls for a distortion in the volume of trade

away from the ﬁrst-best and for giving up some strictly positive information

rents to the most eﬃcient agents.

7.2 The Basic Model

7.2.1 Economic Environment (Technology, Preferences, and In-

formation)

Consider a consumer or a ﬁrm (the principal) who wants to delegate to an agent the

production of q units of a good. The value for the principal of these q units is S(q) where

S

t

> 0, S

tt

< 0 and S(0) = 0.

The production cost of the agent is unobservable to the principal, but it is common

knowledge that the ﬁxed cost is F and the marginal cost belongs to the set Φ = ¦θ,

¯

θ¦.

The agent can be either eﬃcient (θ) or ineﬃcient (

¯

θ) with respective probabilities ν and

140

1 −ν. That is, he has the cost function

C(q, θ) = θq + F with probability ν (7.1)

or

C(q,

¯

θ) =

¯

θq + F with probability 1 −ν (7.2)

Denote by ∆θ =

¯

θ −θ > 0.

7.2.2 Contracting Variables: Outcomes

The contracting variables are the quantity produced q and the transfer t received by the

agent. Let / be the set of feasible allocations that is given by

/ = ¦(q, t) : q ∈ '

+

, t ∈ '¦ (7.3)

These variables are both observable and veriﬁable by a third party such as a benevolent

court of law.

7.2.3 Timing

Unless explicitly stated, we will maintain the timing deﬁned in the ﬁgure below, where A

denotes the agent and P the principal.

Figure 7.1: Timing of contracting under hidden information.

Note that contracts are oﬀered at the interim stage; there is already asymmetric

information between the contracting parties when the principal makes his oﬀer.

141

7.3 The Complete Information Optimal Contract(Benchmark

Case)

7.3.1 First-Best Production Levels

To get a reference system for comparison, let us ﬁrst suppose that there is no asymmetry

of information between the principal and the agent. The eﬃcient production levels are

obtained by equating the principal’s marginal value and the agent’s marginal cost. Hence,

we have the following ﬁrst-order conditions

S

t

(q

∗

) = θ (7.4)

and

S

t

(¯ q

∗

) =

¯

θ. (7.5)

The complete information eﬃcient production levels q

∗

and q

∗

should be both carried out

if their social values, respectively W

∗

= S(q

∗

) −θq

∗

−F, and W

∗

= S(¯ q

∗

) −θ¯ q

∗

−F, are

non-negative.

Since

S(q

∗

) −θq

∗

S(q

∗

) −θ¯ q

∗

S(¯ q

∗

) −

¯

θ¯ q

∗

by deﬁnition of θ and

¯

θ > θ, the social value of production when the agent is eﬃcient,

W

∗

, is greater than when he is ineﬃcient, namely W

∗

.

For trade to be always carried out, it is thus enough that production be socially

valuable for the least eﬃcient type, i.e., the following condition must be satisﬁed

¯

W

∗

= S(¯ q

∗

) −

¯

θ¯ q

∗

−F 0. (7.6)

As the ﬁxed cost F plays no role other than justifying the existence of a single agent, it

is set to zero from now on in order to simplify notations.

Note that, since the principal’s marginal value of output is decreasing, the optimal

production of an eﬃcient agent is greater than that of an ineﬃcient agent, i.e., q

∗

> ¯ q

∗

.

7.3.2 Implementation of the First-Best

For a successful delegation of the task, the principal must oﬀer the agent a utility level

that is at least as high as the utility level that the agent obtains outside the relationship.

142

We refer to these constraints as the agent’s participation constraints. If we normalize to

zero the agent’s outside opportunity utility level (sometimes called his quo utility level),

these participation constraints are written as

t −θq 0, (7.7)

¯

t −

¯

θ¯ q 0. (7.8)

To implement the ﬁrst-best production levels, the principal can make the following

take-it-or-leave-it oﬀers to the agent: If θ =

¯

θ (resp. θ), the principal oﬀers the transfer

¯

t

∗

(resp. t

∗

) for the production level ¯ q

∗

(resp. q

∗

) with

¯

t

∗

=

¯

θ¯ q

∗

(resp.t

∗

= θq

∗

). Thus,

whatever his type, the agent accepts the oﬀer and makes zero proﬁt. The complete

information optimal contracts are thus (t

∗

, q

∗

) if θ = θ and (

¯

t

∗

, ¯ q

∗

) if θ =

¯

θ. Importantly,

under complete information delegation is costless for the principal, who achieves the same

utility level that he would get if he was carrying out the task himself (with the same cost

function as the agent).

Figure 7.2: Indiﬀerence curves of both types.

143

7.3.3 A Graphical Representation of the Complete Information

Optimal Contract

Figure 7.3: First best contracts.

Since

¯

θ > θ, the iso-utility curves for diﬀerent types cross only once as shown in the

above ﬁgure. This important property is called the single-crossing or Spence-Mirrlees

property.

The complete information optimal contract is ﬁnally represented Figure 7.3 by the

pair of points (A

∗

, B

∗

). Note that since the iso-utility curves of the principal correspond

to increasing levels of utility when one moves in the southeast direction, the principal

reaches a higher proﬁt when dealing with the eﬃcient type. We denote by

¯

V

∗

(resp.

V

∗

) the principal’s level of utility when he faces the

¯

θ− (resp. θ−) type. Because the

principal’s has all the bargaining power in designing the contract, we have

¯

V

∗

= W

∗

(resp.

V

∗

= W

∗

) under complete information.

144

7.4 Incentive Feasible Contracts

7.4.1 Incentive Compatibility and Participation

Suppose now that the marginal cost θ is the agent’s private information and let us consider

the case where the principal oﬀers the menu of contracts ¦(t

∗

, q

∗

); (

¯

t

∗

, ¯ q

∗

)¦ hoping that an

agent with type θ will select (t

∗

, q

∗

) and an agent with

¯

θ will select instead (

¯

t

∗

, ¯ q

∗

).

From Figure 7.3 above, we see that B

∗

is preferred to A

∗

by both types of agents.

Oﬀering the menu (A

∗

, B

∗

) fails to have the agents self-selecting properly within this menu.

The eﬃcient type have incentives to mimic the ineﬃcient one and selects also contract

B

∗

. The complete information optimal contracts can no longer be implemented under

asymmetric information. We will thus say that the menu of contracts ¦(t

∗

, q

∗

); (

¯

t

∗

, ¯ q

∗

)¦ is

not incentive compatible.

Deﬁnition 7.4.1 A menu of contracts ¦(t, q); (

¯

t, ¯ q)¦ is incentive compatible when (t, q)

is weakly preferred to (

¯

t, ¯ q) by agent θ and (

¯

t, ¯ q) is weakly preferred to (t, q) by agent

¯

θ.

Mathematically, these requirements amount to the fact that the allocations must satisfy

the following incentive compatibility constraints:

t −θq

¯

t −θ¯ q (7.9)

and

¯

t −

¯

θ¯ q t −

¯

θq (7.10)

Furthermore, for a menu to be accepted, it must satisfy the following two participation

constraints:

t −θq 0, (7.11)

¯

t −

¯

θ¯ q 0. (7.12)

Deﬁnition 7.4.2 A menu of contracts is incentive feasible if it satisﬁes both incentive

and participation constraints (7.9) through (7.12).

The inequalities (7.9) through (7.12) express additional constraints imposed on the allo-

cation of resources by asymmetric information between the principal and the agent.

145

7.4.2 Special Cases

Bunching or Pooling Contracts: A ﬁrst special case of incentive feasible menu of

contracts is obtained when the contracts targeted for each type coincide, i.e., when t =

¯

t = t

p

, q = ¯ q = q

p

and both types of agent accept this contract.

Shutdown of the Least Eﬃcient Type: Another particular case occurs when one

of the contracts is the null contract (0,0) and the nonzero contract (t

s

, q

s

) is only accepted

by the eﬃcient type. Then, (7.9) and (7.11) both reduce to

t

s

−θq

s

0. (7.13)

The incentive constraint of the bad type reduces to

0 t

s

−

¯

θq

s

. (7.14)

7.4.3 Monotonicity Constraints

Incentive compatibility constraints reduce the set of feasible allocations. Moreover, these

quantities must generally satisfy a monotonicity constraint which does not exist under

complete information. Adding (7.9) and (7.10), we immediately have

q ¯ q. (7.15)

We will call condition (7.15) an implementability condition that is necessary and suﬃcient

for implementability.

7.5 Information Rents

To understand the structure of the optimal contract it is useful to introduce the concept

of information rent.

We know from previous discussion, under complete information, the principal is able

to maintain all types of agents at their zero status quo utility level. Their respective

utility levels U

∗

and

¯

U

∗

at the ﬁrst-best satisfy

U

∗

= t

∗

−θq

∗

= 0 (7.16)

146

and

¯

U

∗

=

¯

t

∗

−

¯

θ¯ q

∗

= 0. (7.17)

Generally this will not be possible anymore under incomplete information, at least when

the principal wants both types of agents to be active.

Take any menu ¦(

¯

t, ¯ q); (t, q)¦ of incentive feasible contracts and consider the utility

level that a θ-agent would get by mimicking a

¯

θ-agent. The high-eﬃcient agent would get

¯

t −θ¯ q =

¯

t −

¯

θ¯ q + ∆θ¯ q =

¯

U + ∆θ¯ q. (7.18)

Thus, as long as the principal insists on a positive output for the ineﬃcient type, ¯ q > 0,

the principal must give up a positive rent to a θ-agent. This information rent is generated

by the informational advantage of the agent over the principal.

We use the notations U = t −θq and

¯

U =

¯

t −

¯

θ¯ q to denote the respective information

rent of each type.

7.6 The Optimization Program of the Principal

According to the timing of the contractual game, the principal must oﬀer a menu of

contracts before knowing which type of agent he is facing. Then, the principal’s problem

writes as

max

|(

¯

t,¯ q);(t,q)¦

ν(S(q) −t) + (1 −ν)(S(¯ q) −

¯

t)

subject to (7.9) to (7.12).

Using the deﬁnition of the information rents U = t − θq and

¯

U =

¯

t −

¯

θ¯ q, we can replace

transfers in the principal’s objective function as functions of information rents and outputs

so that the new optimization variables are now ¦(U, q); (

¯

U, ¯ q)¦. The focus on information

rents enables us to assess the distributive impact of asymmetric information, and the

focus on outputs allows us to analyze its impact on allocative eﬃciency and the overall

gains from trade. Thus an allocation corresponds to a volume of trade and a distribution

of the gains from trade between the principal and the agent.

With this change of variables, the principal’s objective function can then be rewritten

as

ν(S(q) −θq) + (1 −ν)(S(¯ q) −

¯

θ¯ q)

. .. .

−(νU + (1 −ν)

¯

U)

. .. .

. (7.19)

147

The ﬁrst term denotes expected allocative eﬃciency, and the second term denotes expected

information rent which implies that the principal is ready to accept some distortions away

from eﬃciency in order to decrease the agent’s information rent.

The incentive constraints (7.9) and (7.10), written in terms of information rents and

outputs, becomes respectively

U

¯

U + ∆θ¯ q, (7.20)

¯

U U −∆θq. (7.21)

The participation constraints (7.11) and (7.12) become respectively

U 0, (7.22)

¯

U 0. (7.23)

The principal wishes to solve problem (P) below:

max

|(U,q);(

¯

U,¯ q)¦

ν(S(q) −θq) + (1 −ν)(S(¯ q) −

¯

θ¯ q) −(νU + (1 −ν)

¯

U)

subject to (7.20) to (7.23).

We index the solution to this problem with a superscript SB, meaning second-best.

7.7 The Rent Extraction-Eﬃciency Trade-Oﬀ

7.7.1 The Optimal Contract Under Asymmetric Information

The major technical diﬃculty of problem (P) is to determine which of the many con-

straints imposed by incentive compatibility and participation are the relevant ones. i.e.,

the binding ones at the optimum or the principal’s problem.

Let us ﬁrst consider contracts without shutdown, i.e., such that ¯ q > 0. This is true

when the so-called Inada condition S

t

(0) = +∞ is satisﬁed and lim

q→0

S

t

(q)q = 0.

Note that the θ-agent’s participation constraint (7.22) is always strictly-satisﬁed. In-

deed, (7.23) and (7.20) immediately imply (7.22). (7.21) also seems irrelevant because

the diﬃculty comes from a θ-agent willing to claim that he is ineﬃcient rather than the

reverse.

148

This simpliﬁcation in the number of relevant constraints leaves us with only two re-

maining constraints, the θ-agent’s incentive constraint (7.20) and the

¯

θ-agent’s partici-

pation constraint (7.23), and both constraints must be binding at the optimum of the

principal’s problem (P):

U = ∆θ¯ q (7.24)

and

¯

U = 0. (7.25)

Substituting (7.24) and (7.25) into the principal’s objective function, we obtain a reduced

program (P

t

) with outputs as the only choice variables:

max

|(q,¯ q)¦

ν(S(q) −θq) + (1 −ν)(S(¯ q) −

¯

θ¯ q) −(ν∆θ¯ q).

Compared with the full information setting, asymmetric information alters the principal’s

optimization simply by the subtraction of the expected rent that has to be given up to the

eﬃcient type. The ineﬃcient type gets no rent, but the eﬃcient type θ gets information

rent that he could obtain by mimicking the ineﬃcient type θ. This rent depends only on

the level of production requested from this ineﬃcient type.

The ﬁrst order conditions are then given by

S

t

(q

SB

) = θ or q

SB

= q

∗

. (7.26)

and

(1 −ν)(S

t

(¯ q

SB

) −

¯

θ) = ν∆θ. (7.27)

(7.27) expresses the important trade-oﬀ between eﬃciency and rent extraction which arises

under asymmetric information.

To validate our approach based on the sole consideration of the eﬃcient type’s incentive

constraint, it is necessary to check that the omitted incentive constraint of an ineﬃcient

agent is satisﬁed. i.e., 0 ∆θ¯ q

SB

− ∆θq

SB

. This latter inequality follows from the

monotonicity of the second-best schedule of outputs since we have q

SB

= q

∗

> ¯ q

∗

> ¯ q

SB

.

In summary, we have the following proposition.

Proposition 7.7.1 Under asymmetric information, the optimal menu of contracts en-

tails:

149

(1) No output distortion for the eﬃcient type test in respect to the ﬁrst-best,

q

SB

= q

∗

. A downward output distortion for the ineﬃcient type, ¯ q

SB

< ¯ q

∗

with

S

t

(¯ q

SB

) =

¯

θ +

ν

1 −ν

∆θ. (7.28)

(2) Only the eﬃcient type gets a positive information rent given by

U

SB

= ∆θ¯ q

SB

. (7.29)

(3) The second-best transfers are respectively given by t

SB

= θq

∗

+∆θ¯ q

SB

and

¯

t

SB

=

¯

θ¯ q

SB

.

7.7.2 A Graphical Representation of the Second-Best Outcome

Figure 7.4: Rent needed to implement the ﬁrst best outputs.

Starting from the complete information optimal contract (A

∗

, B

∗

) that is not incentive

compatible, we can construct an incentive compatible contract (B

∗

, C) with the same

150

production levels by giving a higher transfer to the agent producing q

∗

as shown in the

ﬁgure above. The contract C is on the θ- agent’s indiﬀerence curve passing through B

∗

.

Hence, the θ-agent is now indiﬀerent between B

∗

and C. (B

∗

, C) becomes an incentive-

compatible menu of contracts. The rent that is given up to the θ-ﬁrm is now ∆θ¯ q

∗

.

This contract is not optimal by the ﬁrst order conditions (7.26) and (7.27). The optimal

trade-oﬀ ﬁnally occurs at (A

SB

, B

SB

) as shown in the ﬁgure below.

Figure 7.5: Optimal second-best contract S

SB

and B

SB

.

7.7.3 Shutdown Policy

If the ﬁrst-order condition in (7.28) has no positive solution, ¯ q

SB

should be set at zero.

We are in the special case of a contract with shutdown. B

SB

coincides with 0 and A

SB

with A

∗

in the ﬁgure above. No rent is given up to the θ-ﬁrm by the unique non-null

contract (t

∗

, q

∗

) oﬀered and selected only by agent θ. The beneﬁt of such a policy is that

no rent is given up to the eﬃcient type.

151

Remark 7.7.1 The shutdown policy is dependent on the status quo utility levels. Sup-

pose that, for both types, the status quo utility level is U

0

> 0. Then, from the principal’s

objective function, we have

ν

1 −ν

∆θ¯ q

SB

+ U

0

S(¯ q

SB

) −

¯

θ¯ q

SB

. (7.30)

Thus, for ν large enough, shutdown occurs even if the Inada condition S

t

(0) = +∞ is

satisﬁed. Note that this case also occurs when the agent has a strictly positive ﬁxed cost

F > 0 (to see that, just set U

0

= F).

7.8 The Theory of the Firm Under Asymmetric In-

formation

When the delegation of task occurs within the ﬁrm, a major conclusion of the above

analysis is that, because of asymmetric information, the ﬁrm does not maximize the social

value of trade, or more precisely its proﬁt, a maintained assumption of most economic

theory. This lack of allocative eﬃciency should not be considered as a failure in the

rational use of resources within the ﬁrm. Indeed, the point is that allocative eﬃciency

is only one part of the principal’s objective. The allocation of resources within the ﬁrm

remains constrained optimal once informational constraints are fully taken into account.

Williamson (1975) has advanced the view that various transaction costs may im-

pede the achievement of economic transactions. Among the many origins of these costs,

Williamson stresses informational impact as an important source of ineﬃciency. Even in

a world with a costless enforcement of contracts, a major source of allocative ineﬃciency

is the existence of asymmetric information between trading partners.

Even though asymmetric information generates allocative ineﬃciencies, those eﬃcien-

cies do not call for any public policy motivated by reasons of pure eﬃciency. Indeed, any

benevolent policymaker in charge of correcting these ineﬃciencies would face the same in-

formational constraints as the principal. The allocation obtained above is Pareto optimal

in the set of incentive feasible allocations or incentive Pareto optimal.

152

7.9 Asymmetric Information and Marginal Cost Pric-

ing

Under complete information, the ﬁrst-best rules can be interpreted as price equal to

marginal cost since consumers on the market will equate their marginal utility of con-

sumption to price.

Under asymmetric information, price equates marginal cost only when the producing

ﬁrm is eﬃcient (θ =

¯

θ). Using (7.28), we get the expression of the price p(

¯

θ) for the

ineﬃcient types output

p(

¯

θ) =

¯

θ +

ν

1 −ν

∆θ. (7.31)

Price is higher than marginal cost in order to decrease the quantity ¯ q produced by the

ineﬃcient ﬁrm and reduce the eﬃcient ﬁrm’s information rent. Alternatively, we can say

that price is equal to a generalized (or virtual) marginal cost that includes, in addition to

the traditional marginal cost of the ineﬃcient type

¯

θ, an information cost that is worth

ν

1−ν

∆θ.

7.10 The Revelation Principle

In the above analysis, we have restricted the principal to oﬀer a menu of contracts, one

for each possible type. One may wonder if a better outcome could be achieved with a

more complex contract allowing the agent possibly to choose among more options. The

revelation principle ensures that there is no loss of generality in restricting the principal

to oﬀer simple menus having at most as many options as the cardinality of the type space.

Those simple menus are actually examples of direct revelation mechanisms.

Deﬁnition 7.10.1 A direct revelation mechanism is a mapping g() from Θ to / which

writes as g(θ) = (q(θ), t(θ)) for all belonging to Θ. The principal commits to oﬀer the

transfer t(

˜

θ) and the production level q(

˜

θ) if the agent announces the value

˜

θ for any

˜

θ

belonging to Θ.

Deﬁnition 7.10.2 A direct revelation mechanism g() is truthful if it is incentive com-

patible for the agent to announce his true type for any type, i.e., if the direct revelation

153

mechanism satisﬁes the following incentive compatibility constraints:

t(θ) −θq(θ) t(

¯

θ) −θq(

¯

θ), (7.32)

t(

¯

θ) −

¯

θq(

¯

θ) t(θ −

¯

θq(

¯

θ). (7.33)

Denoting transfer and output for each possible report respectively as t(θ) = t, q(θ) = q,

t(

¯

θ) =

¯

t and q(

¯

θ) = ¯ q, we get back to the notations of the previous sections.

A more general mechanism can be obtained when communication between the prin-

cipal and the agent is more complex than simply having the agent report his type to the

principal.

Let M be the message space oﬀered to the agent by a more general mechanism.

Deﬁnition 7.10.3 A mechanism is a message space M and a mapping ˜ q() from M to

/ which writes as ˜ g(m) = (˜ q(m),

˜

t(m)) for all m belonging to M.

When facing such a mechanism, the agent with type θ chooses a best message m

∗

(θ) that

is implicitly deﬁned as

˜

t(m

∗

(θ)) −θ˜ q(m

∗

(θ))

˜

t( ˜ m) −θ˜ q( ˜ m) for all ˜ m ∈ M. (7.34)

The mechanism (M, ˜ g()) induces therefore an allocation rule a(θ) = (˜ q(m

∗

(θ)),

˜

t(m

∗

(θ)))

mapping the set of types Θ into the set of allocations /.

Then we have the following revelation principle in the one agent case.

Proposition 7.10.1 Any allocation rule a(θ) obtained with a mechanism (M, ˜ g()) can

also be implemented with a truthful direct revelation mechanism.

Proof. The indirect mechanism (M, ˜ g()) induces an allocation rule a(θ) = (˜ q(m

∗

(θ)),

˜

t(m

∗

(θ))) from into /. By composition of ˜ q() and m

∗

(), we can construct a direct

revelation mechanism g() mapping Θ into /, namely g = ˜ g ◦ m

∗

, or more precisely

g(θ) = (q(θ), t(θ)) ≡ ˜ g(m

∗

(θ)) = (˜ q(m

∗

(θ)),

˜

t(m

∗

(θ))) for all θ ∈ Θ.

We check now that the direct revelation mechanism g() is truthful. Indeed, since

(7.34) is true for all ˜ m, it holds in particular for ˜ m = m

∗

(θ

t

) for all θ

t

∈ Θ. Thus we have

˜

t(m

∗

(θ)) −θ˜ q(m

∗

(θ))

˜

t(m

∗

(θ

t

)) −θ˜ q(m

∗

(θ

t

)) for all (θ, θ

t

) ∈ Θ

2

. (7.35)

154

Finally, using the deﬁnition of g(), we get

t(θ) −θq(θ) t(θ

t

) −θq(θ

t

) for all (θ, θ

t

) ∈ Θ

2

. (7.36)

Hence, the direct revelation mechanism g() is truthful.

Importantly, the revelation principle provides a considerable simpliﬁcation of contract

theory. It enables us to restrict the analysis to a simple aid well-deﬁned family of functions,

the truthful direct revelation mechanism.

7.11 A More General Utility Function for the Agent

Still keeping quasi-linear utility functions, let U = t−C(q, θ) now be the agent’s objective

function in the assumptions: C

q

> 0, C

θ

> 0, C

qq

> 0 and C

qθ

> 0. The generalization of

the Spence- Mirrlees property is now C

qθ

> 0. This latter condition still ensures that the

diﬀerent types of the agent have indiﬀerence curves which cross each other at most once.

This Spence-Mirrlees property is quite clear: a more eﬃcient type is also more eﬃcient

at the margin.

Incentive feasible allocations satisfy the following incentive and participation con-

straints:

U = t −C(q, θ)

¯

t −C(¯ q, θ), (7.37)

¯

U =

¯

t −C(¯ q,

¯

θ) t −C(q,

¯

θ), (7.38)

U = t −C(q, θ) 0, (7.39)

¯

U =

¯

t −C(¯ q,

¯

θ) 0. (7.40)

7.11.1 The Optimal Contract

Just as before, the incentive constraint of an eﬃcient type in (7.37) and the participation

constraint of an ineﬃcient type in (7.40) are the two relevant constraints for optimization.

These constraints rewrite respectively as

U

¯

U + Φ(¯ q) (7.41)

where Φ(¯ q) = C(¯ q,

¯

θ) −C(¯ q, θ) (with Φ

t

> 0 and Φ

tt

> 0), and

¯

U 0. (7.42)

155

Those constraints are both binding at the second-best optimum, which leads to the fol-

lowing expression of the eﬃcient type’s rent

U = Φ(¯ q). (7.43)

Since Φ

t

> 0, reducing the ineﬃcient agent’s output also reduces the eﬃcient agent’s

information rent.

With the assumptions made on C(), one can also check that the principal’s objective

function is strictly concave with respect to outputs.

The solution of the principal’s program can be summarized as follows:

Proposition 7.11.1 With general preferences satisfying the Spence-Mirrlees property,

C

qθ

> 0, the optimal menu of contracts entails:

(1) No output distortion with respect to the ﬁrst-best outcome for the eﬃcient

type, q

SB

= q

∗

with

S

t

(q

∗

) = C

q

(q

∗

, θ). (7.44)

A downward output distortion for the ineﬃcient type, ¯ q

SB

< ¯ q

∗

with

S

t

(¯ q

∗

) = C

q

(¯ q

∗

,

¯

θ) (7.45)

and

S

t

(¯ q

SB

) = C

q

(¯ q

SB

,

¯

θ) +

ν

1 −ν

Φ

t

(¯ q

SB

). (7.46)

(2) Only the eﬃcient type gets a positive information rent given by U

SB

=

Φ(¯ q

SB

).

(3) The second-best transfers are respectively given by t

SB

= C(q

∗

, θ) +Φ(¯ q

SB

)

and

¯

t

SB

= C(¯ q

SB

,

¯

θ).

The ﬁrst-order conditions (7.44) and (7.46) characterize the optimal solution if the

neglected incentive constraint (7.38) is satisﬁed. For this to be true, we need to have

¯

t

SB

−C(¯ q

SB

,

¯

θ) t

SB

−C(q

SB

,

¯

θ),

=

¯

t

SB

−C(¯ q

SB

, θ) + C(q

SB

, θ) −C(q

SB

,

¯

θ) (7.47)

156

by noting that (7.37) holds with equality at the optimal output such that t

SB

=

¯

t

SB

−

C(¯ q

SB

, θ) + C(q

SB

, θ). Thus, we need to have

0 Φ(¯ q

SB

) −Φ(q

SB

). (7.48)

Since Φ

t

> 0 from the Spence-Mirrlees property, then (7.48) is equivalent to ¯ q

SB

q

SB

.

But from our assumptions we easily derive that q

SB

= q

∗

> ¯ q

∗

> ¯ q

SB

. So the Spence-

Mirrlees property guarantees that only the eﬃcient type’s incentive constraint has to be

taken into account.

7.11.2 More than Two Goods

Let us now assume that the agent is producing a whole vector of goods q = (q

1

, ..., q

n

) for

the principal. The agents’ cost function becomes C(q, θ) with C() being strictly convex

in q. The value for the principal of consuming this whole bundle is now S(q) with S()

being strictly concave in q.

In this multi-output incentive problem, the principal is interested in a whole set of

activities carried out simultaneously by the agent. It is straightforward to check that the

eﬃcient agent’s information rent is now written as U = Φ(q) with Φ(q) = C(q,

¯

θ)−C(q, θ).

This leads to second- best optimal outputs. The eﬃcient type produces the ﬁrst-best

vector of outputs q

SB

= q

∗

with

S

q

i

(q

∗

) = C

q

i

(q

∗

, θ) for all i ∈ ¦1, ..., n¦. (7.49)

The ineﬃcient types vector of outputs ¯ q

SB

is instead characterized by the ﬁrst-order

conditions

S

q

i

(¯ q

SB

) = C

q

i

(¯ q

SB

,

¯

θ) +

ν

1 −ν

Φ

q

i

(¯ q

SB

) for all i ∈ ¦1, ..., n¦, (7.50)

which generalizes the distortion of models with a single good.

Without further specifying the value and cost functions, the second-best outputs deﬁne

a vector of outputs with some components ¯ q

SB

i

above ¯ q

∗

i

for a subset of indices i.

Turning to incentive compatibility, summing the incentive constraints U

¯

U + Φ(¯ q)

157

and

¯

U U −Φ(q) for any incentive feasible contract yields

Φ(q) = C(q,

¯

θ) −C(q, θ) (7.51)

C(¯ q,

¯

θ) −C(¯ q, θ)

= Φ(¯ q) for all implementable pairs (¯ q, q). (7.52)

Obviously, this condition is satisﬁed if the Spence-Mirrlees property C

q

i

θ

> 0 holds for

each output i and if the monotonicity conditions ¯ q

i

< q

i

for all i are satisﬁed.

7.12 Ex Ante versus Ex Post Participation Constraints

The case of contracts we consider so far is oﬀered at the interim stage, i.e., the agent

already knows his type. However, sometimes the principal and the agent can contract

at the ex ante stage, i.e., before the agent discovers his type. For instance, the contours

of the ﬁrm may be designed before the agent receives any piece of information on his

productivity. In this section, we characterize the optimal contract for this alternative

timing under various assumptions about the risk aversion of the two players.

7.12.1 Risk Neutrality

Suppose that the principal and the agent meet and contract ex ante. If the agent is risk

neutral, his ex ante participation constraint is now written as

νU + (1 −ν)

¯

U 0. (7.53)

This ex ante participation constraint replaces the two interim participation constraints.

Since the principal’s objective function is decreasing in the agent’s expected informa-

tion rent, the principal wants to impose a zero expected rent to the agent and have (7.53)

be binding. Moreover, the principal must structure the rents U and

¯

U to ensure that the

two incentive constraints remain satisﬁed. An example of such a rent distribution that

is both incentive compatible and satisﬁes the ex ante participation constraint with an

equality is

U

∗

= (1 −ν)θ¯ q

∗

> 0 and

¯

U

∗

= −νθ¯ q

∗

< 0. (7.54)

158

With such a rent distribution, the optimal contract implements the ﬁrst-best outputs

without cost from the principal’s point of view as long as the ﬁrst-best is monotonic as

requested by the implementability condition. In the contract deﬁned by (7.54), the agent

is rewarded when he is eﬃcient and punished when he turns out to be ineﬃcient. In

summary, we have

Proposition 7.12.1 When the agent is risk neutral and contracting takes place ex ante,

the optimal incentive contract implements the ﬁrst-best outcome.

Remark 7.12.1 The principal has in fact much more leeway in structuring the rents U

and

¯

U in such a way that the incentive constraints hold and the ex ante participation

constraint (7.53) holds with an equality. Consider the following contracts ¦(t

∗

, q

∗

); (

¯

t

∗

, ¯ q

∗

)¦

where t

∗

= S(q

∗

) − T

∗

and

¯

t

∗

= S(¯ q

∗

) − T

∗

, with T

∗

being a lump-sum payment to be

deﬁned below. This contract is incentive compatible since

t

∗

−θq

∗

= S(q

∗

) −θq

∗

−T

∗

>

¯

t

∗

−θ¯ q

∗

= S(¯ q

∗

) −θ¯ q

∗

−T

∗

(7.55)

by deﬁnition of q

∗

, and

¯

t

∗

−

¯

θ¯ q

∗

= S(¯ q

∗

) −

¯

θ¯ q

∗

−T

∗

> t

∗

−

¯

θq

∗

= S(q

∗

) −

¯

θq

∗

−T

∗

(7.56)

by deﬁnition of ¯ q

∗

.

Note that the incentive compatibility constraints are now strict inequalities. Moreover,

the ﬁxed-fee T

∗

can be used to satisfy the agent’s ex ante participation constraint with an

equality by choosing T

∗

= ν(S(q

∗

)−θq

∗

)+(1−ν)(S(¯ q

∗

)−

¯

θ¯ q

∗

). This implementation of the

ﬁrst-best outcome amounts to having the principal selling the beneﬁt of the relationship

to the risk-neutral agent for a ﬁxed up-front payment T

∗

. The agent beneﬁts from the

full value of the good and trades oﬀ the value of any production against its cost just as

if he was an eﬃciency maximizer. We will say that the agent is residual claimant for the

ﬁrms proﬁt.

7.12.2 Risk Aversion

A Risk-Averse Agent

The previous section has shown us that the implementation of the ﬁrst-best is feasible

with risk neutrality. What happens if the agent is risk-averse?

159

Consider now a risk-averse agent with a Von Neumann-Morgenstern utility function

u() deﬁned on his monetary gains t −θq, such that u

t

> 0, u

tt

< 0 and u(0) = 0. Again,

the contract between the principal and the agent is signed before the agent discovers

his type. The incentive constraints are unchanged but the agent’s ex ante participation

constraint is now written as

νu(U) + (1 −ν)u(

¯

U) 0. (7.57)

As usual, one can check (7.21) is slack at the optimum, and thus the principal’s program

reduces now to

max

|(

¯

U,¯ q);(U,q)¦

ν(S(q) −θq −U) + (1 −ν)(S(¯ q) −

¯

θ¯ q −

¯

U),

subject to (7.20) and (7.57).

We have the following proposition.

Proposition 7.12.2 When the agent is risk-averse and contracting takes place ex ante,

the optimal menu of contracts entails:

(1) No output distortion for the eﬃcient q

SB

= q

∗

. A downward output dis-

tortion for the ineﬃcient type ¯ q

SB

< ¯ q

∗

, with

S

t

(¯ q

SB

) =

¯

θ +

ν(u

t

(

¯

U

SB

) −u

t

(U

SB

))

νu

t

(U

SB

) + (1 −ν)u

t

(

¯

U

SB

)

∆θ. (7.58)

(2) Both (7.20) and (7.57) are the only binding constraints. The eﬃcient

(resp. ineﬃcient) type gets a strictly positive (resp. negative) ex post

information rent, U

SB

> 0 >

¯

U

SB

.

Proof: Deﬁne the following Lagrangian for the principals problem

L(q, ¯ q, U,

¯

U, λ, µ) = ν(S(q) −θq −U) + (1 −ν)(S(¯ q) −

¯

θ¯ q −

¯

U)

+λ(U −

¯

U −∆θ¯ q) + µ(νu(U) + (1 −ν)u(U)). (7.59)

Optimizing w.r.t. U and

¯

U yields respectively

−ν + λ + µνu

t

(U

SB

) = 0 (7.60)

−(1 −ν) −λ + µ(1 −ν)u

t

(

¯

U

SB

) = 0. (7.61)

160

Summing the above two equations, we obtain

µ(νu

t

(U

SB

) + (1 −ν)u

t

(

¯

U

SB

)) = 1. (7.62)

and thus µ > 0. Using (7.62) and inserting it into (7.60) yields

λ =

ν(1 −ν)(u

t

(

¯

U

SB

) −u

t

(U

SB

))

νu

t

(U

SB

) + (1 −ν)u

t

(

¯

U

SB

)

. (7.63)

Moreover, (7.20) implies that U

SB

¯

U

SB

and thus λ 0, with λ > 0 for a positive

output y.

Optimizing with respect to outputs yields respectively

S

t

(q

SB

) = θ (7.64)

and

S

t

(¯ q

SB

) =

¯

θ +

λ

1 −ν

∆θ. (7.65)

Simplifying by using (7.63) yields (7.58).

Thus, with risk aversion, the principal can no longer costlessly structure the agent’s

information rents to ensure the eﬃcient type’s incentive compatibility constraint. Creating

a wedge between U and

¯

U to satisfy (7.20) makes the risk-averse agent bear some risk.

To guarantee the participation of the risk-averse agent, the principal must now pay a risk

premium. Reducing this premium calls for a downward reduction in the ineﬃcient type’s

output so that the risk borne by the agent is lower. As expected, the agent’s risk aversion

leads the principal to weaken the incentives.

When the agent becomes inﬁnitely risk averse, everything happens as if he had an

ex post individual rationality constraint for the worst state of the world given by (7.23).

In the limit, the ineﬃcient agent’s output ¯ q

SB

and the utility levels U

SB

and

¯

U

SB

all

converge toward the same solution. So, the previous model at the interim stage can also

be interpreted as a model with an ex ante inﬁnitely risk-agent at the zero utility level.

A Risk-Averse Principal

Consider now a risk-averse principal with a Von Neumann-Morgenstern utility function

ν() deﬁned on his monetary gains from trade S(q) − t such that ν

t

> 0, ν

tt

< 0 and

ν(0) = 0. Again, the contract between the principal and the risk-neutral agent is signed

before the agent knows his type.

161

In this context, the ﬁrst-best contract obviously calls for the ﬁrst-best output q

∗

and

¯ q

∗

being produced. It also calls for the principal to be fully insured between both states

of nature and for the agent’s ex ante participation constraint to be binding. This leads

us to the following two conditions that must be satisﬁed by the agent’s rents U

∗

and

¯

U

∗

:

S(q

∗

) −θq

∗

−U

∗

= S(¯ q

∗

) −

¯

θ¯ q

∗

−

¯

U

∗

(7.66)

and

νU

∗

+ (1 −ν)

¯

U

∗

= 0. (7.67)

Solving this system of two equations with two unknowns (U

∗

,

¯

U

∗

) yields

U

∗

= (1 −ν)(S(q

∗

) −θq

∗

−(S(¯ q

∗

) −

¯

θ¯ q

∗

)) (7.68)

and

¯

U

∗

= −ν(S(q

∗

) −θq

∗

−(S(¯ q

∗

) −

¯

θ¯ q

∗

)). (7.69)

Note that the ﬁrst-best proﬁle of information rents satisﬁes both types’ incentive

compatibility constraints since

U

∗

−

¯

U

∗

= S(q

∗

) −θq

∗

−(S(¯ q

∗

) −

¯

θ¯ q

∗

) > ∆θ¯ q

∗

(7.70)

(from the deﬁnition of q

∗

) and

¯

U

∗

−U

∗

= S(¯ q

∗

) −

¯

θ¯ q

∗

−(S(q

∗

) −θq

∗

) > −∆θq

∗

, (7.71)

(from the deﬁnition of ¯ q

∗

). Hence, the proﬁle of rents (U

∗

,

¯

U

∗

) is incentive compatible and

the ﬁrst-best allocation is easily implemented in this framework. We can thus generalize

the proposition for the case of risk neutral as follows:

Proposition 7.12.3 When the principal is risk-averse over the monetary gains S(q) −t,

the agent is risk-neutral, and contracting takes place ex ante, the optimal incentive contract

implements the ﬁrst-best outcome.

Remark 7.12.2 It is interesting to note that U

∗

and

¯

U

∗

obtained in (7.70) and (7.71)

are also the levels of rent obtained in (7.55) and (reftransfer222). Indeed, the lump-sum

payment T

∗

= ν(S(q

∗

)−θq

∗

)+(1−ν)(S(¯ q

∗

)−

¯

θ¯ q

∗

), which allows the principal to make the

risk-neutral agent residual claimant for the hierarchy’s proﬁt, also provides full insurance

162

to the principal. By making the risk-neutral agent the residual claimant for the value

of trade, ex ante contracting allows the risk-averse principal to get full insurance and

implement the ﬁrst-best outcome despite the informational problem.

Of course this result does not hold anymore if the agent’s interim participation con-

straints must be satisﬁed. In this case, we still guess a solution such that (7.22) is slack

at the optimum. The principal’s program now reduces to:

max

|(

¯

U,¯ q);U,q)¦

νυ(S(q) −θq −U) + (1 −ν)υ(S(¯ q) −

¯

θ¯ q −

¯

U)

subject to (7.20) to (7.23).

Inserting the values of U and

¯

U that were obtained from the binding constraints in

(7.20) and (7.23) into the principal’s objective function and optimizing with respect to

outputs leads to q

SB

= q

∗

, i.e., no distortion for the eﬃcient type, just as in the ease of

risk neutrality and a downward distortion of the ineﬃcient type’s output ¯ q

SB

< ¯ q

∗

given

by

S

t

(¯ q

SB

) =

¯

θ +

νυ

t

(V

SB

)

(1 −ν)υ

t

(

¯

V

SB

)

∆θ. (7.72)

where V

SB

= S(q

∗

)−θq

∗

−∆θ¯ q

SB

and

¯

V

SB

= S(¯ q

SB

)−

¯

θ¯ q

SB

are the principal’s payoﬀs in

both states of nature. We can check that

¯

V

SB

< V

SB

since S(¯ q

SB

) −θ¯ q

SB

< S(q

∗

) −θq

∗

from the deﬁnition of q

∗

. In particular, we observe that the distortion in the right-hand

side of (7.72) is always lower than

ν

1−ν

∆θ, its value with a risk-neutral principal. The

intuition is straightforward. By increasing ¯ q above its value with risk neutrality, the risk-

averse principal reduces the diﬀerence between V

SB

and

¯

V

SB

. This gives the principal

some insurance and increases his ex ante payoﬀ.

For example, if ν(x) =

1−e

−rx

r

, (7.72) becomes S

t

(¯ q

SB

) =

¯

θ +

ν

1−ν

e

r(

¯

V

SB

−V

SB

)

∆θ. If

r = 0, we get back the distortion obtained in section 7.7 with a risk-neutral principal

and interim participation constraints for the agent. Since

¯

V

SB

< V

SB

, we observe that

the ﬁrst-best is implemented when r goes to inﬁnity. In the limit, the inﬁnitely risk-

averse principal is only interested in the ineﬃcient state of nature for which he wants to

maximize the surplus, since there is no rent for the ineﬃcient agent. Moreover, giving a

rent to the eﬃcient agent is now without cost for the principal.

Risk aversion on the side of the principal is quite natural in some contexts. A local

regulator with a limited budget or a specialized bank dealing with relatively correlated

163

projects may be insuﬃciently diversiﬁed to become completely risk neutral. See Lewis and

Sappington (Rand J. Econ, 1995) for an application to the regulation of public utilities.

7.13 Commitment

To solve the incentive problem, we have implicitly assumed that the principal has a strong

ability to commit himself not only to a distribution of rents that will induce information

revelation but also to some allocative ineﬃciency designed to reduce the cost of this

revelation. Alternatively, this assumption also means that the court of law can perfectly

enforce the contract and that neither renegotiating nor reneging on the contract is a

feasible alternative for the agent and (or) the principal. What can happen when either of

those two assumptions is relaxed?

7.13.1 Renegotiating a Contract

Renegotiation is a voluntary act that should beneﬁt both the principal and the agent. It

should be contrasted with a breach of contract, which can hurt one of the contracting

parties. One should view a renegotiation procedure as the ability of the contracting

partners to achieve a Pareto improving trade if any becomes incentive feasible along the

course of actions.

Once the diﬀerent types have revealed themselves to the principal by selecting the con-

tracts (t

SB

, q

SB

) for the eﬃcient type and (

¯

t

SB

, ¯ q

SB

) for the ineﬃcient type, the principal

may propose a renegotiation to get around the allocative ineﬃciency he has imposed on

the ineﬃcient agent’s output. The gain from this renegotiation comes from raising alloca-

tive eﬃciency for the ineﬃcient type and moving output from ¯ q

SB

to ¯ q

∗

. To share these

new gains from trade with the ineﬃcient agent, the principal must at least oﬀer him the

same utility level as before renegotiation. The participation constraint of the ineﬃcient

agent can still be kept at zero when the transfer of this type is raised from

¯

t

SB

=

¯

θ¯ q

SB

to

¯

t

∗

=

¯

θ¯ q

∗

. However, raising this transfer also hardens the ex ante incentive compatibility

constraint of the eﬃcient type. Indeed, it becomes more valuable for an eﬃcient type

to hide his type so that he can obtain this larger transfer, and truthful revelation by

the eﬃcient type is no longer obtained in equilibrium. There is a fundamental trade-oﬀ

164

between raising eﬃciency ex post and hardening ex ante incentives when renegotiation is

an issue.

7.13.2 Reneging on a Contract

A second source of imperfection arises when either the principal or the agent reneges on

their previous contractual obligation. Let us take the case of the principal reneging on

the contract. Indeed, once the agent has revealed himself to the principal by selecting the

contract within the menu oﬀered by the principal, the latter, having learned the agent’s

type, might propose the complete information contract which extracts all rents without

inducing ineﬃciency. On the other hand, the agent may want to renege on a contract

which gives him a negative ex post utility level as we discussed before. In this case, the

threat of the agent reneging a contract signed at the ex ante stage forces the agent’s

participation constraints to be written in interim terms. Such a setting justiﬁes the focus

on the case of interim contracting.

7.14 Informative Signals to Improve Contracting

In this section, we investigate the impacts of various improvements of the principal’s

information system on the optimal contract. The idea here is to see how signals that are

exogenous to the relationship can be used by the principal to better design the contract

with the agent.

7.14.1 Ex Post Veriﬁable Signal

Suppose that the principal, the agent and the court of law observe ex post a viable signal

σ which is correlated with θ. This signal is observed after the agent’s choice of production.

The contract can then be conditioned on both the agent’s report and the observed signal

that provides useful information on the underlying state of nature.

For simplicity, assume that this signal may take only two values, σ

1

and σ

2

. Let the

conditional probabilities of these respective realizations of the signal be µ

1

= Pr(σ =

σ

1

/θ = θ) 1/2 and µ

2

= Pr(σ = σ

2

/θ =

¯

θ) 1/2. Note that, if µ

1

= µ

2

= 1/2,

the signal σ is uninformative. Otherwise, σ

1

brings good news the fact that the agent is

165

eﬃcient and σ

2

brings bad news, since it is more likely that the agent is ineﬃcient in this

case.

Let us adopt the following notations for the ex post information rents: u

11

= t(θ, σ

1

)−

θq(θ, σ

1

), u

12

= t(θ, σ

2

)−θq(θ, σ

2

), u

21

= t(

¯

θ, σ

1

)−

¯

θq(

¯

θ, σ

1

), and u

22

= t(

¯

θ, σ

2

)−

¯

θq(

¯

θ, σ

2

).

Similar notations are used for the outputs q

jj

. The agent discovers his type and plays the

mechanism before the signal σ realizes. Then the incentive and participation constraints

must be written in expectation over the realization of σ. Incentive constraints for both

types write respectively as

µ

1

u

11

+ (1 −µ

1

)u

12

µ

1

(u

21

+ ∆θq

21

) + (1 −µ

1

)(u

22

+ ∆θq

22

) (7.73)

(1 −µ

2

)u

21

+ µ

2

u

22

(1 −µ

2

)(u

11

−∆θq

11

) + µ

2

(u

12

−∆θq

12

). (7.74)

Participation constraints for both types are written as

µ

1

u

11

+ (1 −µ

1

)u

12

0, (7.75)

(1 −µ

2

)u

21

+µ

2

u

22

0. (7.76)

Note that, for a given schedule of output q

ij

, the system (7.73) through (7.76) has as many

equations as unknowns u

ij

. When the determinant of the coeﬃcient matrix of the system

(7.73) to (7.76) is nonzero, one can ﬁnd ex post rents u

ij

(or equivalent transfers) such

that all these constraints are binding. In this case, the agent receives no rent whatever his

type. Moreover, any choice of production levels, in particular the complete information

optimal ones, can be implemented this way. Note that the determinant of the system is

nonzero when

1 −µ

1

−µ

2

= 0 (7.77)

that fails only if µ

1

= µ

2

=

1

2

, which corresponds to the case of an uninformative and

useless signal.

7.14.2 Ex Ante Nonveriﬁable Signal

Now suppose that a nonveriﬁable binary signal σ about θ is available to the principal at

the ex ante stage. Before oﬀering an incentive contract, the principal computes, using

166

the Bayes law, his posterior belief that the agent is eﬃcient for each value of this signal,

namely

ˆ ν

1

= Pr(θ = θ/σ = σ

1

) =

νµ

1

νµ

1

+ (1 −ν)(1 −µ

2

)

, (7.78)

ˆ ν

2

= Pr(θ = θ/σ = σ

2

) =

ν(1 −µ

1

)

ν(1 −µ

1

) + (1 −ν)µ

2

. (7.79)

Then the optimal contract entails a downward distortion of the ineﬃcient agents produc-

tion ¯ q

SB

(σ

i

)) which is for signals σ

1

, and σ

2

respectively:

S

t

(¯ q

SB

(σ

1

)) =

¯

θ +

´ ν

1

1 − ´ ν

1

∆θ =

¯

θ +

νµ

1

(1 −ν)(1 −µ

2

)

∆θ (7.80)

S

t

(¯ q

SB

(σ

2

)) =

¯

θ +

´ ν

2

1 − ´ ν

2

∆θ =

¯

θ +

ν(1 −µ

1

)

(1 −ν)µ

2

)

∆θ. (7.81)

In the case where µ

1

= µ

2

= µ >

1

2

, we can interpret µ as an index of the informativeness

of the signal. Observing σ

1

, the principal thinks that it is more likely that the agent is

eﬃcient. A stronger reduction in ¯ q

SB

and thus in the eﬃcient type’s information rent is

called for after σ

1

. (7.80) shows that incentives decrease with respect to the case without

informative signal since

µ

1−µ

> 1

**. In particular, if µ is large enough, the principal shuts
**

down the ineﬃcient ﬁrm after having observed σ

1

. The principal oﬀers a high-powered

incentive contract only to the eﬃcient agent, which leaves him with no rent. On the

contrary, because he is less likely to face an eﬃcient type after having observed σ

2

, the

principal reduces less of the information rent than in the case without an informative

signal since

1−µ

µ

< 1

**. Incentives are stronger.
**

7.15 Contract Theory at Work

This section proposes several classical settings where the basic model of this chapter

is useful. Introducing adverse selection in each of these contexts has proved to be a

signiﬁcative improvement of standard microeconomic analysis.

7.15.1 Regulation

In the Baron and Myerson (Econometrica, 1982) regulation model, the principal is a

regulator who maximizes a weighted average of the agents’ surplus S(q) − t and of a

regulated monopoly’s proﬁt U = t − θq, with a weight α < 1 for the ﬁrms proﬁt. The

167

principal’s objective function is written now as V = S(q) −θq −(1−α)U. Because α < 1,

it is socially costly to give up a rent to the ﬁrm. Maximizing expected social welfare

under incentive and participation constraints leads to q

SB

= q

∗

for the eﬃcient type and

a downward distortion for the ineﬃcient type, ¯ q

SB

< ¯ q

∗

which is given by

S

t

(¯ q

SB

) =

¯

θ +

ν

1 −ν

(1 −α)∆θ. (7.82)

Note that a higher value of α reduces the output distortion, because the regulator is

less concerned by the distribution of rents within society as α increases. If α = 1, the

ﬁrm’s rent is no longer costly and the regulator behaves as a pure eﬃciency maximizer

implementing the ﬁrst-best output in all states of nature.

The regulation literature of the last ﬁfteen years has greatly improved our understand-

ing of government intervention under asymmetric information. We refer to the book of

Laﬀont and Tirole (1993) for a comprehensive view of this theory and its various impli-

cations for the design of real world regulatory institutions.

7.15.2 Nonlinear Pricing by a Monopoly

In Maskin and Riley (Rand J. of Economics, 1984), the principal is the seller of a private

good with production cost cq who faces a continuum of buyers. The principal has thus a

utility function V = t − cq. The tastes of a buyer for the private good are such that his

utility function is U = θu(q) −t, where q is the quantity consumed and t his payment to

the principal. Suppose that the parameter θ of each buyer is drawn independently from

the same distribution on Θ = ¦θ,

¯

θ¦ with respective probabilities 1 −ν and ν.

We are now in a setting with a continuum of agents. However, it is mathematically

equivalent to the framework with a single agent. Now ν is the frequency of type θ by the

Law of Large Numbers.

Incentive and participation constraints can as usual be written directly in terms of the

information rents U = θu(q) −t and

¯

U =

¯

θu(¯ q) −

¯

t as

U

¯

U −∆θu(¯ q), (7.83)

¯

U U + ∆θu(q), (7.84)

U 0, (7.85)

168

¯

U 0. (7.86)

The principal’s program now takes the following form:

max

|(

¯

U,¯ q);(U,q)¦

v(

¯

θu(¯ q) + (1 −v)(θu(q) −cq) −(ν

¯

U + (1 −ν)U)

subject to (7.83) to (7.86).

The analysis is the mirror image of that of the standard model discussed before, where

now the eﬃcient type is the one with the highest valuation for the good

¯

θ. Hence, (7.84)

and (7.85) are the two binding constraints. As a result, there is no output distortion

with respect to the ﬁrst-best outcome for the high valuation type and ¯ q

SB

= ¯ q

∗

, where

¯

θu

t

(¯ q

∗

) = c. However, there exists a downward distortion of the low valuation agent’s

output with respect to the ﬁrst-best outcome. We have q

SB

< q

∗

, where

θ −

ν

1 −ν

∆θ

u

t

(q

SB

) = C and θu

t

(q

∗

) = c. (7.87)

7.15.3 Quality and Price Discrimination

Mussa and Rosen (JET, 1978) studied a very similar problem to the nonlinear pricing,

where agents buy one unit of a commodity with quality q but are vertically diﬀerentiated

with respect to their preferences for the good. The marginal cost (and average cost)

of producing one unit of quality q is C(q) and the principal has the utility function

V = t − C(q). The utility function of an agent is now U = θq − t with θ in Θ = ¦θ,

¯

θ¦,

with respective probabilities 1 −ν and ν.

Incentive and participation constraints can still be written directly in terms of the

information rents U = θq −t and

¯

U =

¯

θ¯ q −

¯

t as

U

¯

U −∆θ¯ q, (7.88)

¯

U U + ∆θq, (7.89)

U 0, (7.90)

¯

U 0. (7.91)

The principal solves now:

max

|(U,q);(

¯

U,¯ q)¦

v(

¯

θ¯ q −C(¯ q)) + (1 −ν)(θq −C(q)) −(ν

¯

U + (1 −ν)U)

169

subject to (7.88) to (7.91).

Following procedures similar to what we have done so far, only (7.89) and (7.90) are

binding constraints. Finally, we ﬁnd that the high valuation agent receives the ﬁrst-best

quality ¯ q

SB

= ¯ q

∗

where

¯

θ = C

t

(¯ q

∗

). However, quality is now reduced below the ﬁrst-best

for the low valuation agent. We have q

SB

< q

∗

,where

θ = C

t

(q

SB

) +

ν

1 −ν

∆θ and θ = C

t

(q

∗

) (7.92)

Interestingly, the spectrum of qualities is larger under asymmetric information than under

complete information. This incentive of the seller to put a low quality good on the market

is a well-documented phenomenon in the industrial organization literature. Some authors

have even argued that damaging its own goods may be part of the ﬁrm’s optimal selling

strategy when screening the consumers’ willingness to pay for quality is an important

issue.

7.15.4 Financial Contracts

Asymmetric information signiﬁcantly aﬀects the ﬁnancial markets. For instance, in a

paper by Freixas and Laﬀont (1990), the principal is a lender who provides a loan of size

k to a borrower. Capital costs Rk to the lender since it could be invested elsewhere in

the economy to earn the risk-free interest rate R. The lender has thus a utility function

V = t − Rk. The borrower makes a proﬁt U = θf(k) − t where θf(k) is the production

with k units of capital and t is the borrowers repayment to the lender. We assume that

f

t

> 0 and f

tt

< 0. The parameter θ is a productivity shock drawn from Θ = ¦θ,

¯

θ¦ with

respective probabilities 1 −ν and ν.

Incentive and participation constraints can again be written directly in terms of the

borrower’s information rents U = θf(k) −t and

¯

U =

¯

θf(

¯

k) −

¯

t as

U

¯

U −∆θf(

¯

k), (7.93)

¯

U U + ∆θf(k), (7.94)

U 0, (7.95)

¯

U 0. (7.96)

170

The principal’s program takes now the following form:

max

|(U,k);(

¯

U,

¯

k)¦

v(

¯

θf(

¯

k) −R

¯

k) + (1 −ν)(θf(k)) −Rk) −(ν

¯

U + (1 −ν)U)

subject to (7.93) to (7.96).

One can check that (7.94) and (7.95) are now the two binding constraints. As a

result, there is no capital distortion with respect to the ﬁrst-best outcome for the high

productivity type and

¯

k

SB

= k

∗

where

¯

θf

t

(

¯

k

∗

) = R. In this case, the return on capital

is equal to the risk-free interest rate. However, there also exists a downward distortion

in the size of the loan given to a low productivity borrower with respect to the ﬁrst-best

outcome. We have k

SB

< k

∗

where

θ −

ν

1 −ν

∆θ

f

t

(k

SB

) = R and θf

t

(k

∗

) = R. (7.97)

7.15.5 Labor Contracts

Asymmetric information also undermines the relationship between a worker and the ﬁrm

for which he works. In Green and Kahn (QJE, 1983) and Hart (RES, 1983), the principal

is a union (or a set of workers) providing its labor force l to a ﬁrm.

The ﬁrm makes a proﬁt θf(l)−t, where f(l) is the return on labor and t is the worker’s

payment. We assume that f

t

> 0 and f

tt

< 0. The parameter θ is a productivity shock

drawn from Θ = ¦θ,

¯

θ¦ with respective probabilities 1−ν and ν. The ﬁrm’s objective is to

maximize its proﬁt U = θf(l)−t. Workers have a utility function deﬁned on consumption

and labor. If their disutility of labor is counted in monetary terms and all revenues from

the ﬁrm are consumed, they get V = v(t −l) where l is their disutility of providing l units

of labor and v() is increasing and concave (v

t

> 0, v

tt

< 0).

In this context, the ﬁrm’s boundaries are determined before the realization of the shock

and contracting takes place ex ante. It should be clear that the model is similar to the one

with a risk-averse principal and a risk- neutral agent. So, we know that the risk-averse

union will propose a contract to the risk-neutral ﬁrm which provides full insurance and

implements the ﬁrst-best levels of employments

¯

l and l

∗

deﬁned respectively by

¯

θf

t

(

¯

l

∗

) = 1

and θf

t

(l

∗

) = 1.

When workers have a utility function exhibiting an income eﬀect, the analysis will

become much harder even in two-type models. For details, see Laﬀont and Martimort

171

(2002).

7.16 The Optimal Contract with a Continuum of Types

In this section, we give a brief account of the continuum type case. Most of the principal-

agent literature is written within this framework.

Reconsider the standard model with θ in Θ = [θ,

¯

θ], with a cumulative distribution

function F(θ) and a density function f(θ) > 0 on [θ,

¯

θ]. Since the revelation principle is

still valid with a continuum of types, and we can restrict our analysis to direct revelation

mechanisms ¦(q(

˜

θ), t(

˜

θ))¦, which are truthful, i.e., such that

t(θ) −θq(θ) t(

˜

θ) −θq(

˜

θ) for any (θ,

˜

θ) ∈ Θ

2

. (7.98)

In particular, (7.98) implies

t(θ) −θq(θ) t(θ

t

) −θq(θ

t

), (7.99)

t(θ

t

) −θ

t

q(θ

t

) t(θ) −θ

t

q(θ) for all pairs (θ, θ

t

) ∈ Θ

2

. (7.100)

Adding (7.99) and (7.100) we obtain

(θ −θ

t

)(q(θ

t

) −q(θ)) 0. (7.101)

Thus, incentive compatibility alone requires that the schedule of output q() has to be

nonincreasing. This implies that q() is diﬀerentiable almost everywhere. So we will

restrict the analysis to diﬀerentiable functions.

(7.98) implies that the following ﬁrst-order condition for the optimal response

˜

θ chosen

by type θ is satisﬁed

˙

t(

˜

θ) −θ ˙ q(

˜

θ) = 0. (7.102)

For the truth to be an optimal response for all θ, it must be the case that

˙

t(θ) −θ ˙ q(θ) = 0, (7.103)

and (7.103) must hold for all θ in Θ since θ is unknown to the principal.

It is also necessary to satisfy the local second-order condition,

¨

t(

˜

θ)[

˜

θ=θ

−θ¨ q(

˜

θ)[

˜

θ=θ

0 (7.104)

172

or

¨

t(θ) −θ¨ q(θ) 0. (7.105)

But diﬀerentiating (7.103), (7.105) can be written more simply as

−˙ q(θ) 0. (7.106)

(7.103) and (7.106) constitute the local incentive constraints, which ensure that the

agent does not want to lie locally. Now we need to check that he does not want to lie

globally either, therefore the following constraints must be satisﬁed

t(θ) −θq(θ) t(

˜

θ) −θq(

˜

θ) for any (θ,

˜

θ) ∈ Θ

2

. (7.107)

From (7.103) we have

t(θ) −t(

˜

θ) =

θ

˜

θ

τ ˙ q(τ)dτ = θq(θ) −

˜

θq(

˜

θ) −

θ

˜

θ

q(τ)dτ (7.108)

or

t(θ) −θq(θ) = t(

˜

θ) −θq(

˜

θ) + (θ −

˜

θ)q(

˜

θ) −

θ

¯

θ

q(τ)dτ, (7.109)

where (θ −

˜

θ)q(

˜

θ) −

θ

¯

θ

q(τ)dτ 0, because q() is nonincreasing.

So, it turns out that the local incentive constraints (7.103) also imply the global

incentive constraints.

In such circumstances, the inﬁnity of incentive constraints (7.107) reduces to a diﬀer-

ential equation and to a monotonicity constraint. Local analysis of incentives is enough.

Truthful revelation mechanisms are then characterized by the two conditions (7.103) and

(7.106).

Let us use the rent variable U(θ) = t(θ) −θq(θ). The local incentive constraint is now

written as (by using (7.103))

˙

U(θ) = −q(θ). (7.110)

The optimization program of the principal becomes

max

|(U(),q())¦

¯

θ

θ

(S(q(θ)) −θq(θ) −U(θ))f(θ)dθ (7.111)

173

subject to

˙

U(θ) = −q(θ), (7.112)

˙ q(θ) 0, (7.113)

U(θ) 0. (7.114)

Using (7.110), the participation constraint (7.114) simpliﬁes to U(

¯

θ) 0. As in the

discrete case, incentive compatibility implies that only the participation constraint of the

most ineﬃcient type can be binding. Furthermore, it is clear from the above program

that it will be binding. i.e., U(

¯

θ) = 0.

Momentarily ignoring (7.113), we can solve (7.112)

U(

¯

θ) −U(θ) = −

¯

θ

θ

q(τ)dτ (7.115)

or, since U(

¯

θ) = 0,

U(θ) =

¯

θ

θ

q(τ)dτ (7.116)

The principal’s objective function becomes

¯

θ

θ

S(q(θ)) −θq(θ) −

¯

θ

θ

q(τ)dτ

f(θ)dθ, (7.117)

which, by an integration of parts, gives

¯

θ

θ

S(q(θ)) −

θ +

F(θ)

f(θ)

q(θ)

f(θ)dθ. (7.118)

Maximizing pointwise (7.118), we get the second-best optimal outputs

S

t

(q

SB

(θ)) = θ +

F(θ)

f(θ)

, (7.119)

which is the ﬁrst order condition for the case of a continuum of types.

If the monotone hazard rate property

d

dθ

F(θ)

f(θ)

**0 holds, the solution q
**

SB

(θ) of

(7.119) is clearly decreasing, and the neglected constraint (7.113) is satisﬁed. All types

choose therefore diﬀerent allocations and there is no bunching in the optimal contract.

From (7.119), we note that there is no distortion for the most eﬃcient type (since

F(θ) = 0 and a downward distortion for all the other types.

All types, except the least eﬃcient one, obtain a positive information rent at the

optimal contract

U

SB

(θ) =

¯

θ

θ

q

SB

(τ)dτ. (7.120)

174

Finally, one could also allow for some shutdown of types. The virtual surplus S(q) −

θ +

F(θ)

f(θ)

**q decreases with θ when the monotone hazard rate property holds, and shut-
**

down (if any) occurs on an interval [θ

∗

,

¯

θ]. θ

∗

is obtained as a solution to

max

|θ

∗

¦

θ

∗

θ

S(q

SB

(θ)) −

θ +

F(θ)

f(θ)

q

SB

(θ)

f(θ)dθ.

For an interior optimum, we ﬁnd that

S(q

SB

(θ

∗

)) =

θ

∗

+

F(θ

∗

)

f(θ

∗

)

q

SB

(θ

∗

).

As in the discrete case, one can check that the Inada condition S

t

(0) = +∞ and the

condition lim

q→0

S

t

(q)q = 0 ensure the corner solution θ

∗

=

¯

θ.

Remark 7.16.1 The optimal solution above can also be derived by using the Pontryagin

principle. The Hamiltonian is then

H(q, U, µ, θ) = (S(q) −θq −U)f(θ) −µq, (7.121)

where µ is the co-state variable, U the state variable and q the control variable,

From the Pontryagin principle,

˙ µ(θ) = −

∂H

∂U

= f(θ). (7.122)

From the transversatility condition (since there is no constraint on U() at θ),

µ(θ) = 0. (7.123)

Integrating (7.122) using (7.123), we get

µ(θ) = F(θ). (7.124)

Optimizing with respect to q() also yields

S

t

q

SB

(θ)

= θ +

µ(θ)

f(θ)

, (7.125)

and inserting the value of µ(θ) obtained from (7.124) again yields(7.119).

We have derived the optimal truthful direct revelation mechanism ¦

q

SB

(θ), U

SB

(θ)

¦

or ¦(q

SB

(θ), t

SB

(θ))¦. It remains to be investigated if there is a simple implementation of

175

this mechanism. Since q

SB

() is decreasing, we can invert this function and obtain θ

SB

(q).

Then,

t

SB

(θ) = U

SB

(θ) + θq

SB

(θ) (7.126)

becomes

T(q) = t

SB

(θ

SB

(q)) =

¯

θ

θ(q)

q

SB

(τ)dτ + θ(q)q. (7.127)

To the optimal truthful direct revelation mechanism we have associated a nonlinear

transfer T(q). We can check that the agent confronted with this nonlinear transfer chooses

the same allocation as when he is faced with the optimal revelation mechanism. Indeed,

we have

d

dq

(T(q) −θq) = T

t

(q) −θ =

dt

SB

dθ

dθ

SB

dq

−θ = 0, since

dt

SB

dθ

−θ

dq

SB

dθ

= 0.

To conclude, the economic insights obtained in the continuum case are not diﬀerent

from those obtained in the two-state case.

7.17 Further Extensions

The main theme of this chapter was to determine how the fundamental conﬂict between

rent extraction and eﬃciency could be solved in a principal-agent relationship with ad-

verse selection. In the models discussed, this conﬂict was relatively easy to understand

because it resulted from the simple interaction of a single incentive constraint with a

single participation constraint. Here we would mention some possible extensions.

One can consider a straightforward three-type extension of the standard model. One

can also deal with a bidimensional adverse selection model, a two-type model with type-

dependent reservation utilities, random participation constraints, the limited liability con-

straints, and the audit models. For detailed discussion about these topics and their ap-

plications, see Laﬀont and Martimort (2002).

Reference

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Quarterly Journal of Economics, 89 (1970), 488-500.

Baron, D., and R. Myerson, “Regulating a Monopolist with Unknown Cost,” Economet-

rica, 50 (1982), 745-782.

176

Freixas, X., J.J. Laﬀont, “Optimal banking Contracts,” In Essays in Honor of Edmond

Malinvaud, Vol. 2, Macroeconomics, ed. P. Champsaur et al. Cambridge: MIT

Press, 1990.

Green, J., and C. Kahn, “Wage-Employment Contracts,” Quarterly Journal of Eco-

nomics, 98 (1983), 173-188.

Grossman, S., and O. Hart, “An Analysis of the Principal Agent,” Econometrica, 51

(1983), 7 45.

Hart, O., “Optimal Labor Contracts under Asymmetric Information: An Introduction,”

Review of Economic Studies, 50 (1983), 3-35.

Hurwicz, L. (1972), “On Informational Decentralized Systems,” in Decision and Orga-

nization, Radner, R. and C. B. McGuire, eds., in Honor of J. Marschak, (North-

Holland), 297-336.

Laﬀont, J.-J. and D. Martimort, The Theory of Incentives: The Principal-Agent Model,

Princeton and Oxford: Princeton University Press, 2002, Chapters 1-3.

Laﬀont, J.-J., and J. Tirole, The Theory of Incentives in Procurement and Regulation,

Cambridge: MIT Press, 1993.

Li, J. and G. Tian, “Optimal Contracts for Central Banks Revised,” Working Paper,

Texas A&M University, 2003.

Luenberger, D. Microeconomic Theory, McGraw-Hill, Inc, 1995, Chapter 12.

Mas-Colell, A., M. D. Whinston, and J. Green, Microeconomic, Oxford University Press,

1995, Chapter 13-14.

Maskin, E., and J. Riley, “Monopoly with Incomplete Information,” Rand Journal of

Economics, 15 (1984), 171-196.

Mussa, M., and S. Rosen, “Monopoly and Product Quality,” Journal of Economic The-

ory, 18 (1978), 301-317.

Rothschild, M., and J. Stiglitz, “Equilibrium in Competitive Insurance Markets,” Quar-

terly Journal of Economics, 93 (1976), 541-562.

177

Spence, M, “Job Market Signaling,” Quarterly Journal of Economics, 87 (1973), 355-374.

Stiglitz, J., “Monopoly Non Linear Pricing and IMperfect Information: The Insurance

Market,” Review of Economic Studies, 44 (1977), 407-430.

Varian, H.R., Microeconomic Analysis, W.W. Norton and Company, Third Edition,

1992, Chapters 25.

Williamson, O.E., Markets and Hierarchies: Analysis and Antitrust Implications, the

Free Press: New York, 1975, .

Wolfstetter, E., Topics in Microeconomics - Industrial Organization, Auctions, and In-

centives, Cambridge Press, 1999, Chapters 8-10.

178

Chapter 8

Moral Hazard: The Basic Trade-Oﬀs

8.1 Introduction

In the previous chapter, we stressed that the delegation of tasks creates an information

gap between the principal and his agent when the latter learns some piece of information

relevant to determining the eﬃcient volume of trade. Adverse selection is not the only

informational problem one can imagine. Agents may also choose actions that aﬀect the

value of trade or, more generally, the agent’s performance. The principal often loses any

ability to control those actions that are no longer observable, either by the principal who

oﬀers the contract or by the court of law that enforces it. In such cases we will say that

there is moral hazard.

The leading candidates for such moral hazard actions are eﬀort variables, which pos-

itively inﬂuence the agent’s level of production but also create a disutility for the agent.

For instance the yield of a ﬁeld depends on the amount of time that the tenant has spent

selecting the best crops, or the quality of their harvesting. Similarly, the probability that

a driver has a car crash depends on how safely he drives, which also aﬀects his demand

for insurance. Also, a regulated ﬁrm may have to perform a costly and nonobservable

investment to reduce its cost of producing a socially valuable good.

As in the case of adverse selection, asymmetric information also plays a crucial role

in the design of the optimal incentive contract under moral hazard. However, instead of

being an exogenous uncertainty for the principal, uncertainty is now endogenous. The

probabilities of the diﬀerent states of nature, and thus the expected volume of trade, now

179

depend explicitly on the agent’s eﬀort. In other words, the realized production level is

only a noisy signal of the agent’s action. This uncertainty is key to understanding the

contractual problem under moral hazard. If the mapping between eﬀort and performance

were completely deterministic, the principal and the court of law would have no diﬃculty

in inferring the agent’s eﬀort from the observed output. Even if the agent’s eﬀort was not

observable directly, it could be indirectly contracted upon, since output would itself be

observable and veriﬁable.

We will study the properties of incentive schemes that induce a positive and costly

eﬀort. Such schemes must thus satisfy an incentive constraint and the agent’s participa-

tion constraint. Among such schemes, the principal prefers the one that implements the

positive level of eﬀort at minimal cost. This cost minimization yields the characterization

of the second-best cost of implementing this eﬀort. In general, this second-best cost is

greater than the ﬁrst-best cost that would be obtained by assuming that eﬀort is observ-

able. An allocative ineﬃciency emerges as the result of the conﬂict of interests between

the principal and the agent.

8.2 The Model

8.2.1 Eﬀort and Production

We consider an agent who can exert a costly eﬀort e. Two possible values can be taken by

e, which we normalize as a zero eﬀort level and a positive eﬀort of one: e in ¦0, 1¦. Exerting

eﬀort e implies a disutility for the agent that is equal to ψ(e) with the normalization

ψ(0) = ψ

0

= 0 and ψ

1

= ψ.

The agent receives a transfer t from the principal. We assume that his utility function

is separable between money and eﬀort, U = u(t) −ψ(e), with u() increasing and concave

(u

t

> 0, u

tt

< 0). Sometimes we will use the function h = u

−1

, the inverse function of u(),

which is increasing and convex (h

t

> 0, h

tt

> 0).

Production is stochastic, and eﬀort aﬀects the production level as follows: the stochas-

tic production level ˜ q can only take two values ¦q, ¯ q¦, with ¯ q − q = ∆q > 0, and the

stochastic inﬂuence of eﬀort on production is characterized by the probabilities Pr(˜ q =

¯ q[e = 0) = π

0

, and Pr(˜ q = ¯ q[e = 1) = π

1

, with π

1

> π

0

. We will denote the diﬀerence

180

between these two probabilities by ∆π = π

1

−π

0

.

Note that eﬀort improves production in the sense of ﬁrst-order stochastic dominance,

i.e., Pr(˜ q q

∗

[e) is decreasing with e for any given production q

∗

. Indeed, we have Pr(˜ q

q[e = 1) = 1 −π

1

< 1 −π

0

= Pr(˜ q q[e = 0) and Pr(˜ q ¯ q[e = 1) = 1 =Pr(˜ q ¯ q[e = 0)

8.2.2 Incentive Feasible Contracts

Since the agent’s action is not directly observable by the principal, the principal can only

oﬀer a contract based on the observable and veriﬁable production level. i.e., a function

¦t(˜ q)¦ linking the agent’s compensation to the random output ˜ q. With two possible

outcomes ¯ q and q, the contract can be deﬁned equivalently by a pair of transfers

¯

t and t.

Transfer

¯

t (resp. t) is the payment received by the agent if the production ¯ q (resp. q) is

realized.

The risk-neutral principal’s expected utility is now written as

V

1

= π

1

(S(¯ q) −(

¯

t) + (1 −π

1

)(S(q) −t) (8.1)

if the agent makes a positive eﬀort (e = 1) and

V

0

= π

0

(S(¯ q) −(

¯

t) + (1 −π

0

)(S(q) −t) (8.2)

if the agent makes no eﬀort (e = 0). For notational simplicity, we will denote the princi-

pal’s beneﬁts in each state of nature by S(¯ q) =

¯

S and S(q) = S.

Each level of eﬀort that the principal wishes to induce corresponds to a set of contracts

ensuring moral hazard incentive constraint and participation constraint are satisﬁed:

π

1

u(

¯

t) + (1 −π

1

)u(t) −ψ π

0

u(

¯

t) + (1 −π

0

)u(t) (8.3)

π

1

u(

¯

t) + (1 −π

1

)u(t) −ψ 0. (8.4)

Note that the participation constraint is ensured at the ex ante stage, i.e., before the

realization of the production shock.

Deﬁnition 8.2.1 An incentive feasible contract satisﬁes the incentive and participation

constraints (8.3) and (8.4).

The timing of the contracting game under moral hazard is summarized in the ﬁgure

below.

181

Figure 8.1: Timing of contracting under moral harzard.

8.2.3 The Complete Information Optimal Contract

As a benchmark, let us ﬁrst assume that the principal and a benevolent court of law can

both observe eﬀort. Then, if he wants to induce eﬀort, the principal’s problem becomes

max

|(

¯

t,t)¦

π

1

(

¯

S −

¯

t) + (1 −π

1

)(S −t) (8.5)

subject to (8.4).

Indeed, only the agents participation constraint matters for the principal, because the

agent can be forced to exert a positive level of eﬀort. If the agent were not choosing this

level of eﬀort, the agent could be heavily punished, and the court of law could commit to

enforce such a punishment.

Denoting the multiplier of this participation constraint by λ and optimizing with

respect to

¯

t and t yields, respectively, the following ﬁrst-order conditions:

−π

1

+ λπ

1

u

t

(

¯

t

∗

) = 0, (8.6)

−(1 −π

1

) + λ(1 −π

1

)u

t

(t

∗

) = 0, (8.7)

where

¯

t

∗

and t

∗

are the ﬁrst-best transfers.

From (8.6) and (8.7) we immediately derive that λ =

1

u

(t

∗

)

=

1

u

(

¯

t

∗

)

> 0, and ﬁnally

that t

∗

=

¯

t

∗

= t

∗

.

Thus, with a veriﬁable eﬀort, the agent obtains full insurance from the risk-neutral

principal, and the transfer t

∗

he receives is the same whatever the state of nature. Because

the participation constraint is binding we also obtain the value of this transfer, which is

just enough to cover the disutility of eﬀort, namely t

∗

= h(ψ). This is also the expected

payment made by the principal to the agent, or the ﬁrst-best cost C

FB

of implementing

the positive eﬀort level.

182

For the principal, inducing eﬀort yields an expected payoﬀ equal to

V

1

= π

1

¯

S + (1 −π

1

)S −h(ψ) (8.8)

Had the principal decided to let the agent exert no eﬀort, e

0

, he would make a zero

payment to the agent whatever the realization of output. In this scenario, the principal

would instead obtain a payoﬀ equal to

V

0

= π

0

¯

S + (1 −π

0

)S. (8.9)

Inducing eﬀort is thus optimal from the principal’s point of view when V

1

V

0

, i.e.,

π

1

¯

S + (1 − π

1

)S − h(ψ) π

0

¯

S + (1 − π

0

)S, or to put it diﬀerently, when the expected

gain of eﬀect is greater than ﬁrst-best cost of inducing eﬀect, i.e.,

∆π∆S

. .. .

h(ψ)

....

(8.10)

where ∆S =

¯

S −S > 0.

Denoting the beneﬁt of inducing a strictly positive eﬀort level by B = ∆π∆S, the

ﬁrst-best outcome calls for e

∗

= 1 if and only if B > h(ψ), as shown in the ﬁgure below.

Figure 8.2: First-best level of eﬀort.

8.3 Risk Neutrality and First-Best Implementation

If the agent is risk-neutral, we have (up to an aﬃne transformation) u(t) = t for all t

and h(u) = u for all u. The principal who wants to induce eﬀort must thus choose the

contract that solves the following problem:

max

|(

¯

t,t)¦

π

1

(

¯

S −

¯

t) + (1 −π

1

)(S −t)

π

1

¯

t + (1 −π

1

)t −ψ π

0

¯

t + (1 −π

0

)t (8.11)

183

π

1

¯

t + (1 −π

1

)t −ψ 0. (8.12)

With risk neutrality the principal can, for instance, choose incentive compatible trans-

fers

¯

t and t, which make the agent’s participation constraint binding and leave no rent to

the agent. Indeed, solving (8.11) and (8.12) with equalities, we immediately obtain

t

∗

= −

π

0

∆π

ψ (8.13)

and

¯

t

∗

=

1 −π

0

∆π

ψ. (8.14)

The agent is rewarded if production is high. His net utility in this state of nature

¯

U

∗

=

¯

t

∗

− ψ =

1−π

1

∆π

ψ > 0. Conversely, the agent is punished if production is low. His

corresponding net utility U

∗

= t

∗

−ψ = −

π

1

∆π

ψ < 0.

The principal makes an expected payment π

1

¯

t

∗

+ (1 − π

1

)t

∗

= ψ, which is equal to

the disutility of eﬀort he would incur if he could control the eﬀort level perfectly. The

principal can costlessly structure the agent’s payment so that the latter has the right

incentives to exert eﬀort. Using (8.13) and (8.14), his expected gain from exerting eﬀort

is thus ∆π(

¯

t

∗

−t

∗

) = ψ when increasing his eﬀort from e = 0 to e = 1.

Proposition 8.3.1 Moral hazard is not an issue with a risk-neutral agent despite the

nonobservability of eﬀort. The ﬁrst-best level of eﬀort is still implemented.

Remark 8.3.1 One may ﬁnd the similarity of these results with those described last

chapter. In both cases, when contracting takes place ex ante, the incentive constraint,

under either adverse selection or moral hazard, does not conﬂict with the ex ante participa-

tion constraint with a risk-neutral agent, and the ﬁrst-best outcome is still implemented.

Remark 8.3.2 Ineﬃciencies in eﬀort provision due to moral hazard will arise when the

agent is no longer risk-neutral. There are two alternative ways to model these transaction

costs. One is to maintain risk neutrality for positive income levels but to impose a limited

liability constraint, which requires transfers not to be too negative. The other is to

let the agent be strictly risk-averse. In the following, we analyze these two contractual

environments and the diﬀerent trade-oﬀs they imply.

184

8.4 The Trade-Oﬀ Between Limited Liability Rent

Extraction and Eﬃciency

Let us consider a risk-neutral agent. As we have already seen, (8.3) and (8.4) now take

the following forms:

π

1

¯

t + (1 −π

1

)t −ψ π

0

¯

t + (1 −π

0

)t (8.15)

and

π

1

¯

t + (1 −π

1

)t −ψ 0. (8.16)

Let us also assume that the agent’s transfer must always be greater than some exoge-

nous level −l, with l 0. Thus, limited liability constraints in both states of nature are

written as

¯

t −l (8.17)

and

t −l. (8.18)

These constraints may prevent the principal from implementing the ﬁrst-best level of

eﬀort even if the agent is risk-neutral. Indeed, when he wants to induce a high eﬀort, the

principal’s program is written as

max

|(

¯

t,t)¦

π

1

(

¯

S −

¯

t) + (1 −π

1

)(S −t) (8.19)

subject to (8.15) to (8.18).

Then, we have the following proposition.

Proposition 8.4.1 With limited liability, the optimal contract inducing eﬀort from the

agent entails:

(1) For l >

π

0

∆π

ψ, only (8.15) and (8.16) are binding. Optimal transfers are

given by (8.13) and (8.14). The agent has no expected limited liability rent;

EU

SB

= 0.

(2) For 0 l

π

0

∆π

ψ, (8.15) and (8.18) are binding. Optimal transfers are

then given by:

t

SB

= −l, (8.20)

185

¯

t

SB

= −l +

ψ

∆π

. (8.21)

(3) Moreover, the agent’s expected limited liability rent EU

SB

is non-negative:

EU

SB

= π

1

¯

t

SB

+ (1 −π

1

)t

SB

−ψ = −l +

π

0

∆π

ψ 0. (8.22)

Proof. First suppose that 0 l

π

0

∆π

ψ.We conjecture that (8.15) and (8.18) are

the only relevant constraints. Of course, since the principal is willing to minimize the

payments made to the agent, both constraints must be binding. Hence, t

SB

= −l and

¯

t

SB

= −l +

ψ

∆π

. We check that (8.17) is satisﬁed since −l +

ψ

∆π

> −l. We also check that

(8.16) is satisﬁed since π

1

¯

t

SB

+ (1 −π

1

)t

SB

−ψ = −l +

π

0

∆π

ψ 0.

For l >

π

0

∆π

ψ, note that the transfers t

∗

= −

π

0

∆π

ψ, and

¯

t

∗

= −ψ +

(1−π

1

)

∆π

ψ > t

∗

are such

that both limited liability constraints (8.17) and (8.18) are strictly satisﬁed, and (8.15)

and (8.16) are both binding. In this case, it is costless to induce a positive eﬀort by the

agent, and the ﬁrst-best outcome can be implemented. The proof is completed.

Note that only the limited liability constraint in the bad state of nature may be

binding. When the limited liability constraint (8.18) is binding, the principal is limited

in his punishments to induce eﬀort. The risk- neutral agent does not have enough assets

to cover the punishment if q is realized in order to induce eﬀort provision. The principal

uses rewards when a good state of nature ¯ q is realized. As a result, the agent receives a

non-negative ex ante limited liability rent described by (8.22). Compared with the case

without limited liability, this rent is actually the additional payment that the principal

must incur because of the conjunction of moral hazard and limited liability.

As the agent becomes endowed with more assets, i.e., as l gets larger, the conﬂict

between moral hazard and limited liability diminishes and then disappears whenever l is

large enough.

8.5 The Trade-Oﬀ Between Insurance and Eﬃciency

Now suppose the agent is risk-averse. The principal’s program is written as:

max

|(

¯

t,t)¦

π

1

(

¯

S −

¯

t) + (1 −π

1

)(S −t) (8.23)

subject to (8.3) and (8.4).

186

Since the principal’s optimization problem may not be a concave program for which

the ﬁrst-order Kuhn and Tucker conditions are necessary and suﬃcient, we make the

following change of variables. Deﬁne ¯ u = u(

¯

t) and u = u(t), or equivalently let

¯

t = h(¯ u)

and t= h(u). These new variables are the levels of ex post utility obtained by the agent

in both states of nature. The set of incentive feasible contracts can now be described by

two linear constraints:

π

1

¯ u + (1 −π

1

)u −ψ π

0

¯ u + (1 −π

0

)u, (8.24)

π

1

¯ u + (1 −π

1

)u −ψ 0, (8.25)

which replaces (8.3) and (8.4), respectively.

Then, the principal’s program can be rewritten as

max

|(¯ u,u)¦

π

1

(

¯

S −h(¯ u)) + (1 −π

1

)(S −h(u)) (8.26)

subject to (8.24) and (8.25).

Note that the principal’s objective function is now strictly concave in (¯ u, u) because

h() is strictly convex. The constraints are now linear and the interior of the constrained

set is obviously non-empty.

8.5.1 Optimal Transfers

Letting λ and µ be the non-negative multipliers associated respectively with the con-

straints (8.24) and (8.25), the ﬁrst-order conditions of this program can be expressed

as

−π

1

h

t

(¯ u

SB

) + λ∆π + µπ

1

= −

π

1

u

t

(

¯

t

SB

)

+ λ∆π +µπ

1

= 0, (8.27)

−(1 −π

1

)h

t

(u

SB

) −λ∆π +µ(1 −π

1

) = −

(1 −π

1

)

u

t

(t

SB

)

−λ∆π + µ(1 −π

1

) = 0. (8.28)

where

¯

t

SB

and t

SB

are the second-best optimal transfers. Rearranging terms, we get

1

u

t

(

¯

t

SB

)

= µ + λ

∆π

π

1

, (8.29)

1

u

t

(t

SB

)

= µ −λ

∆π

1 −π

1

. (8.30)

187

The four variables (t

SB

,

¯

t

SB

, λ, µ) are simultaneously obtained as the solutions to the

system of four equations (8.24), (8.25), (8.29), and (8.30). Multiplying (8.29) by π

1

and

(8.30) by 1 −π

1

, and then adding those two modiﬁed equations we obtain

µ =

π

1

u

t

(

¯

t

SB

)

+

1 −π

1

u

t

(t

SB

)

> 0. (8.31)

Hence, the participation constraint (8.16) is necessarily binding. Using (8.31) and (8.29),

we also obtain

λ =

π

1

(1 −π

1

)

∆π

1

u

t

(

¯

t

SB

)

−

1

u

t

(t

SB

)

, (8.32)

where λ must also be strictly positive. Indeed, from (8.24) we have ¯ u

SB

−u

SB

ψ

∆π

> 0

and thus

¯

t

SB

> t

SB

, implying that the right-hand side of (8.32) is strictly positive since

u

tt

< 0. Using that (8.24) and (8.25) are both binding, we can immediately obtain the

values of u(

¯

t

SB

) and u(t

SB

) by solving a system of two equations with two unknowns.

Note that the risk-averse agent does not receive full insurance anymore. Indeed, with

full insurance, the incentive compatibility constraint (8.3) can no longer be satisﬁed.

Inducing eﬀort requires the agent to bear some risk, the following proposition provides a

summary.

Proposition 8.5.1 When the agent is strictly risk-averse, the optimal contract that in-

duces eﬀort makes both the agent’s participation and incentive constraints binding. This

contract does not provide full insurance. Moreover, second- best transfers are given by

¯

t

SB

= h

ψ + (1 −π

1

)

ψ

∆π

(8.33)

and

t

SB

= h

ψ −π

1

ψ

∆π

. (8.34)

8.5.2 The Optimal Second-Best Eﬀort

Let us now turn to the question of the second-best optimality of inducing a high eﬀort,

from the principal’s point of view. The second-best cost C

SB

of inducing eﬀort under

moral hazard is the expected payment made to the agent C

SB

= π

1

¯

t

SB

+ (1 − π

1

)t

SB

.

Using (8.33) and (8.34), this cost is rewritten as

C

SB

= π

1

h

ψ + (1 −π

1

)

ψ

∆π

+ (1 −π

1

)h

ψ −

π

1

ψ

∆π

. (8.35)

188

The beneﬁt of inducing eﬀort is still B = ∆π∆S , and a positive eﬀort e

∗

= 1 is the

optimal choice of the principal whenever

∆π∆S C

SB

= π

1

h

ψ + (1 −π

1

)

ψ

∆π

+ (1 −π

1

)h

ψ −

π

1

ψ

∆π

. (8.36)

Figure 8.3: Second-best level of eﬀort with moral hazard and risk aversion.

With h() being strictly convex, Jensen’s inequality implies that the right-hand side

of (8.36) is strictly greater than the ﬁrst-best cost of implementing eﬀort C

FB

= h(ψ).

Therefore, inducing a higher eﬀort occurs less often with moral hazard than when eﬀort

is observable. The above ﬁgure represents this phenomenon graphically.

For B belonging to the interval [C

FB

, C

SB

], the second-best level of eﬀort is zero and is

thus strictly below its ﬁrst- best value. There is now an under-provision of eﬀort because

of moral hazard and risk aversion.

Proposition 8.5.2 With moral hazard and risk aversion, there is a trade-oﬀ between

inducing eﬀort and providing insurance to the agent. In a model with two possible levels

of eﬀort, the principal induces a positive eﬀort from the agent less often than when eﬀort

is observable.

8.6 More than Two Levels of Performance

We now extend our previous 22 model to allow for more than two levels of performance.

We consider a production process where n possible outcomes can be realized. Those

performances can be ordered so that q

1

< q

2

< < q

i

< q

n

. We denote the principal’s

return in each of those states of nature by S

i

= S(q

i

). In this context, a contract is a n-

tuple of payments ¦(t

1

, . . . , t

n

)¦. Also, let π

ik

be the probability that production q

i

takes

place when the eﬀort level is e

k

. We assume that π

ik

for all pairs (i, k) with

¸

n

i=1

π

ik

= 1.

189

Finally, we keep the assumption that only two levels of eﬀort are feasible. i.e., e

k

in ¦0, 1¦.

We still denote ∆π

i

= π

i1

−π

i0

.

8.6.1 Limited Liability

Consider ﬁrst the limited liability model. If the optimal contract induces a positive eﬀort,

it solves the following program:

max

|(t

1

,...,t

n

)¦

n

¸

i=1

π

i1

(S

i

−t

i

) (8.37)

subject to

n

¸

i=1

π

i1

t

i

−ψ 0, (8.38)

n

¸

i=1

(π

i1

−π

i0

)t

i

ψ, (8.39)

t

i

0, for all i ∈ ¦1, . . . , n¦. (8.40)

(8.38) is the agent’s participation constraint. (8.39) is his incentive constraint. (8.40)

are all the limited liability constraints by assuming that the agent cannot be given a

negative payment.

First, note that the participation constraint (8.38) is implied by the incentive (8.39)

and the limited liability (8.40) constraints. Indeed, we have

n

¸

i=1

π

i1

t

i

−ψ

n

¸

i=1

(π

i1

−π

i0

)t

i

−ψ

. .. .

+

n

¸

i=1

π

i0

t

i

. .. .

0.

Hence, we can neglect the participation constraint (8.38) in the optimization of the

principal’s program.

Denoting the multiplier of (8.39) by λ and the respective multipliers of (8.40) by ξ

i

,

the ﬁrst-order conditions lead to

−π

i1

+ λ∆π

i

+ξ

i

= 0. (8.41)

with the slackness conditions ξ

i

t

i

= 0 for each i in ¦1, . . . , n¦.

For such that the second-best transfer t

SB

i

is strictly positive, ξ

i

= 0, and we must

have λ =

π

i1

π

i1

−π

i0

for any such i. If the ratios

π

i1

−π

i0

π

i1

all diﬀerent, there exists a single

index j such that

π

j1

−π

j0

π

j1

is the highest possible ratio. The agent receives a strictly

190

positive transfer only in this particular state of nature j, and this payment is such that

the incentive constraint (8.39) is binding, i.e., t

SB

j

=

ψ

π

j1

−π

j0

. In all other states, the agent

receives no transfer and t

SB

i

= 0 for all i = j. Finally, the agent gets a strictly positive

ex ante limited liability rent that is worth EU

SB

=

π

j0

ψ

π

j1

−π

j0

.

The important point here is that the agent is rewarded in the state of nature that is the

most informative about the fact that he has exerted a positive eﬀort. Indeed,

π

i1

−π

i0

π

i1

can

be interpreted as a likelihood ratio. The principal therefore uses a maximum likelihood

ratio criterion to reward the agent. The agent is only rewarded when this likelihood

ratio is maximized. Like an econometrician, the principal tries to infer from the observed

output what has been the parameter (eﬀort) underlying this distribution. But here the

parameter is endogenously aﬀected by the incentive contract.

Deﬁnition 8.6.1 The probabilities of success satisfy the monotone likelihood ratio prop-

erty (MLRP) if

π

i1

−π

i0

π

i1

is nondecreasing in i.

Proposition 8.6.1 If the probability of success satisﬁes MLRP, the second-best payment

t

SB

i

received by the agent may be chosen to be nondecreasing with the level of production

q

i

.

8.6.2 Risk Aversion

Suppose now that the agent is strictly risk-averse. The optimal contract that induces

eﬀort must solve the program below:

max

|t

1

,...,tn)¦

n

¸

i=1

π

i1

(S

i

−t

i

) (8.42)

subject to

n

¸

i=1

π

i1

u(t

i

) −ψ

n

¸

i=1

π

i0

u(t

i

) (8.43)

and

n

¸

i=1

π

i1

u(t

i

) −ψ 0, (8.44)

where the latter constraint is the agent’s participation constraint.

Using the same change of variables as before, it should be clear that the program is

again a concave problem with respect to the new variables u

i

= u(t

i

). Using the same

191

notations as before, the ﬁrst-order conditions of the principal’s program are written as:

1

u

t

(t

SB

i

)

= µ + λ

π

i1

−π

i0

π

i1

for all i ∈ ¦1, . . . , n¦. (8.45)

Multiplying each of these equations by π

i1

and summing over i yields µ = E

q

1

u

(t

SB

i

)

> 0,

where E

q

denotes the expectation operator with respect to the distribution of outputs

induced by eﬀort e = 1.

Multiplying (8.45) by π

i1

u(t

SB

i

), summing all these equations over i, and taking into

account the expression of µ obtained above yields

λ

n

¸

i=1

(π

i1

−π

i0

)u(t

SB

i

)

= E

q

u(

˜

t

SB

i

)

1

u

t

(

˜

t

SB

i

)

−E

1

u

t

(

˜

t

SB

i

)

. (8.46)

Using the slackness condition λ

¸

n

i=1

(π

i1

−π

i0

)u(t

SB

i

) −ψ

**= 0 to simplify the left-
**

hand side of (8.46), we ﬁnally get

λψ = cov

u(

˜

t

SB

i

),

1

u

t

(

˜

t

SB

i

)

. (8.47)

By assumption, u() and u

t

() covary in opposite directions. Moreover, a constant wage

t

SB

i

= t

SB

for all i does not satisfy the incentive constraint, and thus t

SB

i

cannot be

constant everywhere. Hence, the right-hand side of (8.47) is necessarily strictly positive.

Thus we have λ > 0, and the incentive constraint is binding.

Coming back to (8.45), we observe that the left-hand side is increasing in t

SB

i

since

u() is concave. For t

SB

i

to be nondecreasing with i, MLRP must again hold. Then higher

outputs are also those that are the more informative ones about the realization of a high

eﬀort. Hence, the agent should be more rewarded as output increases.

8.7 Contract Theory at Work

This section elaborates on the moral hazard paradigm discussed so far in a number of

settings that have been discussed extensively in the contracting literature.

8.7.1 Eﬃciency Wage

Let us consider a risk-neutral agent working for a ﬁrm, the principal. This is a basic

model studied by Shapiro and Stiglitz (AER, 1984). By exerting eﬀort e in ¦0, 1¦, the

192

ﬁrm’s added value is

¯

V (resp. V ) with probability π(e) (resp. 1 − π(e)). The agent can

only be rewarded for a good performance and cannot be punished for a bad outcome,

since they are protected by limited liability.

To induce eﬀort, the principal must ﬁnd an optimal compensation scheme ¦(t,

¯

t)¦ that

is the solution to the program below:

max

|(t,

¯

t)¦

π

1

(

¯

V −

¯

t) + (1 −π

1

)(V −t) (8.48)

subject to

π

1

¯

t + (1 −π

1

)t −ψ π

0

¯

t + (1 −π

0

)t, (8.49)

π

1

¯

t + (1 −π

1

)t −ψ 0, (8.50)

t 0. (8.51)

The problem is completely isomorphic to the one analyzed earlier. The limited liability

constraint is binding at the optimum, and the ﬁrm chooses to induce a high eﬀort when

∆π∆V

π

1

ψ

∆π

. At the optimum, t

SB

= 0 and

¯

t

SB

> 0. The positive wage

¯

t

SB

=

ψ

∆π

is

often called an eﬃciency wage because it induces the agent to exert a high (eﬃcient) level

of eﬀort. To induce production, the principal must give up a positive share of the ﬁrm’s

proﬁt to the agent.

8.7.2 Sharecropping

The moral hazard paradigm has been one of the leading tools used by development

economists to analyze agrarian economies. In the sharecropping model given in Stiglitz

(RES, 1974), the principal is now a landlord and the agent is the landlord’s tenant. By

exerting an eﬀort e in ¦0, 1¦, the tenant increases (decreases) the probability π(e) (resp.

1 − π(e)) that a large ¯ q (resp. small q) quantity of an agricultural product is produced.

The price of this good is normalized to one so that the principal’s stochastic return on

the activity is also ¯ q or q, depending on the state of nature.

It is often the case that peasants in developing countries are subject to strong ﬁnancial

constraints. To model such a setting we assume that the agent is risk neutral and protected

by limited liability. When he wants to induce eﬀort, the principal’s optimal contract must

solve

max

|(t,

¯

t)¦

π

1

(¯ q −

¯

t) + (1 −π

1

)(q −t) (8.52)

193

subject to

π

1

¯

t + (1 −π

1

)t −ψ π

0

¯

t + (1 −π

0

)t, (8.53)

π

1

¯

t + (1 −π

1

)t −ψ 0, (8.54)

t 0. (8.55)

The optimal contract therefore satisﬁes t

SB

= 0 and

¯

t

SB

=

ψ

∆π

. This is again akin to

an eﬃciency wage. The expected utilities obtained respectively by the principal and the

agent are given by

EV

SB

= π

1

¯ q + (1 −π

1

)q −

π

1

ψ

∆π

. (8.56)

and

EU

SB

=

π

0

ψ

∆π

. (8.57)

The ﬂexible second-best contract described above has sometimes been criticized as

not corresponding to the contractual arrangements observed in most agrarian economies.

Contracts often take the form of simple linear schedules linking the tenant’s production

to his compensation. As an exercise, let us now analyze a simple linear sharing rule

between the landlord and his tenant, with the landlord oﬀering the agent a ﬁxed share α

of the realized production. Such a sharing rule automatically satisﬁes the agent’s limited

liability constraint, which can therefore be omitted in what follows. Formally, the optimal

linear rule inducing eﬀort must solve

max

α

(1 −α)(π

1

¯ q + (1 −π

1

)q) (8.58)

subject to

α(π

1

¯ q + (1 −π

1

)q) −ψ α(π

0

¯ q + (1 −π

0

)q), (8.59)

α(π

1

¯ q + (1 −π

1

)q) −ψ 0 (8.60)

Obviously, only (8.59) is binding at the optimum. One ﬁnds the optimal linear sharing

rule to be

α

SB

=

ψ

∆π∆q

. (8.61)

Note that α

SB

< 1 because, for the agricultural activity to be a valuable venture in

the ﬁrst-best world, we must have ∆π∆q > ψ. Hence, the return on the agricultural

activity is shared between the principal and the agent, with high-powered incentives (α

194

close to one) being provided when the disutility of eﬀort ψ is large or when the principal’s

gain from an increase of eﬀort ∆π∆q is small.

This sharing rule also yields the following expected utilities to the principal and the

agent, respectively

EV

α

= π

1

¯ q + (1 −π

1

)q −

π

1

¯ q + (1 −π

1

)q

∆q

ψ

∆π

(8.62)

and

EU

α

=

π

1

¯ q + (1 −π

1

)q

∆q

ψ

∆π

. (8.63)

Comparing (8.56) and (8.62) on the one hand and (8.57) and (8.63) on the other hand,

we observe that the constant sharing rule beneﬁts the agent but not the principal. A linear

contract is less powerful than the optimal second-best contract. The former contract is an

ineﬃcient way to extract rent from the agent even if it still provides suﬃcient incentives to

exert eﬀort. Indeed, with a linear sharing rule, the agent always beneﬁts from a positive

return on his production, even in the worst state of nature. This positive return yields to

the agent more than what is requested by the optimal second-best contract in the worst

state of nature, namely zero. Punishing the agent for a bad performance is thus found to

be rather diﬃcult with a linear sharing rule.

A linear sharing rule allows the agent to keep some strictly positive rent EU

α

. If

the space of available contracts is extended to allow for ﬁxed fees β, the principal can

nevertheless bring the agent down to the level of his outside opportunity by setting a ﬁxed

fee β

SB

equal to

π

1

¯ q+(1−π

1

)q

∆q

ψ

∆π

.

8.7.3 Wholesale Contracts

Let us now consider a manufacturer-retailer relationship studied in Laﬀont and Tirole

(1993). The manufacturer supplies at constant marginal cost c an intermediate good to

the risk-averse retailer, who sells this good on a ﬁnal market. Demand on this market is

high (resp. low)

¯

D(p) (resp. D(p)) with probability π(e) where, again, e is in ¦0, 1¦ and

p denotes the price for the ﬁnal good. Eﬀort e is exerted by the retailer, who can increase

the probability that demand is high if after-sales services are eﬃciently performed. The

wholesale contract consists of a retail price maintenance agreement specifying the prices

¯ p and p on the ﬁnal market with a sharing of the proﬁts, namely ¦(t, p); (

¯

t, ¯ p)¦. When

195

he wants to induce eﬀort, the optimal contract oﬀered by the manufacturer solves the

following problem:

max

|(t,p);(

¯

t, ¯ p)¦

π

1

((¯ p −c)

¯

D(¯ p) −

¯

t) + (1 −π

1

)((p −c)D(p) −t) (8.64)

subject to (8.3) and (8.4).

The solution to this problem is obtained by appending the following expressions of the

retail prices to the transfers given in (8.33) and (8.34): ¯ p

∗

+

¯

D(¯ p

∗

)

D

(¯ p

∗

)

= c, and p

∗

+

D(p

∗

)

D

(p

∗

)

=

c. Note that these prices are the same as those that would be chosen under complete

information. The pricing rule is not aﬀected by the incentive problem.

8.7.4 Financial Contracts

Moral hazard is an important issue in ﬁnancial markets. In Holmstrom and Tirole (AER,

1994), it is assumed that a risk-averse entrepreneur wants to start a project that requires

an initial investment worth an amount I. The entrepreneur has no cash of his own and

must raise money from a bank or any other ﬁnancial intermediary. The return on the

project is random and equal to

¯

V (resp. V ) with probability π(e) (resp. 1 −π(e)), where

the eﬀort exerted by the entrepreneur e belongs to ¦0, 1¦. We denote the spread of proﬁts

by ∆V =

¯

V − V > 0. The ﬁnancial contract consists of repayments ¦(¯ z, z)¦, depending

upon whether the project is successful or not.

To induce eﬀort from the borrower, the risk-neutral lender’s program is written as

max

|(z,¯ z)¦

π

1

¯ z + (1 −π

1

)z −I (8.65)

subject to

π

1

u(

¯

V − ¯ z) + (1 −π

1

)u(V −z) −ψ (8.66)

π

0

u(

¯

V − ¯ z) + (1 −π

0

)u(V −z),

π

1

u(

¯

V − ¯ z) + (1 −π

1

)u(V −z) −ψ 0. (8.67)

Note that the project is a valuable venture if it provides the bank with a positive expected

proﬁt.

With the change of variables,

¯

t =

¯

V − ¯ z and t = V −z, the principal’s program takes

its usual form. This change of variables also highlights the fact that everything happens

196

as if the lender was beneﬁtting directly from the returns of the project, and then paying

the agent only a fraction of the returns in the diﬀerent states of nature.

Let us deﬁne the second-best cost of implementing a positive eﬀort C

SB

, and let us

assume that ∆π∆V C

SB

, so that the lender wants to induce a positive eﬀort level even

in a second-best environment. The lender’s expected proﬁt is worth

V

1

= π

1

¯

V + (1 −π

1

)V −C

SB

−I. (8.68)

Let us now parameterize projects according to the size of the investment I. Only the

projects with positive value V

1

> 0 will be ﬁnanced. This requires the investment to be

low enough, and typically we must have

I < I

SB

= π

1

¯

V + (1 −π

1

)V −C

SB

. (8.69)

Under complete information and no moral hazard, the project would instead be ﬁ-

nanced as soon as

I < I

∗

= π

1

¯

V + (1 −π

1

)V (8.70)

For intermediary values of the investment. i.e., for I in [I

SB

, I

∗

], moral hazard implies

that some projects are ﬁnanced under complete information but no longer under moral

hazard. This is akin to some form of credit rationing.

Finally, note that the optimal ﬁnancial contract oﬀered to the risk-averse and cashless

entrepreneur does not satisfy the limited liability constraint t 0. Indeed, we have t

SB

=

h

ψ −

π

1

ψ

∆π

**< 0. To be induced to make an eﬀort, the agent must bear some risk, which
**

implies a negative payoﬀ in the bad state of nature. Adding the limited liability constraint,

the optimal contract would instead entail t

LL

= 0 and

¯

t

LL

= h

ψ

∆π

. Interestingly, this

contract has sometimes been interpreted in the corporate ﬁnance literature as a debt

contract, with no money being left to the borrower in the bad state of nature and the

residual being pocketed by the lender in the good state of nature.

Finally, note that

¯

t

LL

−t

LL

= h

ψ

∆π

<

¯

t

SB

−t

SB

= h

ψ + (1 −π

1

)

ψ

∆π

(8.71)

−h

ψ −

π

1

ψ

∆π

,

since h() is strictly convex and h(0) = 0. This inequality shows that the debt contract

has less incentive power than the optimal incentive contract. Indeed, it becomes harder

197

to spread the agent’s payments between both states of nature to induce eﬀort if the agent

is protected by limited liability by the agent, who is interested only in his payoﬀ in the

high state of nature, only rewards are attractive.

8.8 A Continuum of Performances

Let us now assume that the level of performance ˜ q is drawn from a continuous distribution

with a cumulative function F([e) on the support [q, ¯ q]. This distribution is conditional

on the agent’s level of eﬀort, which still takes two possible values e in ¦0, 1¦. We denote

by f([e) the density corresponding to the above distributions. A contract t(q) inducing

a positive eﬀort in this context must satisfy the incentive constraint

¯ q

q

u(t(q))f(q[1)dq −ψ

¯ q

q

u(t(q))f(q[0)dq, (8.72)

and the participation constraint

¯ q

q

u(t(q))f(q[1)dq −ψ 0. (8.73)

The risk-neutral principal problem is thus written as

max

|t(q)¦

¯ q

q

(S(q) −t(q))f(q[1)dq, (8.74)

subject to (8.72) and (8.73).

Denoting the multipliers of (8.72) and (8.73) by λ and µ, respectively, the Lagrangian

is written as

L(q, t) = (S(q) −t)f(q[1) + λ(u(t)(f(q[1) −f(q[0)) −ψ) + µ(u(t)f(q[1) −ψ).

Optimizing pointwise with respect to t yields

1

u

t

(t

SB

(q))

= µ + λ

f(q[1) −f(q[0)

f(q[1)

. (8.75)

Multiplying (8.75) by f

1

(q) and taking expectations, we obtain, as in the main text,

µ = E

˜ q

1

u

t

(t

SB

(˜ q))

> 0, (8.76)

198

where E

˜ q

() is the expectation operator with respect to the probability distribution of

output induced by an eﬀort e

SB

. Finally, using this expression of µ, inserting it into

(8.75), and multiplying it by f(q[1)u(t

SB

(q)), we obtain

λ(f(q[1) −f(q[0))u(t

SB

(q)) (8.77)

= f(q[1)u(t

SB

(q))

1

u

t

(t

SB

(q))

−E

˜ q

1

u

t

(t

SB

(q))

.

Integrating over [q, ˜ q] and taking into account the slackness condition λ(

¯ q

q

(f(q[1) −

f(q[0))u(t

SB

(q))dq −ψ) = 0 yields λψ = cov(u(t

SB

(˜ q)),

1

u

(t

SB

(˜ q))

) 0.

Hence, λ 0 because u() and u

t

() vary in opposite directions. Also, λ = 0 only

if t

SB

(q) is a constant, but in this case the incentive constraint is necessarily violated.

As a result, we have λ > 0. Finally, t

SB

(π) is monotonically increasing in π when the

monotone likelihood property

d

dq

f(q[1)−f∗(q[0)

f(q[1)

0 is satisﬁed.

8.9 Further Extension

We have stressed the various conﬂicts that may appear in a moral hazard environment.

The analysis of these conﬂicts, under both limited liability and risk aversion, was made

easy because of our focus on a simple 22 environment with a binary eﬀort and two levels

of performance. The simple interaction between a single incentive constraint with either

a limited liability constraint or a participation constraint was quite straightforward.

When one moves away from the 2 2 model, the analysis becomes much harder, and

characterizing the optimal incentive contract is a diﬃcult task. Examples of such complex

contracting environment are abound. Eﬀort may no longer be binary but, instead, may be

better characterized as a continuous variable. A manager may no longer choose between

working or not working on a project but may be able to ﬁne-tune the exact eﬀort spent

on this project. Even worse, the agent’s actions may no longer be summarized by a one-

dimensional parameter but may be better described by a whole array of control variables

that are technologically linked. For instance, the manager of a ﬁrm may have to choose

how to allocate his eﬀort between productive activities and monitoring his peers and other

workers.

Nevertheless, one can extend the standard model to the cases where the agent can

perform more than two and possibly a continuum of levels of eﬀort, to the case with

199

a multitask model, the case where the agent’s utility function is no longer separable

between consumption and eﬀort. One can also analyze the trade-oﬀ between eﬃciency

and redistribution in a moral hazard context. For detailed discussion, see Chapter 5 of

Laﬀont and Martimort (2002).

Reference

Akerlof, G., “The Market for Lemons: Quality Uncertainty and the Market Mechanism,”

Quarterly Journal of Economics, 89 (1976), 400 500.

Grossman, S., and O. Hart, “An Analysis of the Principal Agent,” Econometrica, 51

(1983), 7 45.

Holmstrom, B., and J. Tirole, “Financial Intermediation, Loanable Funds, and the Real

Sector,” American Economic Review, 84 (1994), 972-991.

Laﬀont, J. -J., “The New Economics of Regulation Ten Years After,” Econometrica 62

(1994), 507 538.

Laﬀont, J.-J., Laﬀont and D. Martimort, The Theory of Incentives: The Principal-Agent

Model, Princeton and Oxford: Princeton University Press, 2002, Chapters 4-5.

Laﬀont, J.-J., and J. Tirole, The Theory of Incentives in Procurement and Regulation,

Cambridge: MIT Press, 1993.

Li, J. and G. Tian, “Optimal Contracts for Central Banks Revised,” Working Paper,

Texas A&M University, 2003.

Luenberger, D. Microeconomic Theory, McGraw-Hill, Inc, 1995, Chapter 12.

Mas-Colell, A., M. D. Whinston, and J. Green, Microeconomic, Oxford University Press,

1995, Chapter 14.

Shapiro, C., and J. Stiglitz, “Equilibrium Unemployment as a Worker Discipline Ddvice,”

American Economic Review, 74 (1984), 433-444.

Stiglitz, J., “Incentives and Risk Sharing in Sharecropping,” Review of Economic Studies,

41 (1974), 219-255.

200

Varian, H.R., Microeconomic Analysis, W.W. Norton and Company, Third Edition,

1992, Chapters 25.

Wolfstetter, E., Topics in Microeconomics - Industrial Organization, Auctions, and In-

centives, Cambridge Press, 1999, Chapters 8-10.

201

Chapter 9

General Mechanism Design

9.1 Introduction

In the previous chapters on the principal-agent theory, we have introduced basic models

to explain the core of the principal-agent theory with complete contracts. It highlights the

various trade-oﬀs between allocative eﬃciency and the distribution of information rents.

Since the model involves only one agent, the design of the principal’s optimal contract has

reduced to a constrained optimization problem without having to appeal to sophisticated

game theory concepts.

In this chapter, we will introduce some of basic results and insights of the mechanism

design in general, and implementation theory in particular for situations where there is

one principal (also called the designer) and several agents. In such a case, asymmetric

information may not only aﬀect the relationship between the principal and each of his

agents, but it may also plague the relationships between agents. To describe the strategic

interaction between agents and the principal, the game theoretic reasoning is thus used

to model social institutions as varied voting systems, auctions, bargaining protocols, and

methods for deciding on public projects.

Incentive problems arise when the social planner cannot distinguish between things

that are indeed diﬀerent so that free-ride problem many appear. A free rider can im-

prove his welfare by not telling the truth about his own un-observable characteristic. Like

the principal-agent model, a basic insight of the incentive mechanism with more than

one agent is that incentive constraints should be considered coequally with resource con-

202

straints. One of the most fundamental contributions of the mechanism theory has been

shown that the free-rider problem may or may not occur, depending on the kind of game

(mechanism) that agents play and other game theoretical solution concepts. A theme

that comes out of the literature is the diﬃculty of ﬁnding mechanisms compatible with

individual incentives that simultaneously results in a desired social goal.

Examples of incentive mechanism design that takes strategic interactions among agents

exist for a long time. An early example is the Biblical story of the famous judgement of

Solomon for determining who is the real mother of a baby. Two women came before the

King, disputing who was the mother of a child. The King’s solution used a method of

threatening to cut the lively baby in two and give half to each. One women was willing

to give up the child, but another women agreed to cut in two. The King then made his

judgement and decision: The ﬁrst woman is the mother, do not kill the child and give the

him to the ﬁrst woman. Another example of incentive mechanism design is how to cut a

pie and divide equally among all participants.

The ﬁrst major development was in the work of Gibbard-Hurwicz-Satterthwaite in

1970s. When information is private, the appropriate equilibrium concept is dominant

strategies. These incentives adopt the form of incentive compatibility constraints where

for each agent to tell truth about their characteristics must be dominant. The fundamental

conclusion of Gibbard-Hurwicz-Satterthwaite’s impossibility theorem is that we have to

have a trade-oﬀ between the truth-telling and Pareto eﬃciency (or the ﬁrst best outcomes

in general). Of course, if one is willing to give up Pareto eﬃciency, we can have a truth-

telling mechanism, such as Groves-Clark mechanism. In many cases, one can ignore the

ﬁrst-best or Pareto eﬃciency, and so one can expect the truth- telling behavior.

On the other hand, we could give up the truth-telling requirement, and want to reach

Pareto eﬃcient outcomes. When the information about the characteristics of the agents

is shared by individuals but not by the designer, then the relevant equilibrium concept

is the Nash equilibrium. In this situation, one can gives up the truth-telling, and uses

a general message space. One may design a mechanism that Nash implements Pareto

eﬃcient allocations.

We will introduce these results and such trade-oﬀs. We will also brieﬂy introduce the

incomplete information case in which agents do not know each other’s characteristics, and

203

we need to consider Bayesian incentive compatible mechanism.

9.2 Basic Settings

Theoretical framework of the incentive mechanism design consists of ﬁve components: (1)

economic environments (fundamentals of economy); (2) social choice goal to be reached;

(3) economic mechanism that speciﬁes the rules of game; (4) description of solution con-

cept on individuals’ self-interested behavior, and (5) implementation of a social choice

goal (incentive-compatibility of personal interests and the social goal at equilibrium).

9.2.1 Economic Environments

e

i

= (Z

i

, w

i

,

i

, Y

i

): economic characteristic of agent i which consists of out-

come space, initial endowment if any, preference relation, and the produc-

tion set if agent i is also a producer;

e = (e

1

, . . . , e

n

): an economy;

E: The set of all priori admissible economic environments.

U = U

1

. . . U

n

: The set of all admissible utility functions.

Remark 9.2.1 Here, E is a general expression of economic environments. However, de-

pending on the situations facing the designer, the set of admissible economic environments

under consideration sometimes may be just given by E = U, or by the set of all possible

initial endowments, or production sets.

The designer is assumed that he does not know the individuals’ economic character-

istics. The individuals may or may not know the characteristics of the others. If they

know, it is called the complete information case, otherwise it is called the incomplete

information case.

9.2.2 Social Goal

Given economic environments, each agent participates economic activities, makes deci-

sions, receives beneﬁts and pays costs on economic activities. Let

204

Z = Z

1

. . . Z

n

: the outcome space (For example, Z = X Y ).

A ⊆ Z: the feasible set.

F : E →→ A: the social goal or called social choice correspondence in which

F(e) is the set of socially desired outcomes at the economy under some

criterion of social optimality.

Examples of Social Choice Correspondences:

P(e): the set of Pareto eﬃcient allocations.

I(e): the set of individual rational allocations.

W(e): the set of Walrasian allocations.

L(e): the set of Lindahl allocations.

FA(e): the set of fare allocations.

When F becomes a single-valued function, denoted by f, it is called a social choice

function.

Examples of Social Choice Functions:

Solomon’s goal.

Majority voting rule.

9.2.3 Economic Mechanism

Since the designer lacks the information about individuals’ economic characteristics, he

needs to design an appropriate incentive mechanism (rules of game) to coordinate the

personal interests and the social goal, i.e., under the mechanism, all individuals have

incentives to choose actions which result in socially optimal outcomes when they pursue

their personal interests. To do so, the designer informs how the information he collected

from individuals is used to determine outcomes, that is, he ﬁrst tells the rules of games.

He then uses the information or actions of agents and the rules of game to determine

outcomes of individuals. Thus, a mechanism consists of a message space and an outcome

function. Let

M

i

: the message space of agent i.

205

M = M

1

. . . M

n

: the message space in which communications take place.

m

i

∈ M

i

: a message reported by agent i.

m = (m

1

, . . . , m

n

) ∈ M: a proﬁle of messages.

h : M → Z: outcome function that translates messages into outcomes.

Γ =< M, h >: a mechanism

That is, a mechanism consists of a message space and an outcome function.

Figure 9.1: Diagrammatic Illustration of Mechanism design Problem.

Remark 9.2.2 A mechanism is often also referred to as a game form. The terminology

of game form distinguishes it from a game in game theory, as the consequence of a proﬁle

of message is an outcome rather than a vector of utility payoﬀs. However, once the

preference of the individuals are speciﬁed, then a game form or mechanism induces a

conventional game. Since the preferences of individuals in the mechanism design setting

vary, this distinction between mechanisms and games is critical.

Remark 9.2.3 In the implementation (incentive mechanism design) literature, one re-

quires a mechanism be incentive compatible in the sense that personal interests are consis-

tent with desired socially optimal outcomes even when individual agents are self-interested

in their personal goals without paying much attention to the size of message. In the re-

alization literature originated by Hurwicz (1972, 1986b), a sub-ﬁeld of the mechanism

206

literature, one also concerns the size of message space of a mechanism, and tries to

ﬁnd economic system to have small operation cost. The smaller a message space of a

mechanism, the lower (transition) cost of operating the mechanism. For the neoclassical

economies, it has been shown that competitive market economy system is the unique most

eﬃcient system that results in Pareto eﬃcient and individually rational allocations (cf,

Mount and Reiter (1974), Walker (1977), Osana (1978), Hurwicz (1986b), Jordan (1982),

Tian (2002d)).

9.2.4 Solution Concept of Self-Interested Behavior

In economics, a basic assumption is that individuals are self-interested in the sense that

they pursue their personal interests. Unless they can be better oﬀ, they in general does

not care about social interests. As a result, diﬀerent economic environments and diﬀerent

rules of game will lead to diﬀerent reactions of individuals, and thus each individual agent’s

strategy on reaction will depend on his self-interested behavior which in turn depends on

the economic environments and the mechanism.

Let b(e, Γ) be the set of equilibrium strategies that describes the self-interested behav-

ior of individuals. Examples of such equilibrium solution concepts include Nash equilib-

rium, dominant strategy, Bayesian Nash equilibrium, etc.

Thus, given E, M, h, and b, the resulting equilibrium outcome is the composite

function of the rules of game and the equilibrium strategy, i.e., h(b(e, Γ)).

9.2.5 Implementation and Incentive Compatibility

In which sense can we see individuals’s personal interests do not have conﬂicts with a

social interest? We will call such problem as implementation problem. The purpose of

an incentive mechanism design is to implement some desired socially optimal outcomes.

Given a mechanism Γ and equilibrium behavior assumption b(e, Γ), the implementation

problem of a social choice rule F studies the relationship of the intersection state of F(e)

and h(b(e, Γ)). Thus, we have the following various concepts on implementation and

incentive compatibility of F.

A Mechanism < M, h > is said to

207

(i) fully implement a social choice correspondence F in equilibrium strategy

b(e, Γ) on E if for every e ∈ E

(a) b(e, Γ) = ∅ (equilibrium solution exists),

(b) h(b(e, Γ)) = F(e) (personal interests are fully consistent with

social goals);

(ii) implement a social choice correspondence F in equilibrium strategy b(e, Γ)

on E if for every e ∈ E

(a) b(e, Γ) = ∅,

(b) h(b(e, Γ)) ⊆ F(e);

(iii) weakly implement a social choice correspondence F in equilibrium strategy

b(e, Γ) on E if for every e ∈ E

(a) b(e, Γ) = ∅,

(b) h(b(e, Γ)) ∩ F(e) = ∅.

A Mechanism < M, h > is said to be b(e, Γ) incentive-compatible with a social choice

correspondence F in b(e, Γ)-equilibrium if it (fully or weakly) implements F in b(e, Γ)-

equilibrium.

Note that we did not give a speciﬁc solution concept so far when we deﬁne the im-

plementability and incentive-compatibility. As shown in the following, whether or not

a social choice correspondence is implementable will depend on the assumption on the

solution concept of self-interested behavior. When information is complete, the solu-

tion concept can be dominant equilibrium, Nash equilibrium, strong Nash equilibrium,

subgame perfect Nash equilibrium, undominanted equilibrium, etc. For incomplete infor-

mation, equilibrium strategy can be Bayesian Nash equilibrium, undominated Bayesian

Nash equilibrium, etc.

9.3 Examples

Before we discuss some basic results in the mechanism theory, we ﬁrst give some economic

environments which show that one needs to design a mechanism to solve the incentive

208

compatible problems.

Example 9.3.1 (A Public Project) A society is deciding on whether or not to build

a public project at a cost c. The cost of the pubic project is to be divided equally.

The outcome space is then Y = ¦0, 1¦, where 0 represents not building the project and

1 represents building the project. Individual i’s value from use of this project is r

i

. In this

case, the net value of individual i is 0 from not having the project built and v

i

≡ r

i

−

c

n

from having a project built. Thus agent i’s valuation function can be represented as

v

i

(y, v

i

) = yr

i

−y

c

n

= yv

i

.

Example 9.3.2 (Continuous Public Goods Setting) In the above example, the pub-

lic good could only take two values, and there is no scale problem. But, in many case, the

level of public goods depends on the collection of the contribution or tax. Now let y ∈ R

+

denote the scale of the public project and c(y) denote the cost of producing y. Thus,

the outcome space is Z = R

+

R

n

, and the feasible set is A = ¦(y, z

1

(y), . . . , z

n

(y)) ∈

R

+

R

n

:

¸

i∈N

z

i

(y) = c(y)¦, where z

i

(y) is the share of agent i for producing the public

goods y. The beneﬁt of i for building y is r

i

(y) with r

i

(0) = 0. Thus, the net beneﬁt of not

building the project is equal to 0, the net beneﬁt of building the project is r

i

(y) −z

i

(y).

The valuation function of agent i can be written as

v

i

(y) = r

i

(y) −z

i

(y).

Example 9.3.3 (Allocating an Indivisible Private Good) An indivisible good is to

be allocated to one member of society. For instance, the rights to an exclusive license

are to be allocated or an enterprise is to be privatized. In this case, the outcome space

is Z = ¦y ∈ ¦0, 1¦

n

:

¸

n

i=1

y

i

= 1¦,where y

i

= 1 means individual i obtains the object,

y

i

= 0 represents the individual does not get the object. If individual i gets the object,

the net value beneﬁtted from the object is v

i

. If he does not get the object, his net value

is 0. Thus, agent i’s valuation function is

v

i

(y) = v

i

y

i

.

Note that we can regard y as n-dimensional vector of public goods since v

i

(y) = v

i

y

i

= vy,

where v = (v

1

, . . . , v

n

).

209

From these examples, a socially optimal decision clearly depends on the individuals’

true valuation function v

i

(). For instance, we have shown previously that a public project

is produced if and only if the total values of all individuals is greater than it total cost,

i.e., if

¸

i∈N

r

i

> c, then y = 1, and if

¸

i∈N

r

i

< c, then y = 0.

Let V

i

be the set of all valuation functions v

i

, let V =

¸

i∈N

V

i

, let h : V → Z is a

decision rule. Then h is said to be eﬃcient if and only if:

¸

i∈N

v

i

(h(v

i

))

¸

i∈N

v

i

(h(v

t

i

)) ∀v

t

∈ V.

9.4 Dominant Strategy and Truthful Revelation Mech-

anism

The strongest solution concept of describing self-interested behavior is dominant strategy.

The dominant strategy identiﬁes situations in which the strategy chosen by each individual

is the best, regardless of choices of the others. An axiom in game theory is that agents

will use it as long as a dominant strategy exists.

For e ∈ E, a mechanism Γ =< M, h > is said to have a dominant strategy equilibrium

m

∗

if for all i

h

i

(m

∗

i

, m

−i

)

i

h

i

(m

i

, m

−i

) for all m ∈ M. (9.1)

Denoted by D(e, Γ) the set of dominant strategy equilibria for Γ =< M, h > and e ∈ E.

Under the assumption of dominant strategy, since each agent’s optimal choice does

not depend on the choices of the others and does not need to know characteristics of the

others, the required information is least when an individual makes decisions. Thus, if it

exists, it is an ideal situation.

When the solution concept is given by dominant strategy equilibrium, i.e., b(e, Γ) =

D(e, Γ), a mechanism Γ =< M, h > implements a social choice correspondence F in

dominant equilibrium strategy on E if for every e ∈ E,

(a) D(e, Γ) = ∅;

(b) h(D(e, Γ)) ⊂ F(e).

The above deﬁnitions have applied to general (indirect) mechanisms, there is, however,

a particular class of game forms which have a natural appeal and have received much

210

attention in the literature. These are called direct or revelation mechanisms, in which the

message space M

i

for each agent i is the set of possible characteristics E

i

. In eﬀect, each

agent reports a possible characteristic but not necessarily his true one.

A mechanism Γ =< M, h > is said to be a revelation or direct mechanism if M = E.

Example 9.4.1 Groves mechanism is a revelation mechanism.

The most appealing revelation mechanisms are those in which truthful reporting of char-

acteristics always turns out to be an equilibrium. It is the absence of such a mechanism

which has been called the “free-rider” problem in the theory of public goods. Perhaps the

most appealing revelation mechanisms of all are those for which each agent has truth as

a dominant strategy.

A revelation mechanism < E, h > is said to implements a social choice correspondence

F truthfully in b(e, Γ) on E if for every e ∈ E,

(a) e ∈ b(e, Γ);

(b) h(e) ⊂ F(e).

Although the message space of a mechanism can be arbitrary, the following Revela-

tion Principle tells us that one only needs to use the so-called revelation mechanism in

which the message space consists solely of the set of individuals’ characteristics, and it is

unnecessary to seek more complicated mechanisms. Thus, it will signiﬁcantly reduce the

complicity of constructing a mechanism.

Theorem 9.4.1 (Revelation Principle) Suppose a mechanism < M, h > implements

a social choice rule F in dominant strategy. Then there is a revelation mechanism <

E, g > which implements F truthfully in dominant strategy.

Proof. Let d be a selection of dominant strategy correspondence of the mechanism

< M, h >, i.e., for every e ∈ E, m

∗

= d(e) ∈ D(e, Γ). Since Γ = 'M, h` implements social

choice rule F, such a selection exists by the implementation of F. Since the strategy of

each agent is independent of the strategies of the others, each agent i’s dominant strategy

can be expressed as m

∗

i

= d

i

(e

i

).

211

Deﬁne the revelation mechanism < E, g > by g(e) ≡ h(d(e)) for each e ∈ E. We ﬁrst

show that the truth-telling is always a dominant strategy equilibrium of the revelation

mechanism 'E, g`. Suppose not. Then, there exists a e

t

and an agent i such that

u

i

[g(e

t

i

, e

t

−i

)] > u

i

[g(e

i

, e

t

−i

)].

However, since g = h ◦ d, we have

u

i

[h(d(e

t

i

), d(e

t

−i

)] > u

i

[h(d(e

i

), d(e

t

−i

)],

which contradicts the fact that m

∗

i

= d

i

(e

i

) is a dominant strategy equilibrium. This is

because, when the true economic environment is (e

i

, e

t

−i

), agent i has an incentive not to

report m

∗

i

= d

i

(e

i

) truthfully, but have an incentive to report m

t

i

= d

i

(e

t

i

), a contradiction.

Finally, since m

∗

= d(e) ∈ D(e, Γ) and < M, h > implements a social choice rule F

in dominant strategy, we have g(e) = h(d(e)) = h(m

∗

) ∈ F(e). Hence, the revelation

mechanism implements F truthfully in dominant strategy. The proof is completed.

Thus, by the Revelation Principle, we know that, if truthful implementation rather

than implementation is all that we require, we need never consider general mechanisms.

In the literature, if a revelation mechanism < E, h > truthfully implements a social choice

rule F in dominant strategy, the mechanism Γ is said to be strongly incentive-compatible

with a social choice correspondence F. In particular, when F becomes a single-valued

function f, < E, f > can be regarded as a revelation mechanism. Thus, if a mechanism

< M, h > implements f in dominant strategy, then the revelation mechanism < E, f >

is incentive compatible in dominant strategy, or called strongly incentive compatible.

Remark 9.4.1 Notice that the Revelation Principle may be valid only for weak imple-

mentation. The Revelation Principle speciﬁes a correspondence between a dominant strat-

egy equilibrium of the original mechanism < M, h > and the true proﬁle of characteristics

as a dominant strategy equilibrium, and it does not require the revelation mechanism has

a unique dominant equilibrium so that the revelation mechanism < E, g > may also exist

non-truthful strategy equilibrium that does not corresponds to any equilibrium. Thus,

in moving from the general (indirect) dominant strategy mechanisms to direct ones, one

may introduce dominant strategies which are not truthful. More troubling, these addi-

tional strategies may create a situation where the indirect mechanism is an implantation

212

of a given F, while the direct revelation mechanism is not. Thus, even if a mechanism

implements a social choice function, the corresponding revelation mechanism < E, g >

may only weakly implement, but not implement F.

9.5 Gibbard-Satterthwaite Impossibility Theorem

The Revelation Principle is very useful to ﬁnd a dominant strategy mechanism. If one

hopes a social choice goal f can be (weakly) implemented in dominant strategy, one

only needs to show the revelation mechanism < E, f > is strongly incentive compatible.

However, the Gibbard-Satterthwaite impossibility theorem in Chapter 4 tells us that, if

the domain of economic environments is unrestricted, such a mechanism does not exist

unless it is a dictatorial mechanism. From the angle of the mechanism design, we state

this theorem repeatly here.

Deﬁnition 9.5.1 A social choice function is dictatorial if there exists an agent whose

optimal choice is the social optimal.

Now we state the Gibbard-Satterthwaite Theorem without the proof that is very

complicated. A proof can be found, say, in Salani´e’s book (2000): Microeconomics of

Market Failures.

Theorem 9.5.1 (Gibbard-Satterthwaite Theorem) If X has at least 3 alternatives,

a social choice function which is strongly incentive compatible and deﬁned on a unrestricted

domain is dictatorial.

9.6 Hurwicz Impossibility Theorem

The Gibbard-Satterthwaite impossibility theorem is a very negative result. This result

is very similar to Arrow’s impossibility result. However, as we will show, when the ad-

missible set of economic environments is restricted, the result may be positive as the

Groves mechanism deﬁned on quasi-linear utility functions. Unfortunately, the following

Hurwicz’s impossibility theorem shows the Pareto eﬃciency and the truthful revelation is

fundamentally inconsistent even for the class of neoclassical economic environments.

213

Theorem 9.6.1 (Hurwicz Impossibility Theorem, 1972) For the neoclassical pri-

vate goods economies, any mechanism < M, h > that yields Pareto eﬃcient and individ-

ually rational allocations is not strongly individually incentive compatible. (Truth-telling

about their preferences is not Nash Equilibrium).

Proof: By the Revelation Principle, we only need to consider any revelation mechanism

that cannot implement Pareto eﬃcient and individually rational allocations in dominant

equilibrium for a particular pure exchange economy.

Consider a private goods economy with two agents (n = 2) and two goods (L = 2),

w

1

= (0, 2), w

2

= (2, 0)

u

i

(x, y) =

3x

i

+ y

i

if x

i

y

i

x

i

+ 3y

i

if x

i

> y

i

Figure 9.2: An illustration of the proof of Hurwicz’s impossibility theorem.

Thus, feasible allocations are given by

A =

¸

[(x

1

, y

1

), (x

2

, y

2

)] ∈ R

4

+

:

x

1

+x

2

= 2

y

1

+ y

2

= 2¦

214

U

i

is the set of all neoclassical utility functions, i.e. they are continuous and quasi-concave,

which agent i can report to the designer. Thus, the true utility function ˚u

i

∈ U

i

. Then,

U = U

1

U

2

h : U → A

Note that, if the true utility function proﬁle ˚u

i

is a Nash Equilibrium, it satisﬁes

˚u

i

(h

i

(˚u

i

, ˚u

−i

)) ˚u

i

(h

i

(u

i

, ˚u

−i

)) (9.2)

We want to show that ˚u

i

is not a Nash equilibrium. Note that,

(1) P(e) = O

1

O

2

(contract curve)

(2) IR(e) ∩ P(e) = ab

(3) h(˚u

1

, ˚u

2

) = d ∈ ab

Now, suppose agent 2 reports his utility function by cheating:

u

2

(x

2

, y

2

) = 2x +y (9.3)

Then, with u

2

, the new set of individually rational and Pareto eﬃcient allocations is given

by

IR(e) ∩ P(e) = ae (9.4)

Note that any point between a and e is strictly preferred to d by agent 2. Thus, the

allocation determined by any mechanism which yields IR and Pareto eﬃcient allocation

under (˚u

1

, u

2

) is some point, say, the point c in the ﬁgure, between the segment of the

line determined by a and e. Hence, we have

˚u

2

(h

2

(˚u

1

, u

2

)) >˚u

2

(h

2

(˚u

1

, ˚u

2

)) (9.5)

since h

2

(˚u

1

, u

2

) = c ∈ ae. Similarly, if d is between ae, then agent 1 has incentive to cheat.

Thus, no mechanism that yields Pareto eﬃcient and individually rational allocations is

incentive compatible. The proof is completed.

Thus, the Hurwicz’s impossibility theorem implies that Pareto eﬃciency and the truth-

ful revelation about individuals’ characteristics are fundamentally incompatible. However,

if one is willing to give up Pareto eﬃciency, say, one only requires the eﬃcient provision

215

of public goods, is it possible to ﬁnd an incentive compatible mechanism which results

in the Pareto eﬃcient provision of a public good and can truthfully reveal individuals’

characteristics? The answer is positive. For the class of quasi-linear utility functions, the

so-called Groves-Clarke-Vickrey Mechanism can be such a mechanism.

9.7 Groves-Clarke-Vickrey Mechanism

From Chapter 6 on public goods, we have known that public goods economies may present

problems by a decentralized resource allocation mechanism because of the free-rider prob-

lem. Private provision of a public good generally results in less than an eﬃcient amount

of the public good. Voting may result in too much or too little of a public good. Are

there any mechanisms that result in the “right” amount of the public good? This is a

question of the incentive compatible mechanism design. For simplicity, let us ﬁrst return

to the model of discrete public good.

9.7.1 Groves-Clark Mechanism for Discrete Public Good

Consider a provision problem of a discrete public good. Suppose that the economy has n

agents. Let

c: the cost of producing the public project.

r

i

: the maximum willingness to pay of i.

g

i

: the contribution made by i.

v

i

= r

i

−g

i

: the net value of i.

The public project is determined according to

y =

1 if

¸

n

i=1

v

i

0

0 otherwise

From the discussion in Chapter 6, it is eﬃcient to produce the public good, y = 1, if and

only if

n

¸

i=1

v

i

=

n

¸

i=1

(r

i

−q

i

) 0.

216

Since the maximum willingness to pay for each agent, r

i

, is private information and

so is the net value v

i

, what mechanism one should use to determine if the project is

built? One mechanism that we might use is simply to ask each agent to report his or

her net value and provide the public good if and only if the sum of the reported value is

positive. The problem with such a scheme is that it does not provide right incentives for

individual agents to reveal their true willingness-to-pay. Individuals may have incentives

to underreport their willingness-to-pay.

Thus, a question is how we can induce each agent to truthfully reveal his true value for

the public good. The so-called Groves-Clark mechanism gives such kind of mechanism.

Suppose the utility functions are quasi-linear in net increment in private good, x

i

−w

i

,

which have the form:

¯ u

i

(x

i

, y) = x

i

−w

i

+ r

i

y

s.t. x

i

+ q

i

y = w

i

+ t

i

where t

i

is the transfer to agent i. Then, we have

u

i

(t

i

, y) = t

i

+ r

i

y −g

i

y

= t

i

+ (r

i

−g

i

)y

= t

i

+ v

i

y.

• Groves Mechanism:

In the Groves mechanism, agents are required to report their net values. Thus the message

space of each agent i is M

i

= '. The Groves mechanism is deﬁned as follows:

Γ = (M

1

, . . . , M

n

, t

1

(), t

2

(), . . . , t

n

(), y()) ≡ (M, t(), y()), where

(1) b

i

∈ M

i

= R: each agent i reports a “bid” for the public good, i.e., report

the net value of agent i which may or may not be his true net value v

i

.

(2) The level of the public good is determined by

y(b) =

1 if

¸

n

i=1

b

i

0

0 otherwise

217

(3) Each agent i receives a side payment (transfer)

t

i

=

¸

j,=i

b

j

if

¸

n

i=1

b

i

0

0 otherwise

(9.6)

Then, the payoﬀ of agent i is given by

φ(b) =

v

i

+ t

i

= v

i

+

¸

j,=i

b

j

if

¸

n

i=1

b

i

0

0 otherwise

(9.7)

We want to show that it is optimal for each agent to report the true net value, b

i

= v

i

,

regardless of what the other agents report. That is, truth-telling is a dominant strategy

equilibrium.

Proposition 9.7.1 The truth-telling is a dominant strategy under the Groves-Clark mech-

anism.

Proof: There are two cases to be considered.

Case 1: v

i

+

¸

j,=i

b

j

> 0. Then agent i can ensure the public good is provided by

reporting b

i

= v

i

. Indeed, if b

i

= v

i

, then

¸

j,=i

b

j

+ v

i

=

¸

n

i=1

b

j

> 0 and thus y = 1. In

this case, φ(v

i

, b

−i

) = v

i

+

¸

j,=i

b

j

> 0.

Case 2: v

i

+

¸

j,=i

b

j

0. Agent i can ensure that the public good is not provided by

reporting b

i

= v

i

so that

¸

n

i=1

b

i

0. In this case, φ(v

i

, b

−i

) = 0 v

i

+

¸

j,=i

b

j

.

Thus, for either cases, agent i has incentives to tell the true value of v

i

. Hence, it is

optimal for agent i to tell the truth. There is no incentive for agent i to misrepresent his

true net value regardless of what other agents do.

The above preference revelation mechanism has a major fault: the total side-payment

may be very large. Thus, it is very costly to induce the agents to tell the truth.

Ideally, we would like to have a mechanism where the sum of the side-payment is equal

to zero so that the feasibility condition holds, and consequently it results in Pareto eﬃcient

allocations, but in general it impossible by Hurwicz’s impossibility theorem. However, we

could modify the above mechanism by asking each agent to pay a “tax”, but not receive

payment. Because of this “waster” tax, the allocation of public goods will not be Pareto

eﬃcient.

218

The basic idea of paying a tax is to add an extra amount to agent i’s side-payment,

d

i

(b

−i

) that depends only on what the other agents do.

A General Groves Mechanism: Ask each agent to pay additional tax, d

i

(b

−i

).

In this case, the transfer is given by

t

i

(b) =

¸

j,=t

b

j

−d

i

(b

−i

) if

¸

n

i=1

b

i

0

−d

i

(b

−i

) if

¸

n

i=1

b

i

< 0

The payoﬀ to agent i now takes the form:

φ(b) =

v

i

+ t

i

−d

i

(b

−i

) = v

i

+

¸

j,=i

b

j

−d

i

(b

−i

) if

¸

n

i=1

b

i

0

−d

i

(b

−i

) otherwise

(9.8)

For exactly the same reason as for the mechanism above, one can prove that it is

optimal for each agent i to report his true net value.

If the function d

i

(b

−i

) is suitably chosen, the size of the side-payment can be signif-

icantly reduced. One nice choice is the so-called Clark mechanism (also called pivotal

mechanism):

The Pivotal Mechanism is a special case of the general Groves Mechanism in which

d

i

(b

−i

) is given by

d

i

(b

−i

) =

¸

j,=i

b

j

if

¸

j,=i

b

j

0

0 if

¸

j,=i

b

j

< 0

In this case, it gives

t

i

(b) =

0 if

¸

n

i=1

b

i

0 and

¸

j,=i

b

i

0,

¸

j,=i

b

j

if

¸

n

i=1

b

i

0 and

¸

j,=i

b

j

< 0

−

¸

j,=i

b

j

if

¸

n

i=1

b

i

< 0 and

¸

j,=i

b

j

0

0 if

¸

n

i=1

b

i

< 0 and

¸

j,=i

b

j

< 0

(9.9)

i.e.,

t

i

(b) =

−[

¸

j,=i

b

i

[ if (

¸

n

i=1

b

i

)(

¸

j,=i

b

i

) < 0

−[

¸

j,=i

b

i

[ if

¸

n

i=1

b

i

= 0 and

¸

j,=i

b

i

< 0

0 otherwise

(9.10)

Therefore, the payoﬀ of agent i

φ

i

(b) =

v

i

if

¸

n

i=1

b

i

0 and

¸

j,=i

b

j

0

v

i

+

¸

j,=i

b

j

if

¸

n

i=1

b

i

0 and

¸

j,=i

b

j

< 0

−

¸

j,=i

b

j

if

¸

n

i=1

b

i

< 0 and

¸

j,=i

b

j

0

0 if

¸

n

i=1

b

i

< 0 and

¸

j,=i

b

j

< 0

(9.11)

219

Remark 9.7.1 Thus, from the transfer given in (9.10), adding in the side-payment has

the eﬀect of taxing agent i only if he changes the social decision. Such an agent is called

the pivotal person. The amount of the tax agent i must pay is the amount by which agent

i’s bid damages the other agents. The price that agent i must pay to change the amount

of public good is equal to the harm that he imposes on the other agents.

9.7.2 The Groves-Clark-Vickery Mechanism with Continuous

Public Goods

Now we are concerned with the provision of continuous public goods. Consider a public

goods economy with n agents, one private good, and K public goods. Denote

x

i

: the consumption of the private good by i;

y: the consumption of the public goods by all individuals;

t

i

: transfer payment to i;

g

i

(y): the contribution made by i;

c(y): the cost function of producing public goods y that satisﬁes the condition:

¸

g

i

(y) = c(y).

Then, agent i’s budget constraint should satisfy

x

i

+ g

i

(y) = w

i

+ t

i

(9.12)

and his utility functions are given by

¯ u

i

(x

i

, y) = x

i

−w

i

+ u

i

(y) (9.13)

By substitution,

u

i

(t

i

, y) = t

i

−(u

i

(y) −g

i

(y))

≡ t

i

+ v

i

(y)

where v

i

(y) is called the valuation function of agent i. From the budget constraint,

n

¸

i=1

¦x

i

+ g

i

(y)¦ =

n

¸

1=i

w

i

+

n

¸

1=i

t

i

(9.14)

220

we have

n

¸

i=1

x

i

+ c(y) =

n

¸

i=1

w

i

+

n

¸

1=i

t

i

(9.15)

The feasibility (or balanced) condition then becomes

n

¸

i=1

t

i

= 0 (9.16)

Recall that Pareto eﬃcient allocations are completely characterized by

max

¸

a

i

¯ u

i

(x

i

, y)

s.t.

n

¸

1=i

x

i

+ c(y) =

n

¸

1=i

w

i

For quasi-linear utility functions it is easily seen that the weights a

i

must be the same

for all agents since a

i

= λ for interior Pareto eﬃcient allocations (no income eﬀect), the

Lagrangian multiplier, and y is thus uniquely determined for the special case of quasi-

linear utility functions u

i

(t

i

, y) = t

i

+ v

i

(y). Then, the above characterization problem

becomes

max

t

i

,y

¸

n

¸

i=1

(t

i

+ v

i

(y))

¸

(9.17)

or equivalently

(1)

max

y

n

¸

i=1

v

i

(y)

(2) (feasibility condition):

¸

n

i=1

t

i

= 0

Then, the Lindahl-Samuelson condition is given by:

n

¸

i=1

v

t

i

(y) = 0.

that is,

n

¸

i=1

u

t

i

(y) = c

t

(y)

Thus, Pareto eﬃcient allocations for quasi-linear utility functions are completely char-

acterized by the Lindahl-Samuelson condition

¸

n

i=1

v

t

i

(y) = 0 and feasibility condition

¸

n

i=1

t

i

= 0.

221

In the Groves mechanism, it is supposed that each agent is asked to report the valuation

function v

i

(y). Denote his reported valuation function by b

i

(y).

To get the eﬃcient level of public goods, the government may announce that it will

provide a level of public goods y

∗

that maximizes

max

y

n

¸

i=1

b

i

(y)

The Groves mechanism has the form:

Γ = (V, h) (9.18)

where V = V

1

. . . V

n

: is the message space that consists of the set of all possible

valuation functions with element b

i

(y) ∈ V

i

, h = (t

1

(b), t

2

(b), . . . , t

n

(b), y(b)) are outcome

functions. It is determined by:

(1) Ask each agent i to report his/her valuation function b

i

(y) which may or

may not be the true valuation v

i

(y).

(2) Determine y

∗

: the level of the public goods, y

∗

= y(b), is determined by

max

y

n

¸

i=1

b

i

(y) (9.19)

(3) Determine t: transfer of agent i, t

i

is determined by

t

i

=

¸

j,=i

b

j

(y

∗

) (9.20)

The payoﬀ of agent i is then given by

φ

i

(b(y

∗

)) = v

i

(y

∗

) + t

i

(b) = v

i

(y

∗

) +

¸

j,=i

b

j

(y

∗

) (9.21)

The social planner’s goal is to have the optimal level y

∗

that solves the problem:

max

y

n

¸

i=1

b

i

(y).

In which case is the individual’s interest consistent with social planner’s interest?

Under the rule of this mechanism, it is optimal for each agent i to truthfully report his

true valuation function b

i

(y) = v

i

(y) since agent i wants to maximize

v

i

(y) +

¸

j,=i

b

j

(y).

222

By reporting b

i

(y) = v

i

(y), agent i ensures that the government will choose y

∗

which

also maximizes his payoﬀ while the government maximizes the social welfare. That

is, individual’s interest is consistent with the social interest that is determined by the

Lindahl-Samuelson condition. Thus, truth-telling, b

i

(y) = v

i

(y)), is a dominant strategy

equilibrium.

In general,

¸

n

i=1

t

i

(b(y)) = 0, which means that a Groves mechanism in general does

not result in Pareto eﬃcient outcomes even if it satisﬁes the Lindahl-Samuelson condition,

i.e., it is Pareto eﬃcient to provide the public goods.

As in the discrete case, the total transfer can be very large, just as before, they can

be reduced by an appropriate side-payment. The Groves mechanism can be modiﬁed to

t

i

(b) =

¸

j,=i

b

j

(y) −d(b

−i

).

The general form of the Groves Mechanism is then Γ =< V, t, y(b) > such that

(1)

¸

n

i=1

b

i

(y(b))

¸

n

i=1

b

i

(y) for y ∈ Y ;

(2) t

i

(b) =

¸

j,=i

b

j

(y) −d(b

−i

).

A special case of the Groves mechanism is independently described by Clark and is

called the Clark mechanism (also called the pivotal mechanism) in which d

i

(b

−i

(y)) is

given by

d(b

−i

) = max

y

¸

j,=i

b

j

(y). (9.22)

That is, the pivotal mechanism, Γ =< V, t, y(b) >, is to choose (y

∗

, t

∗

i

) such that

(1)

¸

n

i=1

b

i

(y

∗

)

¸

n

i=1

b

i

(y) for y ∈ Y ;

(2) t

i

(b) =

¸

j,=i

b

j

(y

∗

) −max

y

¸

j,=i

b

j

(y).

It is interesting to point out that the Clark mechanism contains the well-known Vickery

auction mechanism (the second-price auction mechanism) as a special case. Under the

Vickery mechanism, the highest biding person obtains the object, and he pays the second

highest biding price. To see this, let us explore this relationship in the case of a single

good auction (Example 9.3.3 in the beginning of this chapter). In this case, the outcome

space is

Z = ¦y ∈ ¦0, 1¦

n

:

n

¸

i=1

y

i

= 1¦

223

where y

i

= 1 implies that agent i gets the object, and y

i

= 0 means the person does not

get the object. Agent i’s valuation function is then given by

v

i

(y) = v

i

y

i

.

Since we can regard y as a n-dimensional vector of public goods, by the Clark mechanism

above, we know that

y = g(b) = ¦y ∈ Z : max

n

¸

i=1

b

i

y

i

¦ = ¦y ∈ Z : max

i∈N

b

i

¦,

and the truth-telling is a dominate strategy. Thus, if g

i

(v) = 1, then t

i

(v) =

¸

j,=i

v

j

y

∗

j

−

max

y

¸

j,=i

v

j

y

j

= −max

j,=i

v

j

. If g

i

(b) = 0, then t

i

(v) = 0. This means that the object

is allocated to the individual with the highest valuation and he pays an amount equal to

the second highest valuation. No other payments are made. This is exactly the outcome

predicted by the Vickery mechanism.

9.8 Nash Implementation

9.8.1 Nash Equilibrium and General Mechanism Design

From Hurwicz’s impossibility theorem, we know that, if one wants to get a mechanism

that results in Pareto eﬃcient and individually rational allocations, one must give up the

dominant strategy implementation, and then, by Revelation Principle, we must look at

more general mechanisms < M, h > instead of using a revelation mechanism.

We know the dominant strategy equilibrium is a very strong solution concept. Now, if

we adopt the Nash equilibrium as a solution concept to describe individuals’ self-interested

behavior, can we design an incentive compatible mechanism which implements Pareto

eﬃcient allocations?

For e ∈ E, a mechanism < M, h > is said to have a Nash equilibrium m

∗

∈ M if

h

i

(m

∗

)

i

h

i

(m

i

, m

∗

i

) (9.23)

for all m

i

∈ M

i

and all i. Denote by NE(e, Γ) the set of all Nash equilibria of the

mechanism Γ for e ∈ E.

It is clear every dominant strategy equilibrium is a Nash equilibrium, but the converse

may not be true.

224

A mechanism Γ =< M, h > is said to Nash-implement a social choice correspondence

F on E if for every e ∈ E

(a) NE(e, Γ) = ∅;

(b) h(NE(e, Γ)) ⊆ F(e).

It fully Nash implements a social choice correspondence F on E if for every e ∈ E

(a) NE(e, Γ) = ∅

(b) h(NE(e, Γ)) = F(e).

The following proposition shows that, if a truth-telling about their characteristics is a

Nash equilibrium of the revelation mechanism, it must be a dominant strategy equilibrium

of the mechanism.

Proposition 9.8.1 For a revelation mechanism Γ =< E, h >, a truth-telling e

∗

is a

Nash equilibrium if and only if it is a dominant equilibrium

h(e

∗

i

, e

−i

)

i

h(e

i

, e

−i

) ∀(e

i

, e

−i

) ∈ E&i ∈ N. (9.24)

Proof. Since for every e ∈ E and i, by Nash equilibrium, we have

h(e

i

, e

−i

)

i

h(e

t

i

, e

−i

) for all e

t

i

∈ E

i

.

Since this true for any (e

t

i

, e

−i

), it is a dominant strategy equilibrium. The proof is

completed.

Thus, we cannot get any new results if one insists on the choice of revelation mecha-

nisms. To get more satisfactory results, one must give up the revelation mechanism, and

look for a more general mechanism with general message spaces.

Notice that, when one adopts the Nash equilibrium as a solution concept, the weak

Nash implementation is not a useful concept. To see this, consider any social choice

correspondence F and the following mechanism: each individual’s message space consists

of the set of economic environments, i.e., it is given by M

i

= E. The outcome function

is deﬁned as h(m) = a ∈ F(e) when all agents reports the same economic environment

m

i

= e, and otherwise it is seriously punished by giving a worse outcome. Then, it is clear

the truth-telling is a Nash equilibrium. However, it has a lot of Nash equilibria, in fact

225

inﬁnity number of Nash equilibria. Any false reporting about the economic environment

m

i

= e

t

is also a Nash equilibrium. So, when we use Nash equilibrium as a solution

concept, we need a social choice rule to be implemented or full implemented in Nash

equilibrium.

9.8.2 Characterization of Nash Implementation

Now we discuss what kind of social choice rules can be implemented through Nash incen-

tive compatible mechanism. Maskin in 1977 gave necessary and suﬃcient conditions for

a social choice rule to be Nash implementable (This paper was not published till 1999.

It then appeared in Review of Economic Studies, 1999). Maskin’s result is fundamental

since it not only helps us to understand what kind of social choice correspondence can be

Nash implemented, but also gives basic techniques and methods for studying if a social

choice rule is implementable under other solution concepts.

Maskin’s monotonicity condition can be stated in two diﬀerent ways although they

are equivalent.

Deﬁnition 9.8.1 (Maskin’s Monotonicity) A social choice correspondence F : E →→

A is said to be Maskin’s monotonic if for any e, ¯ e ∈ E, x ∈ F(e) such that for all i and

all y ∈ A, x

i

y implies that x

¯

i

y, then x ∈ F(¯ e).

In words, Maskin’s monotonicity requires that if an outcome x is socially optimal

with respect to economy e and then economy is changed to ¯ e so that in each individual’s

ordering, x does not fall below an outcome that is not below before, then x remains

socially optimal with respect to ¯ e.

226

Figure 9.3: An illustration of Maskin’s monotonicity.

Deﬁnition 9.8.2 (Another Version of Maskin’s Monotonicity) A equivalent con-

dition for a social choice correspondence F : E →→ A to be Maskin’s monotonic is that,

if for any two economic environments e, ¯ e ∈ E, x ∈ F(e) such that x ∈ F(e

t

), there is an

agent i and another y ∈ A such that x

i

y and y

¯

~

i

x.

Maskin’s monotonicity is a reasonable condition, and many well known social choice

rules satisfy this condition.

Example 9.8.1 (Weak Pareto Eﬃciency) The weak Pareto optimal correspondence

P

w

: E →→ A is Maskin’s monotonic.

Proof. If x ∈ P

w

(e), then for all y ∈ A, there exists i ∈ N such that x

i

y. Now if

for any j ∈ N such that x

j

implies x

¯

j

y, then we have x

¯

i

y for particular i. Thus,

x ∈ P

w

(¯ e).

Example 9.8.2 (Majority Rule) The majority rule or call the Condorcet correspon-

dence CON : E →→ A for strict preference proﬁle, which is deﬁned by

CON(e) = ¦x ∈ A : #¦i[x ~

i

y¦ #¦i[y ~

i

x¦ for all y ∈ A¦

is Maskin’s monotonic.

227

Proof. If x ∈ CON(e), then for all y ∈ A,

#¦i[x ~

i

y¦ #¦i[y ~

i

x¦. (9.25)

But if ¯ e is an economy such that, for all i, x ~

i

y implies x

¯

~

i

y, then the left-hand side of

(9.25) cannot fall when we replace e by ¯ e. Furthermore, if the right-hand side rises, then

we must have x ~

i

y and y

¯

~

i

x for some i, a contradiction of the relation between e and

¯ e, given the strictness of preferences. So x is still a majority winner with respect to ¯ e,

i.e., x ∈ CON(¯ e).

In addition to the above two examples, Walrasian correspondence and Lindahl correspon-

dence with interior allocations are Maskin’s monotonic. The class of preferences that

satisfy “single-crossing” property and individuals’ preferences over lotteries satisfy the

von Neumann-Morgenstern axioms also automatically satisfy Maskin’ monotonicity.

The following theorem shows the Maskin’s monotonicity is a necessary condition for

Nash-implementability.

Theorem 9.8.1 For a social choice correspondence F : E →→ A, if it is fully Nash

implementable, then it must be Maskin’s monotonic.

Proof. For any two economies e, ¯ e ∈ E, x ∈ F(e), then by full Nash implementability

of F, there is m ∈ M such that m is a Nash equilibrium and x = h(m). This means that

h(m)

i

h(m

t

i

, m

−i

) for all i and m

t

i

∈ M

i

. Given x

i

y implies x

¯

i

y, h(m)

¯

i

h(m

t

i

, m

−i

),

which means that m is also a Nash equilibrium at ¯ e. Thus, by Nash implementability

again, we have x ∈ F(¯ e).

Maskin’s monotonicity itself can not guarantee a social choice correspondence is fully

Nash implementable. However, under the so-called no-veto power, it becomes suﬃcient.

Deﬁnition 9.8.3 (No-Veto Power) A social choice correspondence F : E →→ A is

said to satisfy no-veto power if whenever for any i and e such that x

j

y for all y ∈ A

and all j = i, then x ∈ F(e).

The no-veto power (NVP) condition implies that if n − 1 agents regard an outcome

is the best to them, then it is social optimal. This is a rather weaker condition. NVP is

satisﬁed by virtually all “standard” social choice rules, including weak Pareto eﬃcient and

228

Condorect correspondences. It is also often automatically satisﬁed by any social choice

rules when the references are restricted. For example, for private goods economies with

at least three agents, if each agent’s utility function is strict monotonic, then there is no

other allocation such that n − 1 agents regard it best, so the no-veto power condition

holds.

Theorem 9.8.2 Under no-veto power, if Maskin’s monotonicity condition is satisﬁed,

then F is fully Nash implementable.

Proof. The proof is by construction. For each agent i, his message space is deﬁned by

M

i

= E A ^

where ^ = ¦1, 2, . . . , ¦. Its elements are denoted by m

i

= (e

i

, a

i

, v

i

), which means each

agent i announces an economic proﬁle, an outcome, and a real number. (For notation

convenience, we have used e

i

to denote the economic proﬁle of all individuals’ economic

characteristics, but not just agent i economic characteristic).

The outcome function is constructed in three cases:

Case(1). If m

1

= m

2

= . . . = m

n

= (e, a, v) and a ∈ F(e), the outcome function is

deﬁned by

h(m) = a.

In words, if players are unanimous in their strategy, and their proposed alterative a is

F-optimal, given their proposed proﬁle e, the outcome is a.

Case(2). For all j = i, m

j

= (e, a, v), m

i

= (e

i

, a

i

, v

i

) = (e, a, v), and a ∈ F(e), deﬁne:

h(m) =

a

i

if a

i

∈ L(a, e

i

)

a if a

i

∈ L(a, e

i

).

where L(a, e

i

) = ¦b ∈ A : a R

i

b¦ which is the lower contour set of R

i

at a. That is,

suppose that all players but one play the same strategy and, given their proposed proﬁle,

their proposed alternative a is F-optimal. Then, the odd-man-out, gets his proposed

alterative, provided that it is in the lower contour set at a of the ordering that the other

players propose for him; otherwise, the outcome is a.

Case(3). If neither Case (1) nor Case (2) applies, then deﬁne

h(m) = a

i∗

229

where i∗ = max¦i ∈ ^ : v

i

= max

j

v

j

¦. In other words, when neither case (1) nor case (2)

applies, the outcome is the alternative proposed by player with the highest index among

those whose proposed number is maximal.

Now we show that the mechanism 'M, h` deﬁned above fully Nash implements social

choice correspondence F, i.e., h(N(e)) = F(e) for all e ∈ E. We ﬁrst show that F(e) ⊂

h(N(e)) for all e ∈ E, i.e., we need to show that for all e ∈ E and a ∈ F(e), there exists

a m ∈ M such that a = h(m) is a Nash equilibrium outcome. To do so, we only need to

show that any m which is given by Case (1) is a Nash equilibrium. Note that h(m) = a

and for any given m

t

i

= (e

t

i

, a

t

i

, v

t

i

) = m

i

, by Case (2), we have

h(m

t

i

, m

−i

) =

a

i

if a

i

∈ L(a, e

i

)

a if a

i

∈ L(a, e

i

).

and thus

h(m) R

i

h(m

t

i

, m

−i

) ∀m

t

i

∈ M

i

.

Hence, m is a Nash equilibrium.

We now show that for each economic environment e ∈ E, if m is a Nash equilibrium,

then h(m) ∈ F(e). First, consider the Nash equilibrium m is given by Case (1) so that

a ∈ F(e), but the true economic proﬁle is e

t

, i.e., m ∈ NE(e

t

, Γ). We need to show

a ∈ F(e

t

). By Case (1), h(m) = a. Since a is a Nash equilibrium outcome with respect to

e

t

, by Case (2), for all i ∈ N and b ∈ L(a, e), we have a R

t

i

b, which can be rewritten as:

for i ∈ N and b ∈ A, a R

i

b implies a R

t

i

b. Thus, by Maskin’s monotonicity condition,

we have a ∈ F(e

t

).

Next, suppose Nash equilibrium m for e

t

is in the Case (2), i.e, for all j = i, m

j

=

(e, a, v), m

i

= (e, a, v). Let a

t

= h(m). By Case (3), each j = i can induce any outcome

b ∈ A by choosing (R

j

, b, v

j

) with suﬃciently a large v

j

(which is greater than max

k,=j

v

k

),

as the outcome at (m

t

i

, m

−i

), i.e,, b = h(m

t

i

, m

−i

). Hence, m is a Nash equilibrium with

respect to e

t

implies that for all j = i, we have

a

t

R

t

j

b.

Thus, by no-veto power assumption, we have a

t

∈ F(e

t

).

The same argument as the above, if m is a Nash equilibrium for e

t

is given by Case

(3), we have a

t

∈ F(e

t

). The proof is completed.

230

Although Maskin’s monotonicity is very weak, it is violated by some social choice rules

such as Solomon’s famous judgement. Solomon’s solution falls under Nash equilibrium

implementation, since each woman knows who is the real mother. His solution, which

consisted in threatening to cut the baby in two, is not entirely foolproof. What would

be have done if the impostor has had the presence of mind to scream like a real mother?

Solomon’s problem can be formerly described by the languages of mechanism design as

follows.

Two women: Anne and Bets

Two economies (states): E = ¦α, β¦, where

α: Anne is the real mother

β: Bets is the real mother

Solomon has three alternatives so that the feasible set is given by A = ¦a, b, c¦,

where

a: give the baby to Anne

b: give the baby to Bets

c: cut the baby in half.

Solomon’s desirability (social goal) is to give the baby to the real mother,

f(α) = a if α happens

f(β) = b if β happens

Preferences of Anne and Bets:

For Anne,

at state α, a ~

α

A

b ~

α

A

c

at β: a ~

β

A

c ~

β

A

b

For Bets,

at state α, b ~

α

B

c ~

α

B

a

at state β: b ~

β

B

a ~

β

B

c

231

To see Solomon’s solution does not work, we only need to show his social choice goal is

not Maskin’s monotonic. Notice that for Anne, since

a ~

α

A

b, c,

a ~

β

A

b, c,

and f(α) = a, by Maskin’s monotonicity, we should have f(β) = a, but we actually have

f(β) = b. So Solomon’s social choice goal is not Nash implementable.

9.9 Better Mechanism Design

Maskin’s theorems gives necessary and suﬃcient conditions for a social choice correspon-

dence to be Nash implementable. However, due to the general nature of the social choice

rules under consideration, the implementing mechanisms in proving characterization the-

orems turn out to be quite complex. Characterization results show what is possible for

the implementation of a social choice rule, but not what is realistic. Thus, like most char-

acterization results in the literature, Maskin’s mechanism is not natural in the sense that

it is not continuous; small variations in an agent’s strategy choice may lead to large jumps

in the resulting allocations, and further it has a message space of inﬁnite dimension since

it includes preference proﬁles as a component. In this section, we give some mechanisms

that have some desired properties.

9.9.1 Groves-Ledyard Mechanism

Groves-Ledyard Mechanism (1977, Econometrica) was the ﬁrst to give a speciﬁc mecha-

nism that Nash implements Pareto eﬃcient allocations for public goods economies.

To show the basic structure of the Groves-Ledyard mechanism, consider a simpliﬁed

Groves-Ledyard mechanism. Public goods economies under consideration have one private

good x

i

, one public good y, and three agents (n = 3). The production function is given

by y = v.

The mechanism is deﬁned as follows:

M

i

= R

i

, i = 1, 2, 3. Its elements, m

i

, can be interpreted as the proposed

contribution (or tax) that agent i is willing to make.

232

t

i

(m) = m

2

i

+2m

j

m

k

: the actual contribution t

i

determined by the mechanism

with the reported m

i

.

y(m) = (m

1

+ m

2

+ m

3

)

2

: the level of public good y.

x

i

(m) = w

i

−t

i

(m): the consumption of the private good.

Then the mechanism is balanced since

3

¸

i=1

x

i

+

3

¸

i=1

t

i

(m)

=

3

¸

i=1

x

i

+ (m

1

+ m

2

+ m

3

)

2

=

n

¸

i=3

x

i

+y =

3

¸

i=1

w

i

The payoﬀ function is given by

v

i

(m) = u

i

(x

i

(m), y(m))

= u

i

(w

i

−t

i

(m), y(m).

To ﬁnd a Nash equilibrium, we set

∂v

i

(m)

∂m

i

= 0 (9.26)

Then,

∂v

i

(m)

∂m

i

=

∂u

i

∂x

i

(−2m

i

) +

∂u

i

∂y

2(m

1

+ m

2

+ m

3

) = 0 (9.27)

and thus

∂u

i

∂y

∂u

i

∂x

i

=

m

i

m

1

+m

2

+ m

3

. (9.28)

When u

i

are quasi-concave, the ﬁrst order condition will be a suﬃcient condition for Nash

equilibrium.

Making summation, we have at Nash equilibrium

3

¸

i=1

∂u

i

∂y

∂u

i

∂x

i

=

¸

m

i

m

1

+ m

2

+ m

3

= 1 =

1

f

t

(v)

(9.29)

that is,

3

¸

i=1

MRS

yx

i

= MRTS

yv

.

233

Thus, the Lindahl-Samuelson and balanced conditions hold which means every Nash equi-

librium allocation is Pareto eﬃcient.

They claimed that they have solved the free-rider problem in the presence of public

goods. However, economic issues are usually complicated. Some agreed that they indeed

solved the problem, some did not. There are two weakness of Groves-Ledyard Mechanism:

(1) it is not individually rational: the payoﬀ at a Nash equilibrium may be lower than at

the initial endowment, and (2) it is not individually feasible: x

i

(m) = w

i

−t

i

(m) may be

negative.

How can we design the incentive mechanism to pursue Pareto eﬃcient and individually

rational allocations?

9.9.2 Walker’s Mechanism

Walker (1981, Econometrica) gave such a mechanism. Again, consider public goods

economies with n agents, one private good, and one public good, and the production

function is given by y = f(v) = v.

The mechanism is deﬁned by:

M

i

= R

Y (m) =

¸

n

i=1

m

i

: the level of public good.

q

i

(m) =

1

n

+m

i+1

−m

i+2

: personalized price of public good.

t

i

(m) = q

i

(m)y(m): the contribution (tax) made by agent i.

x

i

(m) = w

i

−t

i

(m) = w

i

−q

i

(m)y(m): the private good consumption.

Then, the budget constraint holds:

x

i

(m) + q

i

(m)y(m) = w

i

∀m

i

∈ M

i

(9.30)

Making summation, we have

n

¸

i=1

x

i

+

n

¸

i=1

q

i

(m)y(m) =

n

¸

i=1

w

i

and thus

n

¸

i=1

x

i

+ y(m) =

n

¸

i=1

w

i

234

which means the mechanism is balanced.

The payoﬀ function is

v

i

(m) = u

i

(x

i

, y)

= u

i

(w

i

−q

i

(m)y(m), y(m))

The ﬁrst order conditions for interior allocations are given by

∂v

i

∂m

i

= −

∂u

i

∂x

i

¸

∂q

i

∂m

i

y(m) + q

i

(m)

∂y(m)

∂m

i

+

∂u

i

∂y

∂y(m)

∂m

i

= −

∂u

i

∂x

i

q

i

(m) +

∂u

i

∂y

= 0

⇒

∂u

i

∂y

∂u

i

∂x

i

= q

i

(m) (FOC) for the Lindahl Allocation

⇒ N(e) ⊆ L(e)

Thus, if u

i

are quasi-concave, it is also a suﬃcient condition for Lindahl equilibrium. We

can also show every Lindahl allocation is a Nash equilibrium allocation, i.e.,

L(e) ⊆ N(e) (9.31)

Indeed, suppose [(x

∗

, y

∗

), q

∗

i

, . . . , q

∗

n

] is a Lindahl equilibrium. The solution m

∗

of the

following equation

q

∗

i

=

1

n

+m

i+1

−m

i+2

,

y

∗

=

n

¸

i=1

m

i

is a Nash equilibrium.

Thus, Walker’s mechanism fully implements Lindahl allocations which are Pareto ef-

ﬁcient and individually rational.

Walker’s mechanism also has a disadvantage that it is not feasible although it does solve

the individual rationality problem. If a person claims large amounts of t

i

, consumption

of private good may be negative, i.e., x

i

= w

i

−t

i

< 0. Tian proposed a mechanism that

overcomes Walker’s mechanism’s problem. Tian’s mechanism is individually feasible,

balanced, and continuous.

235

9.9.3 Tian’s Mechanism

In Tian’s mechanism (JET, 1991), everything is the same as Walker’s, except that y(m)

is given by

y(m) =

a(m) if

¸

m

i

> a(m)

¸

(m

i

) if 0

¸

m

i

a(m)

0 if

¸

n

i=1

m

i

< 0

(9.32)

where a(m) = min

i∈N

(m)

w

i

q

i

(m)

with N

t

(m) = ¦i ∈ N : q

i

(m) > 0¦.

An interpretation of this formulation is that if the total taxes that the agents are

willing to pay were between zero and the feasible upper bound, the level of public good

to be produced would be exactly the total taxes; if the total taxes were less than zero, no

public good would be produced; if the total taxes exceeded the feasible upper bound, the

level of the public good would be equal to the feasible upper bound.

Figure 9.4: The feasible public good outcome function Y (m).

To show this mechanism has all the nice properties, we need to assume that preferences

are strictly monotonically increasing and convex, and further assume that every interior

allocation is preferred to any boundary allocations: For all i ∈ N, (x

i

, y) P

i

(x

t

i

, y

t

) for all

(x

i

, y) ∈ R

2

++

and (x

t

i

, y

t

) ∈ ∂R

2

+

, where ∂R

2

+

is the boundary of R

2

+

.

To show the equivalence between Nash allocations and Lindahl allocations. We ﬁrst

prove the following lemmas.

Lemma 9.9.1 If (X(m

∗

), Y (m

∗

)) ∈ N

M,h

(e), then (X

i

(m

∗

), Y (m

∗

)) ∈ R

2

++

for all i ∈ N.

236

Proof: We argue by contradiction. Suppose (X

i

(m

∗

), Y (m

∗

)) ∈ ∂R

2

+

. Then X

i

(m

∗

) =

0 for some i ∈ N or Y (m

∗

) = 0. Consider the quadratic equation

y =

w

∗

2(y + c)

, (9.33)

where w

∗

= min

i∈N

w

i

; c = b + n

¸

n

i=1

[m

∗

i

[, where b = 1/n. The larger root of (9.33)

is positive and denoted by ˜ y. Suppose that player i chooses his/her message m

i

= ˜ y −

¸

n

j,=i

m

∗

j

. Then ˜ y = m

i

+

¸

n

j,=i

m

∗

j

> 0 and

w

j

−q

j

(m

∗

/m

i

, i)˜ y w

j

−[b + (n

n

¸

s=1

[m

∗

s

[ + ˜ y)]˜ y

= w

j

−(˜ y + b + n

n

¸

s=1

[m

∗

s

[)˜ y

= w

j

−w

∗

/2 w

j

/2 > 0 (9.34)

for all j ∈ N. Thus, Y (m

∗

/m

i

, i) = ˜ y > 0 and X

j

(m

∗

/m

i

, i) = w

j

−q

j

(m

∗

/m

i

, i)Y (m

∗

/m

i

, i) =

w

j

−q

j

(m

∗

/m

i

, i)˜ y > 0 for all j ∈ N. Thus we have (X

i

(m

∗

/m

i

, i), Y (m

∗

/m

i

, i)) P

i

(X

i

(m

∗

), Y (m

∗

))

by Assumption 4, which contradicts the hypothesis (X(m

∗

), Y (m

∗

)) ∈ N

M,h

(e). Q.E.D.

Lemma 9.9.2 If (X(m

∗

), Y (m

∗

)) ∈ N

M,h

(e), then Y (m

∗

) is an interior point of [0, a(m)]

and thus Y (m

∗

) =

¸

n

i=1

m

∗

i

.

Proof: By Lemma 9.9.1, Y (m

∗

) > 0. So we only need to show Y (m

∗

) < a(m

∗

). Sup-

pose, by way of contradiction, that Y (m

∗

) = a(m

∗

). Then X

j

(m

∗

) = w

j

−q

j

(m

∗

)Y (m

∗

) =

w

j

− q

j

(m

∗

)a(m

∗

) = w

j

− w

j

= 0 for at least some j ∈ N. But X(m

∗

) > 0 by Lemma

9.9.1, a contradiction. Q.E.D.

Proposition 1 If the mechanism has a Nash equilibrium m

∗

, then (X(m

∗

), Y (m

∗

)) is a

Lindahl allocation with (q

1

(m

∗

), . . . , q

n

(m

∗

)) as the Lindahl price vector, i.e., N

M,h

(e) ⊆

L(e).

Proof: Let m

∗

be a Nash equilibrium. Now we prove that (X(m

∗

), Y (m

∗

)) is a Lin-

dahl allocation with (q

1

(m

∗

), . . . , q

n

(m

∗

)) as the Lindahl price vector. Since the mecha-

nism is completely feasible and

¸

n

i=1

q

i

(m

∗

) = 1 as well as X

i

(m

∗

) + q

i

(m

∗

)Y (m

∗

) = w

i

for all i ∈ N, we only need to show that each individual is maximizing his/her pref-

erence. Suppose, by way of contradiction, that there is some (x

i

, y) ∈ R

2

+

such that

237

(x

i

, y) P

i

(X

i

(m

∗

), Y (m

∗

)) and x

i

+ q

i

(m

∗

)y w

i

. Because of monotonicity of pref-

erences, it will be enough to conﬁne ourselves to the case of x

i

+ q

i

(m

∗

)y = w

i

. Let

(x

iλ

, y

λ

) = (λx

i

+(1λ)X

i

(m

∗

), λy+(1λ)Y (m

∗

)). Then by convexity of preferences we have

(x

iλ

, y

λ

) P

i

(X

i

(m

∗

), Y (m

∗

)) for any 0 < λ < 1. Also (x

iλ

, y

λ

) ∈ R

2

+

and x

iλ

+q

i

(m

∗

)y

λ

=

w

i

.

Suppose that player i chooses his/her message m

i

= y

λ

−

¸

n

j,=i

m

∗

j

. Since Y (m

∗

) =

¸

n

j=1

m

∗

i

by Lemma 9.9.2, m

i

= y

λ

− Y (m

∗

) + m

∗

i

. Thus as λ → 0, y

λ

→ Y (m

∗

), and

therefore m

i

→ m

∗

i

. Since X

j

(m

∗

) = w

j

− q

j

(m

∗

)Y (m

∗

) > 0 for all j ∈ N by Lemma

9.9.1, we have w

j

− q

j

(m

∗

/m

i

, i)y

λ

> 0 for all j ∈ N as λ is a suﬃciently small positive

number. Therefore, Y (m

∗

/m

i

, i) = y

λ

and X

i

(m

∗

/m

i

, i) = w

i

−q

i

(m

∗

)Y (m

∗

/m

i

, i) = w

i

−

q

i

(m

∗

)y

λ

= x

iλ

. From (x

iλ

, y

λ

) P

i

(X

i

(m

∗

), Y (m

∗

)), we have (X

i

(m

∗

/m

i

, i), Y (m

∗

/m

i

, i)) P

i

(X

i

(m

∗

), Y (m

∗

)). This contradicts (X(m

∗

), Y (m

∗

)) ∈ N

M,h

(e). Q.E.D.

Proposition 2 If (x

∗

, y

∗

) is a Lindahl allocation with the Lindahl price vector q

∗

=

(q

∗

1

, . . . , q

∗

n

), then there is a Nash equilibrium m

∗

of the mechanism such that X

i

(m

∗

) = x

∗

i

,

q

i

(m

∗

) = q

∗

i

, for all i ∈ N, Y (m

∗

) = y

∗

, i.e., L(e) ⊆ N

M,h

(e).

Proof: We need to show that there is a message m

∗

such that (x

∗

, y

∗

) is a Nash

allocation. Let m

∗

be the solution of the following linear equations system:

??

q

∗

i

=

1

n

+m

i+1

−m

i+2

,

y

∗

=

n

¸

i=1

m

i

Then X

i

(m

∗

) = x

∗

i

, Y (m

∗

) = y

∗

and q

i

(m

∗

) = q

∗

i

for all i ∈ N. Thus from (X(m

∗

/m

i

, i), Y (m

∗

/m

i

, i)) ∈

R

2

+

and X

i

(m

∗

/m

i

, i) + q

i

(m

∗

)Y (m

∗

/m

i

, i) = w

i

for all i ∈ N and m

i

∈ M

i

, we have

(X

i

(m

∗

), Y (m

∗

)) R

i

(X

i

(m

∗

/m

i

, i), Y (m

∗

/m

i

, i)). Q.E.D.

Thus, Tian’s mechanism Nash implements Lindahl allocations.

9.10 Incomplete Information and Bayesian Nash Im-

plementation

Nash implementation has imposed a very strong assumption on information requirement.

Although the designer does not know information about agents’ characteristics, Nash

238

equilibrium assume each agent knows characteristics of the others. This assumption is

hardly satisﬁed in many cases in the real world. Can we remove this assumption? The

answer is positive. One can use the Bayesian-Nash equilibrium, introduced by Harsanyi,

as a solution concept to describe individuals’ self-interested behavior. Although each

agent does not know economic characteristics of the others, he knows the probability

distribution of economic characteristics of the others. In this case, we can still design an

incentive compatible mechanism.

For simplicity, assume the utility function of each agent is known up to one parameter,

θ

i

, so that it can be denoted by u

i

(x, θ

i

). Assume that all agents and the designer know

that the vector of types, θ = (θ

1

, . . . , θ

n

) is distributed according to q(θ) a priori on a set

Θ.

Each agent knows his own type θ

i

, and therefore computes the conditional distribution

of the types of the other agents:

q(θ

−i

[θ

i

) =

q(θ

i

, θ

−i

)

Θ

−i

q(θ

i

,θ

−i

)dθ

−i

.

As usual, a mechanism is a pair, Γ = 'M, h`. Given a mechanism 'M, h`, the choice

of m

i

of each agent i is the function of θ

i

: σ

i

: Θ

i

→ M

i

. Let Σ

i

be the set of all such

strategies of agent i. Given σ = (σ

1

, . . . , σ

n

), agent i’s expected utility at t

i

is given by

Π

i

/M,h)

(σ; θ

i

) =

Θ

−i

u

i

(h(σ(θ)), θ

i

)q(θ

−i

[θ

i

)dθ

−i

. (9.35)

A strategy σ is a Bayesian-Nash equilibrium of 'M, h` if for all θ

i

∈ Θ

i

,

Π

i

(σ; θ

i

) Π

i

(ˆ σ

i

, σ

−i

; θ

i

) ∀ˆ σ

i

∈ Σ

i

.

Given a mechanism 'M, h`, the set of its Bayesian-Nash equilibria depends on economic

environments, denoted by B(e, Γ). Like Nash implementation, Bayesian-Nash incentive

compatibility involves the relationship between F(e)and B(e, Γ). If for all e ∈ E, B(e) is

a subset of F(e), we say the mechanism 'M, h` Bayesian-Nash implements social choice

correspondence F. If for a given social choice correspondence F, there is some mechanism

that Bayesian-Nash implements F, we call this social choice correspondence Bayesian-

Nash implementable.

Pastlewaite–Schmeidler (JET, 1986), Palfrey-Srivastava (RES, 1989), Mookherjee-

Reichelstein (RES, 1990), Jackson (Econometrica, 1991), Dutta-Sen (Econometrica, 1994),

239

Tian (Social Choices and Welfare, 1996; Journal of Math. Econ., 1999) provided neces-

sary and suﬃcient conditions for a social choice correspondence F to be Bayesian-Nash

implementable. Under some technical conditions, they showed that a social choice corre-

spondence F is Bayesian-Nash implementable if and only if F is Bayesian monotonic and

Bayesian-Nash incentive compatible.

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Contents

1 Overview of Economics 1.1 Nature and Role of Modern Economics . . . . . . . . . . . . . . . . . . . . 1.1.1 1.1.2 1.1.3 1.1.4 1.1.5 1.1.6 1.1.7 1.2 Modern Economics and Economic Theory . . . . . . . . . . . . . . The Standard Analytical Framework of Modern Economics . . . . . Key Assumptions Commonly Used or Preferred in Modern Economics Roles of Mathematics in Modern Economics . . . . . . . . . . . . . Conversion between Economic and Mathematical Languages . . . . Limitation and Extension of an Economic Theory . . . . . . . . . . Distinguish Necessary and Suﬃcient Conditions for Statements . . . 1 1 1 2 4 5 5 6 7 8 8 8 9

Partial Equilibrium Model for Competitive Markets . . . . . . . . . . . . . 1.2.1 1.2.2 1.2.3 1.2.4 1.2.5 Assumptions on Competitive Market . . . . . . . . . . . . . . . . . The Role of Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . The Competitive Firm’s Proﬁt Maximization Problem . . . . . . .

Partial Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . 11 Entry and Long-Run Equilibrium . . . . . . . . . . . . . . . . . . . 12

I

General Equilibrium Theory and Social Welfare

14

16

2 Positive Theory of Equilibrium: Existence, Uniqueness, and Stability 2.1 2.2

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 The Structure of General Equilibrium Model . . . . . . . . . . . . . . . . . 18 2.2.1 2.2.2 2.2.3 Economic Environments . . . . . . . . . . . . . . . . . . . . . . . . 18 Institutional Arrangement: the Private Market Mechanism . . . . . 20 Individual Behavior Assumptions: . . . . . . . . . . . . . . . . . . . 20 i

2.2.4 2.3

Competitive Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . 21

Some Examples of GE Models: Graphical Treatment . . . . . . . . . . . . 22 2.3.1 2.3.2 Pure Exchange Economies . . . . . . . . . . . . . . . . . . . . . . . 23 The One-Consumer and One Producer Economy . . . . . . . . . . . 28

2.4

The Existence of Competitive Equilibrium . . . . . . . . . . . . . . . . . . 31 2.4.1 Fixed Point Theorems, KKM Lemma, Maximum Theorem, and Separating Hyperplane Theorem . . . . . . . . . . . . . . . . . . . . 31 2.4.2 2.4.3 2.4.4 The Existence of CE for Aggregate Excess Demand Functions . . . 36 The Existence of CE for Aggregate Excess Demand Correspondences 47 The Existence of CE for General Production Economies . . . . . . . 48

2.5 2.6 2.7

The Uniqueness of Competitive Equilibria . . . . . . . . . . . . . . . . . . 49 Stability of Competitive Equilibrium . . . . . . . . . . . . . . . . . . . . . 50 Abstract Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 2.7.1 2.7.2 Equilibrium in Abstract Economy . . . . . . . . . . . . . . . . . . . 58 The Existence of Equilibrium for General Preferences . . . . . . . . 59 65

3 Normative Theory of Equilibrium: Its Welfare Properties 3.1 3.2 3.3 3.4

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 Pareto Eﬃciency of Allocation . . . . . . . . . . . . . . . . . . . . . . . . . 66 The First Fundamental Theorem of Welfare Economics . . . . . . . . . . . 71 Calculations of Pareto Optimum by First-Order Conditions . . . . . . . . . 74 3.4.1 3.4.2 Exchange Economies . . . . . . . . . . . . . . . . . . . . . . . . . . 74 Production Economies . . . . . . . . . . . . . . . . . . . . . . . . . 75

3.5 3.6

The Second Fundamental Theorem of Welfare Economics . . . . . . . . . . 76 Pareto Optimality and Social Welfare Maximization . . . . . . . . . . . . . 81 3.6.1 3.6.2 Social Welfare Maximization for Exchange Economies . . . . . . . . 82 Welfare Maximization in Production Economy . . . . . . . . . . . . 83

3.7

Political Overtones . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 87

4 Economic Core, Fair Allocations, and Social Choice Theory 4.1 4.2

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 The Core of Exchange Economies . . . . . . . . . . . . . . . . . . . . . . . 88

ii

4.3 4.4

Fairness of Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 Social Choice Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 4.4.1 4.4.2 4.4.3 4.4.4 4.4.5 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 Basic Settings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 Arrow’s Impossibility Theorem . . . . . . . . . . . . . . . . . . . . 100 Some Positive Result: Restricted Domain . . . . . . . . . . . . . . . 101 Gibbard-Satterthwaite Impossibility Theorem . . . . . . . . . . . . 103

II

Externalities and Public Goods

105

108

5 Externalities 5.1 5.2 5.3 5.4

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Consumption Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 Production Externality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 Solutions to Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 5.4.1 5.4.2 5.4.3 5.4.4 Pigovian Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Coase Voluntary Negotiation . . . . . . . . . . . . . . . . . . . . . . 114 Missing Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 The Compensation Mechanism . . . . . . . . . . . . . . . . . . . . 116 121

6 Public Goods 6.1 6.2 6.3

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 Notations and Basic Settings . . . . . . . . . . . . . . . . . . . . . . . . . . 121 Discrete Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 6.3.1 6.3.2 6.3.3 Eﬃcient Provision of Public Goods . . . . . . . . . . . . . . . . . . 123 Free-Rider Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 Voting for a Discrete Public Good . . . . . . . . . . . . . . . . . . . 125 . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

6.4

Continuous Public Goods 6.4.1 6.4.2 6.4.3

Eﬃcient Provision of Public Goods . . . . . . . . . . . . . . . . . . 126 Lindahl Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . 128 Free-Rider Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

iii

III

Incentives, Information, and Mechanism Design

135

139

7 Principal-Agent Model: Hidden Information 7.1 7.2

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 The Basic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140 7.2.1 7.2.2 7.2.3 Economic Environment (Technology, Preferences, and Information) 140 Contracting Variables: Outcomes . . . . . . . . . . . . . . . . . . . 141 Timing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

7.3

The Complete Information Optimal Contract(Benchmark Case) . . . . . . 142 7.3.1 7.3.2 7.3.3 First-Best Production Levels . . . . . . . . . . . . . . . . . . . . . . 142 Implementation of the First-Best . . . . . . . . . . . . . . . . . . . 142 A Graphical Representation of the Complete Information Optimal Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144

7.4

Incentive Feasible Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . 145 7.4.1 7.4.2 7.4.3 Incentive Compatibility and Participation . . . . . . . . . . . . . . 145 Special Cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146 Monotonicity Constraints . . . . . . . . . . . . . . . . . . . . . . . 146

7.5 7.6 7.7

Information Rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146 The Optimization Program of the Principal . . . . . . . . . . . . . . . . . 147 The Rent Extraction-Eﬃciency Trade-Oﬀ . . . . . . . . . . . . . . . . . . . 148 7.7.1 7.7.2 7.7.3 The Optimal Contract Under Asymmetric Information . . . . . . . 148 A Graphical Representation of the Second-Best Outcome . . . . . . 150 Shutdown Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

7.8 7.9

The Theory of the Firm Under Asymmetric Information . . . . . . . . . . 152 Asymmetric Information and Marginal Cost Pricing . . . . . . . . . . . . . 153

7.10 The Revelation Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 7.11 A More General Utility Function for the Agent . . . . . . . . . . . . . . . . 155 7.11.1 The Optimal Contract . . . . . . . . . . . . . . . . . . . . . . . . . 155 7.11.2 More than Two Goods . . . . . . . . . . . . . . . . . . . . . . . . . 157 7.12 Ex Ante versus Ex Post Participation Constraints . . . . . . . . . . . . . . 158 7.12.1 Risk Neutrality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 7.12.2 Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159 iv

. . . .15. . . . . .1 8. . . . . . . . . . .17 Further Extensions . . 167 7. . . . 171 7. . . . . . .15. . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Eﬀort and Production . . . . . . . . .16 The Optimal Contract with a Continuum of Types . . .2.6 More than Two Levels of Performance . . . . . . . . . . . . . . . . . . .2 Nonlinear Pricing by a Monopoly . . . . . 170 7. . . . . . . . . . . . . . . . . . .15 Contract Theory at Work . . . . . . . .2 Optimal Transfers . . . . . . . . . . . . . . . . . . . . .6. . . . 192 Sharecropping . . . . . . . . . . . . 166 7. . .3 8. . . . .7 Contract Theory at Work . . . . . . . . . . 188 8. . . . .2 Ex Ante Nonveriﬁable Signal . . . .15. . . . . . . . .5. . . . . . . . . . . . . . . . . . . . . . . . . . 187 The Optimal Second-Best Eﬀort . . . . . . . . .5. . . . .4 8.6. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 8 Moral Hazard: The Basic Trade-Oﬀs 8. . . . . .15. . . . . . . . . 182 8.5 Risk Neutrality and First-Best Implementation . . . . . . . . . . . . . . . . . . . . . . .1 8. . . . . . . . . . . . . . .2 Limited Liability . . . . . . 165 7.1 Regulation . . . . . . . . . . . . . . .1 8. . 165 7.2. . . . . . . . . . . . . 164 7. . .2 Reneging on a Contract . . . . . . . . . . . . . . . . . . . . . . .1 Ex Post Veriﬁable Signal . . . . . . . . . 169 7. . . . 164 7. . . . . . 189 8. . . . . . . . . 186 8. . . .7. . . . . .1 8. . . 181 The Complete Information Optimal Contract . . . . . . . . . .14. 172 7. . . . . . . . . 190 Risk Aversion . . .7. . . . . . 168 7. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183 The Trade-Oﬀ Between Limited Liability Rent Extraction and Eﬃciency . . . . . . . .1 8. . . . . . 185 The Trade-Oﬀ Between Insurance and Eﬃciency . . . . . . . . . . . . . . .14. . . . . . . .13. . . . .13 Commitment . . . . 191 8. . 180 Incentive Feasible Contracts . . .2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 8. . . . . . . . . . . . 167 7. . . . . . . . . . . 165 7. . . .2 Eﬃciency Wage . . 179 The Model . . . . . . . .4 Financial Contracts . . . .15. . . . . . 193 v . . . . . . . . . . . . . .5 Labor Contracts . . . . . .14 Informative Signals to Improve Contracting .3 Quality and Price Discrimination . . . . 180 8. . . . . .7. . . . . . . . . . . . . . . . .1 Renegotiating a Contract . . . . . . . . . . . . 192 8. . .2 179 Introduction . . . . . . . . . . . . . . . . . . . .

232 Walker’s Mechanism . . . . . . . . 208 Dominant Strategy and Truthful Revelation Mechanism . . . . . . . . . . . . . . . . . . .2 Introduction . . .6 9. 205 Solution Concept of Self-Interested Behavior . . . . . . . . . . .2. .2. .9.8. . . . 199 202 9 General Mechanism Design 9. . . . . . . .1 9. . . . . . . . . . . . . . . . . .2. . . . . .7 Examples .7. . . . . . . . . . . . . . . . .10 Incomplete Information and Bayesian Nash Implementation . . . . . . . . . . . . . . . . . . . . 204 Economic Mechanism . . . . . . . . . . . . 207 Implementation and Incentive Compatibility .2 9. . . .4 8. . . . .2 9. . . . . . . .2 Nash Equilibrium and General Mechanism Design . . . . . . . . . . . . . . . . . . . . . . 195 Financial Contracts . . 224 9. 204 9.3 9. . . . . . . .4 9. . . . . .3 Groves-Ledyard Mechanism . . . .1 9. . 216 9. . . . . . . . . . . . . . 236 9. . . . . . . . . . . . . . . . . . . 216 The Groves-Clark-Vickery Mechanism with Continuous Public Goods220 9. . . . . . . . . . . . . . . 232 9. . . . . . . 202 Basic Settings . . . .2. . . . . . . . . . 213 Hurwicz Impossibility Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226 9. . . . . . . . . . . . . . . . . . . . . . . 234 Tian’s Mechanism . . . . . . . . . . . . . . . .2. .5 9. . . 224 Characterization of Nash Implementation . . . . . . . . . . . . . . . . . .8 Nash Implementation . . . . . . . . . . . . . . . . . . . . . . . . .7. . . . . . . . . . . . . . . . . . . . . . . . . . . . 204 Social Goal . . . . . .9. . .4 9. . . . . .8 8. . . .1 9. . . . 198 Further Extension . . . . . . . 207 9. . . . . . .8. . .8. . . . . . . . . . . . . . . . . . . . . . . . . . 210 Gibbard-Satterthwaite Impossibility Theorem . . . . . . . . 238 vi . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9. .1 9.1 9. . . . 196 A Continuum of Performances . .7. . . . . . . . . . . . .7. . . . . .5 Economic Environments . . . . . . . . . . .2 Groves-Clark Mechanism for Discrete Public Good . . . . . . . . . . .3 9. 213 Groves-Clarke-Vickrey Mechanism . . . . . . . . . . . . . . .3 8. . . .9 Better Mechanism Design . . . . . . . . . . . .9 Wholesale Contracts . . . .

1. but people’s desires are unlimited.1.Chapter 1 Overview of Economics We ﬁrst set out some basic terminologies. Because resources are limited. ﬁrms. government. • Four basic questions must be answered by any economic institution: (1) What goods and services should be produced and in what quantity? (2) How should the product be produced? (3) For whom should it be produced and how should it be distributed? (4) Who makes the decision? 1 .1 • Nature and Role of Modern Economics Modern Economics and Economic Theory What is economics about? Economics is a social science that studies economic phenomena and the economic behavior of individuals. methodologies.1 1. and other economic units as well as how they make choices so that limited resources are allocated among competing uses. and assumptions used in modern economics in general and this course in particular. we need economics to study this fundamental conﬂict.

and conclusions that are derived from the assumptions and the framework. (2) Planning economic institution: Most decisions on economic activities are made by government. basic framework. There are two basic economic institutions that have been used in reality: (1) Market economic institution: Most decisions on economic activities are made by individuals. it consists of three aspects: perspective. In discussing and applying an economic theory to argue some claims. • What is Modern Economics? The market economy has been proved to be only economic institution so far that can keep an economy with sustainable development.1. • Microeconomic theory Microeconomic theory aims to model economic activity as an interaction of individual economic agents pursuing their private interests.2 The Standard Analytical Framework of Modern Economics Modern economics developed in last ﬁfty years stands for an analytical method or framework for studying economic behavior and phenomena. reference system 2 . it is mainly a decentralized decision system. and therefore modern economics mainly studies various economic phenomena and behavior under market economic environment by using an analytical approach. 1. it is mainly a centralized decision system. As a theoretical analytical framework of modern economics. one should pay attention to the assumptions of the economic theory and the applicable range (boundary and limitation) of the theory. • What is Economic Theory? Every economic theory that can be considered as an axiomatic approach consists of a set of presumptions and conditions.The answers depend on the use of economic institution.

The other misunderstanding is that some people may 3 . and analytical tools. Analyzing economic problem using such a perspective has not only consistence in methodology. and takes “equilibrium. They do not know in most situations that a theory does not exactly coincide with the reality. it is also important for people to understand these three aspects: (1) Perspective: modern economics provides various perspectives or angles of looking at economic issues starting from reality. This should be done by making some key and basic assumptions about preferences. Modigliani-Miller Theorem in corporate ﬁnance theory. From these basic assumptions. one needs to start from these three aspects. and “incentives” as focus points. To have a good training in economic theory. economists study how individuals interact under the drive of self-interested motion of individuals with a given mechanism.” “eﬃciency”. The perspective approach can grasp the most essential factors of the issue and take our attention to most key and core characteristics of an issue so that it can avoid those unimportant details. but it only provides a benchmark to see how far a reality is from the ideal status given by a reference system. “information”. but gives a criterion of understanding the real world. That is. reach some equilibria. one studies eﬀects of various economic mechanisms (institutions) on behavior of agents and economic units. For instance. (2) Reference Systems (Benchmark): modern economics provides various reference systems. the general equilibrium theory we will study in this course is such a reference system. Other example includes Coase Theorem in property rights theory and economic law. The importance of a reference system does not relay on whether or not it describes the real world correctly or precisely. and evaluate the status at equilibrium. An economic phenomenon or issue may be very complicated and aﬀected by many factors. and endowments. technologies. Understanding such a role of reference system is useful to clarify two misunderstandings: One is that some people may over-evaluate a theoretical result in a reference system.(benchmark). To understand various economic theories and arguments. but also get surprising (but logic consistent) conclusions.

and (3) the principal-agent model. (3) Analytical Tools: modern economics provides various powerful analytical tools that are actually given by geometrical or mathematical models. (2) Scarcity of Resources: Individuals confront scarce resources. 1.1. 4 . Advantages of such tools can help us to analyze complicated economic behavior and phenomena through a simple diagram or mathematical structure in a model. (4) Decentralized decision makings: One prefers to use the way of decentralized decision marking because most economic information is incomplete to the decision marker. Everyone could talk something about an economic issue from realty. They do not know the value of a theoretical result is not that it can directly explain the world. but that it provides a benchmark for developing new theories to explain the world.under-evaluate a theoretical result in the reference system and think it is not useful because of unrealistic assumptions.3 Key Assumptions Commonly Used or Preferred in Modern Economics Economists usually make some of the following key assumptions and conditions when they study economic problems: (1) Individuals are (bounded) rational: self-interested behavior assumption. including economics. but the main diﬀerence is that a person with systematic training in modern economics have a few reference systems in her mind while a person without a training in modern economics does not so he cannot grasp an essential part of the issue and cannot provide deep analysis and insights. (2) Samuelson’s overlapping generation model. the establishment of a reference system is extremely important for any subject. In fact. (3) Economic freedom: voluntary cooperation and voluntary exchange. Examples include (1) the demand-supply curve model.

(8) Allocative eﬃciency of resources. 1. (6) Well-deﬁned property rights. Relaxing any of these assumptions may result in diﬀerent conclusions. although mathematics is of critical importance in modern economics.4 Roles of Mathematics in Modern Economics Mathematics has become an important tool used in modern economics.1. and (4) it can reduce unnecessary debates and improve or extend existing results. (3) it can give a new result that may not be easily obtained through the observation. rather economics uses mathematics as a tool to model and analyze various economic problems. intuitions. Advantages of using mathematics is that (1) the “language” used is more accurate and precise and the descriptions of assumptions are more clear using mathematics. economics is not mathematics. Almost every ﬁeld in modern economics more or less uses mathematics and statistics. It is not hard to understand why mathematical approach has become a dominant approach because the establishment of a reference system and the development of analytical tools need mathematics. 1.5 Conversion between Economic and Mathematical Languages A product in economics science is an economic conclusion. and conjectures. The production of an economic conclusion usually takes three stages: Stage 1 (non-mathematical language stage). Produce preliminary outputs –propose economic ideas. It should be remarked that. (2) the logic of analysis is more rigorous and it clearly clariﬁes the boundary and limitation of a statement. Mathematical approach is an approach to economic analysis in which the economists make use of mathematical symbols in the statement of a problem and also draw upon known mathematical theorems to aid in reasoning. Produce intermediate outputs – give a formal and 5 . (7) Equity in opportunity.1. (2) Stage 2 (mathematical language stage).(5) Incentive compatibility of parties: the system or economic mechanism should solve the problem of interest conﬂicts between individuals or economic units.

or they say some theory or conclusions have been overthrown when some conditions or assumptions behind the theory or conclusions are criticized. ideal ﬂuid. However. no competition is perfect. limitation. insights. The question is then not whether any particular market is perfectly competitive – almost no market is. Real world markets seldom achieve this ideal. No theory is universe (absolute). and statements that can be understood by non-specialists. although we may criticize that it is too limited or not realistic. Just like frictionless models in physics such as in free falling body movement (no air resistance). and thus it only relatively correct and has its limitation and boundary of suitability. What we need to do is to weaken or relax those assumptions. and applicable range of an economic theory. and obtain new theories based on old theories. we cannot say this new theory topples the old one.1.6 Limitation and Extension of an Economic Theory When making an economic conclusion and discussing an economic problem. The appropriate question is to what degree models of perfect competition can generate insights about realworld market. Every theory is based on some imposed assumptions. In reality. We can always criticize any existing theory because no assumption can coincides fully with reality or cover everything. can describe some important phenomena in the physical world.rigorous result through mathematical modeling. as long as there is no logic errors or inconsistency in theory. ideal gas (molecules do not collide). Stage 3 (non-technical language stage). the frictionless models of perfect competition generates useful insights in the economic world. So. One example is the assumption of perfect competition. we cannot say the theory is wrong. 1. This is usually not a correct way to say it. but it may be more appropriate to say that the new theory extends the old theory to cover more general situation or deal with a diﬀerent economic environments. Produce ﬁnal outputs – conclusions. It is often heard that some people claims they topple an existing theory or conclusion. it is very important to notice the boundary. We think this assumption is approximately correct under some situations. 6 .

So far. The reason they get the wrong conclusion that the market mechanism should not be used is because they did not realize the adoption of a market mechanism is just a necessary condition for a country to be rich. 7 .1. but is not a suﬃcient condition. no example of a country can be found that it is rich in a long run. For instance. it is very important to distinguish: (1) two types of statements: positive analysis and normative analysis.7 Distinguish Necessary and Suﬃcient Conditions for Statements In discussing an economic issue. and (2) two types of conditions: necessary and suﬃcient conditions for a statement to be true. Becoming a rich country also depends on other factors such as political system. but is not a market economy. social infrastructures. Some people often confuse the distinction between necessary condition and suﬃcient condition when they give their claims. it is often heard that the market institution should not used by giving examples that some countries are market economies but are still poor.1. and culture. and get wrong conclusions.

1. (4) Passion of all relevant information (all relevant information are common knowledge): Firms and consumers have all the information necessary to make the correct economic decisions. How is this also true for any number of parties and for production case? The price system is the mechanism that performs this task very well without central direction. Thus. 8 . The price system transmit only the important information and only to the people who need to know. 1. it will not take place unless both believe they will beneﬁt from it.2 Partial Equilibrium Model for Competitive Markets The consumer theory and producer theory study maximizing behavior of consumers and producers by taking market prices as given. 1.2 The Role of Prices The key insight of Adam Smith’s Wealth of Nations is simple: if an exchange between two parties is voluntary. We begin our study of how the competitive market prices are determined by the actions of the individual agents. Prices perform three functions in organizing economic activities in a free market economy: (1)They transmit information about production and consumption.2. (3) Homogeneous product: All the ﬁrms in an industry produce an identical production in the consumers’ eyes.1 Assumptions on Competitive Market The competitive markets is based on the following assumptions: (1) Large number of buyers and sellers — price-taking behavior (2) Unrestricted mobility of resources among industries: no artiﬁcial barrier or impediment to entry or to exit from market. it transmits information in an eﬃciently way.2.

(2) They provide right incentives. They provides incentives to adopt those methods of production that are least costly and thereby use available resources for the most highly valued purposes.1) where y is the output produced by the ﬁrm. FOC) for interior solution gives: p = c (y) ≡ M C(y). In general. (3) They determine the distribution of income. The ﬁrm only needs to choose output level y so as to solve max py − c(y) y (1.2) The ﬁrst order condition becomes a suﬃcient condition if the second-order condition (in short. its proﬁt maximization problem is simple. The ﬁrst-order condition (in short. and c(y) is the cost function of production. p is the price of the product. By p = c (y(p)). If what a person gets does not depend on the price he receives for the services of this resources. what incentive does he have to seek out information on prices or to act on the basis of that information? 1. (1. 9 (1.2.4) (1. SOC) is satisﬁed c (y) > 0.5) (1. we have 1 = c (y(p))y (p) and thus y (p) > 0. They determine who gets how much of the product. one cannot use prices to transmit information and provide an incentive to act that information without using prices to aﬀect the distribution of income. One of the beauties of a free price system is that the prices that bring the information also provide an incentive to react on the information not only about the demand for output but also about the most eﬃcient way to produce a product.3 The Competitive Firm’s Proﬁt Maximization Problem Since the competitive ﬁrm must take the market price as given.3) .

which means the law of supply holds. For the short-run (in short, SR) case, c(y) = cv (y) + F The ﬁrm should produce if py(p) − cv (y) − F and thus we have p cv (y(p)) ≡ AV C. y(p) (1.8) −F, (1.7) (1.6)

That is, the necessary condition for the ﬁrm to produce a positive amount of output is that the price is greater than or equal to the average variable cost.

Figure 1.1: Firm’s supply curve, and AC, AVC, and MC Curves The industry supply function is simply the sum of all individuals’ supply functions so that it is given by

J

y (p) = ˆ

j=1

yj (p)

(1.9)

where yi (p) is the supply function of ﬁrm j for j = 1, . . . , J. Since each ﬁrm chooses a level of output where price equals marginal cost, each ﬁrm that produces a positive amount of output must have the same marginal cost. The industry supply function measures the relationship between industry output and the common cost of producing this output. 10

The aggregate (industry) demand function measures the total output demanded at any price which is given by x(p) = ˆ

i=1 n

xi (p)

(1.10)

where xi (p) is the demand function of consumer i for 1 = 1, . . . , n.

1.2.4

Partial Market Equilibrium

A partial equilibrium price p∗ is a price where the aggregate quantity demanded equals the aggregate quantity supplied. That is, it is the solution of the following equation:

n J

xi (p) =

i=1 j=1

yj (p)

(1.11)

**Example 1.2.1 x(p) = a − bp and c(y) = y 2 + 1. Since M C(y) = 2y, we have ˆ y= and thus the industry supply function is y (p) = ˆ Setting a − bp =
**

Jp , 2

p 2

(1.12)

Jp 2

(1.13)

we have p∗ = a . b + J/2 (1.14)

Now for general case of D(p) and S(p), what happens about the equilibrium price if the number of ﬁrms increases? From D(p(J)) = Jy(p(J)) we have D (p(J))p (J) = y(p) + Jy (p(J))p (J) and thus p (J) = y(p) < 0, X (p) − Jy (p)

which means the equilibrium price decreases when the number of ﬁrms increases.

11

1.2.5

Entry and Long-Run Equilibrium

In the model of entry or exit, the equilibrium number of ﬁrms is the largest number of ﬁrms that can break even so the price must be chosen to minimum price. Example 1.2.2 c(y) = y 2 + 1. The break-even level of output can be found by setting AC(y) = M C(y) so that y = 1, and p = M C(y) = 2. Suppose the demand is linear: X(p) = a − bp. Then, the equilibrium price will be the smallest p∗ that satisﬁes the conditions p∗ = a b + J/2 2.

As J increases, the equilibrium price must be closer and closer to 2.

Reference

Arrow, K and G. Debreu, “Existence of Equilibrium for a Competitive Economy,” Econometrica, 1954, 22. Coase, R., “The Problem of Social Cost,” Journal of Law and Economics, 3 (1960), 1-44. Fridman, M. and R. Frideman, Free to Choose, HBJ, New York, 1980. Debreu, G. (1959), Theory of Value, (Wiley, New York). Mas Colell, A., M. D. Whinston, and J. Green, Microeconomic Theory, Oxford University Press, 1995, Chapter 10. Modigliani, F., and M. Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review, 48 (1958), 261-297. Jehle, G. A., and P. Reny, Advanced Microeconomic Theory, Addison-Wesley, 1998, Chapter 6. Samuelson, P., “An Exact Consumption-Loan Model of Interest with or without the Social Contrivance of Money,” Journal of Political Economy, 66 (1958), 467-482. 12

Tian, G., Market Economics for Masses, (with Fan Zhang), in A Series of Market Economics, Vol. 1, Ed. by G. Tian, Shanghai People’s Publishing House and Hong Kong’s Intelligent Book Ltd, 1993 (in Chinese), Chapters 1-2. Varian, H.R., Microeconomic Analysis, W.W. Norton and Company, Third Edition, 1992, Chapter 13.

13

Part I General Equilibrium Theory and Social Welfare

14

Chapters 2 and 3 constitute the heart of the general equilibrium theory. Chapter 3 discusses the normative properties of the competitive equilibrium by introducing the notion of Pareto eﬃciency. The core is concerned with the proof of the two fundamental theorems of welfare economics. The content of Part I is organized into three chapters. We will discuss the existence. and stability of a competitive equilibrium. We will also discuss a more general setting of equilibrium analysis. We examine the relationship between the competitive equilibrium and Pareto optimality. and social choice theory. We will study the important core equivalence theorem that takes the idea of Walrasian equilibria as the limit of noncooperative equilibria as markets grow large. namely the abstract economy which includes the general equilibrium model as a special case. fairness of allocation. Chapter 4 covers a number of topics whose origins lie in normative theory. Chapter 2 presents the form structure of the equilibrium model. The emphasis is on positive properties of the competitive equilibrium.Part I is devoted to an examination of competitive market economies from a general equilibrium perspective at which all prices are variable and equilibrium requires that all markets clear. 15 . uniqueness. Chapter 4 explores extensions of the basic analysis presented in Chapters 2 and 3. introduces the notion of competitive equilibrium (or called Walrasian equilibrium).

It is often called the Walrasian theory of market from L. Interaction between markets may result in a conclusion that is not obtained in a partial equilibrium framework. A General Equilibrium is deﬁned as a state where the aggregate demand will not excess the aggregate supply for all markets. Thus. (2) It aims at reducing the set of variables taken as exogenous to a small number of physical realities. Walras (1874). The general equilibrium approach has two central features: (1) It views the economy as a closed and inter-related system in which we must simultaneously determine the equilibrium values of all variables of interests (consider all markets together).Chapter 2 Positive Theory of Equilibrium: Existence. and Stability 2.1 Introduction The general equilibrium theory considers equilibrium in many markets simultaneously. unlike partial equilibrium theory which considers only one market at a time. 16 . From a positive viewpoint. Uniqueness. the general equilibrium theory is a theory of the determination of equilibrium prices and quantities in a system of perfectly competitive markets. equilibrium prices are endogenously determined.

Economic institutional environment (the fundamentals of the economy): economy that consists of consumption space. and normative analysis such as allocative eﬃciency of general equilibrium. production sets would ensure a general equilibrium to be social optimal – Pareto eﬃcient? 17 . and stability. preferences. 4.It is to predict the ﬁnal consumption and production in the market mechanism. The existence and determination of a general equilibrium: What kinds of restrictions on economic environments (consumption sets. endowments. The behavior assumptions: price taking behavior for consumers and ﬁrms. B. Questions to be answered in the general equilibrium theory. A. The general equilibrium theory consists of four components: 1. Uniqueness of a general equilibrium: What kinds of restrictions on economic environments would guarantee a general equilibrium to be unique? C. 2. preferences. preferences. production sets) would guarantee the existence of a general equilibrium. and production possibility sets of producers. Welfare properties of a general equilibrium: What kinds of restrictions on consumption sets. uniqueness. Stability of a general equilibrium: What kinds of restrictions economic environments would guarantee us to ﬁnd a general equilibrium by changing prices. especially rasing the price if excess demand prevails and lowering it if excess supply prevails? D. Economic institutional arrangement: It is the price mechanism in which a price is quoted for every commodity. endowments of consumers. 3. utility maximization and proﬁt maximization. Predicting outcomes: equilibrium analysis: positive analysis such as existence. endowments.

Remark: (xi i i is a preference ordering if it is reﬂexive (xi i i i xi ). are deﬁned as b bs for all s = 1. Notice that it can be represented by a are continuous. . i: preferences ordering (or ui if a utility function exists) of i. wi ∈ Xi : endowment of consumer i. The existence of general equilibrium can be obtained even when preferences are weakened to be non-complete or non-transitive.1 Economic Environments The fundamentals of the economy are economic institutional environments that are exogenously given and characterized by the following terms: n: the number of consumers N : the set of agents J: the number of producers (ﬁrms) L: the number of (private) goods Xi ∈ L : the consumption space of consumer i. 18 . .2.2. transitive xi and xi xi implies xi i i xi ). and >. vector inequalities. . . Then a b means as . either xi utility function if xi or xi i xi ). ≥. ei = (Xi . follows: Let a. which speciﬁes the bound- ary of consumptions. a > b means as > bs for all s = 1. m. Some components of an element may be negative such as a labor supply. and complete (for any pair xi and xi .2 The Structure of General Equilibrium Model Throughout this notes. . i . a ≥ b means a but a = b. . 2. and superscripts are used to index goods unless otherwise stated. wi ): the characteristic of consumer i. we will mean either a consumer or a producer. m. b ∈ Rm . . By an agent. As usual. . subscripts are used to index consumers or ﬁrms. collection of all individually feasible consumptions of consumer i.

Recall there can be three types of returns about production scales: nonincreasing returns to scale (i. decreasing returns to scale that αyj ∈ Yj for all α implies any feasible input-output vector can be scaled down. . yj ∈ Yj implies that αyj ∈ Yj for all α 1) returns to scale. . DRS. l l l l yj ∈ Yj : a production plan. . wi }. or called an economic environment.. {Yj }): an economy. . and constant returns to scale i. 1]).1: Various Returns to Scale: IRS. non-decreasing (i. × YJ : production space. J. . 19 . it is a cone. . 2. and CRS e = ({Xi .e. which is the characteristic of producer j. yj > 0 means yj is output and yj < 0 means yj is input.e. × Xn : consumption space. . . increasing returns to scale implies any feasible input-output vector can be scaled up.e. constant returns to scale implies the production set is the conjunction of increasing returns and decreasing returns. . Y = Y1 × Y2 × . Figure 2. yj ∈ Yj implies that αyj ∈ Yj for all α ∈ [0. In other words. yj ∈ Yj implies 0). X = X1 × X2 × . Most elements of yj for a ﬁrm are zero..Yj : production possibility set of ﬁrm j = 1.. Geometrically.

. . θij ∈ +: the proﬁt share of consumer i from ﬁrm j. (2. For i = 1.3) 2.t. .2. .1) J Bi (p) = {xi ∈ Xi : pxi pwi + j=1 θij pyj }. .4) s. j=1 The set of all such private ownership economies are denoted by E. .5) 20 . 2. . which speciﬁes ownership n i=1 θij (property rights) structures.2. and = the total proﬁt dividend received by consumer i for i = 1. . pxi : the expenditure of consumer i for i = 1. . n. max ui (xi ) xi (2. {θij }). .2 Institutional Arrangement: the Private Market Mechanism p = (p1 . p2 . J. . n. {Yj }n . pL ) ∈ L + : a price vector. . consumer i’s budget constraint is given by J pxi and the budget set is given by pwi + j=1 θij pyj (2. 2. n. pyj : the proﬁt of ﬁrm J for j = 1. pwi : the value of endowment of consumer i for i = 1. . (2) Utility maximization: Every consumer maximizes his preferences subject to Bi (p). . n. . . . (2.2. . . . . . J. J j=1 θij pyj = 1 for j = 1. pxi pwi + J θij pyj j=1 (2. . . . so that i = 1. . n.3 Individual Behavior Assumptions: (1) Perfect Competitive Markets: Every player is a price-taker. . . e2 . . . . . . That is. en . . .2) A private ownership economy then is referred to e = (e1 . .

An allocation (x.6) for j = 1. J. That is. 2. . i. . “ˆ” will be used throughout the notes to denote the sum of vectors ai . the allocation is called balanced or attainable. yj ∈Yj max pyj (2. .e. wi : aggregation of endowments. .. J. yJ ). . . .(3) Proﬁt maximization: Every ﬁrm maximizes its proﬁt in Yj . an allocation (x. an economic allocation is feasible if the total amount of each good consumed does not exceed the total amount available from both the initial endowment and production. .7) xi i=1 j=1 yj + i=1 wi (2. {Yj }. Thus.2.1 (Competitive Equilibrium or also called Walrasian Equilibrium) Given a private ownership economy. . . e = (e1 . .8) When inequality holds with equality.4 Competitive Equilibrium Before deﬁning the notion of competitive equilibrium. .2. Denote by A = {(x. xn ) and production vector y = (y1 . ˆ ˆ xi : aggregation of consumption. y) is feasible if it is both individually feasible and (weakly) balanced. {θij }). . . . y) is individually feasible if xi ∈ Xi for all i ∈ N . For notational convenience. Now we deﬁne the notion of competitive equilibrium. we ﬁrst give some notions on allocations which identify the set of possible outcomes in economy e. y) is a speciﬁcation of consumption vector x = (x1 . An allocation (x. en . a := a ˆ Allocation: An allocation (x. Deﬁnition 2. y+w ˆ ˆ (2. . . y) ∈ X × Y : x ˆ Aggregation: x= ˆ y= ˆ w= ˆ n i=1 J j=1 n i=1 y + w} by the set of all feasible allocations. yj ∈ Yj for all j = 1. . An allocation is weakly balanced x ˆ or speciﬁcally n J n al . yj : aggregation of production. y) ∈ 21 . . .

3 Some Examples of GE Models: Graphical Treatment In most economies. z (p) = x(p) − w − y (p) : aggregate excess demand correspondence. w + y. These examples introduce some of the questions. it is called the demand function of consumer i if it is a single-valued function. z (p∗ ) ˆ ˆ 0 is a competitive equilibrium.X × Y and a price vector p ∈ conditions are satisﬁed L + consist of a competitive equilibrium if the following (i) Utility maximization: xi i = 1. . ˆ ˆ xi (p) = {xi ∈ Bi (p) : xi ∈ Bi (p) and xi i xi for all xi ∈ Bi (p)}: the demand correspondence of consumer i under utility maximization. it is called the supply function of ﬁrm j if it is a single-valued xi (p) : the aggregate demand correspondence. ˆ ˆ ˆ ˆ An equivalent deﬁnition of competitive equilibrium then is that a price vector p∗ ∈ is a competitive equilibrium price if there exists z ∈ z (p∗ ) such that z ˆ ˆ ˆ If z (p) is a single-valued. consumption. and common techniques that will occupy us for the rest of this part. (ii) Proﬁt maximization: pyj (iii) Market Clear Condition: x ˆ Denote i xi for all xi ∈ Bi (p) and xi ∈ Bi (p) for pyj for yj ∈ Yj . Before formally stating the existence results on competitive equilibrium. and exchanges. L + 2. . . concepts. yj (p) = {yj ∈ Yj : pyj function. 22 . n. 0. there are three types of economic activities: production. yj (p) : the aggregate supply correspondence. . we will ﬁrst give two simple examples of general equilibrium models: exchange economies and a production economy with only one consumer and one ﬁrm. x(p) = ˆ y (p) = ˆ n i=1 J j=1 pyj for all yj ∈ Yj }: the supply correspondence of the ﬁrm j.

can ˆ be used to represent the initial endowments of two persons. economic activities only consist of trading and consumption.2: Edgeworth Box in which w1 = (1. if w1 = (1. 2) and w2 = (3. In this case. x2 ) and two persons. 3).3. The simplest exchange economy with the possibility of mutual beneﬁt exchange is the exchange economy with two commodities and two consumers. That is. The aggregate excess demand correspondence becomes z (p) = x(p) − w so that we can ˆ ˆ ˆ deﬁne the individual excess demand by zi (p) = xi (p) − wi for this special case.9) . x1 + x2 = w 1 + w 2 23 (2. This is a special case of general economy. 2). Note that the point. this case is amenable to analysis by an extremely handy graphical device known as the Edgeworth box. w2 = (3. The total endowment is w = w1 + w2 .1 Pure Exchange Economies A pure exchange economy is an economy in which there is no production. denoted by w in the Edgeworth Box. Figure 2. • Edgeworth Box: Consider an exchange economy with two goods (x1 . 1). For example. then the total ˆ endowment is: w = (4.2. 1) Advantage of the Edgeworth Box is that it gives all the possible (balanced) trading points. As it turns out.

two indiﬀerence curves are tangent each other at a point that is on the budget line so that the marginal rates of substitutions for the two persons are the same that is equal to the price ratio. x2 ). In the box. both persons want more good 2. is too high so that consumers do not consume the total amounts of the good so that 1 1 there is a surplus for x1 and there is an excess demand for x2 . that is. x2 ) in the box. In this interior equilibrium case. Thus. at price p. As a 1 2 result. every 1 1 2 2 point in the Edgeworth Box stands for an attainable allocation so that x1 + x2 = w1 + w2 . p1 . one person’s budget line is also the budget line of the other person. x2 ) and x2 = (x1 .for all points x = (x1 . any point is not feasible. Thus. 24 . The shaded lens (portion) of the box in the above ﬁgure represents all the trading points that make both persons better oﬀ. This implies that the price of good 1. the budget line will become ﬂatter and ﬂatter till it reaches the equilibrium where the aggregate demand equals the aggregate supply. x1 + x1 < w1 + w2 1 2 2 2 and x2 + x2 > w1 + w2 . the market will adjust itself by decreasing p1 to p1 . Beyond the box.3: In the Edgeworth Box. Originally. Figure 2.4 below shows the market adjustment process to a competitive equilibrium. They share the same budget line in the box. Which point in the Edgeworth Box can be a competitive equilibrium? Figure 2. the point CE is a competitive equilibrium. where x1 = (x1 .

5: A competitive equilibrium may still exist even if two persons’ indiﬀerence curves do not intersect.4: This ﬁgure shows the market adjustment process What happens when indiﬀerence curves are linear? Figure 2. Even so.Figure 2. In this case. 25 . there still exists a competitive equilibrium although the marginal rates of substitutions for the two persons are not the same. there is no tangent point as long as the slopes of the indiﬀerence curves of the two persons are not the same.

One person’s preferences are non-convex. 2. one can see that the one intersection of two consumers’ oﬀer curves is always given at the endowment w. One person’s preference is such that two goods are perfect substitutes (i. The intersection of the two oﬀer curves of the consumers can be used to check if there is a competitive equilibrium. 3.6: The CE is characterized by the intersection of two persons’ oﬀer curves. To enhance the understanding about the competitive equilibrium. Preferences of one person are the Leontief-type (perfect complement) 4. If there is another intersection of two consumers’ oﬀer curves rather than the one at the endowment w. Note that.e.. you try to draw the competitive equilibrium in the following situations: 1. By the above diagram. There are many equilibrium prices. the intersection point must be the competitive equilibrium.Oﬀer Curve: the locus of the optimal consumptions for the two goods when price varies. it consists of tangent points of the indiﬀerence curves and budget lines when price varies. 26 . The oﬀer curves of two persons are given in the following ﬁgure: Figure 2. indiﬀerence curves are linear).

Note that a preference relation i is convex if x i i x implies tx + (1 − t)x i x for i all t ∈ [0. Why? 27 . Figure 2.5. say.7: A CE may not exist if indiﬀerence curves are not convex. The initial endowment may not be an interior point of the consumption space. One person’s preferences are “thick”. One person’s preferences are convex. The initial endowments are given by w1 = (0. Indiﬀerence curves (IC) are not convex. two persons’ oﬀer curves do not intersect. but has a satiation point. say. This may be true when preferences are not convex. when Person 2’s indiﬀerence curves are vertical lines so that u2 (x1 . In that case. x2 ) = x1 . 1) and w2 = (1. then there may not exist a competitive equilibrium. A preference relation all x ∈ Xi . 1] and all x. Consider an exchange economy in which one person’s indiﬀerence curves put no values on one commodity. There may not be a competitive equilibrium. 6. which is given by 2 2 2 the Cobb-Douglas utility function. Person 1’s utility function is regular one. Case 2. If the two oﬀer curves may not be intersected except for at the endowment points. has a satiation point x if x x Cases in which there may be no Walrasian Equilibria: Case 1. 0). x ∈ Xi .

Two agents: one producer so that J = 1 and one consumer so that n = 1.If p1 /p2 > 0. in both sub-cases. ˆ 2 Figure 2. A competitive 2 equilibrium implies that x1 (p) + x1 (p) 1 2 w1 .3.10) so that x1 (p) + x1 (p) > 1 = w1 . However. there is no competitive equilibrium. To do so. L: the total units of leisure time. then x1 = 1 2 x1 > 0 1 (2.2 The One-Consumer and One Producer Economy Now we introduce the possibility of production. Thus.8: A CE may not exist if an endowment is on the boundary. 2. ¯ w = (L. 28 . in the simplest-possible setting in which there are only two price-taking economic agents. we have x1 (p) + ˆ 1 x1 (p) > w1 which violates the feasibility conditions. Two goods: labor (leisure) and the consumption good produced by the ﬁrm. then x1 = ∞ and thus there is not competitive equilibrium. 0): the endowment. ˆ 1 2 If p1 /p2 = 0.

we assume f satisﬁes the Inada condition f (0) = +∞ and limz→0 f (z)z = 0. z(p. x2 ) 1 2 s. The ﬁrm’s problem is to choose the labor z so as to solve max pf (z) − wz z 0 (2. where z is labor input. we assume u satisﬁes the Inada condition ∂u (0) ∂xi ∂u x ∂xi i = +∞ and limxi →0 = 0. px x . u(x1 . w): the price vector of the consumption good and labor.t. The consumer’s problem is to choose the leisure time and the consumption for the good so as to solve max u(x1 . θ = 1: single person economy. π(p. Let q(p. increasing. w) = the proﬁt maximizing output for the consumption good.q = Price ratio) which means the marginal rate of technique substitution of labor for the consumption good q equals the price ratio of the labor input and the consumption good output.12) .f (z): the production function that is strictly increasing. w) = the proﬁt maximizing function. w) = the proﬁt maximizing input for the labor. (FOC:) ∂u ∂x1 ∂u ∂x2 = 29 w p (2. x2 ): is the utility function which is strictly quasi-concave.11) FOC: pf (z) = w ⇒ f (z) = w/p (M RT Sz. and diﬀerentiable. (p. concave.x 2 w(L − x1 ) + π(p. To have an interior solution. w) where x1 is the leisure and x2 is the consumption of good. and diﬀerentiable. To have an interior solution.

By (2. M RSx1 x2 = w/p.which means the marginal rate of substitution of the leisure consumption for the consumption good q equals the price ratio of the leisure and the consumption good.11) and (2. i.e.13) Figure 2.q p (2. 30 . the consumer problem and the CE.9: Figures for the producer’s problem..12) M RSx1 x2 = w = M RT Sz.

w∗ ) at which x2 (p∗ . KKM Lemma. and Separating Hyperplane Theorem This subsection gives various deﬁnitions on continuity of functions and correspondences. For instance. Figure 2. w∗ ).9 shows the problems of ﬁrm and consumer. for simplicity. and the competitive equilibrium. KKM lemma approach. and Separating Hyperplane Theorem which will be used to prove the existence of competitive equilibrium for various economic environments. ﬁxed point theorems. x1 (p∗ .1 Fixed Point Theorems. Before giving the existence result on competitive equilibrium.A competitive equilibrium for this economy involves a price vector (p∗ . one can use the Brouwer ﬁxed point theorem approach.4 The Existence of Competitive Equilibrium In this section we will examine the existence of competitive equilibrium for the three cases: (1) the single-valued aggregate excess demand function. w∗ ) = L That is. the aggregate demand for the two goods equals the aggregate supply for the two goods. w∗ ) = q(p∗ . (2) the aggregate excess demand correspondence. 2. Let X and Y be two topological spaces. deﬁnitions and mathematics results used in this section. w∗ ) + z(p∗ . respectively. KKM lemma. The ﬁrst two cases are based on excess demand instead of underlying preference orderings and consumption and production sets. Although most the results given in this subsection is held for general topological vector spaces. (3) a general class of private ownership production economies. we ﬁrst provide some notation. and abstract economy approach to show the existence of competitive equilibrium for these three cases. we will restrict X and Y to subsets of Euclidian spaces. There are many ways to prove the existence of general equilibrium. 2. 31 . Maximum Theorem.4. and let 2Y be the collection of all subsets of Y . maximum theorem.

Deﬁnition 2. or equivalently. The generalization of 32 f (x0 )} is a closed subset of X > 0.3 A function f : X → R is said to be lower semi-continuous on X if −f is upper semi-continuous. Deﬁnition 2.4. we have f (x) < f (x0 ) + A function f : X → R is said to be upper semi-continuous on X if f is upper semicontinuous at every point x ∈ X. x→x0 lim f (x) = f (x0 ). for any |x − x0 | < δ. 1993.1 A function f : X → R is said to be continuous if at point x0 ∈ X. It is clear that a function f : X → R is continuous on X if and only if it is both upper and lower semi-continuous. for any |x − x0 | < δ.2 A function f : X → R is said to be upper semi-continuous if at point x0 ∈ X.Deﬁnition 2. there is a δ > 0 such that for any x ∈ X satisfying . we have > 0. and Zhou and Tian (1992). To show the existence of a competitive equilibrium for the continuous aggregate excess demand function. there is a δ > 0 such that for any x ∈ X satisfying |f (x) − f (x0 )| < A function f : X → R is said to be continuous on X if f is continuous at every point x ∈ X. we have lim sup f (x) x→x0 f (x0 ).4. F (x0 ) ≡ {x ∈ X : f (x) or equivalently. or equivalently. Even weak conditions on continuity are transfer continuity which characterize many optimization problems and can be found in Tian (1992. The so-called upper semi-continuity and lower semi-continuity continuities are weaker than continuity. we may use the following ﬁxed-point theorem.4. 1994) and Tian and Zhou (1995).

1] is continuous.4. then f has a ﬁxed point (x). 1] → [0. Then.4.1 f : [0.. then f has a ﬁxed point.e. Theorem 2. Deﬁnition 2. We also use F : X →→ Y to denote the mapping F : X → 2Y in this lecture notes. there is a point x∗ ∈ X such that f (x∗ ) = x∗ . To see this. g(1) = f (1) − 1 x∗ = 0.10: Fixed points are given by the intersections of the 450 line and the curve of the function.4. Example 2. there is a point x∗ ∈ [0. compact. i. let g(x) = f (x) − x.1 (Brouwer’s Fixed Theorem) Let X be a non-empty. 1] such that g(x∗ ) = f (x∗ ) − When the aggregate excess demand correspondence is not a single-valued function or is not a continuous function.4 A correspondence F : X → 2Y is upper hemi-continuous if the set {x ∈ X : F (x) ⊂ V } is open in X for every open set subset V of Y .Brouwer’s ﬁxed theorem can be found in Tian (1991) that gives necessary and suﬃcient conditions for a function to have a ﬁxed point. 33 . we have g(0) = f (0) 0 0. If a function f : X → X is continuous on X. we need the ﬁxed point theorem for correspondence or KKM lemma to prove the existence of competitive equilibrium. Figure 2. From the mean-value theorem. and convex subset of Rm .

Theorem 2. Deﬁnition 2. Remark 2.4. y) ∈ X × Y : y ∈ F (x)} is closed.5 A correspondence F : X → 2Y is said to be lower hemi-continuous at x if for any {xk } with xk → x and y ∈ F (x). y) ∈ X × Y : y ∈ F (x)} is open. then F is upper hemi-continuous. then F has a ﬁxed point. then it must be lower hemi-continuous.7 A correspondence F : X → 2Y is said to be closed at x if for any {xk } with xk → x and {yk } with yk → y and yn ∈ F (xk ) implies y ∈ F (x).4.8 A correspondence F : X → 2Y said to be open if ifs graph Gr(F ) = {(x. Deﬁnition 2.1 As with upper (lower) hemi-continuous correspondence.e.2 (Kakutani’s Fixed Point Theorem) Let X be a non-empty.4.6 A correspondence F : X → 2Y is said to be continuous if it is both upper hemi-continuous and lower hemi-continuous. if the set {x ∈ X : F (x) ∩ V = ∅} is open in X for every open set subset V of Y . Deﬁnition 2. 34 .4. compact.4.9 A correspondence F : X → 2Y said to have upper open sections if F (x) is open for all x ∈ X. F is said to be closed if F is closed for all x ∈ X or equivalently Gr(F ) = {(x.3 If a correspondence F : X → 2Y has an open graph. A correspondence F : X → 2Y said to have lower open sections if its inverse set F −1 (y) = {x ∈ X : y ∈ F (x)} is open.4.4. If a correspondence F : X → 2X is a upper hemicontinuous correspondence with non-empty compact and convex values on X.Deﬁnition 2. i.4. If a correspondence F : X → 2Y has lower open sections. then there is a sequence {yk } with yk → y and yn ∈ F (xk ). F is said to be lower hemi-continuous on X if F is lower hemi-continuous for all x ∈ X or equivalently. there is a point x∗ ∈ X such that x∗ ∈ F (x∗ ). Deﬁnition 2. then it has upper and lower open sections.2 If Y is compact and F is closed.4. and convex subset of Rm . if f (·) is a function then the concept of upper (lower) hemi-continuity as a correspondence and of continuity as a function coincide. Remark 2.. Remark 2.

(2) F (x0 ) is compact for some x0 ∈ X. a) x∈F (a) is a continuous function. and a value c ∈ R such that px c py ∀x ∈ A & y ∈ B.4 (Berg’s Maximum Theorem) Suppose f (x. Suppose F : X → 2Y is a correspondence such that (1) F (x) is closed for all x ∈ X. Theorem 2. i=1 Then ∩x∈X F (x) = ∅. the optimal valued function (also called marginal function): M (a) = max f (x.e. and the optimal solution: φ(a) = arg max f (x. . . B ⊂ Rm are convex and A ∩ B = ∅. The various characterization results on Kakutani’s Fixed Point Theorem. xm ∈ X and its convex combination xλ = m i=1 λi xi . who introduced the notion of FS-convexity. (3) F is FS-convex. KKM Lemma. . 1992. a) x∈F (a) is a upper hemi-continuous correspondence. 1994) and Tian and Zhou (1992). i. Then. 35 . we have xλ ∈ ∪m F (xi ). Theorem 2. Then.3 (FKKM Theorem) Let Y be a convex set and ∅ ⊂ X ⊂ Y . The following is a generalized version of KKM lemma due to Ky Fan (1984). and Maximum Theorem can be found in Tian (1991. .4.The Knaster-Kuratowski-Mazurkiewicz (KKM) lemma is quite basic and in some ways more useful than Brouwer’s ﬁxed point theorem. The term FS is for Fan (1984) and Sonnenschein (1971).5 (Separating Hyperplane Theorem) Suppose that A.4. for any x1 .4. there is a vector p ∈ Rm with p = 0. Theorem 2. and the constraint set F : A →→ X is a continuous correspondence with non-empty compact-valued values. a) is a continuous function mapping from A to X. Here.

. (2. 2. From this property. and A ∩ B = ∅. It is so if preference orderings are strictly convex. i } .6 (The Existence Theorem I)) For a private ownership economy e = ({Xi .4. there is a vector p ∈ Rm with p = 0. . Assume the following properties on the aggregate excess demand correspondence z (p). 2. L L l=1 pl . . ˆ z (p) is also continuous. we can normalize a price vector as follows: (1) p l = pl /p1 (2) p l = pl / l = 1. that is. Then. if z (p) is a continuous function and satisﬁes Walras’ Law. Theorem 2. without loss of generality. we can restrict our attention to the unit simplex: L S L−1 = {p ∈ L + : l=1 pl = 1}. ˆ Function: z (p) is a function. wi . suppose that B ⊂ Rm is convex and closed. ˆ Walras’ Law: for all p 0. }).4. there is p∗ ∈ z (p∗ ) ˆ 36 0 such that (2. ˆ (2. {Yj }.Furthermore. we can normalize prices. .15) Then. Thus. Note that if xi (p) and yj (p) are continuous.14) Homogeneity of z (p): it is homogeneous of degree 0 in price x(λp) = z (p) for any ˆ ˆ ˆ λ > 0. {θij . ˆ Continuity: z (p) is continuous. for example.2 The Existence of CE for Aggregate Excess Demand Functions The simplest case for the existence of a competitive equilibrium is the one when the aggregate excess demand correspondence is a single-valued function. Because of homogeneity. A ⊂ Rm is convex and compact.16) . we have the following theorem on the existence of competitive equilibrium. ˆ L + then there exists a competitive equilibrium. and a value c ∈ R such that px < c < py ∀x ∈ A & y ∈ B. p · z (p) = 0.

L. and if (L − 1) markets are in the equilibrium. we have ˆ L L L p z (p ) ˆ l=1 l=1 ∗l l ∗ max{0. z l (p∗ )} = 0. . . there exists a price vector p∗ such that g(p∗ ) = p∗ . By Brouwer’s ﬁxed point theorem.18) We want to show p∗ is in fact a competitive equilibrium price vector. z k (p∗ )} = max{0. L.e. . . p∗ is a competitive equilibrium price vector.4. z (p )} = ˆ l=1 l ∗ z l (p∗ ) max{0. z l (p∗ )} ˆ 1+ L k=1 L L k=1 pl + max{0.20) Then. the L-th market is also in the equilibrium. . z l (P ∗ ) ˆ l = 1. ˆ ˆ Then. i. if z (p∗ ) = 0 ˆ for some p∗ . h(x)} is continuous when f (x) and h(x) are continuous. . the Walras’ Law may not hold unless some types of monotonicity are imposed. Even though Walras’ Law holds.18). ˆ ˆ l=1 (2. z k (p)} ˆ (2. z k (p∗ ) on both sides of (2.4 By Walras’ Law. to have z the summation to be zero. z l (p∗ )}.Proof: Deﬁne a continuous function g : S L−1 → S L−1 by g l (p) = for l = 1.21) Therefore. if p > 0.e. Cross multiplying 1 + p ∗l k=1 max{0. That is. z k (p∗ )} ˆ l = 1. each term of the summations is either zero or (ˆl (p∗ ))2 > 0. . L. i. Remark 2. we must have each term to be zero. we may not have z (p) ˆ 0 for all p... Remark 2. by Walras’ Law.4. p∗l = p∗l + max{0. z l (p∗ )}. . . 2. z l (p)} ˆ 1+ L k=1 max{0. . we have L z l (p∗ ) max{0. The proof is completed.5 Do not confuse a aggregate excess demand function with Walras’ Law. First note that g is a continuous function since max{f (x). .19) max{0. Also. multiplying the above equation by z l (p∗ ) and making summation. we have ˆ (2. (2.17) max{0. Thus. . 0 for 37 . 2. ˆ ˆ (2.

by Fact 1. a contradiction. Walras’ Law is important to prove the existence of a competitive equilibrium. p∗l z l (p∗ ) < 0.Fact 1: (free goods). Under which conditions. Then. Thus. we have n n n J pxi (p) = i=1 i=1 n pwi + i=1 j=1 J θij pyj pyj j=1 = i=1 pwi + which implies that n n J xi (p) − i=1 i=1 wi − j=1 pyj = 0 (2. as long as the budget line holds with equality. then z (p∗ ) = 0. ˆ Fact 2: (Equality of demand and supply). If all goods are desirable and p∗ is a competitive equilibrium price vector. ˆ From the above theorem. Suppose not. we have p∗l = 0. ˆ Proof. Suppose not.22) so that p · z = 0 (W alras Law) ˆ Thus. z l (p∗ ) > 0. ˆ Since good l is desirable. Desirable goods: if pl = 0. ˆ Proof. Then p∗l > 0. then p∗l = 0.23) 38 . and so p∗ z (p∗ ) < 0. contraˆ ˆ dicting Walras’ Law. Walras’ Law must hold. The above existence theorem on competitive equilibrium is based on the assumptions that the aggregate excess demand correspondence is single-valued and satisﬁes the Walras’s Law. if p∗ is a competitive equilibrium price vector and z l (p∗ ) < 0. Under Walras’ Law. is Walras’ Law held? • Conditions for Walras’ Law to be true When each consumer’s budget constraint holds with equality: J pxi = pwi + j=1 θij pyj for all i. The questions are under what conditions on economic environments a budget (2. we must have z l (p∗l ) > 0. We have z l (p∗ ) < 0 for some l.

i (4) Non-satiation: For any x. x and x = x . Figure 2. and the aggregate excess demand correspondence is singlevalued or convex-valued? The following various types of monotonicities and convexities of preferences with the ﬁrst one strongest and the last one weakest may be used to answer these questions. there is x ∈ N (x) such that x i x. then xλ = λx + (1 − λ)x x for λ ∈ (0. • Types of monotonicity conditions (1) Strict monotonicity: For any two consumption market bundles (x ≥ x ) with x = x implies x i x. i (2) Monotonicity: if x > x implies that x x. N (x). (3) Local non-satiation: For any point x and any neighborhood. 1). xλ ≡ λx + (1 − x for λ ∈ (0.constraint holds with equality. i i 39 . (ii) Convexity: If x x . there exists x such that x • Types of convexities (i) Strict convexity: For any x and x with x λ)x i i x.11: Strict convex indiﬀerence curves. 1).

6 Monotonicity of preferences can be interpreted as individuals’ desires for goods: the more. Each of the above condition implies the next one. Figure 2. strictly convex indiﬀerence curves as showed in the above ﬁgures: Remark 2. then xλ i x.13: “Thick” indiﬀerence curves are weakly convex. the converse may not be true by examining thick indiﬀerence curves and linear indiﬀerence curves. but not strict convex.12: Linear indiﬀerence curves are convex. but not convex. 40 . the better.4.Figure 2. Local non-satiation means individuals’ desires are unlimited. (iii) Weak convexity: If x i x .

Proof: By the maximum theorem. closed and bounded) and strictly convex. Remark 2. demand correspondence xi (p) is convex-valued. Now we are ready to answer under which conditions Walras’s Law holds. i. Suppose not. and thus the Walras’s Law holds.8 Under the convexity of preferences. we know that yj (p) is a non-empty valued upper hemi-continuous correspondence by the compactness of yj (by noting that 0 ∈ Yj ) for all L p ∈ R+ . Proposition 2.2 Under the strict convexity of tion.4. satiation. and thus.e. then the supply correspondence yj (p) is a well deﬁned single-valued and continuous function.4 If Yj is compact (i. it guarantees the existence of continuous utility function ui (·). i. Proposition 2. non-satiation implies local non- xi (p) becomes a (single-valued) func- The proof of the following proposition is based on the maximum theorem.4.7 The convexity of preferences implies that people want to diversify their consumptions. Proposition 2. yj and yj are two proﬁt maximizing production plans for p ∈ L +.4. Also notice that the continuity of i is a suﬃcient condition for the continuous utility representations. where intYj denotes the interior points of Yj . and convex-valued. 1 2 Strict convexity of production set: if yj ∈ Yj and yj ∈ Yj .1 Under local no-satiation assumption.4. The following propositions answer the questions.3 Under the weak convexity of preferences. then the convex combination 1 2 λyj + (1 − λ)yj ∈ intYj for all 0 < λ < 1. we 41 .. that is.4. a demand correspondence can be function. we have the budget constraint holds with equality. convexity can be viewed as the formal expression of basic measure of economic markets for diversiﬁcation. Then. 2 1 Now we show it is single-valued. by the strict convexity of Yj .4. and weak convexity of is equivalent to the quasi-concavity of utility function ui .Remark 2. 2 1 and thus pyj = pyj . Why? The proof is lest to readers. Proposition 2. Note that the strict convexity of i implies the i conventional diminishing marginal rates of substitution (MRS).

i } . then xi (p) is a continuous single-valued function and satisﬁes the budget constraint with equality. .5 If i is continuous. . {θij . by the upper hemi-continuity of yj (p). J. and wi > 0. Finally. we know it is a single-valued and continuous function. since wi > 0. As such the Walras’s Law is satisﬁed. 2. 42 . and thus Walras’s Law is satisﬁed. {Yj }. 0 ∈ Yj j = 1. First note that. Note that there’s no utility function representation when preferences are lexicographic. there are continuous. (2. Proof. we know the budget constraint holds with equality.7 For a private ownership economy e = ({Xi . Proposition 2. strictly convex (which guarantee the demand function is single valued) and locally non-satiated (which guarantees Walras’ Law holds). wi . . So yj (p) is a single-valued function. one can show that the budget constrained set Bi (p) is a continuous correspondence with non-empty and compact values and i is continuous. Thus.4. Furthermore. }. (iv) Yj are compact. . by the maximum theorem. Therefore. we know the demand correspondence xi (p) is upper hemi-continuous.1 2 have λyj + (1 − λ)yj ∈ intYj for all 0 < λ < 1.4. it is single-valued and continuous. strictly convex. from the above propositions. we can have the following existence theorem that provides suﬃcient conditions directly based on the fundamentals of the economy by applying the Existence Theorem I above. Then. there exists some t > 1 such that 1 2 t[λyj + (1 − λ)yj ] ∈ intYj . Then. by the strict convexity of preferences. Theorem 2. exists a competitive equilibrium if the following conditions hold (i) Xi ∈ (ii) i L +. by local non-satiation. (iii) wi > 0. locally non-satiated. strictly convex.24) 1 2 1 1 1 Then t[λpyj + (1 − λ)pyj ] = tpyj > pyj which contradicts the fact that yj is a proﬁt maximizing production plan.

The above results require the aggregate excess demand function is continuous. that is. Thus the aggregate excess demand function is a continuous function and satisﬁes Walras’ Law. there is p∗ ∈ S L−1 such that z (p)∗ ˆ Proof. Deﬁne a correspondence F : S → 2S by. {Yj }.8 (The Existence Theorem I ) For a private ownership economy e = ({Xi . 0. then there exists a competitive equilibrium. wi .4. i } . F (q) = {p ∈ S : qˆ(p) z 43 0} for all q ∈ S. Proof: By the assumption imposed. By using the KKM lemma. and the lower contour set Lw (xi ) is given by all points below the indiﬀerence curve in the ﬁgure. Theorem 2. we can prove the existence of competitive equilibrium by only assuming the aggregate excess demand function is lower hemi-continuous. and therefore. we know that xi (p) and yj (p) are continuous single-valued. if the aggregate excess demand function z (p) is a lower semiˆ continuous correspondence and satisﬁes Walras’ Law.14: The upper contour set Uw (xi ) is given by all points above the indiﬀerence curve.Note that i are continuous if the upper contour set Uw (xi ) ≡ {xi ∈ Xi and xi i i xi } and the lower contour set Lw (xi ) ≡ {xi ∈ Xi and xi xi } are closed. there is a competitive equilibrium. Figure 2. (2. {θij }).25) .

. Thus. 0. i. . Examples of Computing CE Example 2. the set F (q) is closed for all q ∈ ˆ m t=1 m t=1 S. . the function deﬁned by φ(q.2 Consider an exchange economy with two consumers and two goods with w1 = (1. qˆ(p∗ ) z we have z (p∗ ) ˆ is completed. KKM lemma. q2 = (0. Suppose. Thus. . . by ˆ 0 for all q ∈ S. . that there some q1 .Since p L l=1 0 and z (·) is lower semi-continuous. 1). . The proof qn = (0. 0. ..26) 0<b<1 u1 (x1 ) = (x1 )a (x2 )1−a 0 < a < 1 1 1 Consumer 1’s problem is to solve max u1 (x1 ) x1 (2. 0).30) 44 . m. . . qλ ∈ F (qt ) for all t = 1. . Then there exists a p∗ ∈ S such that p∗ ∈ ∩q∈S F (q). . . . which means p∗ is a competitive equilibrium price vector.29) (2. p) ≡ qˆ(p) = ˆ z q l z l (p) is lower semi-continuous in p. So F must be FS-convex. Hence. 0). . by way of contradiction. . we have ∩q∈S F (q) = ∅. .27) subject to x1 + px2 = 1 (2. qm ∈ S and some convex combination qλ = Then. the solution is then given by a =a 1 1−a x2 (p) = . 0. L. . 1. 1) (2.e. . p∗ ∈ F (q) for all q ∈ S. 1 p x1 (p) = (2. . .28) Since utility functions are Cobb-Douglas types of functions. 0) u2 (x2 ) = (x1 )b (x2 )1−b 2 2 Let p = p2 p1 λt qt such that qλ ∈ ∪m F (qt ).4. We now prove F is FS-convex. . Then qt ∈ S and thus qt z (p∗ ) = z t (p∗ ) ˆ ˆ w2 = (0. Now let q1 = (1. t=1 λt qt z (qλ ) = qλ z (qλ ) > 0 which ˆ ˆ contradicts the fact that z satisﬁes Walras’ Law. . . Thus 0. Therefore. and 0 for all t = 1.

Consumer 2’s problem is to solve max u2 (x2 ) x2 (2.31) subject to x1 + px2 = p. β > 0 by the a suitable monotonic transformation. continuity.32) This is true because.35) (2. by invariant to monotonic (2. It may be remarked that we can easily derive the demand function for the general function: ui (x2 ) = (x1 )α (x2 )β 1 1 transformation of utility function. ++ and strict quasi-concavity. 1 1 45 (2.33) (2. we can rewrite the utility function as [(x1 )α (x2 )β ] α+β = (x1 ) α+p (x2 ) α+β 1 1 1 1 so that we have x1 (p) 1 and x2 (p) 1 when the budget line is given by p1 x1 + p2 x2 = I. for L = 2. Indeed. 2 p x1 (p) = 2 Then.37) (2. p b (2. by the market clearing condition.9 Since the Cobb-Douglas utility function is widely used as an example of utility functions that have nice properties such as strict monotonicity on RL . it is enough to show only one market clearing.36) (2. Remark 2.40) = = α I α+β p1 β I α+β p2 1 α β α> 0. by Walras’s Law. x1 (p) + x1 (p) = 1 ⇒ a + bp = 1 1 2 and thus the competitive equilibrium is given by p2 1−a p= 1 = .4.39) .38) (2.34) (2. it is very useful to remember the functional form of the demand function derived from the Cobb-Douglas utility functions. 2 2 The solution is given by b·p =b·p 1 (1 − b)p x2 (p) = = (1 − b).

2 2 (2. p∗ = b(1 − a) .46) To make p∗ be a competitive equilibrium price. we need to assume a + b > 1. bx2 } with b > 0 2 2 x2 = 1 (1 − a) . his problem is to solve: max u2 (x2 ) x2 L=2 w2 = (0.48) (2. x1 + px2 = p. 1) 0<a<1 (2.43) s. by x1 (p) + x1 (p) = 1.4.47) bp =1 b+p (2.41) u2 (x2 ) = min{x1 .3 n=2 w1 = (1.45) (2. we have bx2 + px2 = p and thus 2 2 x2 (p) = 2 p b+p and x1 (p) = 2 bp . b+p Then. 2 2 At the optimal consumption. a+b−1 (2. p (2.t. we have 1 2 a+ or (1 − a)(b + p) = bp so that (a + b − 1)p = b(1 − a) Thus.Example 2. we have already obtained x1 (p) = a.44) By substituting the solution into the budget equation. 0) u1 (x1 ) = (x1 )a (x2 )1−a 1 1 For consumer 1. 1 For Consumer 2. 46 .42) (2. we have x1 = bx2 .

9 (The Existence Theorem II)) For a private ownership economy e = ({Xi . by the Separating Hyperplane theorem. there exists some 47 . if z (p) is an non-empty convex and compact-valued upper hemiˆ continuous correspondence and satisﬁes Walras’ Law. we can still prove the existence of competitive equilibrium when the aggregate excess demand correspondence satisﬁes certain conditions. for all z ∈ z (p). there is a price vector r∗ ∈ S such that z (p)∗ ∩ {− ˆ L } = ∅.3 The Existence of CE for Aggregate Excess Demand Correspondences When preferences and/or production sets are not strictly convex. by KKM lemma. and thus the aggregate excess demand correspondence may not be single-valued. p∗ ∈ F (q) for all q ∈ S. Since z (p∗ ) is convex and compact ˆ is convex and closed. that is.4. qλ ∈ F (qt ) t=1 for all t = 1. . So F must ˆ ˆ ˆ be FS-convex. Thus. We now prove F is ˆ FS-convex. . i } .4. that there are some q1 .. we have qλ z > 0 for t = 1. As a result. ˆ ˆ Since z (·) is upper semi-continuous. Deﬁne a correspondence F : S → 2S by. F (q) is closed for each q ∈ S. Thus. Suppose. = 0. {θij }). then there exists a competitive equilibrium. ˆ ˆ ˆ λt qt z = qλ z > 0 which contradicts the fact that z satisﬁes Walras’ Law. Theorem 2. by using the KKM lemma. qm ∈ S and some convex combination qλ = m t=1 m t=1 λt qt such that qλ ∈ ∪m F (qt ). . . . . wi . . . Thus. we have ∩q∈S F (q) = ∅. i. . Therefore.e. Then there exists a p∗ ∈ S such that p∗ ∈ ∩q∈S F (q). m. one cannot use the above existence results to argue the existence of competitive equilibrium. there is z ∈ z (p∗ ) such that ˆ ˆ qˆ z We now prove z (p∗ ) ∩ {− ˆ and − L + L +} 0. . for each q ∈ S. . by way of contradiction. (2. m.2. the demand correspondence and/or supply correspondence may not be single-valued. {Yj }. Then. . F (q) = {p ∈ S : qˆ z 0 for some z ∈ z (p)}.49) Proof. Nevertheless. Suppose not.

4. 2. i = 1. Theorem 2. convex. (iv) Yj are compact. 48 . J) We now state the following existence theorem for general production economies without proof. we must have c > 0 and q · (− 0. for example.10 The last part of the proof can be also shown by applying the following result: Let K be a compact convex set. . . {Yj }. {Yj }.7.10 For a private ownership economy e = ({Xi .4 The Existence of CE for General Production Economies For a general private ownership production economy. exists a competitive equilibrium if the following conditions hold (i) Xi ∈ (ii) i L +. .4. Thus. weakly convex and locally non-satiated. . The proof of this result can be found. {θij }. . Border (1985. The proof is completed. wi }. we have the following existence theorem that provides suﬃcient conditions directly based on economic environments by applying the Existence Theorem II above. 2. j = 1. n) (proﬁt maximization. in the book of K. . (iii) wi > 0. a contradiction. 2. . wi . we refer readers to the proof that can be found in Debreu (1959) who used the existence theorem on equilibrium of the abstract economy on Section 2. . Then K ∩ {− p∈ L +. Similarly. i }). J. L +} = ∅ if and only if for any there exists z ∈ K such that pz 0. i . e = ({Xi . 13). 2. j = 1. Since the proof is very complicated. p. there are continuous. z Remark 2.50) recall that a competitive equilibrium consists of a feasible allocation (x∗ y ∗ ) and a price L vector p∗ ∈ R+ such that (i) x∗ ∈ Di (p∗ ) ≡ xi (p∗ ) i ∗ (ii) yi ∈ Si (p∗ ) ≡ yi (p∗ ) (utility maximization.4. .c∈ L such that q · (− L +) < c < qˆ(p∗ ) z L +) Since (− L +) is a cone. {θij }) (2. q ∈ L + and qˆ(p∗ ) > 0 for all q. . and 0 ∈ Y .

Proof: By the desirability. (5) wi ∈ intXi . convex and bounded from below. Theorem 2. they are not even locally unique. Not only are the equilibria not unique. so we will rule it out by means of the desirability assumption so that every equilibrium price of each good must be strictly positive. are continuous. we can ﬁnd whole ranges of prices that are market equilibria. ∂z h (p) ∂pl > 0 for l = h). Let m = max pp∗l = 49 l pk p∗k for some k.e. By homogeneity . (2) (3) (4) i i i are non-satiated. We want to also assume the continuous diﬀerentiability of the aggregate excess demand function.5.5 The Uniqueness of Competitive Equilibria We can easily give examples in which there are multiple competitive equilibrium price vectors. are convex.Theorem 2.11 (Existence Theorem III. When is there only one normalized price vector that clears all markets? The free goods case is not of great interest here. p∗ > 0.4. (7) Yj are closed and convex (continuity and no IRS) (8) Yj ∩ {−Yj } = {0} (Irreversibility) (9) {− L +} ⊆ Yj (free disposal) 2. we answer this question for only considering the case of p∗ > 0 and z (p) is ˆ diﬀerentiable.. 1959) A competitive equilibrium for the private-ownership economy e exists if the following conditions are satisﬁed: (1) Xi is closed. it is the unique competitive equilibrium price vector. The reason is fairly clear. if indiﬀerence curves have kinks in them. Thus. Debreu. Suppose p is another competitive equilibrium price vector that is not proportional to p∗ . then if p∗ is a competitive equilibrium price vector and Walras’ Law holds. (6) 0 ∈ Yj (possibility of inaction).1 If all goods are desirable and gross substitute for all prices (i.

we know that z (p∗ ) = z (mp∗ ) = 0. L z dt (2. . ˆ 2. by dpl = Gl (ˆ(p)) l = 1. Then we have pl for all l and mp∗h > ph for some h. a Tˆtonnement Adjustment Process is deﬁned. Gl can be an identical mapping such that pl = z l (p) ˙ ˆ p = z (p).and the deﬁnition of competitive equilibrium.53) 50 . Gl (x) > 0 if x > 0. Hence. . we have a shortage and thus price should go up by the laws of demand and supply. .51) where Gl is a sign-preserving function of z (p).52) (2.e. and Gl (x) < 0 if x < 0. i. L and m > ph p∗h for some h. . But. the prices of the other goods are down. . Such a process is called Tˆtonnement adjustment process. when the price of good k is ﬁxed. Thus. A paradoxical relationship between the idea of competition and price adjustment is that: If all agents take prices as given. a contradiction. What forces exist that might tend to move prices to a market-clearing price? This is a topic about the stability on the price adjustment mechanism in a competitive equilibrium. The Walrasian auctioneer is supposed to call the prices and change the price mechanically responding to the aggregate excess demand till the market clears..6 Stability of Competitive Equilibrium The concept of competitive equilibrium is a stationary concept. Gl (x) = 0 if ˆ x = 0. . one introduces a “Walrasian auctioneer” whose sole function is to seek for the market clearing prices. we have z k (p) < 0. . The above equation implies that when the aggregate excess demand is positive. it has given no guarantee that the economy will actually operate at the equilibrium point. according to the laws of demand a and supply. We ˆ ˆ know that m = mp∗l pk p∗k pl p∗l for all l = 1. We must have the demand for good k down by the gross substitutes. ˙ ˆ (2. As a special case of Gl . how can prices move? Who is left to adjust prices? To solve this paradox. .

The path of the prices are restricted on the surface of a k-dimensional sphere. This is another price normalization. and the second and fourth show they are not stable. 51 . Figure 2.15: The ﬁrst and third ﬁgures show the CEs are stable. d d (p p) = dt dt L L (p ) l=1 l 2 =2 l=1 (pl ) · dpl dt = 2p p = pˆ(p) = 0 ˙ z which means that the sum of squares of the prices remain constant as the price adjusts. the second and fourth ﬁgures show a unique unstable equilibrium. Examples of price dynamics in ﬁgures: The ﬁrst and third ﬁgures show a stable equilibrium.Under Walras’ Law.

Deﬁnition 2. to get global stability. (3) dV (x) dt t < ∞ such ∂ z l (p∗ ) ˆ ∂pk < 0. Theorem 2. .6. a ˙ function V is said to be a Liaponov’s function if (1) there is a unique x∗ such that V (x∗ ) = 0. then p z (p) > p z (p ) for all p.2 An equilibrium price p∗ is locally stable if there is δ > 0 and a unique price path p = φ(t. po ) = p∗ .2 (Liaponov’s Theorem) If there exists a Liaponov’s function for x = ˙ f (x).6.6. The local stability of a competitive equilibrium can be easily obtained from the standard result on the local stability of a diﬀerentiate equation. The Weak Axiom of Revealed Preference (WARP) of the aggregate demand function: If pˆ(p) z pˆ(p ).6. Thus.1 An equilibrium price p∗ is globally stable if (i) p∗ is the unique competitive equilibrium. The global stability result can be obtained by Liaponov Theorem. Liaponov’s function: For a diﬀerentiate equation system x = f (x) with x∗ = 0. p0 ) for 0 that limt→∞ φ(t. Deﬁnition 2. the unique stationary point x∗ is globally stable. p ∈ z ˆ ˆ 52 L +. (2) V (x) > 0 for all x = x∗ .1 A competitive equilibrium price p∗ is locally stable if the Jacobean matrix deﬁned by A= has all negative characteristic roots. po ) = p∗ whenever |p − p0 | < δ. Debreu (1974) has shown essentially that any continuous function which satisﬁes the Walras’ Law is an aggregate demand function for some economy. p0 ) such that limt→∞ φ(t. (ii) for all po there exists a unique price path p = φ(t. Theorem 2. utility maximization places no restriction on aggregate behavior. Thus. one has to make some special assumptions.

17: Both individual demand functions satisfy WARP. WARP implies that. ˆ The WARP is a weak restriction than the continuous concave utility function. the aggregate demand function may not satisfy the aggregate WARP as shown in the following ﬁgures. the restriction on the aggregate excess is not as weak as it may been seen. if z (p ) could have been bought at p where z (p) was bought.Figure 2. 53 . However.16: The ﬁgure shows an aggregate demand function satisﬁes WARP. Figure 2. Even though two individuals satisfy the individual WARP. z (p) is outside the budget constraint. then ˆ ˆ at price p .

ˆ Lemma 2.1. So we have pˆ(p) z z p∗ z (p∗ ) = 0 ⇒ p∗ z (p) > 0 for all p = kp∗ . it does not necessarily satisfy the WARP in aggregate. Proof: Suppose p∗ is a competitive equilibrium.2 Under the assumptions of Walras’ Law and WARP in aggregate.54) pˆ(p∗ ). ˆ ˆ Lemma 2. Proof: By Lemma 2.6.6. p∗ z (p) > z ˆ Also. we have p∗ z (p) > 0 for all p = kp∗ where p∗ > 0 is a competitive equilibrium. we have p∗ z (p) > 0 for all p = kp∗ where p∗ is a competitive equilibrium. the competitive equilibrium is unique. p∗ z (p) > 0 which means at least for some l. Figure 2. by WARP. ˆ Lemma 2.1 Under the assumptions of Walras’ Law and WARP. by Walras’ Law pˆ(p) = 0.18: The aggregate excess demand function does not satisfy WARP. for any p = kp∗ .6.Even if the individual demand functions satisfy WARP. ˆ 54 .6. Then.3 Under the assumptions of Walras’ Law and gross substitute. ˆ z l > 0. z (p∗ ) ˆ 0 (2.

then x x x(p) is on the line AB which passes through the point x∗ and whose slope is given by p. we have x2 (p∗ ) > x2 (µp) by the gross substitutability. 1971. x x Using the homogeneity assumption. Let p = αp∗ for any α > 0.6. The proof of this lemma is complicated. ˆ ˆ ˆ Now we are ready to prove the following theorem on the global stability of a competitive equilibrium. Let p∗ be an equilibrium price vector and x∗ = x(p∗ ). Let CD be the line which passes through the point x∗ and whose shope is p∗ . 55 .Proof. We assume that p∗1 /p∗2 > p1 /p2 without loss of generality. Therefore. Now draw a line parallel to CD passing through the point x(p). p∗1 > µp1 and p∗2 = µp2 .3. Then we know p is not an equilibrium price vector by the uniqueness of the competitive equilibrium under the gross substitutability. Figure 2. The general proof of this lemma can be seen in Arrow and Hahn. Since pˆ(p) = pˆ(p∗ ) by Walras’ Law. Thus. 224. The proof is completed.19: An illustration of the proof of Lemma 2. But Walras’ Law implies that µpˆ(µp) = µpˆ(p∗ ) so that we must have x1 (µp) > x1 (p∗ ). p. Then p∗1 /p1 > p∗2 /p2 ≡ µ. We illustrate the proof only for the case of two commodities by aid of the ﬁgure. Hence the point x(p) must lie to the right of the point x∗ in the ﬁgure. We see that p∗ x(p) > p∗ x∗ and thus p∗ z (p) > 0. we get x1 (p) = x1 (µp) > x1 (p∗ ) = x∗1 and x2 (p) = x2 (µp) < x2 (p∗ ) = x∗2 .

6. then the competitive equilibrium price ˆ is globally stable. 0). can the global stability of a competitive equilibrium also hold for complementary goods? Scarf (1961) has constructed examples that show that a competitive equilibrium may not be globally stable. x3 } 3 3 56 . 1) and their utility functions are given by u1 (x1 ) = min{x1 . Proof: Deﬁne a Liaponov’s function by L V (p) = l=1 (pl (t) − p∗l )2 = (p − p∗ ) · (p − p∗ ) (2. x2 } 1 1 u2 (x2 ) = min{x2 . It is natural to ask how far we can relax these assumptions. L=3). Since many goods in reality are complementary goods.1 (Scarf ’s Counterexample on Global Instability) Consider a pure exchange economy with three consumers and three commodities (n=3. the competitive equilibrium price p∗ is unique.6.Theorem 2. 0.3 (Arrow-Block-Hurwicz) Under the assumptions of Walras’ Law. x3 } 2 2 u3 (x3 ) = min{x1 . 0) w3 = (0. we know p = z (p) is globally stable ˙ ˆ by Leaponov’s theorem. homogeneity.1-2. The above theorem establishes the global stability of a competitive equilibrium under Walras’ Law. Also. Suppose consumers’ endowments are given by w1 = (1. since dV dt L = 2 l=1 L (p(t) − p ) l ∗l dpl (t) dt = 2 l=1 zl (pl − p∗l )ˆ(p) (t) = 2[pˆ(p) − p∗ z (p)] z ˆ = −2p∗ z (p) < 0 ˆ by Walras’ Law and Lemma 2.3 for p = kp∗ .6. in particular gross substitutability. if z (p) satisﬁes either gross substitutability. 1.55) By the assumption. w2 = (0. or WARP. 0. and gross substitutability/WARP. Example 2.6.

so that they have L-shaped indiﬀerence curves. (i) there is no substitution eﬀect. Since 3 l 2 l=1 [p (t)] = 3. 3 l 2 l=1 [p (t)] = 3 and pl (t) = 1 for all t. p + p3 p + p3 1 (2. 1952) generalizes the notion of N-person Nash noncooperative game in that a player’s strategy set depends on the strategy choices of all the other players and can be used to prove the existence of competitive equilibrium since the market mechanism can be regarded as an abstract economy as 57 . we may note the following facts. 1. Then. and (iii) the diﬀerence curve has a kink and hence is not diﬀerentiable. Scarf’s examples indicate that instability may occur in a wide variety of cases.7 Abstract Economy The abstract economy deﬁned by Debreu (Econometrica. Thus. d ( p(t)) = p1 p2 p3 + p2 p1 p3 + p3 p1 p2 ˙ ˙ ˙ dt l=1 = z 1 p2 p3 + z 2 p1 p3 + z 3 p1 p2 = 0.58) Then. (ii) the indiﬀerence curve is not strictly convex. ˙ ˆ We know that p(t) = constant for all t by Walras’ Law. Then. we show that the dynamic process is not globally stable. the aggregate excess demand function is given by p2 p3 z (p) = − 1 ˆ + p + p2 p1 + p3 p3 p1 z 2 (p) = − 2 ˆ + 1 p + p3 p + p2 p1 p2 z 3 (p) = − 1 ˆ + 2 . First choose the initial prices pl (0) such that 3 l=1 3 l 2 l=1 [p (0)] = 3 and 3 l=1 pl (0) = 1.57) (2. 2. the dynamic adjustment equation is given by p = z (p). Indeed. Scarf (1961) also provided the examples of instabiity in which the substitution eﬀect is present for the case of Giﬀen’s goods. the only possible equilibrium prices are p∗1 = p∗2 = p∗3 = 1. ˆ ˆ ˆ 3 Now. 1). the solution of the above system of diﬀerential equations cannot converge to the equilibrium price p∗ = (1. Now we want to show that 3 l=1 pl (t) = constant for all t.56) (2. In this example.

1975) extended Debreu’s results to abstract economies without ordered preferences.7. Since Debreu’s seminal work on abstract economies.1 Equilibrium in Abstract Economy Let N be the set of agents which is any countable or uncountable set. the abstract economy reduces to the conventional game Γ = (Xi . Theorem 2. ui ) and the equilibrium is called a Nash equilibrium. 2. Each agent i has a payoﬀ (utility) function ui : X → R. Fi . Deﬁnition 2. the choice of the i-th agent is restricted to a non-empty. of Mathematical Economics.1 (Arrow-Debreu) Let X be a non-empty compact convex subset of RnL . Given x−i (the strategies of others). An abstract economy (or called generalized game) Γ = (Xi . Fi . ii) ui : X × X → R is continuous.shown by Arrow and Debreu (Econometrica 1954). Denote by X the (Cartesian) product and X−i the product j∈N \{i} j∈N Xj Xj . ∀i ∈ N . Denote by x and x−i an element of X and X−i . Debreu (1952) proved the existence of equilibrium in abstract economies with ﬁnitely many agents and ﬁnite dimensional strategy spaces by assuming the existence of continuous utility functions. many existence results have been given in the literature. the feasible strategy set. 58 . but also dependent on the choice of the others.1 A vector x∗ ∈ X is said to be an equilibrium of an abstract economy if ∀i ∈ N (i) x∗ ∈ Fi (x∗ ) and i −i (ii) x∗ maximizes ui (x∗ . Pi ). xi ) over Fi (x∗ ). xi ) over Fi (x−i ). ui )i∈N is deﬁned as a family of ordered triples (Xi . Each agent i chooses a strategy xi in a set Xi of RL . Suppose that i) the correspondence F : X → 2X is a continuous correspondence with nonempty compact and convex values. Shafer and Sonnenschein (J. Note that agent i’s utility is not only dependent on his own choice.7. the i-th agent chooses xi ∈ Fi (x−i ) so as to maximize ui (x−i . i −i −i If Fi (x−i ) ≡ Xi . convex and compact set Fi (x−i ) ⊂ Xi .7.

2 The Existence of Equilibrium for General Preferences The above theorem on the existence of an equilibrium in abstract economy has assumed the preference relation is an ordering and can be represented by a utility function.iii) ui : X × X → R is either quasi-concave in xi or it has a unique maximum on Fi (x−i ) for all x−i ∈ X−i . n Zn+1 = ∆L−1 Fi (xi . Therefore the correspondence M (x) = i∈N Mi (x−i ) is an upper hemi-continuous correspondence with non-empty convex compact-values. Then Γ has an equilibrium. n i=1 xi n i=1 wi at the 2. wi )i∈N . .7. Deﬁne an abstract economy Γ = (Z. by the Maximum Theorem. consider an exchange economy e = (Xi . . there exists x∗ ∈ X such that x∗ ∈ M (x∗ ) and x∗ is an equilibrium in the generalized game. For simplicity. xi ) ui (x−i . . ∀zi ∈ Fi (x−i )}.D A competitive market mechanism can be regarded as an abstract economy. For each i ∈ N . ui . p) = {xi ∈ Xi : pxi Fn+1 = ∆L−1 n pwi } i = 1. Then. by Kakutani’s Fixed Point Theorem. Thus. In 59 . . Proof. Mi is an upper hemi-continuous correspondence with compact-valued. . Also. .E. the correspondence Mi : X−i → 2Xi is non-empty and convex-valued because ui is continuous in x and quasi-concave in xi and Fi (x−i ) is non-empty convex compact-valued. . Fi . ui )i∈N +1 as follows. Let Zi = Xi i = 1. n un+1 (p. zi ). x) = i=1 p(xi − wi ) (2. . Q. deﬁne the maximizing correspondence Mi (x−i ) = {xi ∈ Fi (x−i ) : ui (x−i . we verify that the economy e has a competitive equilibrium if the abstract economy deﬁned above has an equilibrium by noting that equilibrium of the abstract equilibrium.59) Then.

ψ : X → 2Y be correspondences such that i (xi . Pi ).6 and Theorem 3.7. Pi )i∈N is deﬁned as a family of ordered triples (Xi . (ii) Fi : X → 2Xi is a continuous correspondence with non-empty. 1992) proved the following theorem that is more general and generalizes the results of Debreu (1952). Propositions 2. Then Γ has an equilibrium.2 (Shafer-Sonnenschein ) Let Γ = (Xi . Fi . An equilibrium for Γ is an x∗ ∈ X such that x∗ ∈ F (x∗ ) and Pi (x∗ ) ∩ Fi (x∗ ) = ∅ for each i ∈ N .7. Fi . Theorem 2. we state some technical lemmas which were due to Micheal (1956. Lemma 2. Deﬁne agent i’s preference correspondence Pi : X → 2Xi by Pi (x) = {yi ∈ Xi : (yi . x−i )} 60 . Pi )i∈N an abstract economy.5. A generalized game (or an abstract economy) Γ = (Xi . (iii) Pi has open graph. we consider the existence of equilibrium in an abstract economy where individuals’ preferences may be non total or not-transitive. Tian (International Journal of Game Theory.this subsection. 2. Pi )i∈N be an abstract economy satisfying the following conditions for each i ∈ N : (i) Xi is a non-empty. compact. compact. Shafer and Sonnenschein (1975) by relaxing the openness of graphs or lower sections of preference correspondences. Before proceeding to the theorem. (iv) xi ∈ con Pi (x) for all x ∈ Z. Fi . Fi .1 ). This theorem requires the preferences have open graph.1 Let X ⊂ RM and Y ⊂ RK be two convex subsets and φ : X → 2Y . and convex subset in Rli . Shafer and Sonnenschein (1975) proved the following theorem that generalizes the above theorem to an abstract economy with non-complete/non-transitive preferences. and convex values. x−i ) We call Γ = (Xi .

3. so are they in Ui . φ(x) ∩ ψ(x) = ∅. and Fi (x) is non-empty. compact. by Lemma 2.7. and convex subset in Rli . there exists a continuous function 61 .7. and convex for all x ∈ X. Then the correspondence ψ : X → 2Y deﬁned by ψ(x) = con φ(x) is lower hemi-continuous. Since Fi and Pi are lower hemi-continuous in X. Then Γ has an equilibrium. Fi .7. by Lemma 2. and has open upper sections. For each i ∈ N .(i) φ is lower hemi-continuous.1.7. F (x) is non-empty and convex. (ii) Fi is a continuous correspondence. (iv) xi ∈ con Pi (x) for all x ∈ F .2. Fi (x) ∩ con Pi (x) = ∅ for all x ∈ Ui . Pi )i∈N be a generalized game satisfying for each i ∈ N: (i) Xi is a non-empty.3 Let X ⊂ RM and Y ⊂ RK be two convex subsets. the correspondence Ai |Ui : Ui → 2Xi is lower hemi-continuous in Ui and for all x ∈ Ui . Also Xi is ﬁnite dimensional. Suppose F : X → 2Y is a lower hemi-continuous correspondence with non-empty and convex values. Then there exists a continuous function f : X → Y such that f (x) ∈ F (x) for all x ∈ X. Let Ui = {x ∈ X : Ai (x) = ∅}. convex valued. Proof. (iii) for all x ∈ X. Lemma 2.2 Let X ⊂ RM and Y ⊂ RK be two convex subsets. so does conPi in X and thus con Pi in Ui . by Lemma 2. (iii) Pi is lower hemi-continuous and has open upper sections. Further. Lemma 2. Hence. con Pi is lower hemi-continuous in Ui . Then. Hence. Also since Pi has open upper sections in X.7. (ii) ψ is lower hemi-continuous. and let φ : X → 2Y be lower hemi-continuous.7. deﬁne a correspondence Ai : X → 2Xi by Ai (x) = Fi (x)∩con Pi (x). Then the correspondence θ : X → 2Y deﬁned by θ(x) = φ(x) ∩ ψ(x) is lower hemicontinuous. Theorem 2. compact.3 (Tian) Let Γ = (Xi .

” Econometrica. 60 (1993). 62 . G(x) is non-empty. K. K and G.” Review of Economic Studies. 82-109. “On the Stability of the Competitve Equilibrium. Thus the correspondence G : X → 2X deﬁned by G(x) = i∈N Gi (x) is upper hemi-continuous and for all x ∈ X. Hurwicz. and Hahn. “On the Stability of the Competitve Equilibrium. “Existence of Equilibrium for a Competitive Economy. Note that Ui is open since Ai is lower hemi-continuous. and convex. “Characterizations of the Existence of Equilibria in Games with Discontinuous and Nonquasiconcave Payoﬀs. 26 (1958). 22. K.fi : Ui → Xi such that fi (x) ∈ Ai (x) for all x ∈ Ui . Arrow. Holden Day). Hence. and L. 935-948. K. J. and L. the above theorem is indeed weaker. (San Francisco. Note that a correspondence P has open graph implies that it has upper and lower open sections. if x∗ ∈ Ui . General Competitive Analysis. H. x∗ ∈ Ui and thus for all i ∈ N . Hence. 1954. Reference Arrow. Thus. and Tian. closed. there exists a point x∗ ∈ X such that x∗ ∈ G(x∗ ).60) Then Gi is upper hemi-continuous. Arrow.” Econometrica. Hurwicz. Debreu. a correspondence P has lower open sections implies P is lower hemi-continuous.. M. 522-552. x∗ ∈ Fi (x∗ ) and Fi (x∗ ) ∩ con Pi (x∗ ) = ∅ which implies Fi (x∗ ) ∩ Pi (x∗ ) = ∅. Block. I. F. Baye. Deﬁne a correspondence Gi : X → 2Xi by {f (x)} if x ∈ U i i Gi (x) = . (1971). a contradiction to (iv). by Kakutani’s Fixed Point Theorem. Arrow. G. J. F (x) otherwise i (2. D.” Econometrica. II.. then x∗ = fi (x∗ ) ∈ i A(x∗ ) ⊂ con Pi (x∗ ). Thus Γ has i an equilibrium. H. 27 (1959). Note that for each i ∈ N . Zhou.

1 (1974).” Annals of Mathematics 63 (1956). 38 (1952) 386 393. D. A. Addison-Wesley. C. New York). Mas-Colell. and Demand. Cambridge: Cambridge University Press. G. Chapter 7. Takayama. 1995. and J. 266 (1984). 15-22. 519-537. 361 382. 1985. Reny. S. New York. and H. E. Debreu. Luenberger. the second edition. G.. “Some Examples of Global Instability of the Competitive Equilibrium. K. by J. S. 1985. K. “Continuous selections I. Journal of Mathematical Economics 2 (1975) 345 348. A. G. G..” Proceedings of the National Academy of Sciences of the U. “Excess Demand Functions. Chipman. (Wiley. 1 (1960). McGraw-Hill. Sonnenschein. and P. Chapter 7. Sonnenschein. 1998. Fan. W. K. Oxford University Press. 63 . Richter. Utility. Cambridge: Cambridge University Press. with Application to the Theory of Competitive Equilibrium..” Journal of Mathematical Economics. A. Green. Chapters 1-3.” Mathematics Annuls. Microeconomic Theory. Debreu. A. Advanced Microeconomic Theory. Theory of Value. Sonnenschein..Border. M. Mathematical Economics.. H. Preferences. Harcourt Brace Jovanovich. Demand Theory without Transitive Preferences. Whinston. New York. 1995. 157-172. Edited.” International Economic Review. “Some Properties of Convex Sets Related to Fixed Point Theorem. Microeconomic Theory. Fixed Point Theorems with Appplications to Economics and Game Theory. D.. Michael.. 17. Inc. Debreu. 1959. Jehle. Scarf. Shafer. 1971. Chapters 15. Equilibrium in abstract economies without ordered preferences. Hurwicz. and H.. “A Social equilibrium existence theorem. L.. M. H.

Zhou.. G. Zhou. 375-389. Lausanne: Gorbaz. Tian. pp. 1992. Tian. Tian. 379-388. Tian.” Journal of Mathematical Economics. 170 (1992). G. 166 (1992). 60 (1993). Third Edition. Homewood.. and J.” Journal of Mathematical Economics. “Existence of Equilibrium in Abstract Economies with Discontinuous Payoﬀs and Non-Compact Choice Spaces.W. “Generalized KKM Theorem and Minimax Inequalities and Their Applications. Chapters 17-18. G. pp.” Journal of Mathematical Analysis and Applications.“Generalizations of the FKKM Theorem and Ky-Fan Minimax Inequality.” Journal of Optimization Theory and Applications. with Applications to Maximal Elements. 360-375. 281-303. and J. 24 (1995). W. and J.247-254.. Microeconomic Analysis. pp. 1874. “Fixed Points Theorems for Mappings with Non-Compact and Non-Convex Domains. El´ments of d’Economie Politique Pure. 158 (1991). G. “Transfer Continuities. G. 20 (1992). 21. [Transe lated as Elements of Pure Economics. Zhou. “Transfer Method for Characterizing the Existence of Maximal Elements of Binary Relations on Compact or Noncompact Sets. 83 (1994).” Review of Economic Studies. 351-364. G. 1954] 64 . Norton and Company. pp. G. G.” SIAM Journal on Optimization.. Tian.” International Journal of Game Theory. Price Equilibrium. Tian. L. “The Maximum Theorem and the Existence of Nash Equilibrium of (Generalized) Games without Lower Semicontinuities. 949-958. Ill: Irwin. Tian. pp. “Necessary and Suﬃcient Conditions for Maximization of a Class of Preference Relations. Tian. pp. 21 (1992). Generalizations of the Weierstrass Theorem and Maximum Theorem–A Full Characterization. “On the Existence of Equilibria in Generalized Games. 2 (1992). H.Tian.R. 457-471. Varian.” Journal of Mathematical Analysis and Applications. G.”Journal of Mathematical Analysis and Applications. 161-167. ´ Walras. and Complementarity.

Chapter 3 Normative Theory of Equilibrium: Its Welfare Properties 3. i. Then in what sense and under what conditions is a market eﬃcient? The concept of eﬃciency is related to a concern with the well-being of those in the economy. and stability of competitive equilibrium. The normative analysis can not only help us understand what advantage the market mechanism has. (3) Product mix eﬃciency. The term of economic eﬃciency consists of three requirements: (1) Exchange eﬃciency: goods are traded eﬃciently so that no further mutual beneﬁcial trade can be obtained. Economists are interested not only in describing the world of the market economy. as well as help us understand why China and East European countries want to change their economic institutions. but also in evaluating it. we will study the welfare properties of competitive equilibrium. the mix of goods produced by the economy 65 . In this chapter.1 Introduction In the preceding chapter. uniqueness.e. (2) Production eﬃciency: there is no waste of resources in producing goods.. Does a competitive market do a “good” job in allocating resources? Adam Smith’s “invisible hand” says that market economy is eﬃcient. we studied the conditions which would guarantee the existence. it can also help us to evaluate an economic system used in the real world.

O. . we want to know what is the relationship between a market equilibrium and Pareto eﬃciency. 66 .2 Pareto Eﬃciency of Allocation When economists talk about the eﬃciency of allocation resources.reﬂects the preferences of those in the economy.1 (Pareto Eﬃciency. For production economy.O) if it is feasible and there is no other feasible allocation such that one person would be better oﬀ and all other persons are not worse oﬀ. if there is no other allocation x such that (i) n i=1 i xi n i=1 wi k (ii) xi xi for all i and xk xk for some k = 1. . n. xi xk k xi for all i xk for some k A weaker concept about economic eﬃciency is the so-called weak Pareto eﬃciency. Deﬁnition 3. It provides a minimum criterion for eﬃciency of using resources. also called Pareto Optimality) : An allocation is Pareto eﬃcient or Pareto optimal (in short. (x. There are two basic questions: (1) If a market (not necessarily competitive) equilibrium exists. y ) s. y) is Pareto optimal if and only if: (1) x ˆ y+w ˆ ˆ (2) there is no feasible allocation (x . but it also can be used to study the eﬃciency of any economic system. 3. . is it Pareto eﬃcient? (2) Can any Pareto eﬃcient allocation be obtained through the market mechanism by redistributing endowments? The concept of Pareto eﬃciency is not just to study the eﬃciency of a market economy. .2. P.t. Under the market institution. for exchange economies. a feasible allocation x is P. it means Pareto eﬃciency. More precisely.

θ (xi + xi = (1 − θ)xk + x )= n−1 k i=k n xi i=1 (3.2 (Weak Pareto Eﬃciency) An allocation is weakly Pareto eﬃcient if it is feasible and there is no other feasible allocation such that all persons are better oﬀ. there exists a feasible allocation x such that xi Deﬁne x as follows xk = (1 − θ)xk θ xi = xi + x for i = k n−1 k Then we have xk + i=k i xi for all i and xk k xk for some k.2. But the converse may not be true. we must have every weak Pareto eﬃcient allocation is Pareto eﬃcient under the monotonicity and continuity of preferences. Proof. Under which conditions are they equivalent? It is clear that Pareto eﬃciency implies weak Pareto eﬃciency. weak Pareto eﬃciency implies Pareto eﬃciency.1 Some textbooks such as Varian (1992) has used weak Pareto optimality as the deﬁnition of Pareto optimality. Remark 3.1 Under the continuity and strict monotonicity of preferences. and xi ¯ i xi for all i = k by the strict monotonicity of preferences.3 The above proposition also depends on an implicit assumption that the goods under consideration are all private goods. 1988) showed. Remark 3. We will use the same trick to prove the second theorem of welfare economics.2. Then. Furthermore. by the continuity of preferences. xk = (1−θ)xk xk when θ is suﬃciently close to zero.2.1) which means x is feasible. Proposition 3. 67 .2 The trick of taking a little from one person and then equally distribute it to the others will make every one better oﬀ is a useful one.2. Remark 3. However.2. This contradicts the fact that x is weakly Pareto optimal. Thus. the converse is true.Deﬁnition 3. under the continuity and strict monotonicity of preferences. Tian (Economics Letters. Suppose x is weakly Pareto eﬃcient but not Pareto eﬃcient.

4 Equity and Pareto eﬃciency are two diﬀerent concepts.2. we may not have such equivalence between Pareto eﬃciency and weak Pareto eﬃciency under the monotonicity and continuity of preferences. We will show that. The locus of all Pareto eﬃcient is called the contract curve. when Pareto eﬃcient points are given by tangent points of two 68 . if goods are public goods. Remark 3. Actually. Every point in the Edgeworth Box is attainable. Is “A” a weak Pareto optimal? No. all tangent points are Pareto eﬃcient points where there are no incentives for any agent to trade. The points like OA or OB are Pareto optimal points. Is the point “B” a Pareto optimal? YES. Figure 3. government needs to implement some institutional arrangements such as tax. A is the starting point. To make an allocation be relatively equitable and also eﬃcient. for example in the shaded area is better oﬀ to both persons.by example that. subsidy to balance between equity and eﬃciency. but these are extremely unequal. The set of Pareto eﬃcient allocations can be shown with the Edgeworth Box. The point C.1: The set of Pareto eﬃcient allocations is given by the contract curve. but this is a value judgement and policy issue.

Contract curve is then given by the upper and left edge of the box. Suppose that indiﬀerence curves are given by uA (xA ) = x2 A and uB (xB ) = x1 B 69 .2: The set of Pareto eﬃcient allocations is given by the upper and left edges of the box when indiﬀerence curves are linear. then P is a Pareto eﬃcient point. When indiﬀerent curves for A is given. A B M RSx1 x2 < M RSx1 x2 (3. by Line AA.2) In this case. then K is a Pareto eﬃcient point. For linear indiﬀerence curves with positive slope. ˆ When indiﬀerence curves of two agents are never tangent. How can we ﬁnd the set of Pareto eﬃcient allocations in this case? We can do it by comparing the steepness of indiﬀerence curves. say. indiﬀerence curves of agents may not be tangent. when indiﬀerence curves for B is given. by Line BB. we have the following cases.persons’ indiﬀerence curves. say. Case 2. it should satisfy the following conditions: A B M RSx1 x2 = M RSx1 x2 xA + xB = w. Case 1. Figure 3.

only Pareto eﬃcient is the right upper corner point. Notice that utility functions in this example are continuous and monotonic. bx2 } A A and uB (xB ) = min{cx1 . utility functions are given by uA (xA ) = min{ax1 . but a weak Pareto eﬃcient allocation may not be Pareto eﬃcient. This example shows that the strict monotonicity cannot be replaced by the monotonicity for the equivalence of Pareto eﬃciency and weak eﬃciency. Now suppose that indiﬀerence curves are perfect complementary. dx2 } B B A special case is the one where a = b = c = d = 1.3: The only Pareto eﬃcient allocation point is given by the upper and left corner of the box when individuals only care about one commodity.Figure 3. 70 . Then. But the set of weakly Pareto eﬃcient is given by the upper and left edge of the box. Then. Case 3.

The second ﬁgure shows that a weak Pareo eﬃcient allocation may not Pareto eﬃcient when indiﬀerence curves are “thick. much fewer than those for 71 . It claims that every competitive equilibrium allocation is Pareto eﬃcient.” In this case. Case 4. which characterizes a desirable nature of the competitive market institution. in fact. A remarkable part of this theorem is that the theorem requires few assumptions. the set of Pareto optimal allocations is the area given by points between two 450 lines.” Then.4: The ﬁrst ﬁgure shows that the contract curve may be the “thick” when indiﬀerence curves are perfect complementary.3 The First Fundamental Theorem of Welfare Economics There is a well-known theorem. one of the most important theorems in economics. One person’s indiﬀerence curves are “thick. 3.Figure 3. an weak Pareto eﬃcient allocation may not be Pareto eﬃcient.

the existence of competitive equilibrium. or externalities. (3. 72 .1 (The First Fundamental Theorem of Welfare Economics) If (x. y ) such that xi Thus we have. y.3.5) Again. by summation.3) or p[ n xi − i=1 i=1 wi − j=1 yj ] > 0. Since pyj pyj for all yj ∈ Yj by proﬁt maximization. and there are no public goods. (3. and further under local nonsatiation. y) is not weakly Pareto optimal. y ) such that xi i xi for all i. Thus. by local non-saltation. it contradicts the fact that (x . y ) is feasible. To show Pareto eﬃciency. Then there exists another feasible allocation (x . we have n n J pxi > i=1 i=1 n pwi + j=1 J pyj . then there exists another feasible allocation (x . Therefore. goods are divisible. (3. suppose (x. pxi and by xk k pwi + j=1 θij pyj ∀i xk . J i xi for all i and xk k xk for some k . p) is a competitive equilibrium. it is Pareto eﬃcient. Proof: Suppose (x. J pxk > pwk + j=1 θkj pyj n J and thus n n J pxi > i=1 i=1 pwi + j=1 pyj i=1 pwi + j=1 pyj . y ) is feasible. then x is weakly Pareto eﬃcient. we have n n J pxi > i=1 i=1 pwi + j=1 pyj .4) which contradicts the fact that (x . y) is not Pareto optimal. Theorem 3. Some implicit assumptions in this section are that preferences are orderings. we must have pxi > pxi + J j=1 θij pyj for all i.

3.3.5: A CE allocation may not be Pareto eﬃcient when the local non-satiation condition is not satisﬁed. then a competitive equilibrium allocation x may not be Pareto optimal. for the case of thick indiﬀerence curves.3. Remark 3. a competitive equilibrium allocation x may not be Pareto optimal.6: A CE allocation may not be Pareto eﬃcient when goods are indivisible. Figure 3.3 If goods are indivisible. 73 .Remark 3. Remark 3.1 If the local non-satiation condition is not satisﬁed. say.2 Note that neither convexity of preferences nor convexity of production set is assumed in the theorem. The conditions required for Pareto eﬃciency of competitive equilibrium is much weaker than the conditions for the existence of competitive equilibrium. Figure 3.

. The proof is completed. . 3.4. Then x makes one of the agents better oﬀ without hurting any of the other agents. n max ui (xi ) xi s. But. let x solve that particular problem. .4. and the others are not worse oﬀ. suppose x∗ is Pareto eﬃcient. xk uk (xk ) wk uk (x∗ ) for k = i k Proof.The point x is a competitive equilibrium allocation. 2. 3. This means that there is some allocation x where one consumer is better oﬀ. then x∗ does not solve one of the maximizing problems. Hence. However. then we can deﬁne the Lagrangian function to get the optimal solution to the above problem: L = ui (xi ) + q(w − x) + ˆ ˆ k=i tk [uk (xk ) − uk (x∗ )] k 74 . . but it does not solve one of the problems. If utility functions ui (xi ) are diﬀerentiable and x∗ is an interior solution.1 Exchange Economies Proposition 3. Instead. Conversely. which contradicts the assumption that x∗ is Pareto eﬃcient. but not Pareto optimal since x is preferred by person 1.t. the following trick is very useful. the divisibility condition cannot be dropped for the First Fundamental Theorem of Welfare Theorem to be true.1 A feasible allocation x∗ is Pareto eﬃcient if and only if x∗ solves the following problem for all i = 1.4 Calculations of Pareto Optimum by First-Order Conditions The ﬁrst-order conditions for Pareto eﬃciency are a bit harder to formulate. a contradiction. Suppose x∗ solves all maximizing problems but x∗ is not Pareto eﬃcient.

. 2.7) = ql = M RSxl .6) ∂ui (xi ) ∂xl i ∂ui (xi ) ∂xh i (3. . L.6) (3. y ∗ ) is Pareto eﬃcient if and only if (x∗ . L. . .10) which are the necessary conditions for the interior solutions to be Pareto eﬃcient. If utility functions ui (xi ) are diﬀerentiable and x∗ is an interior solution. Let T (y) frontier. . n max ui (xi ) xi s. i = 1.2 A feasible allocation (x∗ .4.xh = · · · = M RSxn . .The ﬁrst order conditions are then given by ∂L ∂ui (xi ) = − q l = 0 l = 1. . . . h = 1.t. L. l ∂xi ∂xl i ∂uk (xk ) ∂L = tk − q l = 0 l = 1. we assume there is only one ﬁrm. . L. k = L ∂xl ∂xl k k By (3. Similarly. which means that the M RS of any two goods are all equal for all agents. 2.xh n n 1 1 l = 1. we can prove the following proposition. . . . . 3. . n. . Proposition 3. . we have M RSxl .xh i i qh (3.4. then we can deﬁne the Lagrangian function to get the ﬁrst order conditions: L = ui (xi ) + λT (w − x) + ˆ ˆ k=i tk [uk (xk ) − uk (x∗ )] k 75 . y ∗ ) solves the following problem for all i = 1. . 2. k∈N xk = k∈N wk + y uk (x∗ ) for k = i k uk (xk ) T (y) 0.7) ∂uk (xk ) ∂xl k ∂uk (xk ) ∂xh k = ql qh (3. . They become suﬃcient conditions when utility functions ui (xi ) are diﬀerentiable and quasi-concave. .2 Production Economies 0 be the transformation For simplicity.8) By (3. 2. .9) Thus. . . (3. 2. .

. L. . .FOC: ∂L ∂ui (xi ) ∂T (y) = − λl = 0 l = 1. We ﬁrst deﬁne the competitive equilibrium with transfer payments (also called an equilibrium relative to a price system). 2. 2. n. 2. . . l l ∂xk ∂xk ∂xl i By (3.12) = (3. . .yh n n 1 1 l = 1. a competitive equilibrium is established after transferring some of initial endowments between agents. we have M RSxl . . . that is. The Second Fundamental Theorem of Welfare Economics gives conditions under which a Pareto optimum allocation can be “supported” by a competitive equilibrium if we allow some redistribution of endowments. . . under its assumptions. . that any desired Pareto optimal allocation can be achieved as a market-based equilibrium with transfers. k = L .xh = M RT Syl .11) (3. .14) Thus. . l l ∂xi ∂xi ∂xl i ∂uk (xk ) ∂L ∂T (y) = tk − λl = 0 l = 1. . L. . . L (3. . . .11) ∂ui (xi ) ∂xl i ∂ui (xi ) ∂xh i ∂T (y) ∂y l .12) ∂uk (xk ) ∂xl k ∂uk (xk ) ∂xh k = ∂T (y) ∂y l . i = 1. ∂T (y) ∂y h (3. L.15) which are the necessary condition for the interior solutions to be Pareto eﬃcient.13) By (3.5 The Second Fundamental Theorem of Welfare Economics Now we can assert a converse of the First Fundamental Theorem of Welfare Economics. which means that the M RS of any two goods for all agents equals the M RT S. 2. ∂T (y) h ∂y (3. 3.xh = · · · = M RSxl . It tells us. including essential condition of convexity of preferences and production sets. h = 1. 76 . They become suﬃcient conditions when utility functions ui (xi ) are diﬀerentiable and quasi-concave and the production functions are concave.

J. i 77 . there is a price vector p ≥ 0 such that (x∗ . . p) is a competitive equilibrium with transfer payments. i. Then. Remark 3.e.Deﬁnition 3. Proof: Let P (x∗ ) = {xi ∈ Xi : xi i be the strict upper contour set and let n i x∗ } i (3. (1) if xi ∗ (2) pyj i x∗ .. .5. . {Yj }).5. then pxi > px∗ for i = 1. The following theorem which is called the Second Fundamental Theorem of Welfare Economics shows that every Pareto eﬃcient allocation can be supported by a competitive equilibrium through a redistribution of endowments so that one does not need to seek any alternative economic institution to reach Pareto eﬃcient allocations.1 (The Second Fundamental Theorem of Welfare Economics) Suppose (x∗ . Theorem 3. w + y (feasibility condition). y. . p) ∈ X × Y × R+ is a competitive equilibrium with transfer payment if (i) xi (ii) pyj (iii) x ˆ i xi for all xi ∈ {xi ∈ Xi : pxi pyj for yj ∈ Yj . . . and suppose that Yj are closed and convex. en . .16) P (x ) = i=1 ∗ P (x∗ ). i i pyj for all yj ∈ Yj and j = 1. . n. . .5.1 (Competitive Equilibrium with Transfer Payments) For an econL omy.17) By the convexity of i. i (3. This is one of the most important theorems in modern economics. An equilibrium with transfer payments is deﬁned without reference to the distribution of initial endowment. . . (x. y ∗ . suppose i are continuous. and the theorem is also one of the theorems in microeconomic theory that is hardest to be proved. . y ∗ ) with x∗ > 0 is Pareto optimal. . .1 An equilibrium with transfer payments is diﬀerent from a competitive equilibrium with respect to a budget constrained utility maximization that uses a value calculated from the initial endowment. . convex and strictly monotonic. e = (e1 . we know that P (x∗ ) and thus P (x∗ ) are convex. n. given the total amount. ˆ ˆ pxi } for i = 1.

and thus. 1. y ∗ ). let el = (0. . Thus. Then W ∩ P (x∗ ) = ∅ by Pareto optimality of (x∗ .20) pˆ σ (3. 0) with the l-th component one and other places zero. ˆ Then z = σ + el ∈ P (x∗ ) by strict monotonicity and redistribution of el .18).7: P (x∗ ) is the set of all points strictly above the indiﬀerence curve through x∗ . . . . . . by the Separating Hyperplane Theorem in last chapter. 0. there is a p = 0 such that pˆ z pˆ for all z ∈ P (x∗ ) and σ ∈ W σ ˆ ˆ (3. p(ˆ + el ) σ and thus pel which means pl 0 f or 78 l = 2. . p 0 To see this. (3. . .Figure 3. L. . .18) Now we show that p is a competitive equilibrium price vector by the following four steps. 1. we ˆ ˆ have by (3.19) . 3. Let z = σ + el ˆ ˆ for some σ ∈ W. .21) 0 (3. i i Let W = {w} + ˆ J j=1 Yj which is closed and convex.

18). then λxi i i x∗ for λ suﬃciently close to one by the continuity of i px∗ = pxi so that λ i 1 by preferences for 0 < λ < 1. . suppose by way of contradiction.22) To see this.25) x∗ . .18) and pw = pˆ∗ − pˆ∗ . . By (3. i 79 .24) and thus we have pxi 4. If xi that pxi = px∗ i Since xi i i px∗ i (3. we know λpxi pxi = px∗ > 0. j = 1. . and thus x ∈ P (x∗ ) if θ is suﬃciently small. To show this. If xi i x∗ . Thus. Since x∗ = y ∗ + w by noting (x∗ .23) xk ) = p[(1 − θ)xi + k=i (x∗ + k θ xi )] n−1 n p k=1 x∗ k (3. we have ˆ p(ˆ − y ∗ ) y ˆ 0. we have xi i x∗ i (3. y ∗ ) is a Pareto eﬃcient allocation and preference ˆ ˆ ˆ orderings are strictly monotonic. by the continuity of for all i ∈ N . which contradicts the fact that λ < 1. ∗ pyj pyj ∀yj ∈ Yj . p(ˆ − y ∗ ). i i (3. then i pxi px∗ .26) x∗ . i (3.∗ 2. we have ˆ y x p(ˆ − x∗ ) z ˆ Letting z → x∗ . we have p(xi + k=i i and the strict monotonicity of k. we have from the above equation. J. by pˆ x ˆ ˆ z in (3. let xi = (1 − θ)xi 0 < θ < 1 θ xk = x∗ + xi f or k = i k n−1 Then. y ˆ p(w + y ) ˆ ˆ ∗ Letting yk = yk for k = j. we have pˆ∗ = p(w + y ∗ ). 3. pyj pyj for all yj ∈ Yj . By step 3. we must have pxi > px∗ .

the competitive equilibrium with transfers is the same as a regular competitive equilibrium with wi = x∗ .5. As a corollary.For exchange economies. suppose wi = x∗ . Diﬀerentiation Version of the Second Fundamental Theorem of Welfare Economics for Exchange Economies Proof: If x∗ > 0 is Pareto Optimal.27) We want to show q is a competitive equilibrium price vector. i Remark 3. . Also note that monotonic transformation does not change preferences so that we may be able to transform a quasi-concave utility function to a concave utility function as follows. then the proof of the Second Fundamental Theorem of Welfare Economics can be much simpler. (3. Indeed. for example u(x. i 80 .t. we only need to show that each consumer maximizes his utility s. y) = x 2 y 2 1 1 1 which is concave after monotonic transformation. Then. convex and strictly monotonic. we have i Corollary 3. x∗ is a competitive equilibrium for the initial endowment can be represented by a concave and diﬀerentiable utility function. B(p) = {xi ∈ Xi : pxi by concavity of ui ui (xi ) u(x∗ ) + Dui (x∗ ) (xi − x∗ ) i i i = u(x∗ ) + q(xi − x∗ )/ti i i u(x∗ ) i px∗ ). y) = xywhich is quasi-concave ⇔ u 2 (x. To do so.1 Suppose x∗ > 0 is Pareto optimal.2 If i i are continuous. n. 2. . A suﬃcient condition for concavity is that the Hessian matrix is negative deﬁnite. . then we have Dui (xi ) = q/ti i = 1.5. .

Under a utilitarian rule. . . .2 (The Rawlsian Social Welfare Function) W (·) = min{u1 (x1 ). i i i 3. . un ) = with ai = 1.Figure 3.8: Concave funtion The reason the inequality holds for a concave function is because that. (3.6. . . The Rawlsian form gives prior81 . from Figure 3. we have ui (xi ) u (x∗ ).28) u(x∗ ) + Dui (x∗ ) (xi − x∗ ). Even if we agree with Pareto optimality. we still do not know which one we should be at. The utilitarian form is by far the most common and widely applied social welfare function in economics. ai n t=1 by W (u1 (x1 ).1 (The Utilitarian Social Welfare Function) W (u1 . One way to solve the problem is to assume the existence of a social welfare function. . Deﬁne a social welfare function W : X → assume that W (·) is monotone increasing.6 Pareto Optimality and Social Welfare Maximization Pareto eﬃciency is only concerned with eﬃciency of allocations and has nothing to say about distribution of welfare. So the utility function is not strictly monotonic increasing. social states are ranked according to the linear sum of utilities.6. un (xn )}. . u2 (x2 ). . we have u(x) − u(x∗ ) x − x∗ Thus. un (xn )) where we ai ui (xi ) 0. Example 3. . . Example 3.8. .

.1 Social Welfare Maximization for Exchange Economies We suppose that a society should operate at a point that maximizes social welfare. Then. we have W (u1 (x1 ).6. Proof: If x∗ is not Pareto Optimal. Proposition 3. . Now we state the following proposition that shows every Pareto eﬃcient allocation is a social welfare maximum for the social welfare function with a suitable weighted sum of utilities. un (xn )) subject to n n xi i=1 i=1 wi . diﬀerentiable and strictly monotonic. .6.ity to the interests of the worst oﬀ members. every social welfare maximum is Pareto eﬃcient. we know that every Pareto eﬃcient allocation is a competitive equilibrium allocation by redistributing endowments. Suppose ui is concave.2 Let x∗ > 0 be a Pareto optimal allocation. . . there exists some choice of weights a∗ such i 82 . . Thus. . Thus. the competitive prices really measure the (marginal) social value of a good.6. Proposition 3. then there is another feasible allocation x such that ui (xi ) ui (xi ) for all i and uk (xk ) > uk (xk ) for some k. . we should choose an allocation x∗ such that x∗ solves max W (u1 (x1 ). 3. un (xn )) > W (u1 (xi ). if x∗ maximizes a social welfare function. . Is the converse necessarily true? By the Second Fundamental Theorem of Welfare Economics. . that is. . and it is used in the ethical system proposed by Rawls (1971). . by strict monotonicity of preferences. which are the multipliers for the welfare maximization. Then. This gives us a further implication of competitive prices. then x∗ must be Pareto Optimal. un (xn )) and thus it does not maximizes the social welfare function. How do the allocations that maximize this welfare function compare to Pareto eﬃcient allocations? The following is a trivial consequence if the strict monotonicity assumption is imposed.1 Under strict monotonicity of preferences.

un (un )) (3.t. . . . it is a competitive equilibrium allocation with wi = x∗ by the second theorem of welfare economies. then a∗ = i the welfare function n t=1 a∗ ui (xi ). So we have i Di ui (x∗ ) = λp i by the ﬁrst order condition. 3. . λi (3. .32) The social welfare maximization problem for the production economy is max W (u1 (x1 ).30) max i=1 ai ui (xi ) xi x∗ i s. a∗ = i 1 λi with λi = ∂Vi (p. .2 Welfare Maximization in Production Economy Deﬁne a choice set by the transformation function n T (ˆ) = 0 x with x= ˆ t=1 xi . Now for the welfare maximization problem n (3. x∗ solves the problem if the ﬁrst order condition ai ∂ui (xi ) =q ∂xi i = 1. since ui is concave. .Ii ) ∂Ii where Vi (·) is the indirect utility function of consumer i. . . un ) = i=1 ai ui (xi ) (3. and this measures the marginal social value of goods. Thus.33) 83 . i Thus. . the price is the Lagrangian multiples of the welfare maximization.31) We know x∗ also maximizes is satisﬁed for some q.6. . (3. .29) Furthermore. if we let p = q. where p is a competitive equilibrium price vector. u2 (x2 ). Proof: Since x∗ is Pareto optimal.that x∗ maximizes the welfare functions n W (u1 . n 1 .

. x The ﬁrst order condition is then given by W (·) and thus ∂ui (xi ) ∂T (ˆ) x −λ = 0.34) (3.9: Welfare maximization 3. l ∂xi ∂xl i ∂ui (xi ) ∂xl i ∂ui (xi ) ∂xk i ∂T (ˆ) x ∂x2 ∂T (ˆ) x ∂xl i (3. un (un )) − λT (ˆ). . implication is that what the government should do is to secure the competitive environment in an economy and give 84 . x Deﬁne the Lagrangian function L = W (u1 (x1 ).7 Political Overtones 1. Figure 3.xk = M RT Sxl .37) The conditions characterizing welfare maximization require that the marginal rate of substitution between each pair of commodities must be equal to the marginal rate of transformation between the two commodities for all agents. By the First Fundamental Theorem of Welfare Economics.36) That is. i i (3.subject to T (ˆ) = 0. . M RSxl .xk . .35) = (3.

If these conditions are not satisﬁed. We can adjust initial endowments to obtain a desired competitive equilibrium by the Second Fundamental Theorem of Welfare Economics. The conditions for the existence of a competitive equilibrium are: (i) convexity (diversiﬁcation of consumption and no IRS). no externalities. and (iii) continuity. we may not guarantee that every competitive equilibrium allocation is Pareto eﬃcient. we have market failures. and (iii) continuity. The conditions for the First Fundamental Theorem of Welfare Economics are: (i) local non-satiation (unlimited desirability). stop a rent control. Thus. one should notice conditions such as divisibility. (iv) divisibility. when we reach the above conclusions. if a derived Pareto optimal is not “fair”. no price ﬂoor. In many cases. no increasing returns to scale. This is. lift the tax and the import-export barriers. no regulations. keeping the competitive environments intact. we may not obtain the existence of a competitive equilibrium. (v) perfect competion. (v) complete information etc. we may not guarantee every Pareto eﬃcient allocation can be supported by a competitive equilibrium with transfers. you might do so by adjusting the initial endowment but not disturbing prices. (v) perfect competion.people full economic freedom. 85 . As for a conclusion from the general equilibrium theory. imposing taxes or regulations. perfect competition. (ii) monotonicity (self-interest). (iv) divisibility. one should pay attention to the assumptions which are implicit and/or explicit involved. complete information. 3. (iii) no externalities. you should note that there are conditions on the results. Even if we want to reach a preferred Pareto optimal outcome which may be diﬀerent from a competitive equilibrium from a given endowment. etc. If these conditions are not satisﬁed. (ii) divisibility. So there should be no subsidizing. Of course. If these conditions are not satisﬁed. etc. The conditions for the Second Fundamental Theorem of Welfare Economics are: (i) the convexity of preferences and production sets. (vi) complete information. 2. all the government has to do is to make a lump-sum transfer payments to the poor ﬁrst. before making an economic statement. (iv) perfect competion. as a general notice. no price ceiling. (ii) monotonicity (self-interest). in the sense that either a competitive equilibrium does not exist or a competitive equilibrium may not be Pareto optimal so that the First or Second Fundamental Theorem of Welfare Economics cannot be applied. (vi) complete information.

. Chapters 1-3. we may adopt another economic institution. Only in this case of a market failure. K. Whinston. 1971. 299-303. Inc. Addison-Wesley. Green. H. Microeconomic Theory. Mas-Colell. A. Luenberger. Cambridge: Harvard University Press. D. Chapters 6. G. Arrow.. 1995. J. Advanced Microeconomic Theory.” Econometrica. (San Francisco. New York).” Economics Letters. M. or a Pareto eﬃcient allocation may not be supported by a competitive equilibrium with transfer payments. J. a competitive equilibrium may not exist or may not be Pareto eﬃcient. G.W. Chapters 17-18. “On the Constrained Walrasian and Lindahl Correspondences. General Competitive Analysis.. A. W. Oxford University Press. (Wiley. Chapter 7. 1998.. Reference Arrow. pp. Takayama. A.If these assumptions are relaxed. A Theory of Justice. 1985. 10. H. Debreu. F. K and G. 86 . McGraw-Hill. Cambridge: Cambridge University Press. 1992. and P. Holden Day). Norton and Company. (1971). “Existence of Equilibrium for a Competitive Economy. Microeconomic Theory. 26 (1988). 1954. and Hahn.R.. Jehle. Debreu. We will discuss the market failure and how to solve the market failure problem in Part II and Part III. Tian. Chapters 10. G. Reny. 1995. Varian. the second edition. 22. 16. Third Edition. (1959). Rawls. Mathematical Economics. D. Theory of Value. Microeconomic Analysis. and J.

Chapter 4 Economic Core. and social choice theory. a We have also seen that Pareto optimality may be too weak a criterion to be meaningful. Fairness is a notion to overcome this diﬃculty. It does not address any question about income distribution and equity of allocations. 87 . namely economic core.1 Introduction In this chapter we brieﬂy discuss some topics in the framework of general equilibrium theory. Theory of core is important because it gives an insight into how a competitive equilibrium is achieved as a result of individual strategic behavior instead of results of an auctioneer and the Walrasian tˆtonnement mechanism. This is one way to restrict a set of Pareto optimum. Alternatives may be diﬀerent from Pareto optimal allocations. fair allocations. The question is: Is it possible to construct a rule satisfying several desirable properties? Both “fairness” and “social welfare function” address a question of social justice. In a slightly diﬀerent framework. Fair Allocations. Let us think of a social “rule” to construct the social ordering (social welfare function) from many individual orderings of diﬀerent alternatives. and Social Choice Theory 4. suppose that a society is deciding the social priority among ﬁnite alternatives.

the resulting allocation can only be a competitive equilibrium allocation when the economy becomes large. If a group of people ﬁnd themselves able. 88 . The r-replication of the original economy: There are r times as many agents of each type in the original economy. (2) xi i i∈S xi k i∈S wi . They may ﬁnd themselves frustrated if the rest of the community resorts to violence or force to prevent them from withdrawing. notion of competition that the theory explores is one in which traders are well informed of the economic characteristics of other traders. and thus it is a subset of n agents.2 The Core of Exchange Economies The use of a competitive (market) system is just one way to allocate resources.4. Deﬁnition 4. xi for all i ∈ S and xk xk for some k ∈ S . we consider exchange economies. What if we use some other social institution? Would we still end up with an allocation that was “close” to a competitive equilibrium allocation? The answer will be that. There is some reason to think that the core is a meaningful political concept. if we allow agents to form coalitions. The core is a concept in which every individual and every group agree to accept an allocation instead of moving away from the social coalition.1 (Blocking Coalition) A group of agents S (a coalition) is said to block (improve upon) a given allocation x if there is some allocation x such that (1) it is feasible for S. Informally. Its conceptual apparatus does not appeal to any speciﬁc trading mechanism nor does it assume any particular institutional setup. and in which the members of any group of traders can bind themselves to any mutually advantageous agreement.2. We say two agents are of the same type if they have the same preferences and endowments. A coalition is a group of agents. ie. For simplicity. Such an allocation is called a core allocation and was originally considered by Edgeworth (1881). using their own resources to achieve a better life.. The theory of the core is distinguished by its parsimony. it is not unreasonable to suppose that they will try to enforce this threat against the rest of community.

What is the relationship between core allocations and competitive equilibrium allocations? 89 .3 (Individual Rationality) An allocation x is individually rational if xi i wi for all i = 1.2.2 (Core) A feasible allocation x is said to be in the core of an economy if it cannot be improved upon for any coalition.2.2.2 Every core allocation must be individually rational.2.3 When n = 2.1 Every core allocation is Pareto optimal (coalition by whole people). . Remark 4. . Figure 4.2. Deﬁnition 4. . an allocation is in the core if and only if it is Pareto optimal and individually rational.4 Even though a Pareto optimal allocation is independent of individual endowments. 2. Remark 4.2. The individual rationality condition is also called the participation condition which means that a person will not participate the economic activity if he is worse oﬀ than at the initial endowment.1: The set of core allocations are simply given by the set of Pareto eﬃcient and individually rational allocations when n = 2. Remark 4.Deﬁnition 4. a core allocation depends on individual endowments. n. Remark 4. .

by local non-satiation. The following proposition is a converse of the above proposition and shows that any allocation that is not a market equilibrium allocation must eventually not be in the rcore of the economy.2 (Shrinking Core Theorem) Suppose i are strictly convex. This means that core allocations in large economies look just like Walrasian equilibria. strongly monotonic. then x is a core allocation. there is some replication V such that y is not in the V -core.1) and xi i xi for all i ∈ S. we have pxi for all i ∈ S and pxi pxk > pxk for some k Therefore. Then. Theorem 4. we have pxi > i∈S i∈S pxi = i∈S wi (4. if (x. Then there is a coalition S and a feasible allocation x such that xi i∈S i∈S wi (4.Theorem 4. p) is a competitive equilibrium. Proof: Suppose x is not a core allocation. Suppose x∗ is a unique competitive equilibrium allocation. Therefore. xk k xk for some k ∈ S. Then.1 Under local non-satiation.2.2) a contradiction. if y is not a competitive equilibrium. and continuous. the competitive equilibrium must be a core allocation. 90 .2.

yB )(in which there are V Type A and V − T Type B). Since y is not a competitive equilibrium. A point like y will eventually not be in the core. . x is feasible in the coalition and gA V -core for the V -replication of the economy. Thus. Form a coalition consisting of V consumers of type A and V − T consumers of type B.Figure 4. . . gA . V gA + (V − T )yB = V T T wA + 1 − + (V − T )yB V V = T wA + (V − T )yA + (V − T )yB = T wA + (V − T )(yA + yB ) = T wA + (V − T )(wA + wB ) = V wA + (V − T )wB by noting yA + yB = wA + wB . Proof: We want to show that there is a coalition such that the point y can be improved upon for V -replication. . We want to show x is feasible for this coalition. there are integers V and T with 0 < T < V such yA . by strict convexity and continuity of that gA ≡ T T wA + (1 − )yA V V A i. indiﬀerence curve through y. say agent A’s. 91 A yA for all agents in type A and yB ∼B yB for all agents in type B which means y is not in the . yB . Consider the allocation x = (gA . . The proof is completed. .2: The shrinking core. Then. the line segment through y and w must cut at least one agent’s.

. and does not give any “equity” implication. 92 .2. uniqueness of competitive equilibrium. This is one way to restrict the whole set of Pareto eﬃcient outcomes to a small set of Pareto eﬃcient outcomes that satisfy the other properties. Fairness is a notion that may overcome this diﬃculty. i.3 Fairness of Allocation Pareto eﬃciency gives a criterion of how the goods are allocated eﬃciently.2. From the above discussion. tend to yield allocations that are close to Walrasian equilibria for larger economies. but it may be too weak a criterion to be meaningful. for each i ∈ N . this theorem shows the essential importance of competition and fully economic freedom.e. 4. Remark 4.e. xi i xk for all k ∈ N .3.3. Theorem 4.3 (Limit Theorem on the Core) Under the strict convexity. strict monotonicity and continuity. Thus. This result means that any allocation which is not a competitive equilibrium allocation is not in the core for some r-replication. xk i xi . like that of core.1 (Envy) An agent i is said to envy agent k if agent i prefers agent k’s consumption. and two types of agents. i. we have the following limit theorem.6 Many of the restrictive assumptions in this proposition can be relaxed such as strict monotonicity. Deﬁnition 4. and the core coincides with the competitive equilibrium allocation if the number of agents goes to inﬁnity. convexity.Remark 4. and thus Walrasian equilibria are robust: even very weak equilibrium concepts..2.2 An allocation x is equitable if no one envies anyone else. It does not address any questions about income distribution. the core of a replicated two person economy shrinks when the number of agents for each type increases.5 The shrinking core theorem then shows that the only allocations that are in the core of a large economy are market equilibrium allocations. What is the equitable allocation? How can we deﬁne the notion of equitable allocation? Deﬁnition 4.

fairness restricts the size of Pareto optimal allocations. 93 .3. Deﬁnition 4. Remark 4. a set of fair allocations is a subset of that of Pareto eﬃcient allocations.3.1 By the deﬁnition.3 (Fairness) An allocation x is said to be fair if it is both Pareto optimal and equitable. 1992.3 For a two person exchange economy.Deﬁnition 4. 57: 158-175).3.3: A fair allocation. where xS = ¯ xj . Therefore.4 An allocation x is strictly equitable or strictly envy-free if no one envies any other coalitions. An agent i envies a coalition S (i ∈ S) at an allocation x if xS / ¯ 1 |S| j∈S i xi . it is impossible for two persons to envy each other.3.2 A set of strictly fair allocation S are a subset of Pareto optimal allocations. Figure 4.5 (Strict Fairness) An allocation x is said to be strictly fair if it is both Pareto optimal and strictly equitable. Deﬁnition 4. Remark 4. if x is Pareto optimal. The following strict fairness concept is due to Lin Zhou (JET.3.3. Remark 4.

However. but it is not Pareto eﬃcient.4 It is clear every strictly fair allocation is a fair allocation. but not equitable. An easy way for agent A to compare his own allocation xA with agent B’s allocation xB in the Edgeworth Box is to ﬁnd a point symmetric of xA against th center of the Box.Remark 4. but not Pareto eﬃcient. a fair allocation is a strictly fair allocation. draw a line from xA to the center of the box and extrapolate it to the other side by the same length to ﬁnd 94 . but the converse may not be true.5: x is equitable. That is.3. when n = 2. How to test a fair allocation? Graphical Procedure for Testing Fairness: Let us restrict an economy to a two-person economy. Figure 4. The following ﬁgure shows that x is Pareto eﬃcient.4: x is Pareto eﬃcient. but not equitable. Figure 4. The ﬁgure below shows that x is equitable.

Theorem 4. p∗ w1 = p∗ w2 = . (Note that xA +xB 2 Is it Pareto optimality? If the answer is “yes”. If the answer is “no” for both Figure 4. If the indiﬀerence curve through xA cuts “below” xA . if all individuals’ income is the same. and then make the comparison. . We have given some desirable property of “fair” allocation. i.1 Let (x∗ . Then we have the following way to test whether an allocation is a fair allocation: Step 1: stop. . 95 .6: How to test a fair allocation. Step 2: Construct a reﬂection point (xB . xA ). then x∗ is a strictly fair allocation. is the center of the Edgeworth box.e. xB . it is a fair allocation.3. if no. Under local non-satiation.) Step 3: Compare xB with xA for person A to see if xB B A xA and compare xA with xB for person B to see if xA persons. then A envies B. go to step 2. p∗ ) be a competitive equilibrium.xA . = p∗ wn . A question is whether it exists at all. The following theorem provides one suﬃcient condition to guarantee the existence of fairness..

There is i and a coalition S with i ∈ S such that x∗ ≡ S 1 |S| x∗ k k∈S i x∗ i (4.4) by noting that p∗ w1 = p∗ w2 = . it must be a strictly fair allocation. This “divide-and-choose” recommendation implies that if the center of the box is chosen as the initial endowment point. But this contradicts the fact that i S p ∗ x∗ = S 1 |S| p ∗ x∗ = k k∈S 1 |S| p∗ wk = p∗ wi k∈S (4. Remark 4. xi implies pxi > pxi wi xi Notice that every equal Walrasian allocation x is a competitive equilibrium allocation with wi = w for all i.Proof: By local non-satiation. However.6 An allocation x ∈ exists a price vector such that (1) pxi (2) xi (3) i nL + is an equal income Walrasian allocation if there pw. A political implication of this remark is straightforward. Remark 4. Therefore.3) Then. an equal division of endowment plus competitive markets result in fair allocations. x∗ is Pareto optimal by the First Fundamental Theorem of Welfare Economics.1 Under local non-satiation.3. every equal income Walrasian allocation is strictly fair allocation. = p∗ wn .5 An “equal” division of resource itself does not give “fairness. the competitive equilibrium allocation is fair. . . We only need to show x∗ is strictly equitable. Deﬁnition 4. Corollary 4.6 A competitive equilibrium from an equitable (but not “equal” division) endowment is not necessarily fair. Suppose not. we have p∗ x∗ > p∗ x∗ = p∗ wi . Consumption of equal bundle is not Pareto optimum.” but trading from “equal” position will result in “fair” allocation.3. 96 .3. if preferences are diﬀerent. where w = 1 n n k=1 wk : average endowment.3.

In general. there is some agent i.7 Fair allocation are deﬁned without reference to initial endowment. when the social endowments are divided equally among two persons.3. or more directly into social decisions. However. If x is not equitable. if i are convex. and if the total endowments are equally divided among individuals. Social choice theory aims at constructing such a rule which could be allied with not only Pareto eﬃcient allocations. We will give some fundamental results of 97 . say. such that xB A xA A wA = 1 (wA + wB ) 2 1 = (xA + xB ) 2 1 A 2 (xA by noting that wA = wB and x is feasible. since A + xB ).4 4. initial endowments can be redistributed among agents in a society.” it is diﬃcult to come up with a criterion (or a constitution) that determines that society’s choice. 4. We only need to show that x is equitable. there is no relationship between core and fair allocations. then the set of core allocations is a subset of (strictly) fair allocation. But. Proof: We know that a core allocation x is Pareto optimal. Theorem 4.4. a contradiction.Remark 4. we present a vary brief summary and introduction of social choice theory.2 In a two-person exchange economy. Since x is a core allocation.3. in a “satisfactory” manner (in a manner compatible with the fulﬁlment of a variety of desirable conditions.1 Social Choice Theory Introduction In this section. xA hand. Since we are dealing with optimality concepts. but also any alternative that a society faces. As was shown in the discussion of “fairness. Thus. then x is individually rational (everyone prefers initial endowments). we have the following theorem. xB A xA implies that 1 (xA + xB ) 2 xA . We analyze the extent to which individual preferences can be aggregated into social preferences. agent A. on the other A is convex.

: strict preference orderings of agent i. (X) = the class of allowed individual orderings. Gibbard-Satterthwaite theorem states that no social choice mechanism exists which is non-dictatorial and can never be advantageously manipulated by some agents. Gibbard-Satterthwaite’s social choice function (SCF) is a mapping from individual preference orderings to the alternatives f :[ (X)]n → X (4. S(X) : the class of allowed social orderings.. a social preference ordering may not be transitive..4. z.. P2 . .. To see this. Does this determine a social welfare function? The answer is in general no by the well-known Condorect paradox..2 Basic Settings N = {1. x2 . Pn ) : a preference ordering proﬁle. 2..4. consider the following example. Arrow’s social welfare function: F :[ (X)]n → S(X) (4. . Consider a society with three agents and three alternatives: x. y.social choice theory: Arrow Impossibility Theorem. [ (X)]n : the set of all proﬁles of individuals orderings. which states there does not exist any non-dictatorial social welfare function satisfying a number of “reasonable” assumptions..xm } : (m Pi = (or i) 3): the set of alternatives (outcomes).1 (The Condorect Paradox) Suppose a social choice is determined by the majority voting rule. Suppose each person’s preference is given by x y 1 2 y z 1 2 z (by person 1) x (by person 2) 98 . . Example 4. P = (P1 . X = {x1 .6) Note that even though individuals’ preference orderings are transitive. 4.5) which is a mapping from individual ordering proﬁles to social orderings.n} : the set of individuals.

You may think of a hypothetical case that you are sending a letter of listing your preference orderings. The number of preference proﬁles can increase very rapidly with increase of number of alternatives. Pi . A question we will investigate is what kinds of desirable conditions should be imposed on these social welfare or choice functions. such as reducing deﬁcits. and z must be socially preferred to x. y. 99 . increasing national defence budget. The social welfare function is a mapping from each of these 216 entries (cases) to one particular social ordering (among six possible social orderings of three alternatives). xF y (by social preference) yF z (by social preference) zF x (by social preference) Then. i. pairwise majority voting tells us that x must be socially preferred to y. n = 3 x x y y z z y z x z x y z y z x y x (X)| = 6.4. there are six possible individual orderings. to your Congressional representative. Example 4.z 3 x 3 y (by person 3) By the majority rule. on announced national projects (alternatives)..2 X = {x. y must be socially preferred to z. For x and y. The Congress convenes with a hug stake of letters P and try to come up with national priorities F (P ). | are | (X)|3 = 63 = 216 possible combinations of 3-individual preference orderings on three alternatives. This cyclic pattern means that social preference is not transitive. For y and z. This is a question addressed in social choice theory. and therefore there Thus. expanding the medical program. z}. reducing society security program. You want the Congress to make a certain rule (the Constitution) to form national priorities out of individual preference orderings.e. For x and z. The social choice function is a mapping from each of these 216 cases to one particular choice (among three alternatives).

2 Pareto Principle (P): if for x. Remark 4. Whinston.4. y. The proof of Arrow’s Impossibility Theorem is very complicated.1 IIA means that the ranking between x and y for any agent is equivalent in terms of P and P implies that the social ranking between x and y by F (P ) and F (P ) is the same. By IIA.4. Obviously. Remark 4..3 Suppose x Pi y Pi z and x Pi z Pi y.3 Arrow’s Impossibility Theorem Deﬁnition 4. P. the social order must also the same on x and y.4 (Dictator) There is some agent i ∈ N such that F (P ) = Pi for all P ∈ [Σ(X)]n . Indeed.g. and Green (1995). then xF (P )y (social preferences).4. is to examine each of the assumptions of the theorem to see which might be given up. any change in preference ordering other than the ordering of x and y should not aﬀect social ordering between x and y. Deﬁnition 4.4. The most pessimistic reaction to it is to conclude that there is just no acceptable way to aggregate individual preferences.4. e. UD. UD is usually relaxed.4. then the results could be positive. A more moderate reaction. if two diﬀerent preference proﬁles that are the same on x and y. Arrow’s impossibility result is a disappointment. P. Deﬁnition 4. and the readers who are interested in the proof are referred to Mas-Colell. and agent i is called a dictator. 100 . Conditions imposed on social welfare functions may be too restrictive.4. P ∈ [Σ(X)]n “xPi y if and only if xPi y for all i ∈ N ” implies that xF (P )y if and only if xF (P )y. IIA conditions is dictatorial. ∈ X. The impact of the Arrow possibility theorem has been quite substantial. y ∈ X. Theorem 4.4. however.4. IN other words. when some conditions are relaxed. Deﬁnition 4. and hence no theoretical basis for treating welfare issues.3 Independence of Irrelevant Alternatives (IIA): For x.4. xPi y for all i ∈ N . then xF (P )y.1 Unrestricted Domain (UD): A class of allowed individual orderings (X) consists of all possible orderings deﬁned on X. if xF (P )y.2 By IIA.1 (Arrow’s Impossibilities Theorem) Any social welfare function that satisﬁes m 3. Example 4.

y ∈ X. satisfaction increases as we approach this peak so that. if alternatives have certain characteristics which could be placed in a spectrum. A famous example is a class of “single-peaked” preferences. and total (for distinct x. preferences may show some patterns and may not exhaust all possibilities orderings on X. in particular. i if there is an alternative x ∈ X such that is increasing with respect to ≥ on the lower contour set L(x) = {y ∈ X : y ≤ x} and decreasing with respect to ≥ on the upper contour set U (x) = {y ∈ X : y ≥ x}. transitive (x ≥ y ≥ z implies x ≥ z). we consider the case of restricted domain. the result may be positive. non-dictatorial aggregation is possible.4. In the following.4. For instance. That is. We show that under the assumption of single-peaked preferences. there cannot be any other peak of satisfaction. (1) x ≥ z > y implies z (2) y > z ≥ x implies z i i y y In words. 101 . thus violating (UD). is said to be single-peaked with respect to the linear order ≥ on X. moreover.6 and x i y. but not both).4 Some Positive Result: Restricted Domain When some of the assumptions imposed in Arrow’s impossibility theorem is removed.4.4. either x ≥ y or y ≥ x. Deﬁnition 4. Example: X = Deﬁnition 4. there is an alternative that represents a peak of satisfaction and.5 A binary relation ≥ on X is a linear order if ≥ is reﬂexive (x ≥ x).

. . n ). i is single-peaked.Figure 4.7 Agent h ∈ N is a median agent for the proﬁle ( N : xi ≥ xh } ≥ I 2 1. Let h ∈ N ˜ be a median agent. Deﬁnition 4. . u in the right ﬁgure is not single-peaked.7: u in the left ﬁgure is single-peaked.1 Suppose that ≥ is a linear order on X. . .4. then the majority rule F ( ) is aggregatable: ˜ xh F ( )y∀y ∈ X. let xi be the maximal alternative for i (we will say that xi is “individual i’s peak”). .8: Five Agents who have single-peaked preferences.4. . 2 Figure 4. 102 . . n) if #{i ∈ and #{i ∈ N : xh ≥ xi } ≥ I . Given a proﬁle of preference ( 1. Proposition 4.

That is. . Whinston. 103 .4. Pi+1 . by single-peakness of i with respect to ≥. Pi ) Pi f (P−i . . Theorem 4. .7) Deﬁnition 4. and Green (1995).2 (Gibbard-Satterthwaite Theorem) If X has at least 3 alternatives.4.10 A SCF is dictatorial if there exists an agent whose optimal choice is the social optimal. .4. Take any y ∈ X and suppose that xh > y (the argument is the same for y > xh ). Any alternative having this property is called a Condorect winner. we get xh #S #{i ∈ N : xh y}. Hence. that is. Pi−1 . we have that #S ≥ n/2 and so #{i ∈ N : y n/2 i xh } #(N \ S) 4. In other words. Proof. Pi ) for all P ∈ [Σ(X)]n (4.4. . S = {i ∈ N : xi ≥ xh }.4. Then xi ≥ xh > y for every i ∈ S. . the peak xh of the median agent is socially optimal ( cannot be defeated by any other alternative) by majority voting.9 A SCF is strongly individually incentive compatible (SIIC) if there exists no preference ordering proﬁle at which it is manipulable. the proof of Gibbard-Satterthwaite’s Impossibility Theorem is very complicated. Pi )Pi f (Pi . Pn ). a SCF which is SIIC and UD is dictatorial. Therefore. Consider the set of agents S ⊂ N that have peaks larger than or equal to xh . a Condorect winner exists whenever the preferences of all agents are single-peaked with respect to the same linear order. the truth telling is a dominant strategy equilibrium: f (P−i . i y for every i ∈ S. Pi ) where P−i = (P1 .8) (4. and the readers who are interested in the proof are referred to Mas-Colell. On the other hand.5 Gibbard-Satterthwaite Impossibility Theorem Deﬁnition 4. We need to show that #{i ∈ N : xh i y} ≥ #{i ∈ N : y i xh }.8 A social choice function (SCF) is manipulable at P ∈ [Σ(X)]n if there exists Pi ∈ Σ(X) such that f (P−i . . Again. Deﬁnition 4. . because agent i h is a median agent.

1995. 587-601.. “Strictly Fair Allocations in Large Exchange Economies. Cambridge: Harvard University Press.” International Economic Review.W. J. G... 26 (1988). Chapters 7-8. “Existence of Equilibrium for a Competitive Economy. 10 (1975). pp. Zhou. L. F. Microeconomic Theory. “Manipulation of Voting Schemes. Addison-Wesley. New York). Chapters 21.R. Mas-Colell. Luenberger. Debreu. Reny.. Green. W. and Hahn. Oxford University Press.” Econometrica. Chapter 10. (1971). Advanced Microeconomic Theory.. Debreu. A. A Theory of Justice. A. 1959. and J. Varian. 158-175 104 . Microeconomic Analysis.. Whinston.. K. “Strategy-Proofness and Arrow’s Existence and Correspondences for Voting Procedures and Social Welfare Functions. Scarf. McGraw-Hill. 1998. H. G.Reference Arrow. H. Debreu. Gibbard. and P. General Competitive Analysis. 235-246. Theory of Value. “A Limit Theorem on the Core of an Economy. (Wiley. Rawls. Third Edition. “On the Constrained Walrasian and Lindahl Correspondences. Chapters 18. Microeconomic Theory. and H. 1995. G. 1954. Arrow. A. Norton and Company.” Journal of Economic Theory. (San Francisco. 22. Tian. Jehle. 41 (1973). D. K and G.” Journal of Economic Theory.. 57 (1992). A. 187-217. J.” Economics Letters. Holden Day). 1971. 1992. Satterthwaite. M. 299-303. M. Inc. G. D..” Econometrica. 4 (1963).

Part II Externalities and Public Goods 105 .

It turns out that private markets are often not a very good mechanism in the presence of externalities and public goods. The ﬁrst welfare theorem provides a set of conditions under which we can be assured that a market economy will achieve a Pareto optimal. In the current part. The second welfare theorem goes even further. and will study a number of ways in which actual markets may depart from this perfectly competitive ideal and where. The concept of Pareto optimality oﬀers a minimal and uncontroversial test that any social optimal economic outcome should pass since it is a formulation of the idea that there is further improvement in society. market equilibria fail to be Pareto optimal. as a result. any ineﬃciency that arise in a market economy. the actions of one agent directly aﬀect the utility or production of other agents in the economy. The remainder of this course. a situation known market failure. In particular.” Thus. It states that under the same set of conditions as the ﬁrst welfare theorem plus convexity and continuity conditions. we have introduced the notions of competitive equilibrium and Pareto optimality. respectively. must be traceable to a violation of at least one of these assumptions of the ﬁrst welfare theorem. can be viewed as a development of this theme. in an important sense. In both cases. all Pareto optimal outcomes can in principle be implemented through the market mechanism by appropriately redistributing wealth and then “letting the market work. We will consider situations of incomplete information 106 . The concept of competitive equilibrium provides us with an appropriate notion of market equilibrium for competitive market economies. and hence any role for Paretoimproving market intervention. it is. We will see these nonmarketed “goods” or “bads” lead to a non-Pareto optimal outcome in general. The important results and insights we obtained in these chapters are the First and Second Fundamental Theorems of Welfare Economics. we will study externalities and public goods in Chapter 5 and Chapter 6. the general equilibrium theory establishes the perfectly competitive case as a benchmark for thinking about outcomes in market economies.In Chapters 2 and 3. the formal expression of Adam Smith’s claim about the “invisible hand” of the market. thus a market failure. in a sense. respectively. and it conveniently separates the issue of economic eﬃciency from more controversial (and political) questions regarding the ideal distribution of well-being across individuals.

which also result in non-Pareto optimal outcomes in general in Part III. 107 .

Production Externality: A ﬁrm’s production includes arguments other than its own inputs.1 (i) One person’s quiet environment is disturbed by another person’s local stereo.Chapter 5 Externalities 5. A envies Mr. (ii) Mr.1. D smoking next to him. xn ) : with preference externality in which other individuals’s consumption enters the person’s utility function. The reason is that there are things that people care about are not priced. and thus there is a market failure.. C’s consumption level increases. A’s satisfaction decreases as Mr. Consumption Externality: ui (xi ) : without preference externality ui (x1 . because Mr. . (ii) Mr. A hates Mr... 108 . Example 5. C’s lifestyle. Externality can happen in both cases of consumption and production.1 Introduction In this chapter we deal with the case of externalities so that a market equilibrium may lead to non-Pareto eﬃcient allocations in general.

downstream ﬁshing is adversely aﬀected by pollutants emitted from an upstream chemical plant. We show this by examining that the ﬁrst order conditions for a competitive equilibrium is not in general the same as the ﬁrst order conditions for Pareto eﬃcient allocations in the presence of consumption externalities. This leads to an examination of various suggestions for alternative ways to allocate resources that may lead to eﬃcient outcomes. xB . xB . Consider the following simple two-person and two-good exchange economy.1) px py and the ﬁrst order conditions for Pareto eﬃciency are given by: A B M RSxy = M RSxy .For example. regulation.2) (5. etc. Achieving an eﬃcient allocation in the presence of externalities essentially involves making sure that agents face the correct prices for their actions. The main purpose of this section is to show that a competitive equilibrium allocation is not in general Pareto eﬃcient when there exists an externality in consumption. yB ) (5. 5.3) 109 . every competitive equilibrium implies Pareto eﬃciency if utility functions are quasiconcave. agent i’s utility function is a function of only his own consumption: ui (xi ) In this case. the ﬁrst order conditions for the competitive equilibrium are given by A B M RSxy = M RSxy = (5.2 Consumption Externalities When there are no consumption externalities. yA ) uB (xA . merges. uA (xA . So. property rights. Ways of solving externality problem include taxation.

yB ) + λ(wx − xA − xB ) + µ(wy − yA − yB ) (5.y) aA uA (xA .7) ˆ ˆ The ﬁrst order conditions for interior solutions are: xA : xB : yA : yB : ∂uA ∂xA ∂uB aA ∂xA ∂uA aA ∂yA ∂uB aB ∂xB aA + aB ∂uB −λ=0 ∂xA ∂uB + aB −λ=0 ∂xB (5. yB ) x A + xB = w x ˆ yA + yB = wy ˆ (5.9) (5.9). we have ∂uA ∂xA ∂uA ∂yA ∂uA ∂xB ∂uA ∂yA + + ∂uB ∂xA ∂uB ∂yB ∂uB ∂xB ∂uB ∂yB = = λ µ λ µ ∂uB ∂xB ∂uB ∂yB (5.which are assumed to be strictly increasing.5) (5. and satisﬁes the Inada condition ∂u (0) ∂xi = +∞ and limxi →0 ∂u x ∂xi i = 0 so it results in interior solutions. A A B B M RSxA yA − M RSxB yA = M RSxB yB − M RSxA yB .11) into (5. The ﬁrst order conditions for the competitive equilibrium are the same as before: A M RSxy = px B = M RSxy .11) −µ=0 −µ=0 Substituting (5. we now solve the following problem max (x.12) (5. Deﬁne L = aA uA (xA .6) s.t.4) (5.10) (5.8) and (5.8) (5.10) and (5. (5. Here good x results in consumption externalities. yA ) + aB uB (xA . yB ) + aB uB (xA .14) That is. xB . xB . py To ﬁnd the ﬁrst order conditions for Pareto eﬃcient allocations. xB .13) and thus ∂uA ∂xA ∂uA ∂yA + ∂uB ∂xA ∂uB ∂yB = ∂uA ∂xB ∂uA ∂yA + (5. quasi-concave. xB .15) 110 .

Firm 1 produces an output x which will be sold in a competitive market.y (5.20) 111 . Let cx (x) and cy (y) be the cost functions of ﬁrms 1 and 2 which are both convex and strictly increasing.18) and (5.3 Production Externality We now show that allocation of resources may not be eﬃcient also for the case of externality in production. which is assumed to be convex and strictly increasing. However.A which is diﬀerent from the ﬁrst order conditions for competitive equilibrium: M RSxB yA = B M RSxB yB . So the competitive equilibrium allocations may not be Pareto optimal because the ﬁrst order conditions’ for competitive equilibrium and Pareto optimality are not the same. The proﬁts of the two ﬁrms: π1 = px x − cx (x) π2 = py y − cy (y) − e(x) (5. Then.17) where px and py are the prices of x and y. consider a simple economy with two ﬁrms.19) However. by the ﬁrst order conditions.18) (5.16) (5. The ﬁrst ﬁrm only takes account of the private cost – the cost that is imposed on itself– but it ignores the social cost – the private cost plus the cost it imposes on the other ﬁrm. π1 + π2 is not maximized at xc and yc which satisfy (5. which is sold in competitive market. What’s the social eﬃcient output? The social proﬁt. the proﬁt maximizing output xc from the ﬁrst order condition is too large from a social point of view. 5. we have for positive amounts of outputs: px = cx (x) py = cy (y) (5. production of x imposes an externality cost denoted by e(x) to ﬁrm 2. To show this.19). Let y be the output produced by ﬁrm 2. If the two ﬁrms merged so as to internalize the externality max px x + py y − cx (x) − e(x) − cy (y) x. respectively.

Thus.1: The eﬃcient output x∗ is less than the competitive output xc .which gives the ﬁrst order conditions: px = cx (x∗ ) + e (x∗ ) py = cy (y ∗ ) where x∗ is an eﬃcient amount of output.4 Solutions to Externalities From the above discussion. Pigovian taxes 2. Figure 5. production of x∗ is less than the competitive output in the externality case by the convexity of e(x) and cx (x). it is characterized by price being equal to the social cost. Voluntary negotiation (Coase Approach) 3. we now introduce some remedies to this market failure of externality such as: 1. and one needs to seek some other alternative mechanisms to solve the market failure problem. In this section. we know that a competitive market in general may not result in Pareto eﬃcient outcome. Compensatory tax/subsidy 112 . 5.

3. Creating a missing markets with property rights 5. π1 = px · x − cx (x) − t · x The ﬁrst order condition is: px = cx (x) + t = cx (x) + e (x∗ ). such that t = e (x∗ ).21) which is the same as the one for social optimality.1 Pigovian Tax Set a tax rate.4. The recipients of the externality is identiﬁable. 5. The cost of preventing (by diﬀerent methods) an externality are perfectly known to everyone. (5. But. The cost of voluntary negotiation is negligible. and a correction tax t = e (x∗ ) should be imposed that will lead to a social optimal outcome that is less that of competitive equilibrium outcome. This tax rate to ﬁrm 1 would internalize the externality. Most of the above proposed solutions need to make the following assumptions: 1.22) (5. it is important to know what kind of information are required to implement a solution listed above. The source and degree of the externality is identiﬁable. how does the authority know the externality and how do they 113 . Merges 7. 6. Such correction taxes are called Pigovian taxes. The causal relationship of the externality can be established objectively. Incentives mechanism design Any of the above solution may result in Pareto eﬃcient outcomes. but may lead to diﬀerent income distributions. The problem with this solution is that it requires that the taxing authority knows the externality cost e(x). Also. 5. t. 2. Direct intervention 6. when ﬁrm 1 faces the wrong price of its action. The cost of implementing taxes and subsides is negligible. 4.4. That is.

Nobel laureate Ronald Coase in a famous article in 1960 argues that government should simply rearrange property rights with appropriately designed property rights. the ﬁsh cannot be eaten. So.4. The ﬁsherman is willing to buy a ﬁlter for the factory. assume that: The cost of the ﬁlter is denoted by cf . The ﬁsherman will pay for the ﬁlter so that the chemical cannot pollute the lake. Market then could take care of externalities without direct government intervention. i) cf < $50. then it will yield an eﬃcient output. Remark 5. the government should give the ownership of the lake either to the chemical ﬁrm or to the ﬁsherman.2 Coase Voluntary Negotiation Coase made an observation that in the presence of externalities. 000 – The chemical is discharged into the lake. it might as well just tell the ﬁrm how much to produce in the ﬁrst place. The ﬁsherman does not want to install any ﬁlter. That is. ii) cf > $50. 5. How does one solve the externality? Coase’s method states that as long as the property rights of the river are clearly assigned.4. the victim has an incentive to pay the ﬁrm to stop the production if the victim can compensate the ﬁrm by paying px − cx (x∗ ). 114 .estimate the value of externality in real world? If the authority knows this information. it will not work well.4. Suppose the river can produce a value of $50. Property Rights Responses To solve the externality problem. in most case. 000.1 Both the Pigovian tax solution and the Coase voluntary negotiation is equivalent in the sense that it achieves Pareto eﬃcient allocation. it results in eﬃcient outcomes. But.1 Two ﬁrms: One is chemical factory that discharges chemicals into a river and the other is the ﬁsherman. they are diﬀerent in resulting the income distribution. Example 5.000. If the chemicals pollute the river. To see this. Case 1: The lake is given to the factory.

000 – The factory buys the ﬁlter so that the chemical cannot pollute the lake. the two parties will agree to move to a slightly lower pollution level. let b(y) be the beneﬁt that the polluter draws from a level of pollutant production y and c(y) the cost thus imposed on the pollutee. in general. Therefore. no matter how the property rights are assigned.000 to the ﬁsherman then the chemical is discharged into the lake.Case 2: The lake is given to the ﬁsherman. 1995. ii) cf > $50. Then the polluter and the pollutee have an interest in negotiating. pp. it is possible to lower the pollution level against a well-chosen transfer from pollutee to polluter. Let be a small positive number. are not negligible. When b is concave and c increasing and convex. The reasoning does not stop here: so long as b (yo ) < c (y0 ). since t < c (y0 ). Suppose that the status quo y0 corresponds to a situation where b (y0 ) < c (y0 ). a privatization is optimal only in case of zero transaction cost and no income eﬀect. Since t > b (y0 ). The problem of this Coase theorem is that. Thus. this oﬀer raises the polluter’s proﬁt. More generally. and it is equally beneﬁcial for the pollutee. 115 . In fact. costs of negotiation and organization. and thus the pollution level is too high. i) cf < $50. the resulting outcomes are eﬃcient. even when the transition cost is zero.4.1 (Coase Theorem) When the transaction cost is negligible and there is no income eﬀect. A very similar argument applies in the case where b (y0 ) > c (y0 ). and the income eﬀect may not be zero. 000 – The ﬁrm pays $50. the optimal pollution level is given b (y ∗ ) = c (y ∗ ). and the ﬁrm’s net product revenue is grater than cf . The end result is the optimal pollution level. and assume that the polluter proposes to lower the pollution level to (y0 − ) against a payment of t . absence of income eﬀects is not only suﬃcient (which is well known) but also necessary for Coase Theorem to be true. 49-74) has proved that. where t is comprised between b (y0 ) and c (y0 ). The formal statement of Coase Theorem thus can be set forth as follows: Theorem 5. Hurwicz (Japan and the World Economy 7.

x1 = the units of pollution that ﬁrm 1 wants to sell.4.4 The Compensation Mechanism The Pigovian taxes were not adequate in general to solve externalities due to the information problem: the tax authority cannot know the cost imposed by the externality.will provide a mechanism for eﬃcient allocations.23) 5. we have 1 2 px = c1 (x∗ ) + e (x∗ ) which results in a social optimal outcome. At the market equilibrium. The proﬁt maximization problems become: π1 = px x1 + rx1 − c1 (x1 ) π2 = py y − rx2 − e2 (x2 ) − cy (y) The ﬁrst order conditions are: px + r = c1 (x1 ) for Firm 1 py = cy (y) for Firm 2 −r = e (x2 ) for Firm 2. a missing market is a market for pollution. x∗ = x∗ = x∗ . Let r be the price of pollution.5.” For the above example in Pigovian taxes. How can one solve this incomplete information problem? 116 . (5.or for a reduction of pollution . Adding a market for ﬁrm 2 to express its demand for pollution . ﬁrm 1 can decide how much pollution it wants to sell. and ﬁrm 2 can decide how much pollution it wants to buy. x2 = the units of pollution for ﬁrm 2 wants to buy. By adding this market.4. Normalize the output of ﬁrm 1 to x1 .3 Missing Market We can regard externality as a lack of a market for an “externality.

Here.. by the convexity of cx . The mechanism has two stages: Stage 1: (Announcement stage): Firms 1 and 2 name Pigovian tax rates. we may use the subgame perfect equilibrium. ﬁrm 1 must pay t2 x to ﬁrm 2.24) Firm 2 will choose y to satisfy py = cy (y). Stage 2: (Choice stage): If ﬁrm 1 produces x units of pollution.26) 117 . 2. an equilibrium in which each ﬁrm takes into account the repercussions of its ﬁrst-stage choice on the outcomes in the second stage. ﬁrm 1 will choose x(t2 ) to satisfy the ﬁrst order condition: px − cx (x) − t2 = 0 Note that. ti .. and t2 is interpreted as a Pigovian tax proposed by ﬁrm 2 and y2 is the proposed level of output by ﬁrm 2. which may or may not be the eﬃcient level of such a tax rate. For Firm 1. cx (x) > 0.Varian (AER 1994) proposed an incentive mechanism which encourages the ﬁrms to correctly reveal the costs they impose on the other. the payoﬀs of two ﬁrms are: ∗ π1 = max px x − cx (x) − t2 x − (t1 − t2 )2 x y ∗ π2 = max py y − cy (y) + t1 x − e(x) − (t1 − t2 )2 .e. if they announce diﬀerent tax rates. In brief. Thus. We will introduce in detail the mechanism design theory in Part III. Stage 1: Each ﬁrm will choose the tax rate t1 and t2 to maximize their payoﬀs. Because this is a two-stage game. Thus. max px x − cx (x) − t2 x(t2 ) − (t1 − t2 )2 t1 (5. Firm 2 receives t1 x units as compensation. we discuss this mechanism.25) (5. where t1 is interpreted as a Pigovian tax proposed by ﬁrm 1 and x1 is the proposed level of output by ﬁrm 1. each ﬁrm takes the tax rate as given. As usual. cx (x) (5. we solve this game by looking at stage 2 ﬁrst. a mechanism consists of a message space and an outcome function (rules of game). we have x (t2 ) = − 1 < 0. Each ﬁrm pays a penalty. i = 1.e. i. At stage 2. x1 )}. i. Strategy Space (Message Space): M = M1 × M2 with M1 = {(t1 . (t1 − t2 )2 .

if ﬁrm 2 thinks ﬁrm 1 will propose a small t1 .30) (5. max py y − cy (y) + t1 x(t2 ) − e(x(t2 )) − (t1 − t2 )2 t2 (5. 1 2 (5. into (??) we have px = cx (x∗ ) + e (x∗ ) which is the condition for social eﬃciency of production.4. t∗ = e (x(t∗ )). the individual’s objective is diﬀerent from the social goal. Remark 5.31) .25). Firm 1 always has an incentive to match the announcement of ﬁrm 2.(5.27) (5.27) and (5. On the other hand.28) so that the ﬁrst order condition is t1 x (t2 ) − e (x(t2 ))x (t2 ) + 2(t1 − t2 ) = 0 and thus [t1 − e (x(t2 ))]x (t2 ) + 2(t1 − t2 ) = 0.which gives us the ﬁrst order condition: 2(t1 − t2 ) = 0 so the optimal solution is t∗ = t2 . Thus. However.29) Substituting the equilibrium tax rate. he wants ﬁrm 1 to be taxed as little as possible so that ﬁrm 1 will produce as much as possible. By (5.29).2 This mechanism works by setting opposing incentives for two agents. In general. it wants ﬁrm 1 to be taxed as much as possible. But consider ﬁrm 2’s incentive. If ﬁrm 2 thinks that ﬁrm 1 will propose a large compensation rate t1 for him. 1 For Firm 2. we have t∗ = e (x(t∗ )) with t∗ = t∗ = t∗ . the only point where ﬁrm 2 is indiﬀerent about the level of production of ﬁrm 1 is where ﬁrm 2 is exactly compensated for the cost of the externality. we may be able to construct an appropriated mechanism so that the individual’s proﬁt maximizing 118 (5.

D.. Salanie. Whinston. McGraw-Hill.. Chapter 6. S. Tian. Callen. Hurwicz. 3 (1960). MIT Press. Reference Aivazian.. Tian (2003a) also gave the solution to the consumption externalities by giving the incentive mechanism that results in Pareto eﬃcient allocations.. “What is the Coase Theorem. 1988. 119 . “Property Rights and the Nature of Chinese Collective Enterprises. Microeconomic Theory. by James and Buchanan and Bettina Monissen. A. Tian. MIT Press. 1 44. 24 (1981). Microeconomics of Market Failures. “A Close Look to the Coase Theorem.” in The Economists’ Vision: Essays in Modern Economic Perspectives. 2000.-J. eds. Frankfur/Mmain: Campus Verlag.” Japan and the World Economy. 175-181. Luenberger. and J. J. “A Theory of Ownership Arrangements and Smooth Transition To A Free Market Economy. Fundamentals of Public Economics. A study of Public Finance. M. J. 1928. Cambridge. L. A. 7 (1995). G. Coase. 1998. 1995. 131-162.” Journal of Institutional and Theoretical Economics. Green. L. Microeconomic. “The Coase Theorem and the Empty Core. 49-74.goal is consistent with the social goal such as eﬃcient allocations. “The Problem of Social Cost.” Journal of Law and Economics. Oxford University Press. 157 (2001).. 1995. and J.. B. 247-268. V.. G. New York: Macmillan. R. D. Inc. Chapter 11. Chapter 9. Mas-Colell.. Chipman.” Journal of Law and Economics. 28 (2000). Laﬀont. Pigou. Tian (2003b) study the informational eﬃciency problem of the mechanisms that results in Pareto eﬃcient allocations for consumption externalities.” Journal of Comparative Economics. A.

W. 1 (2001). in press. 2003.” International Economic Review. Chapters 24. Microeconomic Analysis. in press. G.W.. Third Edition.) Tian.380-412.. 1992. Varian. 120 . H.” American Economic Review. 2004. 1278 1293. Varian. G. “A Solution to the Problem of Externalities when Agents Are Well Informed. (The Chinese version published in China Economic Quarterly. 84 (1994). 45-70.. “A Unique Informationally Eﬃcient Allocation Mechanism in Economies with Consumption Externalities. Tian. “A Solution to the Problem of Consumption Externalities.R.” Journal of Mathematical Economics. Norton and Company.

private goods. and public goods. highway system. A good is non-rival if one person’s consumption does not reduce the amount available to other consumers. ﬁre protection. public parks. and a public project. A pure public good is a good in which consuming one unit of the good by an individual in no way prevents others from consuming the same unit of the good.Chapter 6 Public Goods 6. Let 121 . ﬂood-control project. Examples of Public Goods: street lights. 6. Thus. it turns out that a private market is not a very good mechanism for allocating public goods. policemen. producers. A good is excludable if people can be excluded from consuming it. Local Public Goods: when there is a location restriction for the service of a public good. the good is nonexcludable and non-rival.2 Notations and Basic Settings In a general setting of public goods economy that includes consumers. national defence. public television and radio broadcast. Even if the competitive market is an eﬃcient social institution for allocating private goods in an eﬃcient manner.1 Introduction A public good is a special case of externalities.

but they can be produced from private goods by a ﬁrm. For simplicity. i .1) and y = f (v) e = (e1 . Zi ⊆ Z⊆ xi ∈ y∈ wi ∈ L + nL + L +: K +: L +: × × K +: K +: the consumption space of consumer i..n: the number of consumers. f ): a public goods economy. y) for all consumers i (xk . a consumption of private goods by consumer i. f: L + → K + : production function with y = f (x). y) for some k. An allocation (x. θi ): ei = (Zi . y) is feasible if n n xi + v i=1 i=1 wi (6. y ) and (xk . it is assumed that there is no public goods endowment. assume there is only one ﬁrm to produce the public goods.. y) ∈ Z: an allocation. y ) k i (6. consumption space. θi : the proﬁt share of consumer i from the production. the initial endowment of private goods for consumer i.. y) = (xi . the characteristic of consumer i. K: the number of public goods. a consumption/production of public goods. . For simplicity.. (x.2) (xi . en . y ) such that (xi . . i (or ui if exists) is a preference ordering. xn . v∈ L +: the private goods input. wi . 122 .. An allocation z ≡ (x. L: the number of private goods. y) is Pareto eﬃcient for a public goods economy e if it is feasible and there is no other feasible allocation (x .. (xi . y) ∈ Zi .

1 For the public goods economies. 0. Proof: The proof is by way of an example. 0.5 is weakly Pareto eﬃcient but not Pareto eﬃcient because z = (x . u1 (x1 . constant returns in producing y from x (the input-output coeﬃcient normalized to one). and ui (xi . K) = (3.2. consider a public good economy with n consumers and two goods: one private good and one public good. y ) consumers i. Proposition 6. 1). and the following endowments and utility functions: w1 = w2 = w3 = 1. 1988). y) is strictly monotonic increasing and continuous. L. 3) Pareto-dominates z by consumers 2 and 3. The following proposition is due to Tian (Economics Letters. a weakly Pareto eﬃcient allocation may not be Pareto eﬃcient for the public goods economies. y ) such that (xi .5. even though under the assumptions of continuity and strict monotonicity.3 6. 3.1 Unlike private goods economies. a weakly Pareto eﬃcient allocation may not be Pareto eﬃcient even if preferences satisfy strict monotonicity and continuity. 1. they are equivalent.3. y) with x = (0. However. y ) = (0. y) = x1 + y. 0) and y = 2.An allocation (x. so that xi + gi = wi n gi = v i=1 Assume ui (xi . Then z = (x. Consider an economy with (n. The proof is left to readers. 123 . Remark 6. y) = xi + 2y for i = 2.2. 0. i (xi . Let gi be the contribution made by consumer i. y) for all 6. y) is weakly Pareto eﬃcient for the public goods economy e if it is feasible and there is no other feasible allocation (x . under an additional condition of strict convexity.1 Discrete Public Goods Eﬃcient Provision of Public Goods For simplicity.

6) ri > i=1 i=1 gi c (6. .3.1 Providing the public good Pareto dominates not producing the good if and only if n i=1 ri > n i=1 gi c.e.5) (6. 1) > ui (wi . 1) = ui (wi . 1) for all i By monotonicity of ui . the sum of the willingness-to-pay for the public good must excess the cost of providing it. i.. 6. This condition is necessary. . ri must satisfy ui (wi − ri .7) That is.Let c be the cost of producing the public project so that the production technology is given by 1 y= 0 if n i=1 gi c otherwise . Proposition 6. . 1) > ui (wi . i.e. gn ) such that ui (wi − gi . In fact. In summary.3) n i=1 gi c and If producing the public project Pareto dominates not producing the public project. we have ri > gi and thus n n (6.. 0) ∀i. 0). we have ui (wi − gi . 0) = ui (wi − ri . we have the following proposition. . this condition is also suﬃcient. We ﬁrst want to know under what conditions providing the public good will be Pareto dominate to not producing it.2 Free-Rider Problem How eﬀective is a private market at providing public goods? The answer as shown below is that we cannot expect that purely independent decision will necessarily result in an 124 . we have wi − gi > wi − ri Then.4) for i (6. (6.3. Let ri be the maximum willingness-to-pay (reservation price) of consumer i. there exists (g1 .

This is the prisoner’s dilemma. doesn’t buy). Voting does not result in eﬃcient provision. but wants to free-ride on the other consumer.3. it is given by 100 . Thus. 2 c = 150 (total cost) 150/2 = 75 if both agents make contributions gi = 150 if only agent i makes contribution Each person decides independently whether or not to buy the public good. To see this.eﬃcient amount of the public good being produced. As a result. voluntary contribution in general does not result in the eﬃcient level of the public good. r3 = 30 125 . r2 = 30.3.3 Voting for a Discrete Public Good The amount of a public good is often determined by a voting. 0) Note that net payoﬀs are deﬁned by ri − gi .1 c = 99 r1 = 90. Example 6.150/2 = 25 when both consumers are willing to produce the public project. no body wants to share the cost of producing the public project. the public good is not provided at all even thought it would be eﬃcient to do so. each one has an incentive to be a free-rider on the other as shown the following payoﬀ matrix. Consider the following example. suppose ri = 100 i = 1. Will this generally results in an eﬃcient provision? The answer is no. As a result. Thus. 100) (0. -50) doesn’t buy (-50. 6. 25) (100. but the other person does not. buy buy doesn’t buy (25. and 100-150 = -50 when only one person wants to buy. Thus. The dominant strategy equilibrium in this game is (doesn’t buy.

the set of interior Pareto optimal allocations are characterized by the ﬁrst order condition: ∂L = 0: ∂xi ∂L = 0: ∂v ∂L = 0: ∂y 126 ai ∂ui =λ ∂xi (6. y) n s.11) µf (v) = λ n ai i=1 ∂ui = µ. the public good will not be provided so that we have ineﬃcient provision of the public good. y) + λ i=1 wi − i=1 xi − v + µ(f (v) − y). However. whereas the eﬃcient condition requires a comparison of willingness-to-pay.8) When ui is strictly quasi-concave and diﬀerentiable and f (v) is concave and diﬀerentiable.Clearly. and therefore. (6. So the eﬃcient provision of the public good should be yes.t.10) (6.4 6. 6.1 Continuous Public Goods Eﬃcient Provision of Public Goods Again. and y = f (v). i=1 xi + v i=1 wi y Deﬁne the Lagrangian function: n n f (v) n L= i=1 ai ui (xi . The problem with the majority rule is that it only measures the net beneﬁt for the public good. only consumer 1 votes “yes” since she receives a positive net beneﬁt if the good is provided.9) (6. The welfare maximization approach shows that Pareto eﬃcient allocations can be characterized by n max (x.4. ∂y . r1 + r2 + r3 > c. for simplicity. under the majority rule. gi = 99/3 = 33.y) n i=1 ai ui (xi . The 2nd and 3rd persons vote “no” to produce public good. we assume there is only one public good and one private good that may be regarded as money.

y) = xi + ui (y) the Lindahl-Samuelson condition becomes n (6.13) Thus. the marginal willingness-to-pay for a public good depends on the amount of private goods consumption. In conclusion. f (v) (6. 127 .1 ui = ai ln y + ln xi y = v the Lindahl-Samuelson condition is ∂ui ∂y ∂ui i=1 ∂xi n (6.16) which implies the level of the public good is not uniquely determined.11).12) Substituting (6.15) and thus ai y 1 i=1 xi n n = i=1 a i xi =1⇒ y a i xi = y (6. in general.4. Thus.18) and thus y is uniquely determined.12) into (6. we obtain the well-known Lindahl-Samuelson condition.9) and (6.17) ui (y) = i=1 1 ≡ c (y) f (v) (6. in the case of quasi-linear utility functions. and therefor. the conditions for Pareto eﬃciency are given by n M RS i = M RT S i=1 yv yxi n xi + v i=1 wi y = f (v) Example 6.14) =1 (6.By (6. However. ui (xi .10) ai f (v) = ∂ui µ ∂x i (6. the eﬃcient level of y depends on xi . ∂ui ∂y ∂ui i=1 ∂xi n = 1 .

we apply diﬀerent prices of a public good to diﬀerent consumers. with public goods.20) which implies the level of the public good is uniquely determined. The idea of the Lindahl solution is that the consumption level of a public goods is the same to all consumers. if we tried the competitive solution with a public good and two consumers. e.4. Suppose we devise a mechanism to allocate the production cost of a public good between consumers. the utility maximization would equalize the MRS and the relative price.4. In private-goods-only economies.Example 6. 6. any competitive equilibrium is Pareto optimal. However.2 ui = ai ln y + xi y = v the Lindahl-Samuelson condition is ∂ui ∂y ∂ui i=1 ∂xi n =1 (6. A B M RSyx = M RSyx = py . 128 . Each person is signed a speciﬁc “personalized price” for the public good. The Lindahl solution is a way to mimic the competitive solution in the presence of public goods. then we can achieve the Samuelson-Lindahl condition.19) and thus n i=1 ai = y n i=1 ai =1⇒ y ai = y (6. Lindahl suggested to use a tax method to provide a public good. px This is an immediate violation to the Samuelson-Lindahl optimal condition.2 Lindahl Equilibrium We have given the conditions for Pareto eﬃciency in the presence of public goods. but the price of the public good is personalized among consumers in the way that the price ratio of two goods for each person being equal the marginal rates of substitutions of two goods. a competitive mechanism does not help.g. The next problem is how to achieve a Pareto eﬃcient allocation in a decentralized way. To this end. For instance..

the maximum proﬁt is zero at the Lindahl equilibrium. qi . qn ) a Lindahl equilibrium. . (ii) (xi . consider a public goods economy e with xi ∈ R+ (private goods) and K y ∈ R+ (public goods). For simplicity. Let q = n i=1 qi : the market price vector of y. q1 . . . Remark 6. . We may regard a Walrasian equilibrium as a special case of a Lindahl equilibrium when there are no public goods. There exists another feasible allocation (xi . The ﬁrst part is the simple. p∗ .1 Because of CRS. i (x∗ . y ∗ ) for some j. y ∗ ) with the price system (p∗ . y) such that (xi . . and further under local non-satiation. such that ∗ (i) p∗ x∗ + qi y ∗ i pwi . y ∗ ) implies p∗ xi + qi y > p∗ x∗ + qi y ∗ .L To see this. we assume the CRS for y = f (v).4. y) i j we have p∗ wi for all i = 1. 2.4. Proof: We only prove the second part. . L Let p ∈ R+ be the price vector of private goods. . y) (x∗ . one for each individual i. qn ) is weakly Pareto eﬃcient. Similarly. y ∗ ) for all i and (xj . y ∗ ) ∈ R+ is a Lindahl L equilibrium allocation if it is feasible and there exists a price vector p∗ ∈ K+ and person∗ K alized price vectors qi ∈ R+ . The proﬁt is deﬁned as π = qy − pv with y = f (v).21) K Let qi ∈ R+ be the personalized price vector of consumer i for consuming the public goods. .4. y) i ∗ ∗ (x∗ . A feasible allocation n n xi + v i=1 i=1 wi (6. n for some j.1 (Lindahl Equilibrium) An allocation (x∗ . 129 ∗ p∗ xj + qj y > p∗ wj . i i (iii) q ∗ y ∗ − p∗ v ∗ = 0. . Suppose not. . it is Pareto eﬃcient. Then.1 : Every Lindahl allocation (x∗ . nL+K Deﬁnition 6. ∗ ∗ Theorem 6. y ∗ . . . i where v ∗ = n t=1 wi − n i=1 x∗ and i n ∗ t=1 qi = q∗. by local-non-satiation of j ∗ p∗ xi + qi y i. ∗ ∗ We call (x∗ . we have the following First Fundamental Theorem of Welfare Economics for public goods economies.

p ∗ i=1 ∗ ∗ (xi − wi ) + v > 0 which contradicts the fact that (x. y ∗ ) implies xi + qi y > wi i =q In fact. we can have the ﬁrst order condition: ∂ui ∂y ∂ui ∂y = qi 1 (6. y) is feasible. If (x∗ . .Thus n n n p xi + i=1 i=1 n ∗ qi y > i=1 n p∗ wi (6. 130 . ∗ wi ) and there exists qi . . y ∗ ) is an interior Lindahl equilibrium allocation. from the utility maximization. y ∗ ) is feasible (i. the feasibility condition is automatically satisﬁed when the budget constraints (i) is satisﬁed. An allocation (x∗ . the deﬁnition q of Lindahl equilibrium becomes much simpler. y ∗ ) is a Lindahl Allocation if (x∗ . For a public economy with one private good and one public good y = 1 v.. . n such that n i=1 x∗ +qy ∗ i (i) x∗ + qi y ∗ i (ii) (xi .e. y) (iii) n i=1 qi i wi (x∗ . i=1 which is the necessary condition for Pareto eﬃciency. i = 1. .22) So p or p∗ ∗ xi + q y > i=1 n i=1 n ∗ p∗ wi xi + pv > i=1 i=1 ∗ ∗ n p∗ wi by noting that q y − p v ∗ ∗ q y − p v = 0.23) which means the Lindahl-Samuelson condition holds: n M RSyxi = q. Hence.

25) (6. we have qi = − αi )wi q (1 − αi )wi = y∗ q(1 − αi )wi . we have y∗ = and thus. But because of the free-rider problem. After that.24) (6.26) n (1 − αi )wi . n i=1 (1 − αi )wi (6. we have by (6. 6.25) qi y ∗ = (1 − αi )wi . . we must know the preferences or MRS of each consumer. yn = y ∗ at the equilibrium. n i=1 (1 Then. y) can be determined from the Lindahl-Samuelson condition or the Lindahl solution.27) If we want to ﬁnd a Lindahl equilibrium. a naive method is that we could ask each individual to reveal his 131 .3 Free-Rider Problem When the MRS is known. The demand functions for xi and yi of each i are given by xi = αi wi (1 − αi )wi yi = qi Since y1 = y2 = . a Pareto eﬃcient allocation (x. by (6.4. we have qy ∗ = i=1 f or 0 < αi < 1 (6.Example 6.3 ui (xi . Of course. the contribution of each consumer is given by gi = wi − xi . y) = xαi y (1−αi ) i 1 y = v q The budget constraint is: xi + q i y = w i . . Making summation.4. However.26). it is very diﬃcult for consumers to report their preferences truthfully. the society is hard to know the information about MRS.

φi )n i=1 where Gi = [0. each person wants to be a free-rider and thus is not willing to tell the true MRS. g−i ) ∗ φi (gi . This causes the major diﬃculty in the public economies. gn ) is a Nash i=1 Equilibrium if ∗ ∗ φi (gi . and thus determine the willingness-to-pay.. y) subject to gi ∈ (0. To see this.28) y = f (gi + j=i gj ).. . g ∗ is a dominant strategy equilibrium if ∗ φi (gi . .. From this problem. since each consumer is self-interested. g−i ) = ui [(wi − gi ). Γ = (Gi ...4.. but from the personal interest.. g−i ) for all gi ∈ Gi and all i = 1. f (gi + j=i gi )] (6. they have “incentives to cheat. However.2 For the game.29) ∗ ∗ Deﬁnition 6.. they will have incentives to report a smaller M RS so that they can pay less. each consumer i takes others’ strategies g−i as given. the strategy g ∗ = (g1 . and consume the public good (free riders). each person solves the following problem: max ui (xi . when the consumers are asked to report their utility functions or MRSs.. × Gn → R is the payoﬀ function of i which is deﬁned by n φi (gi .preferences. 2. wi ] is the strategy space of consumer i and φi : G1 × G2 × . φi )n .. notice that the social goal is to reach Pareto eﬃcient allocations for the public goods economy. g−i ) φi (gi . If consumers realize that shares of the contribution for producing public goods (or the personalized prices) depend on their answers. That is.” That is. 132 . . we can form a non-cooperative game: Γ = (Gi . and maximizes his payoﬀs. n. 2. wi ) xi + gi = wi n (6. g−i ) for all g ∈ G and all i = 1.

MIT Press. 133 . a dominant strategy equilibrium is clearly a Nash equilibrium. Only for a very special payoﬀ functions. Econometrica 38 (1970). ∂ui ∂y ∂ui ∂xi n (6. Nash equilibrium allocations are in general not consistent with Pareto eﬃcient allocations. Chapter 2. but the converse may not be true. ∂gi Thus. Therefore. Cambridge. How can one solve this free-ride problem? We will answer this question in the mechanism design theory. J. 1988. there is a dominant strategy while a Nash equilibrium exists for a continuous and quasi-concave payoﬀ functions that are deﬁned on a compact set.-J. Thus. each consumer chooses his best strategy while dominant strategy means that the strategy chosen by each consumer is best regardless of others’ strategies. “Lindahl’s Solution and the Core of an Economy with Public Goods. we have ∂φi ∂ui ∂ui ∗ = (−1) + f (gi + ∂gi ∂xi ∂y So.. Laﬀont. and thus i M RSyxi = M RT Syv . Fundamentals of Public Economics. D. if ui and f are diﬀerentiable. For Nash equilibrium. .30) gj ) = 0 j=i = 1 ∗ f (gi + j=i gj ) . .Remark 6. the Nash equilibrium in general does not result in Pareto eﬃcient allocations. which does not satisfy the Lindahl-Samuelson condition. .2 Note that the diﬀerence between Nash equilibrium (NE) and dominant strategy is that at NE. n.. given best strategy of others. then an interior solution g must satisfy the ﬁrst order condition: ∂φi (g ∗ ) = 0 for all i = 1. Reference Foley. 66 72. . The above equation implies that the low level of public good is produced rather than the Pareto eﬃcient level of the public good. Thus.4.

A.” Journal of Economics Theory 5 (1972). 241 255. 84 (1994). Games and Economic Behavior 7 (1994). Whinston. “Ratio-Lindahl and Ratio Equilibria with Many Goods. 23 42. W. Chapter 5. G.Lindahl. “Theory of Value with Public Goods: a Survey Article. 1958]. 1995. edited by R. Microeconomic Theory. A study of Public Finance. Chapter 9. Roberts. E. Salanie. Mas-Colell.R. Microeconomic Analysis. C. 134 . Microeconomic. D. “The Core and the Lindahl Equilibrium of an Economy with a Public Good. A.. Varian. H.. J. Pigou.” Economics Letters 26 (1988). J. Luenberger. Muench. Tian. Milleron. 2000. Chapter 11. 1928.” American Economic Review. Lund: Gleerup. Musgrave and A. T. Varian. MIT Press. Journal of Economics Theory 4 (1972). D. London: Macmillan. Li. Green. “Die Gerechitgleit der Besteuring. A. B. T.[English tranlastion: Just Taxation – a Positive Solution: In Classics in the Theory of Public Finance. “On the Constrained Walrasian and Lindahl Correspondences. New York: Macmillan. Journal of Public Economics 3 (1974).. 1992..W. Norton and Company. Tian. and J. 1278 1293. “The Lindahl Solution for Economies with Public Goods. “A Solution to the Problem of Externalities when Agents Are Well Informed. Chapters 23. Microeconomics of Market Failures.. and Q. 419 477.. 441 460. M. Oxford University Press. 299 303. D. Inc. G. Third Edition.. 1995. Peacock. McGraw-Hill..

and Mechanism Design 135 .Part III Incentives. Information.

Within the capitalist/private-ownership economics literature. to invest. The incentives structure and information structure are thus two basic features of any economic system. To many economists. etc. and Rothschild and Stiglitz (1976) showed in various ways that asymmetric information was posing a much greater challenge and could not be satisfactorily imbedded in a proper generalization of the Arrow-Debreu theory. and which have a low cost of operation and other desirable properties. one seeks mechanisms which will implement some desirable outcomes (especially those which result in Pareto-eﬃcient and individually rational allocations) for a given class of environments without destroying participants’ incentives. increasing return to scale. economics is to a large extent a matter of incentives: incentives to work hard. The controversy was provoked by von Mises’s skepticism as to even a theoretical feasibility of rational allocation under socialism. The reverse question was stimulated by two major lines in the history of economics. a stimulus arose from studies focusing upon the failure of the competitive market to function as a mechanism for implementing eﬃcient allocations in many nonclassical economic environments such as the presence of externalities. etc. The question was then reversed in the economics literature: instead of regarding mechanisms as given and seeking the class of environments for which they work. Hurwicz (1972). In a sense. A second stimulus arose from the socialist/state-ownership economics literature. 136 . The major project of understanding how prices are formed in competitive markets can proceed without worrying about incentives. and if so – for what categories of economic environments. public goods. imperfect competition. Spence (1974). to study. In a perfectly competitive market. to produce good quality products. economics was mostly concerned with understanding the theory of value in large economies. A central question asked in general equilibrium theory was whether a certain mechanism (especially the competitive mechanism) generated Pareto-eﬃcient allocations. as evidenced in the “socialist controversy” — the debate between Mises-Hayek and LangeLerner in twenties and thirties of the last century.The notion of incentives is a basic and key concept in modern economics. The study of these two features is attributed to these two major lines. At the beginning of the seventies. the theorists went back to basics. to save. works by Akerlof (1970). the pressure of competitive markets solves the problem of incentives for consumers and producers. incomplete information. Until about 30 year ago.

the case of moral hazard or hidden action. Chapters 7 and 8 consider the principal-agent model where the principal delegates an action to a single agent with private information. This problem is the essence of incentive questions. incentives became the central focus of their analysis. and managers. We will discover that. either in agricultural or managerial economics. these informational problems prevent society from achieving the ﬁrst-best allocation of resources that could be possible in a world where all information would be common knowledge.culminating in the theory of mechanism design. All economic mechanisms and systems (including those known and unknown. state-ownership. We will brieﬂy present the incentive theory in three chapters. with proﬁt maximization. Thus. The theory of economic mechanism design which was originated by Hurwicz is very general. in general. by treating the ﬁrm as a black box the theory remains silent on how the owners of ﬁrms succeed in aligning the objectives of its various members. At the micro level. Indeed. This private information can be of two types: either the agent can take an action unobserved by the principal. The additional costs that must be incurred because of the strategic behavior of privately informed economic agents can be viewed as one category of the transaction costs. Before. supervisors. and what is the optimal way 137 . the development of the theory of incentives has also been a major advance in economics in the last thirty years. the case of adverse selection or hidden knowledge. or the agent has some private knowledge about his cost or valuation that is ignored by the principal. economists have been rather successful during the last thirty years in modelling and analyzing these types of costs and providing a good understanding of the limits set by these on the allocation of resources. and mixed-ownership systems) can be studied with this theory. This line of research also provides a whole set of insights on how to begin to take into account agents’ responses to the incentives provided by institutions. delegation of a task to an agent who has diﬀerent objectives than the principal who delegates this task is problematic when information about the agent is imperfect. When economists began to look more carefully at the ﬁrm. private-ownership. conﬂicting objectives and decentralized information are the two basic ingredients of incentive theory. such as workers. Incentive theory considers when this private information is a problem for the principal. Although they do not exhaust all possible transaction costs.

for the principal to cope with it. which describes the strategic interaction between agents under complete or incomplete information. 138 . We will characterize the allocative distortions that the principal ﬁnds desirable to implement in order to mitigate the impact of informational constraints. This simple focus will turn out to be enough to highlight the various trade-oﬀs between allocative eﬃciency and distribution of information rents arising under incomplete information. The design of the principal’s optimal contract can be regarded as a simple optimization problem. Asymmetric information may not only aﬀect the relationship between the principal and each of his agents. The mere existence of informational constraints may generally prevent the principal from achieving allocative eﬃciency. Moreover. Chapter 9 will consider situations with one principal and many agents. those organizational contexts require a solution concept of equilibrium. maintaining the hypothesis that agents adopt an individualistic behavior. but it may also plague the relationships between agents.

A client delegates his defense to an attorney who will be the only one to know the diﬃculty of the case.1 Introduction Incentive problems arise when a principal wants to delegate a task to an agent with private information. An investor delegates the management of his portfolio to a broker. An insurance company provides insurance to agents who privately know how good a driver they are. 4.Chapter 7 Principal-Agent Model: Hidden Information 7. A stockholder delegates the ﬁrm’s day-to-day decisions to a manager. The landlord delegates the cultivation of his land to a tenant. who will be the only one to know the business conditions. Eexample 1. who will be the only one to observe the exact local weather conditions. 5. the precise technology used. we will say that there is adverse selection. The Department of Defense procures a good from the military industry without 139 . The exact opportunity cost of this task. 6. 3. who will privately know the prospects of the possible investments. and how good the matching is between the agent’s intrinsic ability and this technology are all examples of pieces of information that may become private knowledge of the agent. In such cases. 2.

and Information) Consider a consumer or a ﬁrm (the principal) who wants to delegate to an agent the production of q units of a good. but it is common ¯ knowledge that the ﬁxed cost is F and the marginal cost belongs to the set Φ = {θ. 7. The common aspect of all those contracting settings is that the information gap between the principal and the agent has some fundamental implications for the design of the contract they sign. the agent is bounded by the terms of the contract. In general. The production cost of the agent is unobservable to the principal. The main objective of this chapter is to characterize the optimal rent extractioneﬃciency trade-oﬀ faced by the principal when designing his contractual oﬀer to the agent under the set of incentive feasible constraints: incentive and participation constraints. A regulatory agency contracts for service with a Public Utility without having complete information about its technology.knowing its exact cost structure. The main lessons of this optimization is that the optimal second-best contract calls for a distortion in the volume of trade away from the ﬁrst-best and for giving up some strictly positive information rents to the most eﬃcient agents. 7. the principal trades oﬀ his desire to reach allocative eﬃciency against the costly information rent given up to the agent to induce information revelation. S < 0 and S(0) = 0. The value for the principal of these q units is S(q) where S > 0. At the optimal second-best contract.2 7.2. Implicit here is the idea that there exists a legal framework for this contractual relationship. Preferences. The contract can be enforced by a benevolent court of law. incentive constraints are binding at the optimum. θ}.1 The Basic Model Economic Environment (Technology. In order to reach an eﬃcient use of economic resources. ¯ The agent can be either eﬃcient (θ) or ineﬃcient (θ) with respective probabilities ν and 140 . showing that adverse selection clearly impedes the eﬃciency of trade. some information rent must be given up to the privately informed agent.

2. with probability 1 − ν (7. 7. t) : q ∈ +. That is. there is already asymmetric information between the contracting parties when the principal makes his oﬀer. θ) = θq + F or ¯ ¯ C(q.2. he has the cost function C(q. t ∈ } (7. Let A be the set of feasible allocations that is given by A = {(q. θ) = θq + F ¯ Denote by ∆θ = θ − θ > 0. we will maintain the timing deﬁned in the ﬁgure below.2) with probability ν (7.1) 7.3) These variables are both observable and veriﬁable by a third party such as a benevolent court of law. 141 . Figure 7. where A denotes the agent and P the principal.1: Timing of contracting under hidden information.3 Timing Unless explicitly stated.2 Contracting Variables: Outcomes The contracting variables are the quantity produced q and the transfer t received by the agent. Note that contracts are oﬀered at the interim stage.1 − ν.

e. i.5) (7. ¯ 7.. the principal must oﬀer the agent a utility level that is at least as high as the utility level that the agent obtains outside the relationship. since the principal’s marginal value of output is decreasing.6) ∗ As the ﬁxed cost F plays no role other than justifying the existence of a single agent. it is set to zero from now on in order to simplify notations. and W = S(¯∗ ) − θ¯∗ − F . we have the following ﬁrst-order conditions S (q ∗ ) = θ and ¯ S (¯∗ ) = θ.1 First-Best Production Levels To get a reference system for comparison. q ∗ > q ∗ . the following condition must be satisﬁed ¯q ¯ W ∗ = S(¯∗ ) − θ¯∗ − F q 0. i. the optimal production of an eﬃcient agent is greater than that of an ineﬃcient agent. q (7. Hence. (7. is greater than when he is ineﬃcient.. W ∗ .3.7. Note that. are q q non-negative. For trade to be always carried out. 142 . Since S(q ∗ ) − θq ∗ S(q ∗ ) − θ¯∗ q ¯q S(¯∗ ) − θ¯∗ q ∗ ¯ by deﬁnition of θ and θ > θ. it is thus enough that production be socially valuable for the least eﬃcient type. the social value of production when the agent is eﬃcient. let us ﬁrst suppose that there is no asymmetry of information between the principal and the agent.e.3.2 Implementation of the First-Best For a successful delegation of the task. The eﬃcient production levels are obtained by equating the principal’s marginal value and the agent’s marginal cost.4) The complete information eﬃcient production levels q ∗ and q ∗ should be both carried out if their social values. namely W . respectively W ∗ = S(q ∗ ) − θq ∗ − F.3 The Complete Information Optimal Contract(Benchmark Case) 7.

7) (7. t∗ ) for the production level q ∗ (resp. q ∗ ) if θ = θ and (t∗ .8) To implement the ﬁrst-best production levels.We refer to these constraints as the agent’s participation constraints. If we normalize to zero the agent’s outside opportunity utility level (sometimes called his quo utility level). ¯ whatever his type. q ∗ ) with t∗ = θ¯∗ (resp. 143 . 0. Figure 7.t∗ = θq ∗ ). q ∗ ) if θ = θ. the principal oﬀers the transfer ¯q ¯ ¯ t∗ (resp. θ). Thus. (7.2: Indiﬀerence curves of both types. under complete information delegation is costless for the principal. The complete ¯ ¯ ¯ information optimal contracts are thus (t∗ . who achieves the same utility level that he would get if he was carrying out the task himself (with the same cost function as the agent). the agent accepts the oﬀer and makes zero proﬁt. the principal can make the following ¯ take-it-or-leave-it oﬀers to the agent: If θ = θ (resp. these participation constraints are written as t − θq ¯ ¯q t − θ¯ 0. Importantly.

the iso-utility curves for diﬀerent types cross only once as shown in the above ﬁgure.3 by the pair of points (A∗ . B ∗ ).3 A Graphical Representation of the Complete Information Optimal Contract Figure 7.3: First best contracts. ¯ Since θ > θ. V ∗ = W ∗ ) under complete information.3. the principal ¯ reaches a higher proﬁt when dealing with the eﬃcient type. The complete information optimal contract is ﬁnally represented Figure 7. θ−) type.7. 144 . ¯ V ∗ ) the principal’s level of utility when he faces the θ− (resp. we have V ∗ = W ∗ (resp. We denote by V ∗ (resp. Because the ¯ principal’s has all the bargaining power in designing the contract. This important property is called the single-crossing or Spence-Mirrlees property. Note that since the iso-utility curves of the principal correspond to increasing levels of utility when one moves in the southeast direction.

9) Furthermore. q ∗ )} is not incentive compatible.12) express additional constraints imposed on the allocation of resources by asymmetric information between the principal and the agent. q ∗ )} hoping that an ¯ ¯ ¯ agent with type θ will select (t∗ .3 above. (t. 0. ¯¯ Deﬁnition 7. The eﬃcient type have incentives to mimic the ineﬃcient one and selects also contract B ∗ .12).4. From Figure 7. Oﬀering the menu (A∗ . we see that B ∗ is preferred to A∗ by both types of agents.7.9) through (7. (t∗ .1 Incentive Feasible Contracts Incentive Compatibility and Participation Suppose now that the marginal cost θ is the agent’s private information and let us consider ¯ ¯ the case where the principal oﬀers the menu of contracts {(t∗ . We will thus say that the menu of contracts {(t∗ . q).9) through (7. The inequalities (7. q ∗ ) and an agent with θ will select instead (t∗ .2 A menu of contracts is incentive feasible if it satisﬁes both incentive and participation constraints (7. q) by agent θ.4 7.4. q ∗ ). q ∗ ).11) (7. q ) by agent θ and (t. q )} is incentive compatible when (t. Mathematically. these requirements amount to the fact that the allocations must satisfy the following incentive compatibility constraints: t − θq and ¯ ¯q t − θ¯ ¯ t − θq (7.1 A menu of contracts {(t. The complete information optimal contracts can no longer be implemented under ¯ ¯ asymmetric information.10) ¯ t − θ¯ q (7. q ) is weakly preferred to (t. q) ¯ ¯¯ ¯¯ is weakly preferred to (t.12) Deﬁnition 7. B ∗ ) fails to have the agents self-selecting properly within this menu. (t∗ . for a menu to be accepted.4. 145 . q ∗ ). it must satisfy the following two participation constraints: t − θq ¯ ¯q t − θ¯ 0. (7.

13) The incentive constraint of the bad type reduces to 0 ¯ ts − θq s . ¯ (7. Moreover. under complete information. (7.15) an implementability condition that is necessary and suﬃcient for implementability.9) and (7. Then. q s ) is only accepted by the eﬃcient type. these quantities must generally satisfy a monotonicity constraint which does not exist under complete information.5 Information Rents To understand the structure of the optimal contract it is useful to introduce the concept of information rent.4. Their respective ¯ utility levels U ∗ and U ∗ at the ﬁrst-best satisfy U ∗ = t∗ − θq ∗ = 0 (7.4. the principal is able to maintain all types of agents at their zero status quo utility level. 7.16) 146 .e.11) both reduce to ts − θq s 0. i.7.15) We will call condition (7. when t = ¯ t = tp .2 Special Cases Bunching or Pooling Contracts: A ﬁrst special case of incentive feasible menu of contracts is obtained when the contracts targeted for each type coincide.0) and the nonzero contract (ts .10). We know from previous discussion. q = q = q p and both types of agent accept this contract.9) and (7.3 Monotonicity Constraints Incentive compatibility constraints reduce the set of feasible allocations.14) 7. Adding (7. (7.. we immediately have q q. ¯ Shutdown of the Least Eﬃcient Type: Another particular case occurs when one of the contracts is the null contract (0. (7.

¯). With this change of variables. at least when the principal wants both types of agents to be active. the principal’s objective function can then be rewritten as ¯q ¯ ν(S(q) − θq) + (1 − ν)(S(¯) − θ¯) − (νU + (1 − ν)U ) . ¯ ¯ ¯q We use the notations U = t − θq and U = t − θ¯ to denote the respective information rent of each type. q > 0. and the focus on outputs allows us to analyze its impact on allocative eﬃciency and the overall gains from trade. we can replace transfers in the principal’s objective function as functions of information rents and outputs ¯ ¯ so that the new optimization variables are now {(U . ¯ the principal must give up a positive rent to a θ-agent. The high-eﬃcient agent would get ¯ ¯ t − θ¯ = t − θ¯ + ∆θ¯ = U + ∆θ¯. 7. as long as the principal insists on a positive output for the ineﬃcient type.6 The Optimization Program of the Principal According to the timing of the contractual game. (7.(t. q ¯ ¯q q q (7.and ¯q ¯ ¯ U ∗ = t∗ − θ¯∗ = 0. the principal’s problem writes as ¯q {(t.17) Generally this will not be possible anymore under incomplete information. This information rent is generated by the informational advantage of the agent over the principal. Then. ¯ ¯ ¯q Using the deﬁnition of the information rents U = t − θq and U = t − θ¯. Thus an allocation corresponds to a volume of trade and a distribution of the gains from trade between the principal and the agent. (t. q)} of incentive feasible contracts and consider the utility ¯ level that a θ-agent would get by mimicking a θ-agent. ¯¯ Take any menu {(t.9) to (7. the principal must oﬀer a menu of contracts before knowing which type of agent he is facing.12). q 147 (7. q).19) . The focus on information rents enables us to assess the distributive impact of asymmetric information.18) Thus. q ). q )}.q)} max ¯ ν(S(q) − t) + (1 − ν)(S(¯) − t) q subject to (7. (U .

becomes respectively U ¯ U ¯ U + ∆θ¯. The incentive constraints (7.7 7. the binding ones at the optimum or the principal’s problem..20) to (7.e.9) and (7.7.The ﬁrst term denotes expected allocative eﬃciency. meaning second-best.¯)} subject to (7. (7. q U − ∆θq.21) The participation constraints (7. and the second term denotes expected information rent which implies that the principal is ready to accept some distortions away from eﬃciency in order to decrease the agent’s information rent.(U . We index the solution to this problem with a superscript SB.22) (7.e.q). Let us ﬁrst consider contracts without shutdown.23) The principal wishes to solve problem (P ) below: max ¯q ¯ ν(S(q) − θq) + (1 − ν)(S(¯) − θ¯) − (νU + (1 − ν)U ) q ¯ q {(U .1 The Rent Extraction-Eﬃciency Trade-Oﬀ The Optimal Contract Under Asymmetric Information The major technical diﬃculty of problem (P ) is to determine which of the many constraints imposed by incentive compatibility and participation are the relevant ones. 148 .21) also seems irrelevant because the diﬃculty comes from a θ-agent willing to claim that he is ineﬃcient rather than the reverse. such that q > 0. This is true ¯ when the so-called Inada condition S (0) = +∞ is satisﬁed and limq→0 S (q)q = 0. Indeed.20) (7. i.22) is always strictly-satisﬁed.22). i. (7. (7. written in terms of information rents and outputs. 7.12) become respectively U ¯ U 0.23). Note that the θ-agent’s participation constraint (7. 0. (7.20) immediately imply (7..10).23) and (7.11) and (7.

e. q q {(q. 0 ∆θ¯SB − ∆θq SB . but the eﬃcient type θ gets information rent that he could obtain by mimicking the ineﬃcient type θ. The ﬁrst order conditions are then given by S (q SB ) = θ and ¯ (1 − ν)(S (¯SB ) − θ) = ν∆θ. (7. asymmetric information alters the principal’s optimization simply by the subtraction of the expected rent that has to be given up to the eﬃcient type.24) and (7. (7. Proposition 7.27) expresses the important trade-oﬀ between eﬃciency and rent extraction which arises under asymmetric information.This simpliﬁcation in the number of relevant constraints leaves us with only two re¯ maining constraints. i.20) and the θ-agent’s participation constraint (7. the θ-agent’s incentive constraint (7. ¯ ¯ In summary.27) or q SB = q ∗ .25) into the principal’s objective function.. q (7. we have the following proposition. This rent depends only on the level of production requested from this ineﬃcient type.23).¯)} q Compared with the full information setting.24) Substituting (7.7. it is necessary to check that the omitted incentive constraint of an ineﬃcient agent is satisﬁed.25) (7. This latter inequality follows from the q monotonicity of the second-best schedule of outputs since we have q SB = q ∗ > q ∗ > q SB . the optimal menu of contracts entails: 149 . we obtain a reduced program (P ) with outputs as the only choice variables: ¯q max ν(S(q) − θq) + (1 − ν)(S(¯) − θ¯) − (ν∆θ¯). The ineﬃcient type gets no rent.26) (7. and both constraints must be binding at the optimum of the principal’s problem (P ): U = ∆θ¯ q and ¯ U = 0.1 Under asymmetric information. To validate our approach based on the sole consideration of the eﬃcient type’s incentive constraint.

Starting from the complete information optimal contract (A∗ . q (7.7.(1) No output distortion for the eﬃcient type test in respect to the ﬁrst-best.29) (3) The second-best transfers are respectively given by tSB = θq ∗ + ∆θ¯SB and q ¯q ¯ tSB = θ¯SB . 7. we can construct an incentive compatible contract (B ∗ . q SB < q ∗ ¯ ¯ with ¯ S (¯SB ) = θ + q ν ∆θ. A downward output distortion for the ineﬃcient type.4: Rent needed to implement the ﬁrst best outputs.28) (2) Only the eﬃcient type gets a positive information rent given by U SB = ∆θ¯SB . 1−ν (7. q SB = q ∗ .2 A Graphical Representation of the Second-Best Outcome Figure 7. C) with the same 150 . B ∗ ) that is not incentive compatible.

B SB coincides with 0 and ASB with A∗ in the ﬁgure above.7. 151 .26) and (7. No rent is given up to the θ-ﬁrm by the unique non-null contract (t∗ .production levels by giving a higher transfer to the agent producing q ∗ as shown in the ﬁgure above. C) becomes an incentivecompatible menu of contracts.agent’s indiﬀerence curve passing through B ∗ .28) has no positive solution. 7. q This contract is not optimal by the ﬁrst order conditions (7. The beneﬁt of such a policy is that no rent is given up to the eﬃcient type. The contract C is on the θ. Figure 7. The optimal trade-oﬀ ﬁnally occurs at (ASB . The rent that is given up to the θ-ﬁrm is now ∆θ¯∗ . q SB should be set at zero. Hence. B SB ) as shown in the ﬁgure below.3 Shutdown Policy If the ﬁrst-order condition in (7. ¯ We are in the special case of a contract with shutdown. the θ-agent is now indiﬀerent between B ∗ and C.5: Optimal second-best contract S SB and B SB . (B ∗ .27). q ∗ ) oﬀered and selected only by agent θ.

1 The shutdown policy is dependent on the status quo utility levels. 152 . for ν large enough. just set U0 = F ). the status quo utility level is U0 > 0. 7. Indeed. The allocation obtained above is Pareto optimal in the set of incentive feasible allocations or incentive Pareto optimal. a major source of allocative ineﬃciency is the existence of asymmetric information between trading partners. The allocation of resources within the ﬁrm remains constrained optimal once informational constraints are fully taken into account. Even though asymmetric information generates allocative ineﬃciencies. a major conclusion of the above analysis is that.Remark 7. the ﬁrm does not maximize the social value of trade. the point is that allocative eﬃciency is only one part of the principal’s objective. q (7. This lack of allocative eﬃciency should not be considered as a failure in the rational use of resources within the ﬁrm.7.30) Thus. Suppose that. because of asymmetric information. a maintained assumption of most economic theory. shutdown occurs even if the Inada condition S (0) = +∞ is satisﬁed. from the principal’s objective function. for both types. those eﬃciencies do not call for any public policy motivated by reasons of pure eﬃciency. or more precisely its proﬁt. Among the many origins of these costs. Then. Williamson stresses informational impact as an important source of ineﬃciency. Even in a world with a costless enforcement of contracts.8 The Theory of the Firm Under Asymmetric Information When the delegation of task occurs within the ﬁrm. Indeed. Note that this case also occurs when the agent has a strictly positive ﬁxed cost F > 0 (to see that. any benevolent policymaker in charge of correcting these ineﬃciencies would face the same informational constraints as the principal. we have ν ∆θ¯SB + U0 q 1−ν ¯q S(¯SB ) − θ¯SB . Williamson (1975) has advanced the view that various transaction costs may impede the achievement of economic transactions.

the ﬁrst-best rules can be interpreted as price equal to marginal cost since consumers on the market will equate their marginal utility of consumption to price.1 A direct revelation mechanism is a mapping g(·) from Θ to A which writes as g(θ) = (q(θ). Deﬁnition 7.31) Price is higher than marginal cost in order to decrease the quantity q produced by the ¯ ineﬃcient ﬁrm and reduce the eﬃcient ﬁrm’s information rent.10.10. one for each possible type.. we get the expression of the price p(θ) for the ineﬃcient types output ¯ ¯ p(θ) = θ + ν ∆θ. price equates marginal cost only when the producing ¯ ¯ ﬁrm is eﬃcient (θ = θ). Under asymmetric information.9 Asymmetric Information and Marginal Cost Pricing Under complete information. Alternatively. we have restricted the principal to oﬀer a menu of contracts. 1−ν (7. Deﬁnition 7. we can say that price is equal to a generalized (or virtual) marginal cost that includes. an information cost that is worth ν ∆θ.2 A direct revelation mechanism g(·) is truthful if it is incentive compatible for the agent to announce his true type for any type. The revelation principle ensures that there is no loss of generality in restricting the principal to oﬀer simple menus having at most as many options as the cardinality of the type space. One may wonder if a better outcome could be achieved with a more complex contract allowing the agent possibly to choose among more options. 1−ν 7. i.7.10 The Revelation Principle In the above analysis.e. if the direct revelation 153 . Using (7.28). The principal commits to oﬀer the ˜ ˜ ˜ ˜ transfer t(θ) and the production level q(θ) if the agent announces the value θ for any θ belonging to Θ. Those simple menus are actually examples of direct revelation mechanisms. in addition to ¯ the traditional marginal cost of the ineﬃcient type θ. t(θ)) for all belonging to Θ.

Thus we have ˜ ˜ ˜ t(m∗ (θ)) − θ˜(m∗ (θ)) q ˜ t(m∗ (θ )) − θ˜(m∗ (θ )) for all (θ. Let M be the message space oﬀered to the agent by a more general mechanism. ˜ q We check now that the direct revelation mechanism g(·) is truthful. The indirect mechanism (M. ¯ ¯ ¯ t(θ) = t and q(θ) = q .1 Any allocation rule a(θ) obtained with a mechanism (M. Then we have the following revelation principle in the one agent case. ˜ When facing such a mechanism. Proof.35) 154 . or more precisely ˜ ˜ g(θ) = (q(θ). q(θ) = q.3 A mechanism is a message space M and a mapping q (·) from M to ˜ ˜ q A which writes as g (m) = (˜(m). ˜ q ˜ t(m∗ (θ))) from into A. t(m)) for all m belonging to M . t(θ)) ≡ g (m∗ (θ)) = (˜(m∗ (θ)). g (·)) induces an allocation rule a(θ) = (˜(m∗ (θ)). By composition of q (·) and m∗ (·).10.10. (7.34) is true for all m. namely g = g ◦ m∗ . θ ) ∈ Θ2 . ¯ A more general mechanism can be obtained when communication between the principal and the agent is more complex than simply having the agent report his type to the principal. ¯ ¯ t(θ − θq(θ). q ˜ ˜ (7. since (7.34) ˜ The mechanism (M.33) Denoting transfer and output for each possible report respectively as t(θ) = t. we can construct a direct ˜ revelation mechanism g(·) mapping Θ into A. the agent with type θ chooses a best message m∗ (θ) that is implicitly deﬁned as ˜ t(m∗ (θ)) − θ˜(m∗ (θ)) q ˜ ˜ t(m) − θ˜(m) for all m ∈ M .mechanism satisﬁes the following incentive compatibility constraints: t(θ) − θq(θ) ¯ ¯ ¯ t(θ) − θq(θ) ¯ ¯ t(θ) − θq(θ).32) (7. g (·)) induces therefore an allocation rule a(θ) = (˜(m∗ (θ)). t(m∗ (θ))) ˜ q mapping the set of types Θ into the set of allocations A. g (·)) can ˜ also be implemented with a truthful direct revelation mechanism. Deﬁnition 7. we get back to the notations of the previous sections. Indeed. q (7. Proposition 7. t(m∗ (θ))) for all θ ∈ Θ. it holds in particular for m = m∗ (θ ) for all θ ∈ Θ.

the incentive constraint of an eﬃcient type in (7. θ) ¯ ¯ U = t − C(¯. θ).39) (7. This Spence-Mirrlees property is quite clear: a more eﬃcient type is also more eﬃcient at the margin.Mirrlees property is now Cqθ > 0. θ) (with Φ > 0 and Φ > 0).42) . θ) ¯ ¯ U = t − C(¯. q ¯ t − C(q. the truthful direct revelation mechanism. θ) q ¯ ¯ t − C(¯. Incentive feasible allocations satisfy the following incentive and participation constraints: U = t − C(q. 7.40) 7. (7. Cθ > 0.11 A More General Utility Function for the Agent Still keeping quasi-linear utility functions. Importantly. and q q ¯ q ¯ U 0. the revelation principle provides a considerable simpliﬁcation of contract theory. Cqq > 0 and Cqθ > 0.Finally. (7.40) are the two relevant constraints for optimization. This latter condition still ensures that the diﬀerent types of the agent have indiﬀerence curves which cross each other at most once. we get t(θ) − θq(θ) t(θ ) − θq(θ ) for all (θ. It enables us to restrict the analysis to a simple aid well-deﬁned family of functions. the direct revelation mechanism g(·) is truthful. using the deﬁnition of g(·). θ) q ¯ U = t − C(q.37) and the participation constraint of an ineﬃcient type in (7. θ) − C(¯.41) where Φ(¯) = C(¯. 0. θ ) ∈ Θ2 .37) (7. θ) now be the agent’s objective function in the assumptions: Cq > 0.36) Hence.1 The Optimal Contract Just as before. θ).38) (7. 0.11. 155 (7. These constraints rewrite respectively as U ¯ U + Φ(¯) q (7. let U = t − C(q. The generalization of the Spence.

45) (2) Only the eﬃcient type gets a positive information rent given by U SB = Φ(¯SB ). q (3) The second-best transfers are respectively given by tSB = C(q ∗ . q SB = q ∗ with S (q ∗ ) = Cq (q ∗ . Cqθ > 0. we need to have ¯ ¯ tSB − C(¯SB .46) characterize the optimal solution if the neglected incentive constraint (7. For this to be true. θ). q The ﬁrst-order conditions (7. reducing the ineﬃcient agent’s output also reduces the eﬃcient agent’s information rent. With the assumptions made on C(·). q 1−ν (7. ¯ ¯ = tSB − C(¯SB .44) A downward output distortion for the ineﬃcient type. The solution of the principal’s program can be summarized as follows: Proposition 7. which leads to the following expression of the eﬃcient type’s rent U = Φ(¯). θ) + C(q SB . θ) q (7. θ) − C(q SB . θ) q ¯ tSB − C(q SB .47) 156 . θ).43) Since Φ > 0. θ) + q q ν Φ (¯SB ).1 With general preferences satisfying the Spence-Mirrlees property.46) (7.Those constraints are both binding at the second-best optimum. one can also check that the principal’s objective function is strictly concave with respect to outputs. q (7.38) is satisﬁed. θ) q q ¯ and ¯ S (¯SB ) = Cq (¯SB . θ). (7.44) and (7. q SB < q ∗ with ¯ ¯ S (¯∗ ) = Cq (¯∗ . θ) + Φ(¯SB ) q ¯ ¯ and tSB = C(¯SB . the optimal menu of contracts entails: (1) No output distortion with respect to the ﬁrst-best outcome for the eﬃcient type.11.

Since Φ > 0 from the Spence-Mirrlees property. θ) + q q ν Φq (¯SB ) for all i ∈ {1.best optimal outputs. It is straightforward to check that the ¯ eﬃcient agent’s information rent is now written as U = Φ(q) with Φ(q) = C(q. This leads to second. (7. 7. . Without further specifying the value and cost functions. The agents’ cost function becomes C(q. θ) with C(·) being strictly convex in q. Thus.... the principal is interested in a whole set of activities carried out simultaneously by the agent. θ)−C(q.37) holds with equality at the optimal output such that tSB = tSB − C(¯SB .. θ).. θ). q 1−ν i (7. summing the incentive constraints U ¯ U + Φ(¯) q 157 . q (7. n}.2 More than Two Goods Let us now assume that the agent is producing a whole vector of goods q = (q1 . qn ) for the principal. The value for the principal of consuming this whole bundle is now S(q) with S(·) being strictly concave in q. we need to have q 0 Φ(¯SB ) − Φ(q SB ). n}.48) q SB . In this multi-output incentive problem. .. . ¯SB Turning to incentive compatibility..11. The eﬃcient type produces the ﬁrst-best vector of outputs q SB = q ∗ with Sqi (q ∗ ) = Cqi (q ∗ .49) The ineﬃcient types vector of outputs q SB is instead characterized by the ﬁrst-order ¯ conditions ¯ Sqi (¯SB ) = Cqi (¯SB . θ) + C(q SB .. the second-best outputs deﬁne ¯∗ a vector of outputs with some components qi above qi for a subset of indices i. then (7.50) which generalizes the distortion of models with a single good.. So the Spence¯ ¯ Mirrlees property guarantees that only the eﬃcient type’s incentive constraint has to be taken into account.¯ by noting that (7. θ) for all i ∈ {1.48) is equivalent to q SB ¯ But from our assumptions we easily derive that q SB = q ∗ > q ∗ > q SB .

q q (7. If the agent is risk neutral.e. the contours of the ﬁrm may be designed before the agent receives any piece of information on his productivity. i. the agent already knows his type. we characterize the optimal contract for this alternative timing under various assumptions about the risk aversion of the two players. Moreover. this condition is satisﬁed if the Spence-Mirrlees property Cqi θ > 0 holds for each output i and if the monotonicity conditions qi < q i for all i are satisﬁed. before the agent discovers his type.52) (7.54) 158 .53) ¯ be binding.¯ and U U − Φ(q) for any incentive feasible contract yields ¯ Φ(q) = C(q. his ex ante participation constraint is now written as ¯ νU + (1 − ν)U 0. q q (7. the principal must structure the rents U and U to ensure that the two incentive constraints remain satisﬁed.. θ) − C(¯.12. However.1 Risk Neutrality Suppose that the principal and the agent meet and contract ex ante.53) This ex ante participation constraint replaces the two interim participation constraints. θ) q ¯ q = Φ(¯) for all implementable pairs (¯.. For instance. θ) C(¯.e. θ) − C(q. the principal wants to impose a zero expected rent to the agent and have (7. In this section. sometimes the principal and the agent can contract at the ex ante stage. i. 7. An example of such a rent distribution that is both incentive compatible and satisﬁes the ex ante participation constraint with an equality is ¯ U ∗ = (1 − ν)θ¯∗ > 0 and U ∗ = −νθ¯∗ < 0. q).12 Ex Ante versus Ex Post Participation Constraints The case of contracts we consider so far is oﬀered at the interim stage.51) Obviously. (7. Since the principal’s objective function is decreasing in the agent’s expected information rent. ¯ 7.

The agent beneﬁts from the full value of the good and trades oﬀ the value of any production against its cost just as if he was an eﬃciency maximizer.54).1 When the agent is risk neutral and contracting takes place ex ante. the optimal incentive contract implements the ﬁrst-best outcome. ¯ Note that the incentive compatibility constraints are now strict inequalities. This contract is incentive compatible since ¯ t∗ − θq ∗ = S(q ∗ ) − θq ∗ − T ∗ > t∗ − θ¯∗ = S(¯∗ ) − θ¯∗ − T ∗ q q q by deﬁnition of q ∗ . What happens if the agent is risk-averse? 159 . This implementation of the ﬁrst-best outcome amounts to having the principal selling the beneﬁt of the relationship to the risk-neutral agent for a ﬁxed up-front payment T ∗ . q ∗ ).12. Remark 7. and ¯q ¯q ¯ ¯ ¯ t∗ − θ¯∗ = S(¯∗ ) − θ¯∗ − T ∗ > t∗ − θq ∗ = S(q ∗ ) − θq ∗ − T ∗ q by deﬁnition of q ∗ . the agent is rewarded when he is eﬃcient and punished when he turns out to be ineﬃcient. Consider the following contracts {(t∗ . In summary.55) 7.2 Risk Aversion A Risk-Averse Agent The previous section has shown us that the implementation of the ﬁrst-best is feasible with risk neutrality. q ∗ )} ¯ where t∗ = S(q ∗ ) − T ∗ and t∗ = S(¯∗ ) − T ∗ .With such a rent distribution. (t∗ . Moreover. the ﬁxed-fee T ∗ can be used to satisfy the agent’s ex ante participation constraint with an ¯q q equality by choosing T ∗ = ν(S(q ∗ )−θq ∗ )+(1−ν)(S(¯∗ )− θ¯∗ ).1 The principal has in fact much more leeway in structuring the rents U ¯ and U in such a way that the incentive constraints hold and the ex ante participation ¯ ¯ constraint (7.12.12. we have Proposition 7. (7.53) holds with an equality. In the contract deﬁned by (7. the optimal contract implements the ﬁrst-best outputs without cost from the principal’s point of view as long as the ﬁrst-best is monotonic as requested by the implementability condition.56) (7. We will say that the agent is residual claimant for the ﬁrms proﬁt. with T ∗ being a lump-sum payment to be q deﬁned below.

one can check (7.t.59) . λ.Consider now a risk-averse agent with a Von Neumann-Morgenstern utility function u(·) deﬁned on his monetary gains t − θq. U . u < 0 and u(0) = 0. 160 (7. ineﬃcient) type gets a strictly positive (resp.¯). Proposition 7. the optimal menu of contracts entails: (1) No output distortion for the eﬃcient q SB = q ∗ . U . We have the following proposition. ¯ νu (U SB ) + (1 − ν)u (U SB ) (7. and thus the principal’s program reduces now to ¯ q {(U . such that u > 0.q)} max ¯q ¯ ν(S(q) − θq − U ) + (1 − ν)(S(¯) − θ¯ − U ). µ) = ν(S(q) − θq − U ) + (1 − ν)(S(¯) − θ¯ − U ) ¯ q ¯ +λ(U − U − ∆θ¯) + µ(νu(U ) + (1 − ν)u(U )). negative) ex post ¯ information rent.r.57) are the only binding constraints. the contract between the principal and the agent is signed before the agent discovers his type. U SB > 0 > U SB . (7. q subject to (7.20) and (7. U and U yields respectively −ν + λ + µνu (U SB ) = 0 ¯ −(1 − ν) − λ + µ(1 − ν)u (U SB ) = 0.58) (2) Both (7. with ¯ ¯ ¯ S (¯ ) = θ + q SB ¯ ν(u (U SB ) − u (U SB )) ∆θ.12.21) is slack at the optimum. The eﬃcient (resp.20) and (7. Again.61) (7.60) (7.57) As usual. q ¯ Optimizing w. Proof: Deﬁne the following Lagrangian for the principals problem ¯q ¯ ¯ L(q. The incentive constraints are unchanged but the agent’s ex ante participation constraint is now written as ¯ νu(U ) + (1 − ν)u(U ) 0. A downward output distortion for the ineﬃcient type q SB < q ∗ .57).(U . q .2 When the agent is risk-averse and contracting takes place ex ante.

20) implies that U SB output y. So.63) yields (7. the contract between the principal and the risk-neutral agent is signed before the agent knows his type. Reducing this premium calls for a downward reduction in the ineﬃcient type’s output so that the risk borne by the agent is lower. 1−ν (7. 161 λ ∆θ. Thus. As expected. Again. with risk aversion. (7. and thus µ > 0. everything happens as if he had an ex post individual rationality constraint for the worst state of the world given by (7. Creating ¯ a wedge between U and U to satisfy (7.64) .58). the principal must now pay a risk premium. the agent’s risk aversion leads the principal to weaken the incentives. the ineﬃcient agent’s output q SB and the utility levels U SB and U SB all ¯ converge toward the same solution. Using (7.23). the previous model at the interim stage can also be interpreted as a model with an ex ante inﬁnitely risk-agent at the zero utility level. When the agent becomes inﬁnitely risk averse.62) and inserting it into (7.Summing the above two equations.20) makes the risk-averse agent bear some risk. we obtain ¯ µ(νu (U SB ) + (1 − ν)u (U SB )) = 1. with λ > 0 for a positive Optimizing with respect to outputs yields respectively S (q SB ) = θ and ¯ S (¯SB ) = θ + q Simplifying by using (7.60) yields λ= ¯ ν(1 − ν)(u (U SB ) − u (U SB )) . ¯ In the limit.65) (7. the principal can no longer costlessly structure the agent’s information rents to ensure the eﬃcient type’s incentive compatibility constraint. A Risk-Averse Principal Consider now a risk-averse principal with a Von Neumann-Morgenstern utility function ν(·) deﬁned on his monetary gains from trade S(q) − t such that ν > 0. 0.62) Moreover.63) (7. SB ¯ νu (U ) + (1 − ν)u (U SB ) ¯ U SB and thus λ (7. To guarantee the participation of the risk-averse agent. ν < 0 and ν(0) = 0.

67) (7.69) (7.12.68) (7.71) are also the levels of rent obtained in (7.In this context. q (7. ¯ Solving this system of two equations with two unknowns (U ∗ . U ∗ ) yields ¯q U ∗ = (1 − ν)(S(q ∗ ) − θq ∗ − (S(¯∗ ) − θ¯∗ )) q and ¯q ¯ U ∗ = −ν(S(q ∗ ) − θq ∗ − (S(¯∗ ) − θ¯∗ )). the agent is risk-neutral. the ﬁrst-best contract obviously calls for the ﬁrst-best output q ∗ and q ∗ being produced. This leads ¯ us to the following two conditions that must be satisﬁed by the agent’s rents U ∗ and U ∗ : ¯q ¯ S(q ∗ ) − θq ∗ − U ∗ = S(¯∗ ) − θ¯∗ − U ∗ q and ¯ νU ∗ + (1 − ν)U ∗ = 0. Indeed. U ∗ ) is incentive compatible and ¯ the ﬁrst-best allocation is easily implemented in this framework. the proﬁle of rents (U ∗ .71) (7.70) ¯ (from the deﬁnition of q ∗ ).2 It is interesting to note that U ∗ and U ∗ obtained in (7. It also calls for the principal to be fully insured between both states ¯ of nature and for the agent’s ex ante participation constraint to be binding.66) Note that the ﬁrst-best proﬁle of information rents satisﬁes both types’ incentive compatibility constraints since ¯q ¯ q q U ∗ − U ∗ = S(q ∗ ) − θq ∗ − (S(¯∗ ) − θ¯∗ ) > ∆θ¯∗ (from the deﬁnition of q ∗ ) and ¯q ¯ U ∗ − U ∗ = S(¯∗ ) − θ¯∗ − (S(q ∗ ) − θq ∗ ) > −∆θq ∗ .12. which allows the principal to make the q risk-neutral agent residual claimant for the hierarchy’s proﬁt. also provides full insurance 162 .3 When the principal is risk-averse over the monetary gains S(q) − t. ¯ Remark 7. Hence.70) and (7.55) and (reftransfer222). q (7. We can thus generalize the proposition for the case of risk neutral as follows: Proposition 7. the lump-sum ¯q payment T ∗ = ν(S(q ∗ )−θq ∗ )+(1−ν)(S(¯∗ )− θ¯∗ ). and contracting takes place ex ante. the optimal incentive contract implements the ﬁrst-best outcome.

1−ν its value with a risk-neutral principal. we still guess a solution such that (7. In particular. ¯ Inserting the values of U and U that were obtained from the binding constraints in (7. Moreover. (7.20) and (7. We can check that V SB < V SB since S(¯SB ) − θ¯SB < S(q ∗ ) − θq ∗ q q from the deﬁnition of q ∗ . we observe that the distortion in the right-hand side of (7. The intuition is straightforward. if ν(x) = 1−e−rx . By making the risk-neutral agent the residual claimant for the value of trade. giving a rent to the eﬃcient agent is now without cost for the principal. the risk¯ ¯ averse principal reduces the diﬀerence between V SB and V SB .U . Risk aversion on the side of the principal is quite natural in some contexts.23) into the principal’s objective function and optimizing with respect to outputs leads to q SB = q ∗ . Since V SB < V SB . no distortion for the eﬃcient type. r ¯ (7.20) to (7. The principal’s program now reduces to: ¯ q {(U . 1−ν If r = 0. Of course this result does not hold anymore if the agent’s interim participation constraints must be satisﬁed. we get back the distortion obtained in section 7.¯). ex ante contracting allows the risk-averse principal to get full insurance and implement the ﬁrst-best outcome despite the informational problem.to the principal. In this case.72) becomes S (¯SB ) = θ + q SB ¯ SB ν er(V −V ) ∆θ. For example.q)} max ¯q ¯ νυ(S(q) − θq − U ) + (1 − ν)υ(S(¯) − θ¯ − U ) q subject to (7.22) is slack at the optimum. By increasing q above its value with risk neutrality. just as in the ease of risk neutrality and a downward distortion of the ineﬃcient type’s output q SB < q ∗ given ¯ ¯ by ¯ S (¯SB ) = θ + q q where V SB = S(q ∗ ) − θq ∗ − ∆θ¯SB νυ (V SB ) ∆θ.72) is always lower than ν ∆θ. the inﬁnitely riskaverse principal is only interested in the ineﬃcient state of nature for which he wants to maximize the surplus.72) ¯ (1 − ν)υ (V SB ) ¯q ¯ and V SB = S(¯SB ) − θ¯SB are the principal’s payoﬀs in q ¯ both states of nature. we observe that the ﬁrst-best is implemented when r goes to inﬁnity.7 with a risk-neutral principal ¯ and interim participation constraints for the agent. This gives the principal some insurance and increases his ex ante payoﬀ. since there is no rent for the ineﬃcient agent. In the limit. i. A local regulator with a limited budget or a specialized bank dealing with relatively correlated 163 ..e.23).

Alternatively. this assumption also means that the court of law can perfectly enforce the contract and that neither renegotiating nor reneging on the contract is a feasible alternative for the agent and (or) the principal. Once the diﬀerent types have revealed themselves to the principal by selecting the con¯ ¯ tracts (tSB . q SB ) for the eﬃcient type and (tSB . One should view a renegotiation procedure as the ability of the contracting partners to achieve a Pareto improving trade if any becomes incentive feasible along the course of actions. To share these ¯ ¯ new gains from trade with the ineﬃcient agent. the principal may propose a renegotiation to get around the allocative ineﬃciency he has imposed on the ineﬃcient agent’s output. Econ. which can hurt one of the contracting parties. The gain from this renegotiation comes from raising allocative eﬃciency for the ineﬃcient type and moving output from q SB to q ∗ . 1995) for an application to the regulation of public utilities. the principal must at least oﬀer him the same utility level as before renegotiation. Indeed.projects may be insuﬃciently diversiﬁed to become completely risk neutral. q SB ) for the ineﬃcient type.1 Renegotiating a Contract Renegotiation is a voluntary act that should beneﬁt both the principal and the agent. raising this transfer also hardens the ex ante incentive compatibility constraint of the eﬃcient type. 7. What can happen when either of those two assumptions is relaxed? 7. it becomes more valuable for an eﬃcient type to hide his type so that he can obtain this larger transfer. See Lewis and Sappington (Rand J. we have implicitly assumed that the principal has a strong ability to commit himself not only to a distribution of rents that will induce information revelation but also to some allocative ineﬃciency designed to reduce the cost of this revelation. There is a fundamental trade-oﬀ 164 . and truthful revelation by the eﬃcient type is no longer obtained in equilibrium. The participation constraint of the ineﬃcient ¯q ¯ agent can still be kept at zero when the transfer of this type is raised from tSB = θ¯SB to ¯q ¯ t∗ = θ¯∗ . It should be contrasted with a breach of contract. However.13 Commitment To solve the incentive problem.13.

1 Ex Post Veriﬁable Signal Suppose that the principal. For simplicity. we investigate the impacts of various improvements of the principal’s information system on the optimal contract. Otherwise. Note that. In this case. 7. once the agent has revealed himself to the principal by selecting the contract within the menu oﬀered by the principal. The contract can then be conditioned on both the agent’s report and the observed signal that provides useful information on the underlying state of nature. 7. the agent may want to renege on a contract which gives him a negative ex post utility level as we discussed before.14 Informative Signals to Improve Contracting In this section. Such a setting justiﬁes the focus on the case of interim contracting. might propose the complete information contract which extracts all rents without inducing ineﬃciency. Let the conditional probabilities of these respective realizations of the signal be µ1 = Pr(σ = σ1 /θ = θ) ¯ 1/2 and µ2 = Pr(σ = σ2 /θ = θ) 1/2. the threat of the agent reneging a contract signed at the ex ante stage forces the agent’s participation constraints to be written in interim terms. On the other hand. having learned the agent’s type. 7. σ1 and σ2 . assume that this signal may take only two values. This signal is observed after the agent’s choice of production.2 Reneging on a Contract A second source of imperfection arises when either the principal or the agent reneges on their previous contractual obligation.between raising eﬃciency ex post and hardening ex ante incentives when renegotiation is an issue. the latter. the signal σ is uninformative. Let us take the case of the principal reneging on the contract.14. if µ1 = µ2 = 1/2. Indeed. σ1 brings good news the fact that the agent is 165 .13. the agent and the court of law observe ex post a viable signal σ which is correlated with θ. The idea here is to see how signals that are exogenous to the relationship can be used by the principal to better design the contract with the agent.

using 166 . and u22 = t(θ. the agent receives no rent whatever his type. one can ﬁnd ex post rents uij (or equivalent transfers) such that all these constraints are binding. 7.75) (7. σ2 ) − θq(θ.73) to (7. Moreover. Incentive constraints for both types write respectively as µ1 u11 + (1 − µ1 )u12 (1 − µ2 )u21 + µ2 u22 µ1 (u21 + ∆θq21 ) + (1 − µ1 )(u22 + ∆θq22 ) (1 − µ2 )(u11 − ∆θq11 ) + µ2 (u12 − ∆θq12 ). Note that the determinant of the system is nonzero when 1 − µ1 − µ2 = 0 (7. σ1 ) − ¯ ¯ ¯ ¯ ¯ ¯ θq(θ. Similar notations are used for the outputs qjj . can be implemented this way. any choice of production levels. u21 = t(θ. 0.77) 1 that fails only if µ1 = µ2 = 2 . Then the incentive and participation constraints must be written in expectation over the realization of σ.74) Participation constraints for both types are written as µ1 u11 + (1 − µ1 )u12 (1 − µ2 )u21 + µ2 u22 0. σ2 ). Let us adopt the following notations for the ex post information rents: u11 = t(θ. (7. in particular the complete information optimal ones.73) through (7. (7.76) is nonzero. σ2 ). σ2 ) − θq(θ.76) has as many equations as unknowns uij . which corresponds to the case of an uninformative and useless signal.2 Ex Ante Nonveriﬁable Signal Now suppose that a nonveriﬁable binary signal σ about θ is available to the principal at the ex ante stage.eﬃcient and σ2 brings bad news. σ1 ). When the determinant of the coeﬃcient matrix of the system (7. the principal computes. u12 = t(θ. since it is more likely that the agent is ineﬃcient in this case. In this case. σ1 ) − θq(θ. σ1 ). for a given schedule of output qij . the system (7.76) Note that.14.73) (7. Before oﬀering an incentive contract. The agent discovers his type and plays the mechanism before the signal σ realizes.

namely ν1 = P r(θ = θ/σ = σ1 ) = ˆ ν2 = P r(θ = θ/σ = σ2 ) = ˆ νµ1 . 7. In particular. 7.15 Contract Theory at Work This section proposes several classical settings where the basic model of this chapter is useful. if µ is large enough. The principal oﬀers a high-powered incentive contract only to the eﬃcient agent. the principal reduces less of the information rent than in the case without an informative signal since 1−µ µ < 1 .1 Regulation In the Baron and Myerson (Econometrica. the principal shuts down the ineﬃcient ﬁrm after having observed σ1 . because he is less likely to face an eﬃcient type after having observed σ2 . his posterior belief that the agent is eﬃcient for each value of this signal.78) (7.80) shows that incentives decrease with respect to the case without informative signal since µ 1−µ > 1 . the principal is a regulator who maximizes a weighted average of the agents’ surplus S(q) − t and of a regulated monopoly’s proﬁt U = t − θq.the Bayes law. 1982) regulation model. which leaves him with no rent.81) ¯ S (¯SB (σ2 )) = θ + q In the case where µ1 = µ2 = µ > 1 . Observing σ1 . A stronger reduction in q SB and thus in the eﬃcient type’s information rent is ¯ called for after σ1 . On the contrary. the principal thinks that it is more likely that the agent is eﬃcient. ∆θ = θ + 1 − ν2 (1 − ν)µ2 ) (7. ν(1 − µ1 ) + (1 − ν)µ2 (7.79) Then the optimal contract entails a downward distortion of the ineﬃcient agents production q SB (σi )) which is for signals σ1 . with a weight α < 1 for the ﬁrms proﬁt. νµ1 + (1 − ν)(1 − µ2 ) ν(1 − µ1 ) . and σ2 respectively: ¯ ¯ S (¯SB (σ1 )) = θ + q ν1 νµ1 ¯ ∆θ = θ + ∆θ 1 − ν1 (1 − ν)(1 − µ2 ) ν2 ¯ ν(1 − µ1 ) ∆θ. The 167 .15. Introducing adverse selection in each of these contexts has proved to be a signiﬁcative improvement of standard microeconomic analysis.80) (7. Incentives are stronger. (7. we can interpret µ as an index of the informativeness 2 of the signal.

If α = 1.83) (7.84) (7.85) . 168 (7. where q is the quantity consumed and t his payment to the principal. it is socially costly to give up a rent to the ﬁrm. The principal has thus a utility function V = t − cq. q SB < q ∗ which is given by ¯ ¯ ¯ S (¯SB ) = θ + q ν (1 − α)∆θ. However.15. Maximizing expected social welfare under incentive and participation constraints leads to q SB = q ∗ for the eﬃcient type and a downward distortion for the ineﬃcient type. Incentive and participation constraints can as usual be written directly in terms of the ¯ q ¯ ¯ information rents U = θu(q) − t and U = θu(¯) − t as U ¯ U ¯ U − ∆θu(¯). q U + ∆θu(q). We are now in a setting with a continuum of agents. Suppose that the parameter θ of each buyer is drawn independently from ¯ the same distribution on Θ = {θ. The tastes of a buyer for the private good are such that his utility function is U = θu(q) − t. 7.principal’s objective function is written now as V = S(q) − θq − (1 − α)U . the principal is the seller of a private good with production cost cq who faces a continuum of buyers. The regulation literature of the last ﬁfteen years has greatly improved our understanding of government intervention under asymmetric information. We refer to the book of Laﬀont and Tirole (1993) for a comprehensive view of this theory and its various implications for the design of real world regulatory institutions. it is mathematically equivalent to the framework with a single agent. Now ν is the frequency of type θ by the Law of Large Numbers. 1984). of Economics. because the regulator is less concerned by the distribution of rents within society as α increases. θ} with respective probabilities 1 − ν and ν.2 Nonlinear Pricing by a Monopoly In Maskin and Riley (Rand J. the ﬁrm’s rent is no longer costly and the regulator behaves as a pure eﬃciency maximizer implementing the ﬁrst-best output in all states of nature. Because α < 1.82) Note that a higher value of α reduces the output distortion. U 0. 1−ν (7.

84) and (7.¯)} (7.3 Quality and Price Discrimination Mussa and Rosen (JET. there is no output distortion with respect to the ﬁrst-best outcome for the high valuation type and q SB = q ∗ .83) to (7. q U + ∆θq.q)} max ¯ q ¯ v(θu(¯) + (1 − v)(θu(q) − cq) − (ν U + (1 − ν)U ) subject to (7. 0. where agents buy one unit of a commodity with quality q but are vertically diﬀerentiated with respect to their preferences for the good. (7. where ¯ now the eﬃcient type is the one with the highest valuation for the good θ.15.87) 7.88) (7.(U . Hence. 1978) studied a very similar problem to the nonlinear pricing.¯). where θ− ν ∆θ u (q SB ) = C 1−ν and θu (q ∗ ) = c.91) 0. However.90) (7. max ¯q ¯ v(θ¯ − C(¯)) + (1 − ν)(θq − C(q)) − (ν U + (1 − ν)U ) q 169 . We have q SB < q ∗ . (7. (7. Incentive and participation constraints can still be written directly in terms of the ¯q ¯ ¯ information rents U = θq − t and U = θ¯ − t as U ¯ U ¯ U − ∆θ¯. The marginal cost (and average cost) of producing one unit of quality q is C(q) and the principal has the utility function ¯ V = t − C(q).89) (7. with respective probabilities 1 − ν and ν. there exists a downward distortion of the low valuation agent’s output with respect to the ﬁrst-best outcome.85) are the two binding constraints. U ¯ U The principal solves now: ¯ q {(U . The utility function of an agent is now U = θq − t with θ in Θ = {θ. where ¯ ¯ ¯ q θu (¯∗ ) = c.86) The principal’s program now takes the following form: ¯ q {(U .86). As a result.(U . θ}.¯ U 0.q). The analysis is the mirror image of that of the standard model discussed before.

However.95) (7.where θ = C (q SB ) + ν ∆θ 1−ν and θ = C (q ∗ ) (7. The lender has thus a utility function V = t − Rk. in a paper by Freixas and Laﬀont (1990). we ﬁnd that the high valuation agent receives the ﬁrst-best ¯ quality q SB = q ∗ where θ = C (¯∗ ).92) Interestingly. U + ∆θf (k).94) (7. quality is now reduced below the ﬁrst-best ¯ ¯ q for the low valuation agent.88) to (7. (7. We have q SB < q ∗ . θ} with respective probabilities 1 − ν and ν. The borrower makes a proﬁt U = θf (k) − t where θf (k) is the production with k units of capital and t is the borrowers repayment to the lender.89) and (7. Some authors have even argued that damaging its own goods may be part of the ﬁrm’s optimal selling strategy when screening the consumers’ willingness to pay for quality is an important issue.4 Financial Contracts Asymmetric information signiﬁcantly aﬀects the ﬁnancial markets. The parameter θ is a productivity shock drawn from Θ = {θ. the principal is a lender who provides a loan of size k to a borrower. For instance.15. 7. We assume that ¯ f > 0 and f < 0. Following procedures similar to what we have done so far.96) 170 .subject to (7. U ¯ U 0.93) (7.90) are binding constraints. Finally. only (7. the spectrum of qualities is larger under asymmetric information than under complete information. Incentive and participation constraints can again be written directly in terms of the ¯ ¯ ¯ ¯ borrower’s information rents U = θf (k) − t and U = θf (k) − t as U ¯ U ¯ ¯ U − ∆θf (k). This incentive of the seller to put a low quality good on the market is a well-documented phenomenon in the industrial organization literature. 0.91). Capital costs Rk to the lender since it could be invested elsewhere in the economy to earn the risk-free interest rate R.

we know that the risk-averse union will propose a contract to the risk-neutral ﬁrm which provides full insurance and ¯ l implements the ﬁrst-best levels of employments ¯ and l∗ deﬁned respectively by θf (¯∗ ) = 1 l and θf (l∗ ) = 1. If their disutility of labor is counted in monetary terms and all revenues from the ﬁrm are consumed.The principal’s program takes now the following form: ¯ ¯ {(U .96). The parameter θ is a productivity shock ¯ drawn from Θ = {θ. We have k SB < k ∗ where θ− ν ∆θ f (k SB ) = R and θf (k ∗ ) = R. However. θ} with respective probabilities 1−ν and ν.93) to (7. We assume that f > 0 and f < 0. One can check that (7. In this case. 1983). there is no capital distortion with respect to the ﬁrst-best outcome for the high ¯ ¯ ¯ productivity type and k SB = k ∗ where θf (k ∗ ) = R. In this context. When workers have a utility function exhibiting an income eﬀect. the principal is a union (or a set of workers) providing its labor force l to a ﬁrm. It should be clear that the model is similar to the one with a risk-averse principal and a risk. In Green and Kahn (QJE. 1−ν (7. The ﬁrm makes a proﬁt θf (l)−t. the ﬁrm’s boundaries are determined before the realization of the shock and contracting takes place ex ante.(U . there also exists a downward distortion in the size of the loan given to a low productivity borrower with respect to the ﬁrst-best outcome.94) and (7. Workers have a utility function deﬁned on consumption and labor. the analysis will become much harder even in two-type models.95) are now the two binding constraints. The ﬁrm’s objective is to maximize its proﬁt U = θf (l) − t. So.5 Labor Contracts Asymmetric information also undermines the relationship between a worker and the ﬁrm for which he works.k)} max ¯ ¯ ¯ ¯ v(θf (k) − Rk) + (1 − ν)(θf (k)) − Rk) − (ν U + (1 − ν)U ) subject to (7. v < 0). As a result.k).neutral agent.97) 7. For details. where f (l) is the return on labor and t is the worker’s payment. they get V = v(t − l) where l is their disutility of providing l units of labor and v(·) is increasing and concave (v > 0. 1983) and Hart (RES.15. the return on capital is equal to the risk-free interest rate. see Laﬀont and Martimort 171 .

101) Thus. such that t(θ) − θq(θ) In particular.99) and (7. θ) ∈ Θ2 . we give a brief account of the continuum type case. incentive compatibility alone requires that the schedule of output q(·) has to be nonincreasing. Since the revelation principle is still valid with a continuum of types. ˙ and (7.100) we obtain (θ − θ )(q(θ ) − q(θ)) 0. θ].e. (7.103) (7. θ ) ∈ Θ2 . Most of the principalagent literature is written within this framework. 7. So we will restrict the analysis to diﬀerentiable functions. This implies that q(·) is diﬀerentiable almost everywhere. it must be the case that ˙ t(θ) − θq(θ) = 0.16 The Optimal Contract with a Continuum of Types In this section. (7. θ].100) ˜ ˜ ˜ t(θ) − θq(θ) for any (θ.(2002).99) (7. (7..98) implies t(θ) − θq(θ) t(θ ) − θ q(θ ) t(θ ) − θq(θ ).102) .104) (7. i. which are truthful. ˜ (7. ¨˜ ˜ t(θ)|θ=θ − θ¨(θ)|θ=θ q ˜ ˜ 172 0 (7. t(θ))}. t(θ) − θ q(θ) for all pairs (θ. with a cumulative distribution ¯ function F (θ) and a density function f (θ) > 0 on [θ.98) Adding (7. It is also necessary to satisfy the local second-order condition. ¯ Reconsider the standard model with θ in Θ = [θ. (7.103) must hold for all θ in Θ since θ is unknown to the principal.98) implies that the following ﬁrst-order condition for the optimal response θ chosen by type θ is satisﬁed ˙ ˜ t(θ) − θq(θ) = 0. ˙ ˜ For the truth to be an optimal response for all θ. and we can restrict our analysis to direct revelation ˜ ˜ mechanisms {(q(θ).

because q(·) is nonincreasing.103) and (7.103) and (7.103)) ˙ U (θ) = −q(θ). (7. The local incentive constraint is now written as (by using (7.q(·))} (7.109) q(τ )dτ 0. (7. The optimization program of the principal becomes ¯ θ {(U (·). Local analysis of incentives is enough.103).107) ˜ ˜ τ q(τ )dτ = θq(θ) − θq(θ) − ˙ θ ˜ θ q(τ )dτ (7.110) max (S(q(θ)) − θq(θ) − U (θ))f (θ)dθ θ (7. So.111) 173 . (7. therefore the following constraints must be satisﬁed t(θ) − θq(θ) From (7.103) also imply the global incentive constraints.106). Now we need to check that he does not want to lie globally either. In such circumstances.or ¨ t(θ) − θ¨(θ) q 0.105) can be written more simply as −q(θ) ˙ 0. (7. the inﬁnity of incentive constraints (7. it turns out that the local incentive constraints (7.105) But diﬀerentiating (7.106) constitute the local incentive constraints.103) we have ˜ t(θ) − t(θ) = or ˜ ˜ ˜ ˜ t(θ) − θq(θ) = t(θ) − θq(θ) + (θ − θ)q(θ) − ˜ ˜ where (θ − θ)q(θ) − θ ¯ θ ¯ θ θ ˜ θ ˜ ˜ ˜ t(θ) − θq(θ) for any (θ. which ensure that the agent does not want to lie locally. θ) ∈ Θ2 .107) reduces to a diﬀerential equation and to a monotonicity constraint.106) (7. Let us use the rent variable U (θ) = t(θ) − θq(θ). (7.108) θ q(τ )dτ. Truthful revelation mechanisms are then characterized by the two conditions (7.

All types. incentive compatibility implies that only the participation constraint of the most ineﬃcient type can be binding.112) ¯ U (θ) − U (θ) = − θ ¯ θ q(τ )dτ (7..113). U (θ) = 0. Momentarily ignoring (7. gives ¯ θ S(q(θ)) − θ + θ F (θ) f (θ) q(θ) f (θ)dθ.113) (7. (7. since U (θ) = 0.115) ¯ or. f (θ) (7. by an integration of parts. obtain a positive information rent at the optimal contract U SB (θ) = θ ¯ θ q SB (τ )dτ. except the least eﬃcient one.subject to ˙ U (θ) = −q(θ). q(θ) ˙ U (θ) 0. (7. we can solve (7.114) 0. it is clear from the above program ¯ that it will be binding.116) The principal’s objective function becomes ¯ θ ¯ θ S(q(θ)) − θq(θ) − θ θ q(τ )dτ f (θ)dθ. If the monotone hazard rate property d dθ F (θ) f (θ) 0 holds.114) simpliﬁes to U (θ) discrete case.119).119) is clearly decreasing. Furthermore. 0.113) is satisﬁed.117) which. i.e. As in the ¯ Using (7.112) (7.110). All types choose therefore diﬀerent allocations and there is no bunching in the optimal contract. the solution q SB (θ) of (7. we note that there is no distortion for the most eﬃcient type (since F (θ) = 0 and a downward distortion for all the other types.119) which is the ﬁrst order condition for the case of a continuum of types.118) Maximizing pointwise (7. the participation constraint (7.118). (7. we get the second-best optimal outputs S (q SB (θ)) = θ + F (θ) . U (θ) = θ ¯ θ q(τ )dτ (7. and the neglected constraint (7. From (7.120) 174 . (7.

122) (7. µ.123) and inserting the value of µ(θ) obtained from (7. Integrating (7. and shut- ¯ down (if any) occurs on an interval [θ∗ . It remains to be investigated if there is a simple implementation of 175 .Finally. f (θ) (7. From the Pontryagin principle.122) using (7. The virtual surplus S(q) − θ+ F (θ) f (θ) q decreases with θ when the monotone hazard rate property holds.1 The optimal solution above can also be derived by using the Pontryagin principle. U SB (θ) } or {(q SB (θ).119). tSB (θ))}. U. µ(θ) = − ˙ ∂H = f (θ). The Hamiltonian is then H(q. we get µ(θ) = F (θ). one can check that the Inada condition S (0) = +∞ and the ¯ condition limq→0 S (q)q = 0 ensure the corner solution θ∗ = θ. For an interior optimum. where µ is the co-state variable. we ﬁnd that S(q SB (θ∗ )) = θ∗ + F (θ∗ ) f (θ∗ ) q SB (θ∗ ). We have derived the optimal truthful direct revelation mechanism { q SB (θ).121) From the transversatility condition (since there is no constraint on U (·) at θ). Remark 7. θ) = (S(q) − θq − U )f (θ) − µq. U the state variable and q the control variable. one could also allow for some shutdown of types. µ(θ) = 0.16. ∂U (7.123). Optimizing with respect to q(·) also yields S q SB (θ) = θ + µ(θ) .124) again yields(7.125) (7.124) (7. θ∗ is obtained as a solution to θ∗ max ∗ {θ } S(q SB (θ)) − θ + θ F (θ) f (θ) q SB (θ) f (θ)dθ. θ]. As in the discrete case.

” Econometrica. and the audit models. 176 . Indeed. the economic insights obtained in the continuum case are not diﬀerent from those obtained in the two-state case.” Quarterly Journal of Economics. tSB (θ) = U SB (θ) + θq SB (θ) becomes T (q) = t SB ¯ θ (7. dθ SB To conclude.. Then. Myerson. In the models discussed. (7. the limited liability constraints.126) (θ SB (q)) = θ(q) q SB (τ )dτ + θ(q)q. Since q SB (·) is decreasing. and R.. 7. 488-500. a two-type model with typedependent reservation utilities. see Laﬀont and Martimort (2002). For detailed discussion about these topics and their applications. We can check that the agent confronted with this nonlinear transfer chooses the same allocation as when he is faced with the optimal revelation mechanism. we can invert this function and obtain θSB (q). this conﬂict was relatively easy to understand because it resulted from the simple interaction of a single incentive constraint with a single participation constraint. One can also deal with a bidimensional adverse selection model. 745-782. D. “Regulating a Monopolist with Unknown Cost. random participation constraints.127) To the optimal truthful direct revelation mechanism we have associated a nonlinear transfer T (q). Here we would mention some possible extensions.17 Further Extensions The main theme of this chapter was to determine how the fundamental conﬂict between rent extraction and eﬃciency could be solved in a principal-agent relationship with adverse selection. since − θ dq = 0. we have d (T (q) dq dtSB dθ dθSB dq dtSB dθ − θq) = T (q) − θ = · − θ = 0. 50 (1982). G. “The Market for Lemons: Quality Uncertainty and the Market Mechanism. 89 (1970). One can consider a straightforward three-type extension of the standard model. Reference Akerlof.this mechanism. Baron.

Princeton and Oxford: Princeton University Press. 1990. 93 (1976). 2003. (1972). J. 98 (1983). P. B. M.” Working Paper. Macroeconomics. Whinston. 1993.. Hart. Chapters 1-3. The Theory of Incentives in Procurement and Regulation. Chapter 12. J. 177 . “Optimal banking Contracts. Champsaur et al. 541-562. Microeconomic Theory. E. Texas A&M University. X. D. L.” Quarterly Journal of Economics. Cambridge: MIT Press. Luenberger. J. 173-188.” In Essays in Honor of Edmond Malinvaud. M. and C. 1995.-J. S. and G. Laﬀont. Li.” Rand Journal of Economics. “Monopoly and Product Quality. (NorthHolland). and D. 18 (1978). Martimort. “Equilibrium in Competitive Insurance Markets. O. and S. and C.J. 297-336. 3-35. Mussa. A. Stiglitz. R. and J. Cambridge: MIT Press. Tian. J. Tirole. and J. 2002.. “On Informational Decentralized Systems. McGuire.-J. in Honor of J. “Optimal Contracts for Central Banks Revised. Marschak. Vol.. J. Rosen. Laﬀont. 50 (1983). The Theory of Incentives: The Principal-Agent Model. “Optimal Labor Contracts under Asymmetric Information: An Introduction. 171-196.. Maskin. Radner.Freixas..” Quarterly Journal of Economics. 301-317. Riley. Microeconomic...” Journal of Economic Theory. Kahn. Chapter 13-14. Inc.. Hart. and J.. Hurwicz. “An Analysis of the Principal Agent. eds. 7 45. Oxford University Press. 2.. 51 (1983). Green. “Monopoly with Incomplete Information. ed. Rothschild.” in Decision and Organization. and J. 1995. and O. M.” Review of Economic Studies. Grossman. D. McGraw-Hill. Laﬀont. “Wage-Employment Contracts.” Econometrica. Mas-Colell. 15 (1984). Green.

W. Cambridge Press. Topics in Microeconomics . . 407-430.. 44 (1977).. 87 (1973). Auctions. Williamson. Chapters 25.R.” Review of Economic Studies. 178 . 1992. Chapters 8-10. 1975. the Free Press: New York. H. Third Edition. Markets and Hierarchies: Analysis and Antitrust Implications.” Quarterly Journal of Economics. E. Norton and Company. Stiglitz. J.Spence. 355-374. 1999.W.Industrial Organization.. O. Wolfstetter. Varian.E. “Monopoly Non Linear Pricing and IMperfect Information: The Insurance Market. Microeconomic Analysis. “Job Market Signaling. M. and Incentives..

Chapter 8 Moral Hazard: The Basic Trade-Oﬀs 8. As in the case of adverse selection. The probabilities of the diﬀerent states of nature. uncertainty is now endogenous. or the quality of their harvesting. we stressed that the delegation of tasks creates an information gap between the principal and his agent when the latter learns some piece of information relevant to determining the eﬃcient volume of trade. a regulated ﬁrm may have to perform a costly and nonobservable investment to reduce its cost of producing a socially valuable good. which positively inﬂuence the agent’s level of production but also create a disutility for the agent. The principal often loses any ability to control those actions that are no longer observable. In such cases we will say that there is moral hazard. and thus the expected volume of trade. now 179 . Similarly. which also aﬀects his demand for insurance. the probability that a driver has a car crash depends on how safely he drives. the agent’s performance. more generally. instead of being an exogenous uncertainty for the principal. asymmetric information also plays a crucial role in the design of the optimal incentive contract under moral hazard. However. Also.1 Introduction In the previous chapter. For instance the yield of a ﬁeld depends on the amount of time that the tenant has spent selecting the best crops. The leading candidates for such moral hazard actions are eﬀort variables. either by the principal who oﬀers the contract or by the court of law that enforces it. Adverse selection is not the only informational problem one can imagine. Agents may also choose actions that aﬀect the value of trade or.

depend explicitly on the agent’s eﬀort. In other words, the realized production level is only a noisy signal of the agent’s action. This uncertainty is key to understanding the contractual problem under moral hazard. If the mapping between eﬀort and performance were completely deterministic, the principal and the court of law would have no diﬃculty in inferring the agent’s eﬀort from the observed output. Even if the agent’s eﬀort was not observable directly, it could be indirectly contracted upon, since output would itself be observable and veriﬁable. We will study the properties of incentive schemes that induce a positive and costly eﬀort. Such schemes must thus satisfy an incentive constraint and the agent’s participation constraint. Among such schemes, the principal prefers the one that implements the positive level of eﬀort at minimal cost. This cost minimization yields the characterization of the second-best cost of implementing this eﬀort. In general, this second-best cost is greater than the ﬁrst-best cost that would be obtained by assuming that eﬀort is observable. An allocative ineﬃciency emerges as the result of the conﬂict of interests between the principal and the agent.

8.2

8.2.1

The Model

Eﬀort and Production

We consider an agent who can exert a costly eﬀort e. Two possible values can be taken by e, which we normalize as a zero eﬀort level and a positive eﬀort of one: e in {0, 1}. Exerting eﬀort e implies a disutility for the agent that is equal to ψ(e) with the normalization ψ(0) = ψ0 = 0 and ψ1 = ψ. The agent receives a transfer t from the principal. We assume that his utility function is separable between money and eﬀort, U = u(t) − ψ(e), with u(·) increasing and concave (u > 0, u < 0). Sometimes we will use the function h = u−1 , the inverse function of u(·), which is increasing and convex (h > 0, h > 0). Production is stochastic, and eﬀort aﬀects the production level as follows: the stochas¯ ¯ tic production level q can only take two values {q, q }, with q − q = ∆q > 0, and the ˜ stochastic inﬂuence of eﬀort on production is characterized by the probabilities Pr(˜ = q q |e = 0) = π0 , and Pr(˜ = q |e = 1) = π1 , with π1 > π0 . We will denote the diﬀerence ¯ q ¯ 180

between these two probabilities by ∆π = π1 − π0 . Note that eﬀort improves production in the sense of ﬁrst-order stochastic dominance, i.e., Pr(˜ q q ∗ |e) is decreasing with e for any given production q ∗ . Indeed, we have Pr(˜ q q|e = 0) and Pr(˜ q q |e = 1) = 1 =Pr(˜ ¯ q q |e = 0) ¯

q|e = 1) = 1 − π1 < 1 − π0 = Pr(˜ q

8.2.2

Incentive Feasible Contracts

Since the agent’s action is not directly observable by the principal, the principal can only oﬀer a contract based on the observable and veriﬁable production level. i.e., a function {t(˜)} linking the agent’s compensation to the random output q . With two possible q ˜ ¯ outcomes q and q, the contract can be deﬁned equivalently by a pair of transfers t and t. ¯ ¯ Transfer t (resp. t) is the payment received by the agent if the production q (resp. q) is ¯ realized. The risk-neutral principal’s expected utility is now written as ¯ V1 = π1 (S(¯) − (t) + (1 − π1 )(S(q) − t) q if the agent makes a positive eﬀort (e = 1) and ¯ V0 = π0 (S(¯) − (t) + (1 − π0 )(S(q) − t) q (8.2) (8.1)

if the agent makes no eﬀort (e = 0). For notational simplicity, we will denote the princi¯ pal’s beneﬁts in each state of nature by S(¯) = S and S(q) = S. q Each level of eﬀort that the principal wishes to induce corresponds to a set of contracts ensuring moral hazard incentive constraint and participation constraint are satisﬁed: ¯ π1 u(t) + (1 − π1 )u(t) − ψ ¯ π1 u(t) + (1 − π1 )u(t) − ψ ¯ π0 u(t) + (1 − π0 )u(t) 0. (8.3) (8.4)

Note that the participation constraint is ensured at the ex ante stage, i.e., before the realization of the production shock. Deﬁnition 8.2.1 An incentive feasible contract satisﬁes the incentive and participation constraints (8.3) and (8.4). The timing of the contracting game under moral hazard is summarized in the ﬁgure below. 181

Figure 8.1: Timing of contracting under moral harzard.

8.2.3

The Complete Information Optimal Contract

As a benchmark, let us ﬁrst assume that the principal and a benevolent court of law can both observe eﬀort. Then, if he wants to induce eﬀort, the principal’s problem becomes

¯ {(t,t)}

¯ ¯ max π1 (S − t) + (1 − π1 )(S − t)

(8.5)

subject to (8.4). Indeed, only the agents participation constraint matters for the principal, because the agent can be forced to exert a positive level of eﬀort. If the agent were not choosing this level of eﬀort, the agent could be heavily punished, and the court of law could commit to enforce such a punishment. Denoting the multiplier of this participation constraint by λ and optimizing with ¯ respect to t and t yields, respectively, the following ﬁrst-order conditions: ¯ −π1 + λπ1 u (t∗ ) = 0, −(1 − π1 ) + λ(1 − π1 )u (t∗ ) = 0, ¯ where t∗ and t∗ are the ﬁrst-best transfers. From (8.6) and (8.7) we immediately derive that λ = ¯ that t∗ = t∗ = t∗ . Thus, with a veriﬁable eﬀort, the agent obtains full insurance from the risk-neutral principal, and the transfer t∗ he receives is the same whatever the state of nature. Because the participation constraint is binding we also obtain the value of this transfer, which is just enough to cover the disutility of eﬀort, namely t∗ = h(ψ). This is also the expected payment made by the principal to the agent, or the ﬁrst-best cost C F B of implementing the positive eﬀort level. 182

1 u (t∗ )

(8.6) (8.7)

=

1 ¯ u (t∗ )

> 0, and ﬁnally

For the principal, inducing eﬀort yields an expected payoﬀ equal to ¯ V1 = π1 S + (1 − π1 )S − h(ψ) (8.8)

Had the principal decided to let the agent exert no eﬀort, e0 , he would make a zero payment to the agent whatever the realization of output. In this scenario, the principal would instead obtain a payoﬀ equal to ¯ V0 = π0 S + (1 − π0 )S. Inducing eﬀort is thus optimal from the principal’s point of view when V1 ¯ π1 S + (1 − π1 )S − h(ψ) gain of eﬀect is greater than ﬁrst-best cost of inducing eﬀect, i.e., ∆π∆S ¯ where ∆S = S − S > 0. Denoting the beneﬁt of inducing a strictly positive eﬀort level by B = ∆π∆S, the ﬁrst-best outcome calls for e∗ = 1 if and only if B > h(ψ), as shown in the ﬁgure below. h(ψ) (8.10) (8.9) V0 , i.e.,

¯ π0 S + (1 − π0 )S, or to put it diﬀerently, when the expected

Figure 8.2: First-best level of eﬀort.

8.3

Risk Neutrality and First-Best Implementation

If the agent is risk-neutral, we have (up to an aﬃne transformation) u(t) = t for all t and h(u) = u for all u. The principal who wants to induce eﬀort must thus choose the contract that solves the following problem: ¯ ¯ max π1 (S − t) + (1 − π1 )(S − t) ¯ π0 t + (1 − π0 )t (8.11)

¯ {(t,t)}

¯ π1 t + (1 − π1 )t − ψ 183

¯ π1 t + (1 − π1 )t − ψ

0.

(8.12)

With risk neutrality the principal can, for instance, choose incentive compatible trans¯ fers t and t, which make the agent’s participation constraint binding and leave no rent to the agent. Indeed, solving (8.11) and (8.12) with equalities, we immediately obtain t∗ = − and 1 − π0 ¯ t∗ = ψ. ∆π ¯ ¯ U ∗ = t∗ − ψ =

1−π1 ψ ∆π

π0 ψ ∆π

(8.13)

(8.14)

The agent is rewarded if production is high. His net utility in this state of nature > 0. Conversely, the agent is punished if production is low. His

π1 corresponding net utility U ∗ = t∗ − ψ = − ∆π ψ < 0.

¯ The principal makes an expected payment π1 t∗ + (1 − π1 )t∗ = ψ, which is equal to the disutility of eﬀort he would incur if he could control the eﬀort level perfectly. The principal can costlessly structure the agent’s payment so that the latter has the right incentives to exert eﬀort. Using (8.13) and (8.14), his expected gain from exerting eﬀort ¯ is thus ∆π(t∗ − t∗ ) = ψ when increasing his eﬀort from e = 0 to e = 1. Proposition 8.3.1 Moral hazard is not an issue with a risk-neutral agent despite the nonobservability of eﬀort. The ﬁrst-best level of eﬀort is still implemented. Remark 8.3.1 One may ﬁnd the similarity of these results with those described last chapter. In both cases, when contracting takes place ex ante, the incentive constraint, under either adverse selection or moral hazard, does not conﬂict with the ex ante participation constraint with a risk-neutral agent, and the ﬁrst-best outcome is still implemented. Remark 8.3.2 Ineﬃciencies in eﬀort provision due to moral hazard will arise when the agent is no longer risk-neutral. There are two alternative ways to model these transaction costs. One is to maintain risk neutrality for positive income levels but to impose a limited liability constraint, which requires transfers not to be too negative. The other is to let the agent be strictly risk-averse. In the following, we analyze these two contractual environments and the diﬀerent trade-oﬀs they imply.

184

15) and (8. the optimal contract inducing eﬀort from the agent entails: (1) For l > π0 ψ.20) . (8. EU SB = 0.19) ¯ {(t. with l written as ¯ t and t −l. when he wants to induce a high eﬀort. limited liability constraints in both states of nature are These constraints may prevent the principal from implementing the ﬁrst-best level of eﬀort even if the agent is risk-neutral.18) are binding. Proposition 8.3) and (8. Optimal transfers are given by (8.17) 0.15) to (8.8. we have the following proposition.4) now take the following forms: ¯ π1 t + (1 − π1 )t − ψ and ¯ π1 t + (1 − π1 )t − ψ 0.18) −l (8. the principal’s program is written as ¯ ¯ max π1 (S − t) + (1 − π1 )(S − t) (8. ∆π (8. (2) For 0 l π0 ψ. ∆π only (8.16) ¯ π0 t + (1 − π0 )t (8. (8.13) and (8.15) Let us also assume that the agent’s transfer must always be greater than some exogenous level −l.14). (8. Indeed.1 With limited liability.16) are binding. The agent has no expected limited liability rent. Then.15) and (8. Thus.t)} subject to (8. As we have already seen.4.18). 185 then given by: (8. Optimal transfers are tSB = −l.4 The Trade-Oﬀ Between Limited Liability Rent Extraction and Eﬃciency Let us consider a risk-neutral agent.

18) are the only relevant constraints. i. Note that only the limited liability constraint in the bad state of nature may be binding.23) ¯ {(t. 186 . The risk. Compared with the case without limited liability.4). the conﬂict between moral hazard and limited liability diminishes and then disappears whenever l is large enough.neutral agent does not have enough assets to cover the punishment if q is realized in order to induce eﬀort provision.17) and (8. As the agent becomes endowed with more assets. the principal is limited in his punishments to induce eﬀort.e.5 The Trade-Oﬀ Between Insurance and Eﬃciency Now suppose the agent is risk-averse.22). In this case. tSB = −l and ¯ tSB = −l + ψ . Hence.21) (3) Moreover.15) and (8. as l gets larger. (8. We also check that 0. 8. it is costless to induce a positive eﬀort by the agent. When the limited liability constraint (8. ∆π ψ ∆π We check that (8.15) and (8. since the principal is willing to minimize the payments made to the agent.18) is binding. this rent is actually the additional payment that the principal must incur because of the conjunction of moral hazard and limited liability. both constraints must be binding.3) and (8. The principal uses rewards when a good state of nature q is realized. The proof is completed.t)} subject to (8. the agent’s expected limited liability rent EU SB is non-negative: π0 ¯ EU SB = π1 tSB + (1 − π1 )tSB − ψ = −l + ψ ∆π Proof.We ∆π 0.16) is satisﬁed since π1 tSB + (1 − π1 )tSB − ψ = −l + For l > π0 ψ. and (8. Of course.16) are both binding. ∆π π0 ψ ∆π π0 ¯ note that the transfers t∗ = − ∆π ψ. The principal’s program is written as: ¯ ¯ max π1 (S − t) + (1 − π1 )(S − t) (8. First suppose that 0 l π0 ψ. ¯ (8.22) conjecture that (8.17) is satisﬁed since −l + > −l. the agent receives a ¯ non-negative ex ante limited liability rent described by (8.18) are strictly satisﬁed.. ∆π (8. and t∗ = −ψ + (1−π1 ) ψ > t∗ are such ∆π that both limited liability constraints (8. and the ﬁrst-best outcome can be implemented.ψ ¯ tSB = −l + . As a result.

or equivalently let t = h(¯) ¯ and t= h(u). Then. the ﬁrst-order conditions of this program can be expressed as −π1 h (¯SB ) + λ∆π + µπ1 = − u −(1 − π1 )h (uSB ) − λ∆π + µ(1 − π1 ) = − π1 + λ∆π + µπ1 = 0. Rearranging terms.3) and (8.1 Optimal Transfers Letting λ and µ be the non-negative multipliers associated respectively with the constraints (8. Deﬁne u = u(t) and u = u(t).Since the principal’s optimization problem may not be a concave program for which the ﬁrst-order Kuhn and Tucker conditions are necessary and suﬃcient. ¯ u (tSB ) (8.28) (1 − π1 ) − λ∆π + µ(1 − π1 ) = 0. Note that the principal’s objective function is now strictly concave in (¯.30) 187 .u)} u ¯ max π1 (S − h(¯)) + (1 − π1 )(S − h(u)) u (8. the principal’s program can be rewritten as {(¯.29) (8. ¯SB ) u (t π1 1 ∆π =µ−λ . (8. SB 1 − π1 u (t ) (8.25) π1 u + (1 − π1 )u − ψ ¯ which replaces (8. respectively.25).4). ¯ 0. u) because u h(·) is strictly convex. we get ∆π 1 =µ+λ . These new variables are the levels of ex post utility obtained by the agent in both states of nature.24) and (8.27) (8.5. The constraints are now linear and the interior of the constrained set is obviously non-empty.24) (8. The set of incentive feasible contracts can now be described by two linear constraints: π1 u + (1 − π1 )u − ψ ¯ π0 u + (1 − π0 )u.25).24) and (8. we make the ¯ ¯ u following change of variables. 8.26) subject to (8. u (tSB ) ¯ where tSB and tSB are the second-best optimal transfers.

5. Note that the risk-averse agent does not receive full insurance anymore.29) by π1 and (8. (8. and then adding those two modiﬁed equations we obtain µ= π1 1 − π1 + > 0.25). Using that (8.29).¯ The four variables (tSB . Using (8. Indeed. This contract does not provide full insurance.32) ψ ∆π where λ must also be strictly positive. we can immediately obtain the ¯ values of u(tSB ) and u(tSB ) by solving a system of two equations with two unknowns. with full insurance.24) we have uSB − uSB ¯ >0 ¯ and thus tSB > tSB .34) (8.3) can no longer be satisﬁed. ¯ u (tSB ) u (tSB ) (8. second. λ. from (8. the following proposition provides a summary. The second-best cost C SB of inducing eﬀort under ¯ moral hazard is the expected payment made to the agent C SB = π1 tSB + (1 − π1 )tSB .16) is necessarily binding.33) 8. (8.5.32) is strictly positive since u < 0. (8. implying that the right-hand side of (8.30) by 1 − π1 . µ) are simultaneously obtained as the solutions to the system of four equations (8.best transfers are given by ψ ¯ tSB = h ψ + (1 − π1 ) ∆π and tSB = h ψ − π1 ψ ∆π . (8.33) and (8. Multiplying (8. from the principal’s point of view.34).30). this cost is rewritten as C SB = π1 h ψ + (1 − π1 ) ψ ∆π 188 + (1 − π1 )h ψ − π1 ψ ∆π . we also obtain λ= π1 (1 − π1 ) ∆π 1 1 − SB ) ¯ u (t u (tSB ) . Using (8.24).35) .25) are both binding. Inducing eﬀort requires the agent to bear some risk.29). tSB .24) and (8. the optimal contract that induces eﬀort makes both the agent’s participation and incentive constraints binding. the incentive compatibility constraint (8.31) Hence.31) and (8. and (8.2 The Optimal Second-Best Eﬀort Let us now turn to the question of the second-best optimality of inducing a high eﬀort. the participation constraint (8.1 When the agent is strictly risk-averse. (8. Proposition 8. Moreover. Indeed.

The beneﬁt of inducing eﬀort is still B = ∆π∆S , and a positive eﬀort e∗ = 1 is the optimal choice of the principal whenever ∆π∆S C SB = π1 h ψ + (1 − π1 ) ψ ∆π + (1 − π1 )h ψ − π1 ψ ∆π . (8.36)

Figure 8.3: Second-best level of eﬀort with moral hazard and risk aversion. With h(·) being strictly convex, Jensen’s inequality implies that the right-hand side of (8.36) is strictly greater than the ﬁrst-best cost of implementing eﬀort C F B = h(ψ). Therefore, inducing a higher eﬀort occurs less often with moral hazard than when eﬀort is observable. The above ﬁgure represents this phenomenon graphically. For B belonging to the interval [C F B , C SB ], the second-best level of eﬀort is zero and is thus strictly below its ﬁrst- best value. There is now an under-provision of eﬀort because of moral hazard and risk aversion. Proposition 8.5.2 With moral hazard and risk aversion, there is a trade-oﬀ between inducing eﬀort and providing insurance to the agent. In a model with two possible levels of eﬀort, the principal induces a positive eﬀort from the agent less often than when eﬀort is observable.

8.6

More than Two Levels of Performance

We now extend our previous 2 × 2 model to allow for more than two levels of performance. We consider a production process where n possible outcomes can be realized. Those performances can be ordered so that q1 < q2 < · · · < qi < qn . We denote the principal’s return in each of those states of nature by Si = S(qi ). In this context, a contract is a ntuple of payments {(t1 , . . . , tn )}. Also, let πik be the probability that production qi takes place when the eﬀort level is ek . We assume that πik for all pairs (i, k) with 189

n i=1

πik = 1.

Finally, we keep the assumption that only two levels of eﬀort are feasible. i.e., ek in {0, 1}. We still denote ∆πi = πi1 − πi0 .

8.6.1

Limited Liability

Consider ﬁrst the limited liability model. If the optimal contract induces a positive eﬀort, it solves the following program:

n {(t1 ,...,tn )}

max

πi1 (Si − ti )

i=1

(8.37)

subject to

n

πi1 ti − ψ

i=1 n

0, ψ,

(8.38) (8.39) (8.40)

(πi1 − πi0 )ti

i=1

ti

0,

for all i ∈ {1, . . . , n}.

(8.38) is the agent’s participation constraint. (8.39) is his incentive constraint. (8.40) are all the limited liability constraints by assuming that the agent cannot be given a negative payment. First, note that the participation constraint (8.38) is implied by the incentive (8.39) and the limited liability (8.40) constraints. Indeed, we have

n n n

πi1 ti − ψ

i=1 i=1

(πi1 − πi0 )ti − ψ +

i=1

πi0 ti

0.

Hence, we can neglect the participation constraint (8.38) in the optimization of the principal’s program. Denoting the multiplier of (8.39) by λ and the respective multipliers of (8.40) by ξi , the ﬁrst-order conditions lead to −πi1 + λ∆πi + ξi = 0. with the slackness conditions ξi ti = 0 for each i in {1, . . . , n}. For such that the second-best transfer tSB is strictly positive, ξi = 0, and we must i have λ =

πi1 πi1 −πi0

(8.41)

**for any such i. If the ratios
**

πj1 −πj0 πj1

πi1 −πi0 πi1

all diﬀerent, there exists a single

index j such that

is the highest possible ratio. The agent receives a strictly 190

positive transfer only in this particular state of nature j, and this payment is such that the incentive constraint (8.39) is binding, i.e., tSB = j ex ante limited liability rent that is worth EU SB =

ψ . πj1 −πj0

In all other states, the agent

**receives no transfer and tSB = 0 for all i = j. Finally, the agent gets a strictly positive i
**

πj0 ψ . πj1 −πj0

The important point here is that the agent is rewarded in the state of nature that is the most informative about the fact that he has exerted a positive eﬀort. Indeed,

πi1 −πi0 πi1

can

be interpreted as a likelihood ratio. The principal therefore uses a maximum likelihood ratio criterion to reward the agent. The agent is only rewarded when this likelihood ratio is maximized. Like an econometrician, the principal tries to infer from the observed output what has been the parameter (eﬀort) underlying this distribution. But here the parameter is endogenously aﬀected by the incentive contract. Deﬁnition 8.6.1 The probabilities of success satisfy the monotone likelihood ratio property (MLRP) if

πi1 −πi0 πi1

is nondecreasing in i.

Proposition 8.6.1 If the probability of success satisﬁes MLRP, the second-best payment tSB received by the agent may be chosen to be nondecreasing with the level of production i qi .

8.6.2

Risk Aversion

Suppose now that the agent is strictly risk-averse. The optimal contract that induces eﬀort must solve the program below:

n {t1 ,...,tn )}

max

πi1 (Si − ti )

i=1

(8.42)

subject to

n

n

πi1 u(ti ) − ψ

i=1 i=1 n

πi0 u(ti )

(8.43)

and

πi1 u(ti ) − ψ

i=1

0,

(8.44)

where the latter constraint is the agent’s participation constraint. Using the same change of variables as before, it should be clear that the program is again a concave problem with respect to the new variables ui = u(ti ). Using the same 191

notations as before, the ﬁrst-order conditions of the principal’s program are written as: 1 =µ+λ u (tSB ) i πi1 − πi0 πi1 for all i ∈ {1, . . . , n}.

1 u (tSB ) i

(8.45) > 0,

Multiplying each of these equations by πi1 and summing over i yields µ = Eq induced by eﬀort e = 1.

where Eq denotes the expectation operator with respect to the distribution of outputs Multiplying (8.45) by πi1 u(tSB ), summing all these equations over i, and taking into i account the expression of µ obtained above yields

n

λ

i=1

(πi1 − πi0 )u(tSB ) i

˜i = Eq u(tSB )

n i=1 (πi1

1 −E ˜i u (tSB )

1 ˜i u (tSB )

.

(8.46)

Using the slackness condition λ hand side of (8.46), we ﬁnally get

− πi0 )u(tSB ) − ψ = 0 to simplify the lefti

˜i λψ = cov u(tSB ),

1 ˜i u (tSB )

.

(8.47)

By assumption, u(·) and u (·) covary in opposite directions. Moreover, a constant wage tSB = tSB for all i does not satisfy the incentive constraint, and thus tSB cannot be i i constant everywhere. Hence, the right-hand side of (8.47) is necessarily strictly positive. Thus we have λ > 0, and the incentive constraint is binding. Coming back to (8.45), we observe that the left-hand side is increasing in tSB since i u(·) is concave. For tSB to be nondecreasing with i, MLRP must again hold. Then higher i outputs are also those that are the more informative ones about the realization of a high eﬀort. Hence, the agent should be more rewarded as output increases.

8.7

Contract Theory at Work

This section elaborates on the moral hazard paradigm discussed so far in a number of settings that have been discussed extensively in the contracting literature.

8.7.1

Eﬃciency Wage

Let us consider a risk-neutral agent working for a ﬁrm, the principal. This is a basic model studied by Shapiro and Stiglitz (AER, 1984). By exerting eﬀort e in {0, 1}, the 192

¯ ﬁrm’s added value is V (resp. V ) with probability π(e) (resp. 1 − π(e)). The agent can only be rewarded for a good performance and cannot be punished for a bad outcome, since they are protected by limited liability. ¯ To induce eﬀort, the principal must ﬁnd an optimal compensation scheme {(t, t)} that is the solution to the program below:

¯ {(t,t)}

¯ ¯ max π1 (V − t) + (1 − π1 )(V − t)

(8.48)

subject to ¯ π1 t + (1 − π1 )t − ψ ¯ π0 t + (1 − π0 )t, 0, (8.49) (8.50) (8.51)

¯ π1 t + (1 − π1 )t − ψ t 0.

The problem is completely isomorphic to the one analyzed earlier. The limited liability constraint is binding at the optimum, and the ﬁrm chooses to induce a high eﬀort when ∆π∆V

π1 ψ . ∆π

¯ ¯ At the optimum, tSB = 0 and tSB > 0. The positive wage tSB =

ψ ∆π

is

often called an eﬃciency wage because it induces the agent to exert a high (eﬃcient) level of eﬀort. To induce production, the principal must give up a positive share of the ﬁrm’s proﬁt to the agent.

8.7.2

Sharecropping

The moral hazard paradigm has been one of the leading tools used by development economists to analyze agrarian economies. In the sharecropping model given in Stiglitz (RES, 1974), the principal is now a landlord and the agent is the landlord’s tenant. By exerting an eﬀort e in {0, 1}, the tenant increases (decreases) the probability π(e) (resp. 1 − π(e)) that a large q (resp. small q) quantity of an agricultural product is produced. ¯ The price of this good is normalized to one so that the principal’s stochastic return on the activity is also q or q, depending on the state of nature. ¯ It is often the case that peasants in developing countries are subject to strong ﬁnancial constraints. To model such a setting we assume that the agent is risk neutral and protected by limited liability. When he wants to induce eﬀort, the principal’s optimal contract must solve

¯ {(t,t)}

max π1 (¯ − t) + (1 − π1 )(q − t) q ¯ 193

(8.52)

(8.57) π1 ψ .56) The ﬂexible second-best contract described above has sometimes been criticized as not corresponding to the contractual arrangements observed in most agrarian economies.59) is binding at the optimum. the optimal linear rule inducing eﬀort must solve max(1 − α)(π1 q + (1 − π1 )q) ¯ α (8. with the landlord oﬀering the agent a ﬁxed share α of the realized production.60) α(π1 q + (1 − π1 )q) − ψ ¯ Obviously. Contracts often take the form of simple linear schedules linking the tenant’s production to his compensation. Formally.53) (8.61) Note that αSB < 1 because. ¯ The optimal contract therefore satisﬁes tSB = 0 and tSB = This is again akin to an eﬃciency wage. the return on the agricultural activity is shared between the principal and the agent. let us now analyze a simple linear sharing rule between the landlord and his tenant. ∆π (8. ¯ 0 (8.59) (8. for the agricultural activity to be a valuable venture in the ﬁrst-best world. which can therefore be omitted in what follows.54) (8. Such a sharing rule automatically satisﬁes the agent’s limited liability constraint.58) subject to α(π1 q + (1 − π1 )q) − ψ ¯ α(π0 q + (1 − π0 )q). with high-powered incentives (α 194 . 0. The expected utilities obtained respectively by the principal and the agent are given by EV SB = π1 q + (1 − π1 )q − ¯ and EU SB = π0 ψ . Hence. ∆π (8. One ﬁnds the optimal linear sharing rule to be αSB = ψ . we must have ∆π∆q > ψ. ∆π ¯ π1 t + (1 − π1 )t − ψ t 0.55) ψ . only (8. ∆π∆q (8. As an exercise.subject to ¯ π1 t + (1 − π1 )t − ψ ¯ π0 t + (1 − π0 )t.

the agent always beneﬁts from a positive return on his production. e is in {0. respectively EVα = π1 q + (1 − π1 )q − ¯ and EUα = π1 q + (1 − π1 )q ¯ ∆q ψ . even in the worst state of nature.63) Comparing (8. This sharing rule also yields the following expected utilities to the principal and the agent. p).close to one) being provided when the disutility of eﬀort ψ is large or when the principal’s gain from an increase of eﬀort ∆π∆q is small. again. The manufacturer supplies at constant marginal cost c an intermediate good to the risk-averse retailer. with a linear sharing rule. D(p)) with probability π(e) where. ∆π ψ ∆π (8. A linear contract is less powerful than the optimal second-best contract. If the space of available contracts is extended to allow for ﬁxed fees β. who sells this good on a ﬁnal market. we observe that the constant sharing rule beneﬁts the agent but not the principal. who can increase the probability that demand is high if after-sales services are eﬃciently performed.56) and (8. ∆π 8. Indeed. namely zero. The wholesale contract consists of a retail price maintenance agreement specifying the prices ¯¯ p and p on the ﬁnal market with a sharing of the proﬁts. This positive return yields to the agent more than what is requested by the optimal second-best contract in the worst state of nature.7. Punishing the agent for a bad performance is thus found to be rather diﬃcult with a linear sharing rule. A linear sharing rule allows the agent to keep some strictly positive rent EUα . Eﬀort e is exerted by the retailer.62) π1 q + (1 − π1 )q ¯ ∆q (8.57) and (8. p)}.62) on the one hand and (8. When ¯ 195 . The former contract is an ineﬃcient way to extract rent from the agent even if it still provides suﬃcient incentives to exert eﬀort. low) D(p) (resp.63) on the other hand. (t.3 Wholesale Contracts Let us now consider a manufacturer-retailer relationship studied in Laﬀont and Tirole (1993). the principal can nevertheless bring the agent down to the level of his outside opportunity by setting a ﬁxed fee β SB equal to π1 q +(1−π1 )q ¯ ∆q ψ . 1} and p denotes the price for the ﬁnal good. Demand on this market is ¯ high (resp. namely {(t.

The ﬁnancial contract consists of repayments {(¯. The solution to this problem is obtained by appending the following expressions of the retail prices to the transfers given in (8.33) and (8. and p∗ + D(p∗ ) D (p∗ ) = c. 1}. the risk-neutral lender’s program is written as ¯ max π1 z + (1 − π1 )z − I (8. t = V − z and t = V − z. 1994).64) ¯p {(t. The entrepreneur has no cash of his own and must raise money from a bank or any other ﬁnancial intermediary. (8. 8.7. it is assumed that a risk-averse entrepreneur wants to start a project that requires an initial investment worth an amount I.3) and (8. In Holmstrom and Tirole (AER.65) z {(z.he wants to induce eﬀort.66) Note that the project is a valuable venture if it provides the bank with a positive expected proﬁt. The pricing rule is not aﬀected by the incentive problem. We denote the spread of proﬁts ¯ z by ∆V = V − V > 0.¯)} subject to (8.34): p∗ + ¯ ¯ p D(¯∗ ) D (¯∗ ) p = c. This change of variables also highlights the fact that everything happens 196 . The return on the ¯ project is random and equal to V (resp.4). where the eﬀort exerted by the entrepreneur e belongs to {0. the principal’s program takes its usual form. V ) with probability π(e) (resp.(t. z)}. ¯ ¯ π1 u(V − z ) + (1 − π1 )u(V − z) − ψ 0.¯)} subject to ¯ ¯ π1 u(V − z ) + (1 − π1 )u(V − z) − ψ ¯ ¯ π0 u(V − z ) + (1 − π0 )u(V − z).67) (8. To induce eﬀort from the borrower.p). 1 − π(e)). depending upon whether the project is successful or not. Note that these prices are the same as those that would be chosen under complete information. ¯ ¯ ¯ With the change of variables.4 Financial Contracts Moral hazard is an important issue in ﬁnancial markets. the optimal contract oﬀered by the manufacturer solves the following problem: max ¯ p ¯ π1 ((¯ − c)D(¯) − t) + (1 − π1 )((p − c)D(p) − t) p (8.

for I in [I SB .70) For intermediary values of the investment. ¯ the optimal contract would instead entail tLL = 0 and tLL = h . note that ¯ tLL − tLL = h ψ ∆π ¯ < tSB − tSB = h ψ + (1 − π1 ) π1 ψ ∆π . and typically we must have ¯ I < I SB = π1 V + (1 − π1 )V − C SB .71) −h ψ − since h(·) is strictly convex and h(0) = 0. This inequality shows that the debt contract has less incentive power than the optimal incentive contract.68) Let us now parameterize projects according to the size of the investment I.. This requires the investment to be low enough. Interestingly. (8. To be induced to make an eﬀort. ψ ∆π (8. so that the lender wants to induce a positive eﬀort level even in a second-best environment. Let us deﬁne the second-best cost of implementing a positive eﬀort C SB . and then paying the agent only a fraction of the returns in the diﬀerent states of nature. this contract has sometimes been interpreted in the corporate ﬁnance literature as a debt contract. Indeed. Finally. moral hazard implies that some projects are ﬁnanced under complete information but no longer under moral hazard. which ψ ∆π implies a negative payoﬀ in the bad state of nature. note that the optimal ﬁnancial contract oﬀered to the risk-averse and cashless entrepreneur does not satisfy the limited liability constraint t h ψ− π1 ψ ∆π 0. The lender’s expected proﬁt is worth ¯ V1 = π1 V + (1 − π1 )V − C SB − I. Finally. i. Adding the limited liability constraint. This is akin to some form of credit rationing. the agent must bear some risk. I ∗ ]. it becomes harder 197 . Only the projects with positive value V1 > 0 will be ﬁnanced.as if the lender was beneﬁtting directly from the returns of the project. with no money being left to the borrower in the bad state of nature and the residual being pocketed by the lender in the good state of nature. Indeed.e.69) Under complete information and no moral hazard. we have tSB = < 0. the project would instead be ﬁnanced as soon as ¯ I < I ∗ = π1 V + (1 − π1 )V (8. (8. and let us assume that ∆π∆V C SB .

to spread the agent’s payments between both states of nature to induce eﬀort if the agent is protected by limited liability by the agent. (8. This distribution is conditional ¯ on the agent’s level of eﬀort. (8.72) and (8. t) = (S(q) − t)f (q|1) + λ(u(t)(f (q|1) − f (q|0)) − ψ) + µ(u(t)f (q|1) − ψ).76) 198 . respectively. (8.73) by λ and µ. q (8. Optimizing pointwise with respect to t yields 1 u (tSB (q)) =µ+λ f (q|1) − f (q|0) f (q|1) . only rewards are attractive.72) and (8. we obtain. 8.73) The risk-neutral principal problem is thus written as q ¯ {t(q)} max (S(q) − t(q))f (q|1)dq. We denote by f (·|e) the density corresponding to the above distributions. who is interested only in his payoﬀ in the high state of nature. A contract t(q) inducing a positive eﬀort in this context must satisfy the incentive constraint q ¯ q ¯ u(t(q))f (q|1)dq − ψ q q u(t(q))f (q|0)dq.72) and the participation constraint q ¯ u(t(q))f (q|1)dq − ψ q 0. as in the main text.73). q ]. µ = Eq ˜ 1 u (tSB (˜)) q > 0. the Lagrangian is written as L(q. Denoting the multipliers of (8. which still takes two possible values e in {0.75) Multiplying (8. (8.74) subject to (8.75) by f1 (q) and taking expectations.8 A Continuum of Performances Let us now assume that the level of performance q is drawn from a continuous distribution ˜ with a cumulative function F (·|e) on the support [q. 1}.

the analysis becomes much harder.9 Further Extension We have stressed the various conﬂicts that may appear in a moral hazard environment. λ 1 ) u (tSB (˜)) q − 0. 0 because u(·) and u (·) vary in opposite directions. When one moves away from the 2 × 2 model.where Eq (·) is the expectation operator with respect to the probability distribution of ˜ output induced by an eﬀort eSB . Also. λ = 0 only if tSB (q) is a constant. The analysis of these conﬂicts. Finally. and characterizing the optimal incentive contract is a diﬃcult task. Even worse. but in this case the incentive constraint is necessarily violated. the manager of a ﬁrm may have to choose how to allocate his eﬀort between productive activities and monitoring his peers and other workers. Examples of such complex contracting environment are abound. q ¯ (f (q|1) q Integrating over [q. we obtain λ(f (q|1) − f (q|0))u(tSB (q)) 1 1 = f (q|1)u(tSB (q)) − Eq ˜ SB (q)) SB (q)) u (t u (t (8. A manager may no longer choose between working or not working on a project but may be able to ﬁne-tune the exact eﬀort spent on this project. was made easy because of our focus on a simple 2×2 environment with a binary eﬀort and two levels of performance. q Hence.75). the agent’s actions may no longer be summarized by a onedimensional parameter but may be better described by a whole array of control variables that are technologically linked. to the case with 199 . under both limited liability and risk aversion. inserting it into (8.77) . one can extend the standard model to the cases where the agent can perform more than two and possibly a continuum of levels of eﬀort. q ] and taking into account the slackness condition λ( ˜ f (q|0))u(tSB (q))dq − ψ) = 0 yields λψ = cov(u(tSB (˜)). tSB (π) is monotonically increasing in π when the monotone likelihood property d dq f (q|1)−f ∗(q|0) f (q|1) 0 is satisﬁed. using this expression of µ. The simple interaction between a single incentive constraint with either a limited liability constraint or a participation constraint was quite straightforward. 8. As a result. may be better characterized as a continuous variable. Nevertheless. Eﬀort may no longer be binary but. instead. and multiplying it by f (q|1)u(tSB (q)). For instance. we have λ > 0. Finally.

Laﬀont. 2003. Laﬀont.a multitask model. J. 972-991. Chapter 12. 41 (1974). 89 (1976).. D. Whinston. Shapiro. A. Tian. the case where the agent’s utility function is no longer separable between consumption and eﬀort. G. 433-444.” Econometrica 62 (1994). Luenberger.” Working Paper. B. Laﬀont..-J. and G. and J. McGraw-Hill. Inc. Mas-Colell. Grossman. and the Real Sector. see Chapter 5 of Laﬀont and Martimort (2002). 200 . 1995. 219-255. 7 45. M. Martimort. Stiglitz. Chapter 14.” Quarterly Journal of Economics.” Review of Economic Studies. Oxford University Press. C. J. Tirole. “Incentives and Risk Sharing in Sharecropping. Laﬀont and D. 400 500. “Equilibrium Unemployment as a Worker Discipline Ddvice. “The New Economics of Regulation Ten Years After. Stiglitz. For detailed discussion. The Theory of Incentives in Procurement and Regulation. and J. Holmstrom. Reference Akerlof. 84 (1994). J. The Theory of Incentives: The Principal-Agent Model.” American Economic Review. “Optimal Contracts for Central Banks Revised. Microeconomic Theory... Tirole. One can also analyze the trade-oﬀ between eﬃciency and redistribution in a moral hazard context. Microeconomic. 74 (1984). “Financial Intermediation. D.” Econometrica. Texas A&M University.-J. Green.. Hart. “The Market for Lemons: Quality Uncertainty and the Market Mechanism. and J. Princeton and Oxford: Princeton University Press. Chapters 4-5. 1995. 2002. J. “An Analysis of the Principal Agent. S.” American Economic Review.. Li. J. and J.. 1993. 507 538.. Cambridge: MIT Press. 51 (1983). Loanable Funds.. -J. and O.

W. and Incentives. E. Topics in Microeconomics .. Cambridge Press. H. Third Edition.R.Industrial Organization. 1992. Chapters 8-10. 201 . Chapters 25.. Microeconomic Analysis.Varian. W. Norton and Company. 1999. Wolfstetter. Auctions.

Incentive problems arise when the social planner cannot distinguish between things that are indeed diﬀerent so that free-ride problem many appear. Since the model involves only one agent.1 Introduction In the previous chapters on the principal-agent theory. In such a case. Like the principal-agent model. we have introduced basic models to explain the core of the principal-agent theory with complete contracts. the game theoretic reasoning is thus used to model social institutions as varied voting systems. asymmetric information may not only aﬀect the relationship between the principal and each of his agents. auctions. a basic insight of the incentive mechanism with more than one agent is that incentive constraints should be considered coequally with resource con- 202 . we will introduce some of basic results and insights of the mechanism design in general. To describe the strategic interaction between agents and the principal. A free rider can improve his welfare by not telling the truth about his own un-observable characteristic. bargaining protocols. It highlights the various trade-oﬀs between allocative eﬃciency and the distribution of information rents.Chapter 9 General Mechanism Design 9. the design of the principal’s optimal contract has reduced to a constrained optimization problem without having to appeal to sophisticated game theory concepts. but it may also plague the relationships between agents. and implementation theory in particular for situations where there is one principal (also called the designer) and several agents. and methods for deciding on public projects. In this chapter.

In many cases. The King’s solution used a method of threatening to cut the lively baby in two and give half to each. disputing who was the mother of a child. A theme that comes out of the literature is the diﬃculty of ﬁnding mechanisms compatible with individual incentives that simultaneously results in a desired social goal. depending on the kind of game (mechanism) that agents play and other game theoretical solution concepts. we can have a truthtelling mechanism. Another example of incentive mechanism design is how to cut a pie and divide equally among all participants. We will also brieﬂy introduce the incomplete information case in which agents do not know each other’s characteristics. the appropriate equilibrium concept is dominant strategies. then the relevant equilibrium concept is the Nash equilibrium. We will introduce these results and such trade-oﬀs. When information is private. In this situation. one can ignore the ﬁrst-best or Pareto eﬃciency. These incentives adopt the form of incentive compatibility constraints where for each agent to tell truth about their characteristics must be dominant. Examples of incentive mechanism design that takes strategic interactions among agents exist for a long time. and so one can expect the truth. and uses a general message space. An early example is the Biblical story of the famous judgement of Solomon for determining who is the real mother of a baby. and want to reach Pareto eﬃcient outcomes. if one is willing to give up Pareto eﬃciency. One women was willing to give up the child. one can gives up the truth-telling. we could give up the truth-telling requirement. Of course. do not kill the child and give the him to the ﬁrst woman.telling behavior. On the other hand. such as Groves-Clark mechanism. One may design a mechanism that Nash implements Pareto eﬃcient allocations. The ﬁrst major development was in the work of Gibbard-Hurwicz-Satterthwaite in 1970s. The fundamental conclusion of Gibbard-Hurwicz-Satterthwaite’s impossibility theorem is that we have to have a trade-oﬀ between the truth-telling and Pareto eﬃciency (or the ﬁrst best outcomes in general). When the information about the characteristics of the agents is shared by individuals but not by the designer. The King then made his judgement and decision: The ﬁrst woman is the mother. One of the most fundamental contributions of the mechanism theory has been shown that the free-rider problem may or may not occur. but another women agreed to cut in two.straints. and 203 . Two women came before the King.

2. (2) social choice goal to be reached. (3) economic mechanism that speciﬁes the rules of game. initial endowment if any.1 Here. E is a general expression of economic environments. Yi ): ei = (Zi . Let 204 . and (5) implementation of a social choice goal (incentive-compatibility of personal interests and the social goal at equilibrium). depending on the situations facing the designer. The designer is assumed that he does not know the individuals’ economic characteristics. . . the set of admissible economic environments under consideration sometimes may be just given by E = U .1 Economic Environments i .2. 9. (4) description of solution concept on individuals’ self-interested behavior. .2 Basic Settings Theoretical framework of the incentive mechanism design consists of ﬁve components: (1) economic environments (fundamentals of economy). U = U1 × . otherwise it is called the incomplete information case. it is called the complete information case. or by the set of all possible initial endowments. en ): an economy. wi .2.2 Social Goal Given economic environments. . × Un : The set of all admissible utility functions. 9. 9. . or production sets. . economic characteristic of agent i which consists of out- come space. However. each agent participates economic activities. makes decisions. E: The set of all priori admissible economic environments. The individuals may or may not know the characteristics of the others. and the production set if agent i is also a producer. preference relation. receives beneﬁts and pays costs on economic activities. If they know.we need to consider Bayesian incentive compatible mechanism. e = (e1 . Remark 9.

Let Mi : the message space of agent i.. F : E →→ A: the social goal or called social choice correspondence in which F (e) is the set of socially desired outcomes at the economy under some criterion of social optimality. 9. a mechanism consists of a message space and an outcome function. Examples of Social Choice Correspondences: P (e): the set of Pareto eﬃcient allocations.Z = Z1 × . F A(e): the set of fare allocations. the designer informs how the information he collected from individuals is used to determine outcomes.3 Economic Mechanism Since the designer lacks the information about individuals’ economic characteristics. × Zn : the outcome space (For example. L(e): the set of Lindahl allocations. A ⊆ Z: the feasible set. Z = X × Y ). that is. To do so. denoted by f . all individuals have incentives to choose actions which result in socially optimal outcomes when they pursue their personal interests. . it is called a social choice function.2. 205 . Majority voting rule. i. W (e): the set of Walrasian allocations. he ﬁrst tells the rules of games. Thus. he needs to design an appropriate incentive mechanism (rules of game) to coordinate the personal interests and the social goal. When F becomes a single-valued function.e. under the mechanism. I(e): the set of individual rational allocations. He then uses the information or actions of agents and the rules of game to determine outcomes of individuals. Examples of Social Choice Functions: Solomon’s goal. .

Γ =< M. . mi ∈ Mi : a message reported by agent i. Remark 9. a sub-ﬁeld of the mechanism 206 . h >: a mechanism That is.M = M1 × . mn ) ∈ M : a proﬁle of messages. Remark 9. . Since the preferences of individuals in the mechanism design setting vary. . once the preference of the individuals are speciﬁed.2 A mechanism is often also referred to as a game form.2.1: Diagrammatic Illustration of Mechanism design Problem. a mechanism consists of a message space and an outcome function. However. as the consequence of a proﬁle of message is an outcome rather than a vector of utility payoﬀs.2. h : M → Z: outcome function that translates messages into outcomes. m = (m1 . 1986b). . then a game form or mechanism induces a conventional game. × Mn : the message space in which communications take place. Figure 9. .3 In the implementation (incentive mechanism design) literature. The terminology of game form distinguishes it from a game in game theory. one requires a mechanism be incentive compatible in the sense that personal interests are consistent with desired socially optimal outcomes even when individual agents are self-interested in their personal goals without paying much attention to the size of message. In the realization literature originated by Hurwicz (1972. this distinction between mechanisms and games is critical. .

we have the following various concepts on implementation and incentive compatibility of F . Given a mechanism Γ and equilibrium behavior assumption b(e. The purpose of an incentive mechanism design is to implement some desired socially optimal outcomes. Walker (1977). Bayesian Nash equilibrium. the implementation problem of a social choice rule F studies the relationship of the intersection state of F (e) and h(b(e.5 Implementation and Incentive Compatibility In which sense can we see individuals’s personal interests do not have conﬂicts with a social interest? We will call such problem as implementation problem. it has been shown that competitive market economy system is the unique most eﬃcient system that results in Pareto eﬃcient and individually rational allocations (cf. a basic assumption is that individuals are self-interested in the sense that they pursue their personal interests. Thus. the lower (transition) cost of operating the mechanism.literature. Jordan (1982). Hurwicz (1986b). Osana (1978). A Mechanism < M.2. i. For the neoclassical economies. Thus. the resulting equilibrium outcome is the composite function of the rules of game and the equilibrium strategy. h. Γ) be the set of equilibrium strategies that describes the self-interested behavior of individuals. 9. Γ)). and thus each individual agent’s strategy on reaction will depend on his self-interested behavior which in turn depends on the economic environments and the mechanism. dominant strategy. Examples of such equilibrium solution concepts include Nash equilibrium. Tian (2002d)). Γ).e. given E. Let b(e. h > is said to 207 .2.. and b. The smaller a message space of a mechanism. they in general does not care about social interests. diﬀerent economic environments and diﬀerent rules of game will lead to diﬀerent reactions of individuals.4 Solution Concept of Self-Interested Behavior In economics. h(b(e. etc. and tries to ﬁnd economic system to have small operation cost. 9. Mount and Reiter (1974). Unless they can be better oﬀ. As a result. one also concerns the size of message space of a mechanism. Γ)). M .

(ii) implement a social choice correspondence F in equilibrium strategy b(e. 9. strong Nash equilibrium. As shown in the following. h > is said to be b(e. Γ) on E if for every e ∈ E (a) b(e. For incomplete information.3 Examples Before we discuss some basic results in the mechanism theory. Γ)) ⊆ F (e). (b) h(b(e. (b) h(b(e. Γ)) ∩ F (e) = ∅. (b) h(b(e. Γ)equilibrium. whether or not a social choice correspondence is implementable will depend on the assumption on the solution concept of self-interested behavior. Note that we did not give a speciﬁc solution concept so far when we deﬁne the implementability and incentive-compatibility. When information is complete. etc. Γ)-equilibrium if it (fully or weakly) implements F in b(e. undominated Bayesian Nash equilibrium. subgame perfect Nash equilibrium. etc. (iii) weakly implement a social choice correspondence F in equilibrium strategy b(e. Γ) incentive-compatible with a social choice correspondence F in b(e. we ﬁrst give some economic environments which show that one needs to design a mechanism to solve the incentive 208 . Γ) on E if for every e ∈ E (a) b(e. undominanted equilibrium. equilibrium strategy can be Bayesian Nash equilibrium. A Mechanism < M. Γ) = ∅. Nash equilibrium.(i) fully implement a social choice correspondence F in equilibrium strategy b(e. Γ) on E if for every e ∈ E (a) b(e. the solution concept can be dominant equilibrium. Γ) = ∅ (equilibrium solution exists). Γ)) = F (e) (personal interests are fully consistent with social goals). Γ) = ∅.

the outcome space is Z = {y ∈ {0. . . the rights to an exclusive license are to be allocated or an enterprise is to be privatized. The outcome space is then Y = {0. . Note that we can regard y as n-dimensional vector of public goods since vi (y) = vi yi = vy. The valuation function of agent i can be written as vi (y) = ri (y) − zi (y). the net value of individual i is 0 from not having the project built and vi ≡ ri − from having a project built. and there is no scale problem. vi ) = yri − y c = yvi .compatible problems. 1}. For instance. the net value beneﬁtted from the object is vi . Thus. the outcome space is Z = R+ × Rn . The beneﬁt of i for building y is ri (y) with ri (0) = 0. zn (y)) ∈ R+ × Rn : i∈N zi (y) = c(y)}. . In this case. Thus. If he does not get the object. Example 9. Now let y ∈ R+ denote the scale of the public project and c(y) denote the cost of producing y. 209 . yi = 0 represents the individual does not get the object.3. In this case. where 0 represents not building the project and 1 represents building the project. vn ). If individual i gets the object. 1}n : n i=1 yi = 1}. Example 9. Individual i’s value from use of this project is ri . agent i’s valuation function is vi (y) = vi yi .3 (Allocating an Indivisible Private Good) An indivisible good is to be allocated to one member of society.2 (Continuous Public Goods Setting) In the above example. Thus agent i’s valuation function can be represented as vi (y. in many case. . the net beneﬁt of building the project is ri (y) − zi (y). the public good could only take two values. z1 (y).1 (A Public Project) A society is deciding on whether or not to build a public project at a cost c. where v = (v1 . n c n Example 9. .3. the net beneﬁt of not building the project is equal to 0. his net value is 0.where yi = 1 means individual i obtains the object. where zi (y) is the share of agent i for producing the public goods y. But. and the feasible set is A = {(y. The cost of the pubic project is to be divided equally. the level of public goods depends on the collection of the contribution or tax. . Thus. .3.

m−i ) for all m ∈ M .e. b(e. we have shown previously that a public project is produced if and only if the total values of all individuals is greater than it total cost.. Γ) = D(e. The above deﬁnitions have applied to general (indirect) mechanisms. regardless of choices of the others.e.4 Dominant Strategy and Truthful Revelation Mechanism The strongest solution concept of describing self-interested behavior is dominant strategy. let h : V → Z is a vi (h(vi )) ∀v ∈ V. Γ)) ⊂ F (e).. 9. (a) D(e. For instance. a mechanism Γ =< M. When the solution concept is given by dominant strategy equilibrium. since each agent’s optimal choice does not depend on the choices of the others and does not need to know characteristics of the others. For e ∈ E.From these examples. m−i ) i i hi (mi . if i∈N ri > c. (9. there is. i∈N Let Vi be the set of all valuation functions vi . h > and e ∈ E. An axiom in game theory is that agents will use it as long as a dominant strategy exists. the required information is least when an individual makes decisions. Γ). (b) h(D(e. Under the assumption of dominant strategy. if it exists. i. and if i∈N ri < c. then y = 0. i. Γ) the set of dominant strategy equilibria for Γ =< M. Thus. a socially optimal decision clearly depends on the individuals’ true valuation function vi (·).1) Denoted by D(e. The dominant strategy identiﬁes situations in which the strategy chosen by each individual is the best. h > is said to have a dominant strategy equilibrium m∗ if for all i hi (m∗ . then y = 1. a mechanism Γ =< M. h > implements a social choice correspondence F in dominant equilibrium strategy on E if for every e ∈ E. Then h is said to be eﬃcient if and only if: vi (h(vi )) i∈N i∈N Vi . Γ) = ∅. it is an ideal situation. let V = decision rule. however. a particular class of game forms which have a natural appeal and have received much 210 .

the following Revelation Principle tells us that one only needs to use the so-called revelation mechanism in which the message space consists solely of the set of individuals’ characteristics.4. Then there is a revelation mechanism < E. Let d be a selection of dominant strategy correspondence of the mechanism < M. Γ). It is the absence of such a mechanism which has been called the “free-rider” problem in the theory of public goods. Although the message space of a mechanism can be arbitrary. Perhaps the most appealing revelation mechanisms of all are those for which each agent has truth as a dominant strategy.. each agent i’s dominant strategy can be expressed as m∗ = di (ei ).4. (b) h(e) ⊂ F (e).1 Groves mechanism is a revelation mechanism. Theorem 9. Since Γ = M. i. h implements social choice rule F . Since the strategy of each agent is independent of the strategies of the others. A revelation mechanism < E. h > is said to implements a social choice correspondence F truthfully in b(e. h > implements a social choice rule F in dominant strategy. Thus. such a selection exists by the implementation of F . h > is said to be a revelation or direct mechanism if M = E. h >. for every e ∈ E. Example 9. i 211 . m∗ = d(e) ∈ D(e. Proof. In eﬀect. g > which implements F truthfully in dominant strategy. The most appealing revelation mechanisms are those in which truthful reporting of characteristics always turns out to be an equilibrium. each agent reports a possible characteristic but not necessarily his true one. and it is unnecessary to seek more complicated mechanisms. A mechanism Γ =< M.e. in which the message space Mi for each agent i is the set of possible characteristics Ei .1 (Revelation Principle) Suppose a mechanism < M. it will signiﬁcantly reduce the complicity of constructing a mechanism. (a) e ∈ b(e. These are called direct or revelation mechanisms. Γ). Γ) on E if for every e ∈ E.attention in the literature.

Deﬁne the revelation mechanism < E, g > by g(e) ≡ h(d(e)) for each e ∈ E. We ﬁrst show that the truth-telling is always a dominant strategy equilibrium of the revelation mechanism E, g . Suppose not. Then, there exists a e and an agent i such that ui [g(ei , e−i )] > ui [g(ei , e−i )]. However, since g = h ◦ d, we have ui [h(d(ei ), d(e−i )] > ui [h(d(ei ), d(e−i )], which contradicts the fact that m∗ = di (ei ) is a dominant strategy equilibrium. This is i because, when the true economic environment is (ei , e−i ), agent i has an incentive not to report m∗ = di (ei ) truthfully, but have an incentive to report mi = di (ei ), a contradiction. i Finally, since m∗ = d(e) ∈ D(e, Γ) and < M, h > implements a social choice rule F in dominant strategy, we have g(e) = h(d(e)) = h(m∗ ) ∈ F (e). Hence, the revelation mechanism implements F truthfully in dominant strategy. The proof is completed. Thus, by the Revelation Principle, we know that, if truthful implementation rather than implementation is all that we require, we need never consider general mechanisms. In the literature, if a revelation mechanism < E, h > truthfully implements a social choice rule F in dominant strategy, the mechanism Γ is said to be strongly incentive-compatible with a social choice correspondence F . In particular, when F becomes a single-valued function f , < E, f > can be regarded as a revelation mechanism. Thus, if a mechanism < M, h > implements f in dominant strategy, then the revelation mechanism < E, f > is incentive compatible in dominant strategy, or called strongly incentive compatible. Remark 9.4.1 Notice that the Revelation Principle may be valid only for weak implementation. The Revelation Principle speciﬁes a correspondence between a dominant strategy equilibrium of the original mechanism < M, h > and the true proﬁle of characteristics as a dominant strategy equilibrium, and it does not require the revelation mechanism has a unique dominant equilibrium so that the revelation mechanism < E, g > may also exist non-truthful strategy equilibrium that does not corresponds to any equilibrium. Thus, in moving from the general (indirect) dominant strategy mechanisms to direct ones, one may introduce dominant strategies which are not truthful. More troubling, these additional strategies may create a situation where the indirect mechanism is an implantation 212

of a given F , while the direct revelation mechanism is not. Thus, even if a mechanism implements a social choice function, the corresponding revelation mechanism < E, g > may only weakly implement, but not implement F .

9.5

Gibbard-Satterthwaite Impossibility Theorem

The Revelation Principle is very useful to ﬁnd a dominant strategy mechanism. If one hopes a social choice goal f can be (weakly) implemented in dominant strategy, one only needs to show the revelation mechanism < E, f > is strongly incentive compatible. However, the Gibbard-Satterthwaite impossibility theorem in Chapter 4 tells us that, if the domain of economic environments is unrestricted, such a mechanism does not exist unless it is a dictatorial mechanism. From the angle of the mechanism design, we state this theorem repeatly here. Deﬁnition 9.5.1 A social choice function is dictatorial if there exists an agent whose optimal choice is the social optimal. Now we state the Gibbard-Satterthwaite Theorem without the proof that is very complicated. A proof can be found, say, in Salani´’s book (2000): Microeconomics of e Market Failures. Theorem 9.5.1 (Gibbard-Satterthwaite Theorem) If X has at least 3 alternatives, a social choice function which is strongly incentive compatible and deﬁned on a unrestricted domain is dictatorial.

9.6

Hurwicz Impossibility Theorem

The Gibbard-Satterthwaite impossibility theorem is a very negative result. This result is very similar to Arrow’s impossibility result. However, as we will show, when the admissible set of economic environments is restricted, the result may be positive as the Groves mechanism deﬁned on quasi-linear utility functions. Unfortunately, the following Hurwicz’s impossibility theorem shows the Pareto eﬃciency and the truthful revelation is fundamentally inconsistent even for the class of neoclassical economic environments. 213

Theorem 9.6.1 (Hurwicz Impossibility Theorem, 1972) For the neoclassical private goods economies, any mechanism < M, h > that yields Pareto eﬃcient and individually rational allocations is not strongly individually incentive compatible. (Truth-telling about their preferences is not Nash Equilibrium). Proof: By the Revelation Principle, we only need to consider any revelation mechanism that cannot implement Pareto eﬃcient and individually rational allocations in dominant equilibrium for a particular pure exchange economy. Consider a private goods economy with two agents (n = 2) and two goods (L = 2), w1 = (0, 2), w2 = (2, 0) 3x + y if xi yi i i ui (x, y) = x + 3y if xi > yi i i

**Figure 9.2: An illustration of the proof of Hurwicz’s impossibility theorem. Thus, feasible allocations are given by A =
**

4 [(x1 , y1 ), (x2 , y2 )] ∈ R+ :

x1 + x2 = 2 y1 + y2 = 2} 214

Ui is the set of all neoclassical utility functions, i.e. they are continuous and quasi-concave, which agent i can report to the designer. Thus, the true utility function ˚i ∈ Ui . Then, u U = U1 × U2 h : U →A

Note that, if the true utility function proﬁle ˚i is a Nash Equilibrium, it satisﬁes u ˚i (hi (˚i , ˚−i )) u u u ˚i (hi (ui , ˚−i )) u u (9.2)

We want to show that ˚i is not a Nash equilibrium. Note that, u (1) P (e) = O1 O2 (contract curve) (2) IR(e) ∩ P (e) = ab (3) h(˚1 , ˚2 ) = d ∈ ab u u Now, suppose agent 2 reports his utility function by cheating: u2 (x2 , y2 ) = 2x + y (9.3)

Then, with u2 , the new set of individually rational and Pareto eﬃcient allocations is given by IR(e) ∩ P (e) = ae (9.4)

Note that any point between a and e is strictly preferred to d by agent 2. Thus, the allocation determined by any mechanism which yields IR and Pareto eﬃcient allocation under (˚1 , u2 ) is some point, say, the point c in the ﬁgure, between the segment of the u line determined by a and e. Hence, we have ˚2 (h2 (˚1 , u2 )) > ˚2 (h2 (˚1 , ˚2 )) u u u u u (9.5)

since h2 (˚1 , u2 ) = c ∈ ae. Similarly, if d is between ae, then agent 1 has incentive to cheat. u Thus, no mechanism that yields Pareto eﬃcient and individually rational allocations is incentive compatible. The proof is completed. Thus, the Hurwicz’s impossibility theorem implies that Pareto eﬃciency and the truthful revelation about individuals’ characteristics are fundamentally incompatible. However, if one is willing to give up Pareto eﬃciency, say, one only requires the eﬃcient provision 215

of public goods, is it possible to ﬁnd an incentive compatible mechanism which results in the Pareto eﬃcient provision of a public good and can truthfully reveal individuals’ characteristics? The answer is positive. For the class of quasi-linear utility functions, the so-called Groves-Clarke-Vickrey Mechanism can be such a mechanism.

9.7

Groves-Clarke-Vickrey Mechanism

From Chapter 6 on public goods, we have known that public goods economies may present problems by a decentralized resource allocation mechanism because of the free-rider problem. Private provision of a public good generally results in less than an eﬃcient amount of the public good. Voting may result in too much or too little of a public good. Are there any mechanisms that result in the “right” amount of the public good? This is a question of the incentive compatible mechanism design. For simplicity, let us ﬁrst return to the model of discrete public good.

9.7.1

Groves-Clark Mechanism for Discrete Public Good

Consider a provision problem of a discrete public good. Suppose that the economy has n agents. Let c: the cost of producing the public project. ri : the maximum willingness to pay of i. gi : the contribution made by i. vi = ri − gi : the net value of i. The public project is determined according to 1 if n v i=1 i y= 0 otherwise

0

**From the discussion in Chapter 6, it is eﬃcient to produce the public good, y = 1, if and only if
**

n n

vi =

i=1 i=1

(ri − qi )

0.

216

Thus the message space of each agent i is Mi = . The Groves mechanism is deﬁned as follows: Γ = (M1 . what mechanism one should use to determine if the project is built? One mechanism that we might use is simply to ask each agent to report his or her net value and provide the public good if and only if the sum of the reported value is positive. . is private information and so is the net value vi . . ri . . • Groves Mechanism: In the Groves mechanism. . Thus.t. Mn . . xi + qi y = wi + ti where ti is the transfer to agent i. tn (·). a question is how we can induce each agent to truthfully reveal his true value for the public good. Individuals may have incentives to underreport their willingness-to-pay. t(·). xi − wi . i. Then. Suppose the utility functions are quasi-linear in net increment in private good. y) = ti + ri y − gi y = ti + (ri − gi )y = ti + vi y. agents are required to report their net values. we have ui (ti .. t2 (·). report the net value of agent i which may or may not be his true net value vi . . y(·)). . y(·)) ≡ (M. t1 (·). The problem with such a scheme is that it does not provide right incentives for individual agents to reveal their true willingness-to-pay.e. . (2) The level of the public good is determined by 1 if n b i=1 i y(b) = 0 otherwise 0 217 . where (1) bi ∈ Mi = R: each agent i reports a “bid” for the public good. y) = xi − wi + ri y ¯ s. The so-called Groves-Clark mechanism gives such kind of mechanism.Since the maximum willingness to pay for each agent. which have the form: ui (xi .

truth-telling is a dominant strategy equilibrium.7. Indeed. but in general it impossible by Hurwicz’s impossibility theorem. Thus. There is no incentive for agent i to misrepresent his true net value regardless of what other agents do. However. Ideally. φ(vi . and consequently it results in Pareto eﬃcient allocations. Case 1: vi + j=i bj > 0. we would like to have a mechanism where the sum of the side-payment is equal to zero so that the feasibility condition holds. the payoﬀ of agent i is given by v +t =v + i i i φ(b) = 0 (9. That is. regardless of what the other agents report.6) j=i bj if n i=1 bi 0 otherwise (9. In this case.(3) Each agent i receives a side payment (transfer) bj if n bi 0 i=1 j=i ti = 0 otherwise Then. b−i ) = vi + Case 2: vi + j=i bj j=i bj + vi = n i=1 bj > 0 and thus y = 1. The above preference revelation mechanism has a major fault: the total side-payment may be very large. In > 0.7) We want to show that it is optimal for each agent to report the true net value. the allocation of public goods will not be Pareto eﬃcient. 218 . but not receive payment. if bi = vi . Thus. agent i has incentives to tell the true value of vi . bi = vi . φ(vi . Proposition 9. for either cases. 0. Proof: There are two cases to be considered. it is optimal for agent i to tell the truth. it is very costly to induce the agents to tell the truth. we could modify the above mechanism by asking each agent to pay a “tax”. Because of this “waster” tax. Then agent i can ensure the public good is provided by j=i bj reporting bi = vi .1 The truth-telling is a dominant strategy under the Groves-Clark mechanism. then this case. Agent i can ensure that the public good is not provided by n i=1 bi reporting bi = vi so that 0. Hence. b−i ) = 0 vi + j=i bj .

it gives 0 − 0 0 j=i bj if if j=i bj j=i bj 0 <0 if j=i bj n i=1 bi n i=1 bi n i=1 bi n i=1 bi 0 and 0 and < 0 and < 0 and j=i bi ) j=i bi j=i bj j=i bj j=i bj 0. One nice choice is the so-called Clark mechanism (also called pivotal mechanism): The Pivotal Mechanism is a special case of the general Groves Mechanism in which di (b−i ) is given by di (b−i ) = In this case. A General Groves Mechanism: Ask each agent to pay additional tax. the transfer is given by j=t bj − di (b−i ) if ti (b) = −d (b ) if i −i The payoﬀ to agent i now takes the form: v + t − d (b ) = v + i i i −i i φ(b) = −d (b ) i −i n i=1 bi n i=1 bi 0 <0 n i=1 bi j=i bj − di (b−i ) if 0 otherwise (9. di (b−i ).. di (b−i ) that depends only on what the other agents do.11) 219 . the payoﬀ of agent i vi if v + if i j=i bj φi (b) = − if j=i bj 0 if 0 and 0 and < 0 and < 0 and j=i bj j=i bj j=i bj j=i bj 0 <0 0 <0 (9.The basic idea of paying a tax is to add an extra amount to agent i’s side-payment. one can prove that it is optimal for each agent i to report his true net value.9) ti (b) = if j=i bj if if j=i bi | j=i bi | i. −| ti (b) = −| 0 if ( if n i=1 bi )( n i=1 bi <0 j=i bi = 0 and <0 (9. the size of the side-payment can be significantly reduced. If the function di (b−i ) is suitably chosen.8) For exactly the same reason as for the mechanism above. <0 0 <0 (9.10) otherwise n i=1 bi n i=1 bi n i=1 bi n i=1 bi Therefore. In this case.e.

n n n (9. 9.2 The Groves-Clark-Vickery Mechanism with Continuous Public Goods Now we are concerned with the provision of continuous public goods. y) = ti − (ui (y) − gi (y)) ≡ ti + vi (y) where vi (y) is called the valuation function of agent i. y: the consumption of the public goods by all individuals. From the budget constraint. ti : transfer payment to i.14) 220 . and K public goods.1 Thus.7. The price that agent i must pay to change the amount of public good is equal to the harm that he imposes on the other agents. ui (ti . one private good. adding in the side-payment has the eﬀect of taxing agent i only if he changes the social decision.12) (9. Such an agent is called the pivotal person. from the transfer given in (9. The amount of the tax agent i must pay is the amount by which agent i’s bid damages the other agents. y) = xi − wi + ui (y) ¯ By substitution. agent i’s budget constraint should satisfy xi + gi (y) = wi + ti and his utility functions are given by ui (xi . Denote xi : the consumption of the private good by i.13) {xi + gi (y)} = i=1 1=i wi + 1=i ti (9. Consider a public goods economy with n agents.Remark 9.10).7. gi (y): the contribution made by i. Then. c(y): the cost function of producing public goods y that satisﬁes the condition: gi (y) = c(y).

1=i xi + c(y) = 1=i wi For quasi-linear utility functions it is easily seen that the weights ai must be the same for all agents since ai = λ for interior Pareto eﬃcient allocations (no income eﬀect). the above characterization problem becomes max ti .we have n n n xi + c(y) = i=1 i=1 wi + 1=i ti (9. Then.15) The feasibility (or balanced) condition then becomes n ti = 0 i=1 (9. and y is thus uniquely determined for the special case of quasilinear utility functions ui (ti .17) or equivalently (1) max y i=1 n vi (y) (2) (feasibility condition): n i=1 ti =0 Then.y i=1 n (ti + vi (y)) (9. Pareto eﬃcient allocations for quasi-linear utility functions are completely characterized by the Lindahl-Samuelson condition n i=1 ti n i=1 vi (y) = 0 and feasibility condition = 0. n ui (y) = c (y) i=1 Thus. y) = ti + vi (y). the Lagrangian multiplier.16) Recall that Pareto eﬃcient allocations are completely characterized by max n ai ui (xi . the Lindahl-Samuelson condition is given by: n vi (y) = 0. i=1 that is. 221 . y) ¯ n s.t.

.In the Groves mechanism. To get the eﬃcient level of public goods. × Vn : is the message space that consists of the set of all possible valuation functions with element bi (y) ∈ Vi . y ∗ = y(b).18) where V = V1 × .20) The payoﬀ of agent i is then given by φi (b(y ∗ )) = vi (y ∗ ) + ti (b) = vi (y ∗ ) + j=i bj (y ∗ ) (9. . h = (t1 (b). It is determined by: (1) Ask each agent i to report his/her valuation function bi (y) which may or may not be the true valuation vi (y). (2) Determine y ∗ : the level of the public goods. . y(b)) are outcome functions. . it is optimal for each agent i to truthfully report his true valuation function bi (y) = vi (y) since agent i wants to maximize vi (y) + j=i bj (y). it is supposed that each agent is asked to report the valuation function vi (y). . the government may announce that it will provide a level of public goods y ∗ that maximizes n max y i=1 bi (y) The Groves mechanism has the form: Γ = (V. 222 . h) (9. . Denote his reported valuation function by bi (y). t2 (b). tn (b). In which case is the individual’s interest consistent with social planner’s interest? Under the rule of this mechanism. is determined by n max y i=1 bi (y) (9. ti is determined by ti = j=i bj (y ∗ ) (9.21) The social planner’s goal is to have the optimal level y ∗ that solves the problem: n max y i=1 bi (y).19) (3) Determine t: transfer of agent i.

t. Γ =< V. and he pays the second highest biding price. is to choose (y ∗ .22) That is. j=i bj (y). The Groves mechanism can be modiﬁed to ti (b) = j=i bj (y) − d(b−i ). As in the discrete case. The general form of the Groves Mechanism is then Γ =< V.e. In general. the highest biding person obtains the object. (2) ti (b) = − d(b−i ). they can be reduced by an appropriate side-payment. individual’s interest is consistent with the social interest that is determined by the Lindahl-Samuelson condition. the total transfer can be very large. n i=1 ti (b(y)) = 0. t. just as before. Under the Vickery mechanism. A special case of the Groves mechanism is independently described by Clark and is called the Clark mechanism (also called the pivotal mechanism) in which di (b−i (y)) is given by d(b−i ) = max y j=i bj (y). That is. bi (y) = vi (y)). it is Pareto eﬃcient to provide the public goods. (9. is a dominant strategy equilibrium. the pivotal mechanism. truth-telling. y(b) >. y(b) > such that (1) n i=1 bi (y(b)) j=i bj (y) n i=1 bi (y) for y ∈ Y . (2) ti (b) = ) − maxy It is interesting to point out that the Clark mechanism contains the well-known Vickery auction mechanism (the second-price auction mechanism) as a special case. Thus. the outcome space is Z = {y ∈ {0.3 in the beginning of this chapter). 1}n : i=1 n yi = 1} 223 .By reporting bi (y) = vi (y). In this case. agent i ensures that the government will choose y ∗ which also maximizes his payoﬀ while the government maximizes the social welfare. t∗ ) such that i (1) n ∗ i=1 bi (y ) j=i bj (y n i=1 bi (y) ∗ for y ∈ Y . which means that a Groves mechanism in general does not result in Pareto eﬃcient outcomes even if it satisﬁes the Lindahl-Samuelson condition.3.. let us explore this relationship in the case of a single good auction (Example 9. To see this. i.

by Revelation Principle. if one wants to get a mechanism that results in Pareto eﬃcient and individually rational allocations.where yi = 1 implies that agent i gets the object. and then. if gi (v) = 1. then ti (v) = 0. we know that. 9. It is clear every dominant strategy equilibrium is a Nash equilibrium. we know that n y = g(b) = {y ∈ Z : max i=1 bi yi } = {y ∈ Z : max bi }.8 9. and yi = 0 means the person does not get the object. can we design an incentive compatible mechanism which implements Pareto eﬃcient allocations? For e ∈ E. This means that the object is allocated to the individual with the highest valuation and he pays an amount equal to the second highest valuation. h > instead of using a revelation mechanism. then ti (v) = maxy j=i vj yj = − maxj=i vj . one must give up the dominant strategy implementation. Since we can regard y as a n-dimensional vector of public goods. Thus. No other payments are made.8. m∗ ) i (9. if we adopt the Nash equilibrium as a solution concept to describe individuals’ self-interested behavior. i∈N j=i ∗ vj y j − and the truth-telling is a dominate strategy. by the Clark mechanism above. a mechanism < M. We know the dominant strategy equilibrium is a very strong solution concept. This is exactly the outcome predicted by the Vickery mechanism. h > is said to have a Nash equilibrium m∗ ∈ M if hi (m∗ ) i hi (mi .23) for all mi ∈ Mi and all i.1 Nash Implementation Nash Equilibrium and General Mechanism Design From Hurwicz’s impossibility theorem. 224 . Denote by N E(e. Now. but the converse may not be true. Γ) the set of all Nash equilibria of the mechanism Γ for e ∈ E. we must look at more general mechanisms < M. Agent i’s valuation function is then given by vi (y) = vi yi . If gi (b) = 0.

8. e−i ) i i h(ei . e−i ). by Nash equilibrium. and otherwise it is seriously punished by giving a worse outcome.e. e−i ) for all ei ∈ Ei . h >. Γ) = ∅. we cannot get any new results if one insists on the choice of revelation mechanisms. and look for a more general mechanism with general message spaces. i. the weak Nash implementation is not a useful concept.24) Proof. we have h(ei . e−i ) ∀(ei .A mechanism Γ =< M. Then.1 For a revelation mechanism Γ =< E. h > is said to Nash-implement a social choice correspondence F on E if for every e ∈ E (a) N E(e. Since for every e ∈ E and i.. Thus. consider any social choice correspondence F and the following mechanism: each individual’s message space consists of the set of economic environments. The outcome function is deﬁned as h(m) = a ∈ F (e) when all agents reports the same economic environment mi = e. it has a lot of Nash equilibria. in fact 225 . However. To see this. Proposition 9. The following proposition shows that. it must be a dominant strategy equilibrium of the mechanism. it is clear the truth-telling is a Nash equilibrium. The proof is completed. Γ) = ∅ (b) h(N E(e. if a truth-telling about their characteristics is a Nash equilibrium of the revelation mechanism. It fully Nash implements a social choice correspondence F on E if for every e ∈ E (a) N E(e. a truth-telling e∗ is a Nash equilibrium if and only if it is a dominant equilibrium h(e∗ . Γ)) ⊆ F (e). one must give up the revelation mechanism. e−i ) i h(ei . it is given by Mi = E. e−i ) ∈ E&i ∈ N. (b) h(N E(e. Γ)) = F (e). when one adopts the Nash equilibrium as a solution concept. (9. it is a dominant strategy equilibrium. To get more satisfactory results. Since this true for any (ei . Notice that.

Any false reporting about the economic environment mi = e is also a Nash equilibrium.8. 9. x ∈ F (e) such that for all i and ¯ all y ∈ A. Maskin’s monotonicity condition can be stated in two diﬀerent ways although they are equivalent. x i y implies that x ¯ i y. we need a social choice rule to be implemented or full implemented in Nash equilibrium. e ∈ E. ¯ 226 . Maskin’s monotonicity requires that if an outcome x is socially optimal with respect to economy e and then economy is changed to e so that in each individual’s ¯ ordering. when we use Nash equilibrium as a solution concept. then x ∈ F (¯). then x remains socially optimal with respect to e. e In words. Deﬁnition 9. but also gives basic techniques and methods for studying if a social choice rule is implementable under other solution concepts. Maskin’s result is fundamental since it not only helps us to understand what kind of social choice correspondence can be Nash implemented. 1999).2 Characterization of Nash Implementation Now we discuss what kind of social choice rules can be implemented through Nash incentive compatible mechanism. So. x does not fall below an outcome that is not below before.inﬁnity number of Nash equilibria. It then appeared in Review of Economic Studies.8.1 (Maskin’s Monotonicity) A social choice correspondence F : E →→ A is said to be Maskin’s monotonic if for any e. Maskin in 1977 gave necessary and suﬃcient conditions for a social choice rule to be Nash implementable (This paper was not published till 1999.

if for any two economic environments e. e Example 9. there is an ¯ agent i and another y ∈ A such that x i y and y ¯ i x.2 (Majority Rule) The majority rule or call the Condorcet correspondence CON : E →→ A for strict preference proﬁle. If x ∈ Pw (e).3: An illustration of Maskin’s monotonicity.2 (Another Version of Maskin’s Monotonicity) A equivalent condition for a social choice correspondence F : E →→ A to be Maskin’s monotonic is that. x ∈ F (e) such that x ∈ F (e ). there exists i ∈ N such that x for any j ∈ N such that x x ∈ Pw (¯). i j i y.1 (Weak Pareto Eﬃciency) The weak Pareto optimal correspondence Pw : E →→ A is Maskin’s monotonic. then for all y ∈ A. Thus. e ∈ E.8. Deﬁnition 9.8. y} #{i|y i x} for all y ∈ A} 227 . Maskin’s monotonicity is a reasonable condition. Proof.Figure 9. then we have x ¯ i y for particular i. Now if implies x ¯ j y. Example 9.8. and many well known social choice rules satisfy this condition. which is deﬁned by CON (e) = {x ∈ A : #{i|x is Maskin’s monotonic.

The following theorem shows the Maskin’s monotonicity is a necessary condition for Nash-implementability. m−i ). However. for all i. For any two economies e. e In addition to the above two examples.25) But if e is an economy such that. then ¯ we must have x i y and y ¯ i x for some i.Proof. it becomes suﬃcient. Proof. Given x i y implies x ¯i y. if the right-hand side rises. then x ∈ F (e). including weak Pareto eﬃcient and 228 j y for all y ∈ A . The no-veto power (NVP) condition implies that if n − 1 agents regard an outcome is the best to them. If x ∈ CON (e). then the left-hand side of (9. under the so-called no-veto power. So x is still a majority winner with respect to e. Walrasian correspondence and Lindahl correspondence with interior allocations are Maskin’s monotonic. by Nash implementability ¯ again. #{i|x i y} #{i|y i i x}. NVP is satisﬁed by virtually all “standard” social choice rules. m−i ) for all i and mi ∈ Mi . then it is social optimal. x ∈ CON (¯).3 (No-Veto Power) A social choice correspondence F : E →→ A is said to satisfy no-veto power if whenever for any i and e such that x and all j = i.. x ¯ y implies x ¯ i y.8. This means that h(m) i h(mi . we have x ∈ F (¯). The class of preferences that satisfy “single-crossing” property and individuals’ preferences over lotteries satisfy the von Neumann-Morgenstern axioms also automatically satisfy Maskin’ monotonicity. then it must be Maskin’s monotonic.25) cannot fall when we replace e by e. Furthermore. e Maskin’s monotonicity itself can not guarantee a social choice correspondence is fully Nash implementable. This is a rather weaker condition. which means that m is also a Nash equilibrium at e. x ∈ F (e).8. Thus. a contradiction of the relation between e and e. ¯ ¯ i. (9. Theorem 9. if it is fully Nash implementable. given the strictness of preferences. then by full Nash implementability ¯ of F . h(m) ¯i h(mi . then for all y ∈ A. there is m ∈ M such that m is a Nash equilibrium and x = h(m). e ∈ E. Deﬁnition 9.1 For a social choice correspondence F : E →→ A.e.

i i where L(a. v). which means each agent i announces an economic proﬁle. That is. and their proposed alterative a is F -optimal. for private goods economies with at least three agents. deﬁne: a if a ∈ L(a. the outcome is a. mj = (e. so the no-veto power condition holds. Theorem 9. given their proposed proﬁle e. e ) i i i h(m) = a if a ∈ L(a. (For notation convenience. given their proposed proﬁle. v) and a ∈ F (e). 2. a. . if each agent’s utility function is strict monotonic.8. his message space is deﬁned by Mi = E × A × N where N = {1. vi ). }. For each agent i.2 Under no-veto power. then F is fully Nash implementable. Case(2). Proof. ai . In words. their proposed alternative a is F -optimal. The outcome function is constructed in three cases: Case(1). if players are unanimous in their strategy.Condorect correspondences. and a real number. . but not just agent i economic characteristic). It is also often automatically satisﬁed by any social choice rules when the references are restricted. and a ∈ F (e). The proof is by construction. then deﬁne h(m) = ai∗ 229 . Its elements are denoted by mi = (ei . . Then. if Maskin’s monotonicity condition is satisﬁed. Case(3). ai . . gets his proposed alterative. an outcome. If m1 = m2 = . . provided that it is in the lower contour set at a of the ordering that the other players propose for him. then there is no other allocation such that n − 1 agents regard it best. = mn = (e. If neither Case (1) nor Case (2) applies. v). For example. e ). the outcome function is deﬁned by h(m) = a. vi ) = (e. a. the outcome is a. the odd-man-out. . suppose that all players but one play the same strategy and. For all j = i. mi = (ei . ei ) = {b ∈ A : a Ri b} which is the lower contour set of Ri at a. we have used ei to denote the economic proﬁle of all individuals’ economic characteristics. otherwise. a.

Hence. The proof is completed. v). a. but the true economic proﬁle is e . vi ) = mi . h(N (e)) = F (e) for all e ∈ E. e ).. Let a = h(m). b. we only need to show that any m which is given by Case (1) is a Nash equilibrium. i. consider the Nash equilibrium m is given by Case (1) so that a ∈ F (e). by Case (2). a. 230 . h(m) = a. i i and thus h(m) Ri h(mi . for all j = i. we have a ∈ F (e ). by Maskin’s monotonicity condition. First. by no-veto power assumption. e). m ∈ N E(e . we have a Ri b. Note that h(m) = a and for any given mi = (ei . we have a ∈ F (e ).e. if m is a Nash equilibrium. m−i ). i. for all i ∈ N and b ∈ L(a. The same argument as the above. we have a Rj b. we have a if a ∈ L(a. i. the outcome is the alternative proposed by player with the highest index among those whose proposed number is maximal. Next. Thus. We now show that for each economic environment e ∈ E. m is a Nash equilibrium with respect to e implies that for all j = i. a Ri b implies a Ri b. ai .. each j = i can induce any outcome b ∈ A by choosing (Rj . Γ). as the outcome at (mi .. i. by Case (2). we need to show that for all e ∈ E and a ∈ F (e). vj ) with suﬃciently a large vj (which is greater than maxk=j vk ). which can be rewritten as: for i ∈ N and b ∈ A. if m is a Nash equilibrium for e is given by Case (3). By Case (3). In other words.e. We need to show a ∈ F (e ). mi = (e..e. To do so. suppose Nash equilibrium m for e is in the Case (2). v). there exists a m ∈ M such that a = h(m) is a Nash equilibrium outcome. we have a ∈ F (e ). m−i ) ∀mi ∈ Mi .e. when neither case (1) nor case (2) applies. By Case (1). m−i ). mj = (e. e ) i i i h(mi . b = h(mi . Since a is a Nash equilibrium outcome with respect to e . then h(m) ∈ F (e).e. Now we show that the mechanism M. h deﬁned above fully Nash implements social choice correspondence F . i. We ﬁrst show that F (e) ⊂ h(N (e)) for all e ∈ E. Thus. m is a Nash equilibrium.where i∗ = max{i ∈ N : vi = maxj vj }. Hence. m−i ) = a if a ∈ L(a.

c}. where α: Anne is the real mother β: Bets is the real mother Solomon has three alternatives so that the feasible set is given by A = {a. b. it is violated by some social choice rules such as Solomon’s famous judgement. is not entirely foolproof. Solomon’s solution falls under Nash equilibrium implementation. Solomon’s desirability (social goal) is to give the baby to the real mother. b at state β: b α B β B β A α A β A b b α A c c c a α B β B a c 231 . at state α. What would be have done if the impostor has had the presence of mind to scream like a real mother? Solomon’s problem can be formerly described by the languages of mechanism design as follows.Although Maskin’s monotonicity is very weak. β}. since each woman knows who is the real mother. a at β: a For Bets. at state α. which consisted in threatening to cut the baby in two. f (α) = a if α happens f (β) = b if β happens Preferences of Anne and Bets: For Anne. Two women: Anne and Bets Two economies (states): E = {α. His solution. where a: give the baby to Anne b: give the baby to Bets c: cut the baby in half.

can be interpreted as the proposed contribution (or tax) that agent i is willing to make. and three agents (n = 3). and f (α) = a. Its elements. To show the basic structure of the Groves-Ledyard mechanism.9. Characterization results show what is possible for the implementation of a social choice rule. The mechanism is deﬁned as follows: Mi = Ri . The production function is given by y = v. Maskin’s mechanism is not natural in the sense that it is not continuous. like most characterization results in the literature. we should have f (β) = a. Thus. b. c. So Solomon’s social choice goal is not Nash implementable. the implementing mechanisms in proving characterization theorems turn out to be quite complex. 2. 9.To see Solomon’s solution does not work. one public good y. by Maskin’s monotonicity.9 Better Mechanism Design Maskin’s theorems gives necessary and suﬃcient conditions for a social choice correspondence to be Nash implementable. we give some mechanisms that have some desired properties. consider a simpliﬁed Groves-Ledyard mechanism. but we actually have f (β) = b. However. due to the general nature of the social choice rules under consideration.1 Groves-Ledyard Mechanism Groves-Ledyard Mechanism (1977. since a a α A β A b. Notice that for Anne. 9. Econometrica) was the ﬁrst to give a speciﬁc mechanism that Nash implements Pareto eﬃcient allocations for public goods economies. In this section. we only need to show his social choice goal is not Maskin’s monotonic. small variations in an agent’s strategy choice may lead to large jumps in the resulting allocations. but not what is realistic. i = 1. 3. mi . Public goods economies under consideration have one private good xi . and further it has a message space of inﬁnite dimension since it includes preference proﬁles as a component. c. 232 .

Then the mechanism is balanced since 3 3 xi + i=1 3 i=1 ti (m) = i=1 n xi + (m1 + m2 + m3 )2 3 = i=3 xi + y = i=1 wi The payoﬀ function is given by vi (m) = ui (xi (m). we set ∂vi (m) =0 ∂mi Then. xi (m) = wi − ti (m): the consumption of the private good. we have at Nash equilibrium ∂ui ∂y ∂ui i=1 ∂xi 3 = 1 mi =1= m1 + m2 + m3 f (v) 3 (9. the ﬁrst order condition will be a suﬃcient condition for Nash equilibrium. ∂vi (m) ∂ui ∂ui = (−2mi ) + 2(m1 + m2 + m3 ) = 0 ∂mi ∂xi ∂y and thus ∂ui ∂y ∂ui ∂xi (9.29) that is. y(m).27) = mi .ti (m) = m2 +2mj mk : the actual contribution ti determined by the mechanism i with the reported mi .26) (9. To ﬁnd a Nash equilibrium. m1 + m2 + m3 (9. i=1 233 . M RSyxi = M RT Syv . y(m)) = ui (wi − ti (m).28) When ui are quasi-concave. Making summation. y(m) = (m1 + m2 + m3 )2 : the level of public good y.

ti (m) = qi (m)y(m): the contribution (tax) made by agent i. Some agreed that they indeed solved the problem. we have n n n (9. There are two weakness of Groves-Ledyard Mechanism: (1) it is not individually rational: the payoﬀ at a Nash equilibrium may be lower than at the initial endowment. + mi+1 − mi+2 : personalized price of public good. xi (m) = wi − ti (m) = wi − qi (m)y(m): the private good consumption. the budget constraint holds: xi (m) + qi (m)y(m) = wi ∀mi ∈ Mi Making summation. They claimed that they have solved the free-rider problem in the presence of public goods. However. and (2) it is not individually feasible: xi (m) = wi − ti (m) may be negative. and one public good. one private good. the Lindahl-Samuelson and balanced conditions hold which means every Nash equilibrium allocation is Pareto eﬃcient.2 Walker’s Mechanism Walker (1981. Again.30) xi + i=1 i=1 qi (m)y(m) = i=1 wi and thus n n xi + y(m) = i=1 i=1 wi 234 . some did not. Econometrica) gave such a mechanism. consider public goods economies with n agents. Then.Thus. The mechanism is deﬁned by: Mi = R Y (m) = qi (m) = 1 n n i=1 mi : the level of public good. economic issues are usually complicated. and the production function is given by y = f (v) = v.9. How can we design the incentive mechanism to pursue Pareto eﬃcient and individually rational allocations? 9.

. n n y∗ = i=1 mi is a Nash equilibrium. i. Tian proposed a mechanism that overcomes Walker’s mechanism’s problem. if ui are quasi-concave. The payoﬀ function is vi (m) = ui (xi . qi . y(m)) The ﬁrst order conditions for interior allocations are given by ∂vi ∂mi ∂ui ∂qi ∂y(m) ∂ui ∂y(m) y(m) + qi (m) + ∂xi ∂mi ∂mi ∂y ∂mi ∂ui ∂ui qi (m) + =0 = − ∂xi ∂y = − ⇒ ∂ui ∂y ∂ui ∂xi = qi (m) (FOC) for the Lindahl Allocation ⇒ N (e) ⊆ L(e) Thus. The solution m∗ of the following equation ∗ qi = 1 + mi+1 − mi+2 .e.e.. Tian’s mechanism is individually feasible. i. and continuous. . suppose [(x∗ . y ∗ ). . If a person claims large amounts of ti . it is also a suﬃcient condition for Lindahl equilibrium. . Walker’s mechanism also has a disadvantage that it is not feasible although it does solve the individual rationality problem. y) = ui (wi − qi (m)y(m). We can also show every Lindahl allocation is a Nash equilibrium allocation. 235 .31) ∗ ∗ Indeed. xi = wi − ti < 0. L(e) ⊆ N (e) (9. qn ] is a Lindahl equilibrium. Thus. .which means the mechanism is balanced. consumption of private good may be negative. Walker’s mechanism fully implements Lindahl allocations which are Pareto efﬁcient and individually rational. balanced.

we need to assume that preferences are strictly monotonically increasing and convex.3 Tian’s Mechanism In Tian’s mechanism (JET. y) ∈ R2 and (xi . y) Pi (xi . except that y(m) is given by a(m) if y(m) = (mi ) if 0 0 if wi (m) qi (m) mi > a(m) mi n i=1 a(m) (9. + + + ++ To show the equivalence between Nash allocations and Lindahl allocations. no public good would be produced. We ﬁrst prove the following lemmas. the level of public good to be produced would be exactly the total taxes. Y (m∗ )) ∈ R2 for all i ∈ N . Y (m∗ )) ∈ NM.9.9. Figure 9. if the total taxes were less than zero. 1991).9. (xi . if the total taxes exceeded the feasible upper bound. everything is the same as Walker’s. y ) for all (xi . y ) ∈ ∂R2 . To show this mechanism has all the nice properties.4: The feasible public good outcome function Y (m). then (Xi (m∗ ). ++ 236 . An interpretation of this formulation is that if the total taxes that the agents are willing to pay were between zero and the feasible upper bound. and further assume that every interior allocation is preferred to any boundary allocations: For all i ∈ N. where ∂R2 is the boundary of R2 .h (e). Lemma 9.32) mi < 0 where a(m) = mini∈N with N (m) = {i ∈ N : qi (m) > 0}. the level of the public good would be equal to the feasible upper bound.1 If (X(m∗ ).

that there is some (xi . Then Xi (m∗ ) = + 0 for some i ∈ N or Y (m∗ ) = 0. Y (m∗ ) > 0. qn (m∗ )) as the Lindahl price vector. So we only need to show Y (m∗ ) < a(m∗ ). Now we prove that (X(m∗ ). i)Y (m∗ /mi .1. Suppose (Xi (m∗ ).2 If (X(m∗ ). NM. Y (m∗ )) ∈ NM.34) = wj − w /2 ∗ wj /2 > 0 for all j ∈ N . Y (m∗ )) is a Lindahl allocation with (q1 (m∗ ).33) i is positive and denoted by y . .1. Y (m∗ )) ∈ ∂R2 . i) = wj −qj (m∗ /mi . qn (m∗ )) as the Lindahl price vector. i)˜ y ∗ wj − [b + (n s=1 |m∗ | + y )]˜ ˜ y s n = wj − (˜ + b + n y s=1 |m∗ |)˜ s y (9. where b = 1/n. Suppose. . by way of contradiction. The larger root of (9.E. Proof: Let m∗ be a Nash equilibrium. Then Xj (m∗ ) = wj −qj (m∗ )Y (m∗ ) = wj − qj (m∗ )a(m∗ ) = wj − wj = 0 for at least some j ∈ N . a(m)] and thus Y (m∗ ) = n i=1 m∗ . Since the mechanism is completely feasible and n ∗ i=1 qi (m ) = 1 as well as Xi (m∗ ) + qi (m∗ )Y (m∗ ) = wi for all i ∈ N .D. But X(m∗ ) > 0 by Lemma 9. we only need to show that each individual is maximizing his/her preference. .D. then Y (m∗ ) is an interior point of [0. i)˜ > 0 for all j ∈ N . Y (m∗ )) is a Lindahl allocation with (q1 (m∗ ). Consider the quadratic equation y= where w∗ = mini∈N wi . i) = y > 0 and Xj (m∗ /mi . Y (m∗ )) y by Assumption 4.h (e) ⊆ L(e).33) |m∗ |. i). i. Then y = mi + ˜ j n j=i m∗ > 0 and j n wj − qj (m /mi . Thus we have (Xi (m∗ /mi . by way of contradiction. .. . i)) Pi (Xi (m∗ ). Y (m∗ /mi . which contradicts the hypothesis (X(m∗ ). . Suppose. . c = b + n n j=i n i=1 w∗ .9. Suppose that player i chooses his/her message mi = y − ˜ ˜ m∗ .9. then (X(m∗ ).e.9. .h (e). Thus. i) = ˜ wj −qj (m∗ /mi . that Y (m∗ ) = a(m∗ ). 2(y + c) (9. Proposition 1 If the mechanism has a Nash equilibrium m∗ .Proof: We argue by contradiction. Y (m∗ /mi . Q. Lemma 9.h (e). i Proof: By Lemma 9. y) ∈ R2 such that + 237 . Q. a contradiction. Y (m∗ )) ∈ NM.E.

i)) Pi (Xi (m∗ ). Thus. i).. and i i therefore mi → m∗ . i) + qi (m∗ )Y (m∗ /mi . i)yλ > 0 for all j ∈ N as λ is a suﬃciently small positive number. .(xi .D. yλ ) Pi (Xi (m∗ ). n n y ∗ = i=1 mi ∗ Then Xi (m∗ ) = x∗ . . L(e) ⊆ NM. . then there is a Nash equilibrium m∗ of the mechanism such that Xi (m∗ ) = x∗ . Y (m∗ /mi .E. Then by convexity of preferences we have (xiλ . Y (m∗ /mi .9. i) = wi − qi (m∗ )yλ = xiλ . i). we have wj − qj (m∗ /mi . i) = wi for all i ∈ N and mi ∈ Mi . y ∗ ) is a Lindahl allocation with the Lindahl price vector q ∗ = ∗ ∗ (q1 . y) Pi (Xi (m∗ ). i).h (e). qn ). Y (m∗ ) = y ∗ and qi (m∗ ) = qi for all i ∈ N . Proposition 2 If (x∗ . Let (xiλ . for all i ∈ N . Therefore. Y (m∗ )) and xi + qi (m∗ )y wi . Suppose that player i chooses his/her message mi = yλ − n j=1 n j=i m∗ . Thus from (X(m∗ /mi . yλ ) = (λxi +(1λ)Xi (m∗ ). Let m∗ be the solution of the following linear equations system:?? ∗ qi = 1 + mi+1 − mi+2 . 9. Y (m∗ )) Ri (Xi (m∗ /mi . From (xiλ .10 Incomplete Information and Bayesian Nash Implementation Nash implementation has imposed a very strong assumption on information requirement. Q. This contradicts (X(m∗ ).E. it will be enough to conﬁne ourselves to the case of xi + qi (m∗ )y = wi . Nash 238 . Tian’s mechanism Nash implements Lindahl allocations. λy +(1λ)Y (m∗ )). . Y (m∗ )). Since Xj (m∗ ) = wj − qj (m∗ )Y (m∗ ) > 0 for all j ∈ N by Lemma i 9. i. i) = wi −qi (m∗ )Y (m∗ /mi . yλ ) ∈ R2 and xiλ + qi (m∗ )yλ = + wi . i) = yλ and Xi (m∗ /mi . Because of monotonicity of pref- erences. Y (m∗ )) for any 0 < λ < 1. Y (m∗ )).9. we have (Xi (m∗ /mi . Thus as λ → 0. yλ ) Pi (Xi (m∗ ). Since Y (m∗ ) = j m∗ by Lemma 9. i)). Y (m∗ /mi . i ∗ qi (m∗ ) = qi . Y (m∗ /mi .h (e).1. we have + (Xi (m∗ ).2. Although the designer does not know information about agents’ characteristics. Also (xiλ . i)) ∈ i R2 and Xi (m∗ /mi . y ∗ ) is a Nash allocation. Proof: We need to show that there is a message m∗ such that (x∗ .e. Y (m∗ )) ∈ NM. yλ → Y (m∗ ). mi = yλ − Y (m∗ ) + m∗ . Q. Y (m∗ ) = y ∗ .D.

Θ−i (9. If for all e ∈ E. Given a mechanism M. . there is some mechanism that Bayesian-Nash implements F . . Each agent knows his own type θi . Although each agent does not know economic characteristics of the others. h . 1989). Pastlewaite–Schmeidler (JET. the set of its Bayesian-Nash equilibria depends on economic environments. This assumption is hardly satisﬁed in many cases in the real world. we call this social choice correspondence BayesianNash implementable. θi . Can we remove this assumption? The answer is positive. . Jackson (Econometrica. h Bayesian-Nash implements social choice correspondence F . θi ) ∀ˆi ∈ Σi . Assume that all agents and the designer know that the vector of types. 1986). θ−i ) Θ−i q(θi . θn ) is distributed according to q(θ) a priori on a set Θ. . the choice of mi of each agent i is the function of θi : σi : Θi → Mi . Given σ = (σ1 . a mechanism is a pair. denoted by B(e. 1990). Γ). we can still design an incentive compatible mechanism.θ−i )dθ−i . h . as a solution concept to describe individuals’ self-interested behavior. and therefore computes the conditional distribution of the types of the other agents: q(θ−i |θi ) = q(θi . so that it can be denoted by ui (x. In this case. Γ = M. Dutta-Sen (Econometrica. Let Σi be the set of all such strategies of agent i. One can use the Bayesian-Nash equilibrium. B(e) is a subset of F (e). σ σ Given a mechanism M. θi ) Πi (ˆi . Bayesian-Nash incentive compatibility involves the relationship between F (e)and B(e. MookherjeeReichelstein (RES. θi )q(θ−i |θi )dθ−i . . he knows the probability distribution of economic characteristics of the others. θi ). For simplicity. If for a given social choice correspondence F . σn ). assume the utility function of each agent is known up to one parameter. 1991). Like Nash implementation. h . h if for all θi ∈ Θi . . Palfrey-Srivastava (RES. . introduced by Harsanyi. agent i’s expected utility at ti is given by Πi M. As usual. Γ). σ−i . θi ) = ui (h(σ(θ)).h (σ. 239 . 1994).35) A strategy σ is a Bayesian-Nash equilibrium of M. Πi (σ. θ = (θ1 . we say the mechanism M. .equilibrium assume each agent knows characteristics of the others.

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