Asymmetric Information Models in Economics

Econ 201c, UCLA Simon Board
4. Asymmetric Information
May 28, 2020
These notes study models with hidden information. They are useful in every branch of economics:
• Industrial organization: How to regulate a firm when the firm privately knows it costs?
• Public economics: How to design tax policy when agents privately know their productivity?
• Finance: How to design markets when traders privately know their values for goods?
• Labor economics: How to design employment contracts when workers privately know their
ability?
• Health economics: How to design health insurance when agents privately know their health?
A taxonomy of models.
• Screening vs signaling
– Signaling: An informed agent moves first (e.g. choosing education). See 201B.
– Screening: An uninformed principal designs a mechanism to separate different types of
agents (e.g. different versions of products).
• Numbers of agents
– Single-agent model: One principal (e.g. monopolist) plays against a single agent or a
continuum of agents (e.g. customers).
– Multiple-agent model: One principal (e.g. auctioneer) plays against multiple agents (e.g.
bidders).
– Competing principal model: Multiple principals (e.g. competing sellers) design contracts
and agents choose one principal (exclusive contracts) or more (multi-homing).
• Information structure (single-agent model)
– Private values: Principal only cares about agent’s type via mechanism (e.g. via the price
paid).
– Common values: Principal care about agent’s type directly (e.g. quality of good being
purchased).
• Information structure (auctions)
– Private values: Agents know their own values for the good being sold.
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∗ Values may be independent or correlated.

– Interdependent values: Agents i’s value depends on j’s signal. For example in a “common
values” auction agents have the same value for the good being sold.
∗ Signals may still be independent (e.g. vi = θi + θj , where signals θi , θj are indepen-
dent) or correlated.
• Type of implementation (multi-agent models)
– Bayesian Nash Equilibrium: I want to tell the truth if everyone else is telling the truth.
– Ex-post Equilibrium: I want to tell the truth even after I know the types of everyone
else.
– Dominant strategy Equilibrium: I want to tell the truth no matter what everyone else
reports.
– Partial: There is some equilibrium then achieves the desired objective (e.g. efficient
trade).
– Full: Every equilibrium achieves the desired objective.
A guide to this class:
• These notes: Single-agent models.
– Revelation principle
– Nonlinear pricing
– Regulation
– Common values
• Multi-agent models
– Auctions
– Public goods: BNE vs. dominant implementation.
– Trading games
• Dynamics
– Multi-period mechanism design

– Coase conjecture and commitment
• Competition
– Private values - Competing auctioneers

– Common values - Akerlof, Rothschild Stiglitz
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1 Revelation and Taxation Principle
1.1 Nonlinear Pricing
Model
• There is one agent with unknown value θ ∼ F [θ, θ].
• Equivalently, there is continuum of agents with IID values θ ∼ F [θ, θ].
• Agent buys good of quality q ∈ R+ for price t (the “t” stands for “transfer”). Utility is
u = θq − t.
• Principal has increasing, convex cost c(q) of supplying quality q.
Revelation principle
• Suppose the firm charges price schedule T (q).
• The revelation principle says we can implement the same outcomes with a direct revelation
mechanism (DRM) hq(θ), t(θ)i in which the agent reports her type truthfully and is assigned
quality q(θ) at price t(θ).
• See Figure 1.1 (left). Given the price schedule T (q) agent θH chooses (qH , tH ), while agent θL
chooses (qL , tL ). The DRM says offers a menu of h(qH , tH ), (qL , tL )i and says “if you report
θH you get (qH , tH )” and “if you report θL you get (qL , tL )”. Thus, the principal mimics the
optimal choice the agent was making under the original schedule. Moreover, by only offering
two options, it removes other potential deviations (i.e. choosing quality q 6= qL , qH ).
Taxation principle
• Suppose we start with a DRM hq(θ), t(θ)i.
• The taxation principle says we can implement the same outcomes with an indirect price
schedule T (q).
• Given mechanism h(qH , tH ), (qL , tL )i we have to make sure that T (qH ) = tH and T (qL ) = tL ,
but have a lot of flexibility elsewhere. For example we could pick

t(θ) if q = q(θ)
T (q) =
+∞ otherwise
Figure 1.1 (right) shows how we can implement the allocations from Figure 1.1 (left) using a
“step” price schedule.
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Figure 1.1: Revelation Principle (left) and Taxation Principle (right). See text for explanation.
1.2 Revelation Principle for Bayesian Implementation
Model
• There are N agents have types θ = (θ1 , . . . , θN ) ∈ ×i Θi . Denote the distribution by F .
• There is an allocation y ∈ Y , e.g. with nonlinear pricing, y = (q, t).
• Agent i has utility ui (y, θ). Thus i may care about j’s type.
A mechanism (M1 , . . . , MN , g)
• Agent i reports a message mi ∈ Mi . Let M = (M1 , . . . MN )
• The principal implements allocation g : M → Y .
• We look for a BNE m∗ (θ) = (m∗1 (θ1 ), . . . m∗N (θN )).
• For example, a price schedule T (q) is a mechanism where the message is the quality an agent
wants to buy.
Acceptance of the mechanism is WLOG
• Suppose an agent can reject the mechanism and get some outside option ∅.
• We can always include a null message m0 in Mi such that g(m0 ) = ∅.
Direct revelation mechanism
• Agent i’s message space is her type space, Mi = Θi .
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• We change the allocation function to be ḡ(θ) = g(m∗ (θ)). That is, we take the equilibrium
outcomes in the original mechanism and play them for the agent.
Proposition 1. Truth-telling is a BNE of the direct revelation mechanism
Proof. Let “E−i ” denote the expectation over others’ signals given i’s signal. Under truth-telling
the agent obtains expected utility
E−i [ui (ḡ(θ), θ)] = E−i [ui (g(m∗ (θ)), θ)]

≥ max E−i ui (g(m̃i , m∗−i (θ)), θ)

m̃i
h i
≥ max E−i ui (ḡ(θ̃i , θ−i , ), θ)
θ˜i
which implies truth-telling is optimal. The first line comes from the definition of the DRM. The
second uses the definition of a BNE. The third uses the fact that there are weakly fewer deviations
under the DRM than the original mechanism: Under the DRM i can only claim allocations obtained
by other types in equilibrium; under the original mechanism there may have been messages that
are sent by no types in equilibrium.
Corollary 1. The revelation principle. Suppose the mechanism (M, g) has a BNE m∗ (θ). Then
there is a DRM (Θ, ḡ) such that all agents accept (IR), and all agents report their types truthfully
(IC).
Remarks.
• The attractive feature of a DRM is that we know this is the best we can do in all mechanisms.
We are not artificially restricting the space of things the principal can do.
• We only claim that there is some BNE in the DRM that implements the original outcome.
This is about partial implementation since the DRM may introduce additional equilibria.
• One can extend the revelation principle to moral hazard (Myerson, JME, 1983). That is: each
agent has a set of types and chooses a decision. The principal then requests information and
sends out recommended actions to the agents. The principal can thus use i’s information to
inform j’s action, and coordinate agents’ actions. The generalized revelation principle says
that we can focus on mechanisms in which the agent is “honest” (agents report truthfully) and
“obedient” (agents take the recommended action). Of course we must check that the agent
does not want to mis-report her type, or take an action that was not recommended.
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2 Single Agent Problems
We first study the nonlinear pricing problem. Let’s set it up generally. We’ll then provide two
methods to solve the problem.
• The firm’s problem is to choose a direct mechanism hq(θ), t(θ)i to solve:
max Π = E[t(θ) − c(q(θ))]

q(θ),t(θ)
s.t. (IR) u(θ, θ) ≥ 0 ∀θ

(IC) u(θ, θ) ≥ u(θ, θ̃) ∀θ, θ̃
where an agent of type θ who reports θ̃ gets utility u(θ, θ̃) = θq(θ̃) − t(θ̃).
First-best benchmark.
• Under the first-best contract the agent’s type θ is observed by the principal. We can thus
ignore the (IC) constraint.
• The principal chooses t(θ) to hold each type equal to her outside option, so profits are
Π = E[θq(θ) − c(q(θ))]
Pointwise maximization gives rise to the FOC
θ = c0 (q(θ))
Higher types have a higher marginal benefit from quality and so get higher quality in the
first-best contract.
• Payments are given by t(θ) = θq(θ) to leave each type with zero utility.
2.1 Nonlinear Pricing: Two Types
Suppose θ ∈ {θL , θH }, where θH > θL and Pr(θ = θL ) = α. The principal’s problem is then:
max Π = (1 − α)[tH − c(qH )] + α[tL − c(qL )]

qL ,qH ,tL ,tH
s.t. (IRL ) θL qL − tL ≥ 0
(IRH ) θH qH − tH ≥ 0
(ICL ) θL qL − tL ≥ θL qH − tH
(ICH ) θH qH − tH ≥ θH qL − tL
Claim 1. (IRH ) can be ignored.
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• (ICH ) and (IRL ) imply (IRH ) . Formally, θH qH − tH ≥ θH qL − tL ≥ θL qL − tL ≥ 0.
Claim 2. qH ≥ qL
• (ICL ) and (ICH ) imply that θH (qH − qL ) ≥ tH − tL ≥ θL (qH − qL ).
Claim 3. (IRL ) binds
• If not then increase tL and tH by . This raises profits but does not affect either (ICL ) or
(ICH ).
Claim 4. (ICH ) binds
• If not then increase tH by . This raises profits, weakens (ICL ) and does not affect (IRL ).
Claim 5. If qH ≥ qL then (ICL ) can be ignored.
• If (ICH ) binds and qH ≥ qL then tH − tL = θH (qH − qL ) ≥ θL (qH − qL ) and so (ICL ) holds.
Solving the problem
• Given these claims, the principal’s problem becomes
max Π = (1 − α)[tH − c(qH )] + α[tL − c(qL )]

qL ,qH ,tL ,tH
s.t. (IRL ) θL qL − tL = 0
(ICH ) θH qH − tH = θH qL − tL
(M ON ) qH ≥ qL
• Let U (θ) = u(θ, θ) be equilibrium utility. We can also write the constraints as
(IRL ) U (θL ) = 0
(ICH ) U (θH ) = U (θL ) + (θH − θL )qL
(M ON ) qH ≥ qL
this will look familiar when we come to the continuous type model.
• To solve the problem, we ignore (M ON ) which gives us a relaxed problem. Substituting the
constraints into the objective we get

1−α
Π = (1 − α) [θH qH − c(qH )] + α θL qL − c(qL ) − (θH − θL )qL
α
The first term is the welfare from θH . The second term is the welfare from θL minus the
likelihood ratio times the rent θH gets from pretending to be θL .
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• The FOCs are then
θH = c0 (qH )
1−α
θL − (θH − θL ) = c0 (qL )
α
Hence θH gets the efficient quantity while θL gets less than first best.
• It follows that (M ON ) holds, so this is the solution for the full problem.
• Transfers can then be derived from (IRL ) and (ICH ).
The Wilson approach. There is an alternative way to interpret this problem.
• Suppose we considered each quality unit q separately and ask what price a monopolist should
set. Recall the cost of supplying the qth unit is c0 (q).
• Pick an arbitrary q. The principal has three options: (i) set a price p = θH and make
π = (1 − α)[θH − c0 (q)], (ii) set a price p = θL and make π = [θL − c0 (q)], or (iii) sell to neither
type and make π = 0.
• The principal is indifferent between selling to one and both types if [θL − c0 (q)] = (1 − α)[θH −
c0 (q)]. Rearranging, this becomes
1−α
θL − (θH − θL ) = c0 (q)
α
which is the same as above. That is, for the first set of units the monopolist prefers to sell to
both types. For later types when c0 (q) is higher, the monopolist prefers to raise its price and
only sell to θH . See Figure 2.1 for an illustration.
• We’ll come back to the relation between the monopoly problem and the mechanism design
problem below.
2.2 Nonlinear Pricing: Continuous Types
Assume θ is continuously distributed with distribution function F (·) and density f (·) on [θ, θ].
• Incentive compatibility is a tough constraint: we must check that every type θ doesn’t want
to copy any other type θ̃.
• This is a lot of constraints! Fortunately, we can characterize incentive compatible allocations

and utilities.
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$
$
.′(()
.′(()
0"
0"
CS of θH
!" − #′(&! ) 0#
0#
!! − #′(&! )
Incremental Price of
Price of High Bundle
Low bundle
qL qL* qH=qH* q qL qL* qH=qH* q
Figure 2.1: The Two Approaches to Price Discrimination. The left panel shows how to implement the
optimum with a nonlinear price (this is the Wilson approach). Suppose we sell each unit q seperately. We keep
7 θH when (1 − α)[θH − c0 (qL )] = [θ − c0 (qL )]. The right panel shows
initially charge θL and the price jumps up to 5/11/20
8 5/11/20
how to implement the optimum with two menus. The low type gets qL , pays the blue region and gets no consumer
surplus. The high type gets qH , pays the sum of the blue and green regions, and gets consumer surplus equal to the
yellow region (as if she copied the low type). If the firm raises qL a little it gains profit from θL but gives away more
consumer surplus to θH . At the optimum these balance, implying θL − 1−α α
(θH − θL ) = c0 (qL ).
Lemma 1. Mechanism (q, t) is incentive compatible iff

(i) Utilities are given by the integral equation:
Z θ
U (θ) = U (θ) + q(s)ds (1)
θ
(ii) Quality q(θ) is weakly increasing in θ
Proof. [⇒] (i) Equation (1) follows from the envelope theorem. That is
d ∂
U (θ) = u(θ, θ̃)|θ̃=θ = q(θ̃)|θ̃=θ = q(θ)
dθ ∂θ
where we use the fact that the agent chooses θ̃ to maximize her utility, and that θ̃ = θ is optimal.
Now integrate up.
(ii) Monotonicity. Pick θH > θL . Using (IC) twice
θH (qH − qL ) ≥ tH − tL ≥ θL (qH − qL ).
[⇐] Pick θH > θL . Part (i) implies that

Z θH
U (θH ) = U (θL ) + q(s)ds
θL
Z θH
≥ U (θL ) + q(θL )ds
θL
= U (θL ) + (θH − θL )q(θL ) = u(θH , θL )
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where the inequality uses part (ii). Hence θH doesn’t copy θL . An analogous proof applies for why
θL doesn’t copy θH .
Note that equation (1) implies that U (θ) is weakly increasing in θ, so we need only check the (IR)
constraint for the lowest type. The principal’s problem is then:
max Π = E[t(θ) − c(q(θ))]

q(θ),t(θ)
s.t. (IRθ ) U (θ) ≥ 0

Z θ
(ICF OC) U (θ) = U (θ) + q(s)ds
θ
(M ON ) q(θ) is increasing
As above, we ignore (M ON ) giving rise to a relaxed problem. We then check monotonicity after-
wards. We solve in three steps.
• Step 1: Observe that profits equal surplus minus utility,
Π = E[θq(θ) − c(q(θ)) − U (θ)]
Crucially, this means the objective and the constraints only depend on quality and not trans-
fers.
• Step 2: Calculate the expected utility of the agent.

Z θ
E[U (θ)] = U (θ)f (θ)dθ
θ
Z θ
= − [U (θ)(1 − F (θ))]θθ
+ U 0 (θ)(1 − F (θ))dθ
θ

1 − F (θ)
= U (θ) + E q(θ)
f (θ)
d
Here, the second line integrates by parts, using the observation that dθ [−(1 − F (θ))] = f (θ).
The third line uses (ICF OC).
• Step 3: Substitute in expected utility into the profit equation, we wish to maximize
Π = E [M R(θ)q(θ) − c(q(θ))] − U (θ) (2)
subject to (IRθ ), where

1 − F (θ)
M R(θ) := θ − . (3)
f (θ)
• The function M R(θ) stands for “marginal revenue”; more on this, below. We can interpret
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M R(θ) as follows. If we allocate a little more quality to type θ then all the types above get
information rents since they can always mimic type θ. The ratio (1 − F (θ))/f (θ) reflects the
measure of types with value above θ to the measure of types with value θ.
Proposition 2. Assume M R(θ) is increasing. The optimal quality q(θ) is given by
M R(θ) = c0 (q(θ)). (4)
The optimal mechanism sets U (θ) = 0, so transfers are given by

Z θ
t(θ) = θq(θ) − q(s)ds
θ
Proof. The FOC follows from pointwise optimization. Condition (M ON ) then holds since M R(θ)
is increasing.
In the optimal mechanism, (IR) binds for the lowest type. The principal doesn’t want to throw
money away. The transfers then use (ICFOC) and the fact that U (θ) = θq(θ) − t(θ).
Example 1: Here’s a simple parametric example.
• Suppose θ ∼ U [0, 1] and c(q) = 21 q 2 . Then M R = 2θ − 1 and (4) becomes
q = max{0, 2θ − 1}
• In comparison, the efficient quantity is q = θ.
Example 2: The following example shows how monopoly pricing is related to nonlinear pricing
(Bulow and Roberts, 1989, JPE).
• Suppose c(q) = cq and q ∈ [0, 1]. Then the optimal allocation is


0 if M R(θ) < c
q(θ) =
1 if M R(θ) > c
• This looks similar to a classic monopoly problem with linear costs. We can make this more
transparent. Let x be quantity and p(x) be demand, so profit is Π = p(x)x − cx. Differenti-
ating, marginal revenue is
m(x) = p(x) + p0 (x)x
We then allocate a unit if marginal revenue exceeds marginal costs.
• How exactly is this related? Given a price p, quantity is given by x = 1 − F (p). Changing
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variables from x to p, marginal revenue is

x(p) 1 − F (p)
m(p) = p + =p−
dx/dp f (p)
which is the same as (3).
Example 3: This example shows how a monopolist should allocate goods over time (Stokey, QJE,
1979).
• Suppose a firm can choose to allocate type θ a good at time τ ∈ {0, 1, . . .}. The agent’s utility
is u = θδ τ (θ) − t(θ). The firm’s costs are zero, so Π = E[t(θ)].
• Equation (2) becomes

Π = E[M R(θ)δ τ (θ) ]
The optimal allocation is 

∞ if M R(θ) < 0
τ (θ) =
0 if M R(θ) > 0
• Hence agents with positive marginal revenue get a unit immediately. Agents with negative
marginal revenues never get a unit. This is sometimes knows as a “no haggling theorem”.
• Is this policy time consistent? In period t = 1, why doesn’t the firm further lower its price?
More on this later!
Remark: Is there one agent or many? It’s easiest to think of this as a firm selling to a single agent
with unknown value. But we can equivalently think of a firm selling to a continuum of agents, as
in the classic monopoly problem. This works if:
• There are no links on the agents’ side. In particular, we need to assume that agents’ values
are IID. If not, we can extract information about agent i by asking agent j.
• There are no links on the firm’s side. If q is interpreted as quantity then the firm’s costs equal
P
c( j qj ). If there are many agents, this is locally linear, meaning that costs are essentially
constant (see Example 2). In contrast, if q is quality then it is natural to specify costs as
P
j c(qj ), and Proposition 2 applies.
What if M R(θ) is not increasing?
• In this case the solution to the relaxed problem (4) does not satisfy (M ON ) and is thus not
incentive compatible.
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Figure 2.2: Ironing. In the left picture the firm chooses to sell θ0 units. In the center picture the firm chooses to
sell θ00 units. The right picture shows the ironed marginal revenue function.
• We need to “iron” the M R(θ) function to make is monotone. One can do this via optimal
control (Guesnerie and Laffont, JPubE,1984) or by looking at the convex hull (Myerson,
MathOR, 1981). However, the idea goes back to Hotelling (JPE, 1931).
• Figure 2.2 shows the intuition. Suppose the M R(θ) is as shown and costs are constant. We
know allocations must be monotone, so if we allocate the good to type θ then we must allocate
it to all types above. In the left figure costs are high; if we decrease the cutoff from θ0 to θ00
then we gain area A but lose area B. Comparing these regions, we should stick with the high
cutoff.1 In the center figure costs are low, and A exceeds B, so we should choose the low
cutoff. There is a cost in the middle where we are indifferent between θ0 and θ00 , where A
equals B. This gives us the ironed marginal revenue curve, shown in the right figure. Since
this is monotone we can replace M R with M R and then ignore (M ON ).
We can also solve the problem via optimal control. It’s unecessary here, but useful in other appli-
cations (e.g. optimal taxation).
• Once we know that U (θ) = 0, we can write the principal’s problem as

Z θ
max [θq(θ) − c(q(θ)) − U (θ)] dF (θ)
q(θ) θ
s.t.(ICF OC) U 0 (θ) = q(θ)
where the constraint is the differential version of (1). In the classic intertemporal consumption
problem, I choose consumption over time, which determines the evolution of my savings. In
this problem, I choose quality for each type, which determines the evolution of the agent’s
utility.
1
The figure doesn’t illustrate the distribution over θ, so it’s not necessarily true that A is larger than B. But let’s
assume it is!
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• To solve this, set up a Hamiltonian:2
H = [θq(θ) − c(q(θ)) − U (θ)]f (θ) + µ(θ)[q(θ)]
In general, the FOCs are

∂H ∂H dµ
=0 and =−
∂q ∂U dθ
with the complementary slackness condition at the “endpoint”, µ(θ)U (θ) = 0.
• The FOCs become

dµ
[θ − c0 (q(θ))]f (θ) + µ(θ) = 0 and f (θ) =
dθ
• We can integrate up the second equation to obtain

Z θ
µ(θ) = f (s)ds + µ(θ) = 1 − F (θ)
θ
where we use complementary slackness.
• Substituting into the first equation, the optimal quality is detemined by

1 − F (θ)
θ− = c0 (q(θ))
f (θ)
as above.
Exercise 1 (Monoposonist): Consider the following variant of the non-linear pricing problem.
• A principal wishes to acquire q ∈ R+ units of a good off from an agent with unknown cost.
• The agent’s type is θ ∼ G[θ, θ]. They have cost θq.
• The principal’s value from q units V (q) is concave.
• A mechanism is given by a transfer and a quantity, ht(θ), q(θ)i.
• The agent’s utility is u = t(θ) − θ, while the principal’s profit is π = E[V (q(θ)) − t(θ)].
• Show the optimal quantity equates marginal benefit and marginal costs
V 0 (q(θ)) = M C(θ)
where the marginal cost is given by

F (θ)
M C(θ) := θ + .
f (θ)
2
See https://en.wikipedia.org/wiki/Hamiltonian_(control_theory) for the quick version. My favorite “how to”
guide is Appendix A.3 in Barro and Sala-i-Martin’s book, “Economic Growth”.
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• What are the optimal transfers?
Exercise 2 (Common Values): Consider a variant of the above problem.
• A principal wishes to acquire q ∈ [0, 1] units of a good off from an agent with unknown cost
and quality.
• The agent’s type is θ ∼ F [θ, θ]. They have cost θq.
• The principal’s per-unit value v(θ) depends directly on the type of the agent.
• The agent’s utility is u = t(θ) − θq, while the principal’s profit is π = E[v(θ)q(θ) − t(θ)].
• (i) Suppose v(θ) = v, and M C(θ) = θ + Ff (θ)

(θ)
is increasing in θ. What is the principal’s optimal
mechanism?
• (ii) Suppose v(θ) is increasing in θ and v(θ)−M C(θ) is increasing in θ. What is the principal’s
optimal mechanism?
• See HW4 for an extension of this question to multiple agents.
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3 Multiple Agents
In these notes we suppose a principal faces several agents who have private information. There are
three canonical applications:
• Auctions: A principal has a unit of a good to sell. Bidders have private values. What auction
maximizes the principal’s revenue?
• Public goods: N agents have private values for a public good (e.g. a new road). Is there a
mechanism that aggregates agent’s values and achieves efficiency?
• Trade: A buyer/seller have private value/cost, and must decide whether to trade. What
mechanism maximizes the value of trade?
References:
• MWG, Chapter 23.
• Segal and Tadelis, Chapter 2.
3.1 Auctions
• Myerson (Math OR, 1981)
Model
• The principal has one unit of a good. They value it at θ0 .
• There are N agents with IID values θi ∼ F [θ, θ]. These are private information.
• All of this is common knowledge.
• Let θ = (θ1 , . . . θN ). Let reports be θ̃ = (θ˜1 , . . . , θ̃N ). Let θ−i be the vector of values excluding
i.
Direct revelation mechanism.

P
• Let agent i’s probability of winning be pi (θ̃) ∈ [0, 1], where i pi (θ̃) ≤ 1.
• Let agent i’s payment be ti (θ̃) ∈ <.
Payoffs
• Agent i’s utility is ui = θi pi − ti . Properties:
– Risk neutrality: Agent i only cares about expected payments.
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– Private values: Agent i doesn’t directly care about j’s value (only his report).
• The seller’s payoff is the sum of payments and the value they get from the object if they don’t
P P
sell it, i ti + (1 − i pi )θ0
Examples
• First-price auction, where i bids b(θ̃i )
pi (θ̃) = 1 if θ̃i > θ̃j ∀j

ti (θ̃) = pi (θ̃)b(θ̃i )
• Second-price auction, where i bids B(θ̃i )
pi (θ̃) = 1 if θ̃i > θ̃j ∀j

ti (θ̃) = pi (θ̃) max B(θ̃j )
j6=i
• All-pay auction, where i bids β(θ̃i )
pi (θ̃) = 1 if θ̃i > θ̃j ∀j

ti (θ̃) = β(θ̃i )
• Raffle, where i buys n(θ̃i ) tickets.
n(θ̃i )
pi (θ̃) = P
i n(θ̃i )
ti (θ̃) = n(θ̃i )
Welfare-Maximization
• A welfare-maximizing principal wishes to solve3

" ! #
X X
max W = Eθ pi (θ)θi + 1− pi (θ) θ0
pi ,ti
i i
X
s.t. (F EA) pi (θ) ∈ [0, 1] and pi (θ) ≤ 1
i
(IR) ui (θi , θi ) ≥ 0 ∀θi

(IC) ui (θi , θi ) ≥ ui (θi , θ̃i ) ∀θi , θ̃i
• We can ignore (IR) and (IC). These determine the agents’ utilities, but they don’t feature in
the principal’s objective.
3
We should also worry about (IC) and (IR), but they don’t enter the argument.
17
• This problem is linear in probabilities, so we get:
Proposition 3. The welfare-maximizing auction allocates the good to the agent with the highest
value θi , assuming that θi > θ0 .
How can we implement this?
• A first-price auction with a reserve price of r = θ0 .

To see this, consider a FPA with reserve r. Agents with values below r will not participate,
while the agent with value r will just bid the reserve. If we set r = θ0 , and bidders use a
symmetric bidding strategy then we implement the first-best.
• A second-price auction with a reserve price of r = θ0

A problem with the SPA is that there may be asymmetric BNE where one bidder bids very
aggresively, while the other bidders bid zero. This is the difference between partial imple-
mentation (one equilibrium implements the desired outcome) and full implementation (all
equilibria implement the desired outcome).
• An all-pay auction with a reserve price of r = θ0 F N −1 (θ0 ).

To see this, consider an APA with reserve r, and let θ∗ be the lowest type who participates
in the auction (and thus gets zero utility). They pay r and win with probability F N −1 (θ∗ ).
Hence θ∗ is determined by u = θ∗ F N −1 (θ∗ ) − r = 0. If we wish θ0 to be the marginal type,
then we should set r = θ0 F N −1 (θ0 ).
• A first-price or second-price auction with an entry fee of e = θ0 F N −1 (θ0 ).

To see this, consider a SPA with entry fee e, and let θ∗ be the lowest type who participates
in the auction (and thus gets zero utility). They pay e and win with probability F N −1 (θ∗ );
when they win, they are the only active bidder and thus pay zero. Hence θ∗ is determined
by u = θ∗ F N −1 (θ∗ ) − r = 0. If we wish θ0 to be the marginal type, then we should set
e = θ0 F N −1 (θ0 ).
Revenue maximization
• Let i’s interim expected utility in the direct revelation mechanism be

h i
ui (θi , θ̃i ) = E−i θi pi (θ̃i , θ−i ) − ti (θ̃i , θ−i ) ,
where E−i is the expectation over other’s values. Let Ui (θi ) = ui (θi , θi ) be i’s utility when he
tells the truth.
18
• The principal’s problem is

" ! #
X X
max Eθ ti (θ) + 1− pi (θ) θ0
Pi (θ),ti (θ)
i i
X
s.t. (F EA) pi (θ) ∈ [0, 1] and pi (θ) ≤ 1
i
(IR) ui (θi , θi ) ≥ 0 ∀θi

(IC) ui (θi , θi ) ≥ ui (θi , θ̃i ) ∀θi , θ̃i
• We now wish to use (IC) to characterize agents’ utilities. Think of q(θ̃i ) = E−i [p(θ̃i , θ−i )] and
T (θ̃i ) = E−i [t(θ̃i , θ−i )] as the expected allocation and payment. Then agent i’s utility is
ui (θi , θ̃i ) = θi q(θ̃i ) − T (θ̃i )
which is just like the one-agent prrice discrimination problem.
• We can now adopt Lemma 1
Lemma 2. A mechanism hpi , ti i is incentive compatible if and only if:

Rθ
(ICFOC) Ui (θi ) = Ui (θ) + θ i E−i [pi (s, θ−i )] ds, and
(MON) E−i [pi (θi , θ−i )] is increasing in θi
• The integral equation is call “Payoff Equivalence” since it says that payoffs only depend on
the allocation function and not the details of the transfers.
• The integral equation uses the independence assumption. We derive if using the envelope
theorem....
To solve the problem, we drop the monotonicity constraint. We then solve the relaxed problem
using the usual three steps:
• Step 1: Observe that the principal’s payoff equal welfare minus utilities,
" #
X X
Revenue = Eθ pi (θ)(θi − θ0 ) + θ0 − Ui (θ)
i i

1 − F (θ)
Eθi [Ui (θi )] = Ui (θ) + Eθ pi (θ)
f (θ)
• Step 3: Substitute in expected utility into the objective function.

" #
X X
Revenue = Eθ pi (θ)(M R(θi ) − θ0 ) + θ0 − Ui (θ)
i i
19
where
1 − F (θi )
M R(θi ) := θi − .
f (θi )
• Observe that revenue only depends on the allocation function and the utility of the lowest
type, but not the details of the transfer function.
Proposition 4 (Revenue Equivalence). Any auction that (i) awards the lowest type no surplus, and
(ii) has the same allocation function yields the same revenue.
• This means that the First-price auction, Second-price auction, English auction and All-pay
auction all yield the same expected revenue if the same types participate (e.g. they have no
reserve price).
• The revenue maximization problem is thus

" #
X X
maxEθ pi (θ)(M R(θi ) − θ0 ) + θ0 − Ui (θ)
i i
s.t. (IR) Ui (θ) ≥ 0

(M ON ) E−i [pi (θi , θ−i )] is increasing in θi
X
(F EA) pi (θ) ∈ [0, 1] and pi (θ) ≤ 1
i
• In the optimal auction, the principal sets Ui (θ) = 0 for all i. She then wishes to award the
good to the agent with the highest marginal revenue, assuming this exceeds the reserve. If
M R is increasing, this corresponds to allocating the good to the agent with the highest value,
which implies the monotonicity constraint is satisfied. In summary:
Proposition 5. Assume M R is increasing. The revenue-maximizing auction allocates the good to

the agent with the highest value θi , assuming that M R(θi ) > θ0 .
On the reserve price
• Define the cutoff type by M R(θ∗ ) = θ0 or θ∗ = M R−1 (θ0 ). We thus want type θ∗ to be
indifferent about entering and not. Of the agents who enter, we then want to allocate the
good to the agent with the highest value.
• Surprisingly, the optimal reserve price is independent of the number of bidders! In particular,
it is the same as the monopoly price in a model with one bidder, where θ0 is the seller’s cost.
See Example 2 in the last set of notes.
• Why does the reserve price exceed θ0 ? Just like monopoly pricing, when type θi is awarded a
unit, all the above types get rents.
20
How can we implement this?
• A first-price auction with a reserve price of r = M R−1 (θ0 )
• A second-price auction with a reserve price of r = M R−1 (θ0 )
• An all-pay auction with a reserve price of r = M R−1 (θ0 )F N −1 (M R−1 (θ0 ))
• A second-price auction with an entry fee of e = M R−1 (θ0 )F N −1 (M R−1 (θ0 ))
Application: We can use Payoff Equivalence to derive bidding strategies for common auctions.
• First-Price Auction. In the symmetric BNE, agents bid according to b(θi ) and the good is
allocated to the agent with highest value, so E−i [pi (θ)] = F N −1 (θi ). Utility is thus given by
Rθ
Ui (θ) = (θi − b(θi ))F N −1 (θi ). Payoff Equivalence, then tells us that Ui (θi ) = θ i F N −1 (s)ds.
Equating these,
R θi
θ F N −1 (s)ds
b(θi ) = θi −
F N −1 (θi )
• All-Pay Auction. In the symmetric BNE, agents bid according to β(θi ) and the good is
allocated to the agent with highest value, so E−i [pi (θ)] = F N −1 (θi ). Utility is thus given by
Rθ
Ui (θi ) = θi F N −1 (θi ) − β(θi ). Payoff Equivalence then tells us that Ui (θi ) = θ i F N −1 (s)ds.
Equating these,
Z θi
N −1
β(θi ) = θi F (θi ) − F N −1 (s)ds
θ
Who do we relate the formulas for the FPA, the SPA and the MR?
• To see this, let θ1 and θ2 be the highest and 2nd highest value of the N agents.
• Moving from the SPA to the FPA. The distribution of the second order statistic given the
first is G(θ2 |θ1 ) = F N −1 (θ2 )/F N −1 (θ1 ). Integrating by parts,
R θ1
θ F N −1 (θ2 )dθ2
E[θ2 |θ1 ] = θ1 − = b(θ1 )
F N −1 (θ1 )
which is the bid in the FPA.
• Moving from the FPA to MR. The distribution of the first order statistic is G(θ1 ) = F N (θ1 ).
Integrating by parts,
Z θ Z θ
N
F N −1 (θ1 ) − F N (θ1 ) dθ1 = Eθ1 [M R(θ1 )]

Eθ1 [b(θ1 )] = θ1 dF (θ1 ) − N
θ θ
Extension: What if M R is not increasing?
21
• Then we allocate the good to the agent with the highest ironed marginal revenue. See Myerson
(1981).
Extension: Asymmetric agents
• If agents have different distribution functions Fi (θi ), then the auction awards the good to the
agent with the highest marginal revenue M Ri (θi ), subject to that exceeding θ0 .
• Thus, the auctioneer biases the auction towards weaker bidders. This is analogous to third-
degree price discrimination.
Extension: Interdependent values
• One can extend the analysis to interdependent values so long as signals are independent.
• In the general interdependent setting, agent i has value vi (θ).
– Special case: Agents have common values if vi (θ) does not depend on i. E.g. every agent
P
values the good at v = i θi .
• Assuming signals are independent, the above analysis is the same. The major difference is
that marginal revenue becomes
∂vi (θ) 1 − F (θi )
M Ri (θ) = vi (θ) −
∂θi f (θi )
Extension: Correlated signals
• Suppose agents signals are correlated. They may have private or interdependent signals.
• For the derivation of bidding for “standard” auctions, and the revenue comparison, see Mol-
grom and Weber (1982, Ecta).
• Agent i’s value tells him something about j’s value, so we can ask i to bet on it. Myerson
(1981) and Cremer-McLean (1985) show that if we make these bets very large we can elicit
values truthfully at no cost. Thus, first-best is achievable.
• In a counterpoint, Neeman (2004) pointed out that this model implicitly assumes that each
payoff type only has one belief type. He considers an example where values are positively
correlated, but i may be optimistic or pessimistic about j’s type. Full extraction is no longer
possible.
22
3.2 Public Goods (and Dominant-Strategy Implementation)
Model:
• N agents consider building a public project (e.g. a new road). The project costs c.
• Agents have IID values θi ∼ F [θ, θ].
Mechanism
• The project is build with probability p(θ̃) ∈ [0, 1]
• Let agent i’s transfer be ti (θ̃) ∈ <.
Payoffs
• Agent i’s utility is ui = θi p − ti .

P
• First-best: We wish to build the project if i θi > c.
Equal sharing mechanism

P
• Suppose we build if i θ̃i > c, and everyone pays ti = c/N if the project is built. Will agents
tell the truth?
• No! If θi > c/N then agent i is happy to pay the price and will report θ̃i = θ. Similarly, if
θi < c/N then θ̃i = θ.
• Intuitively, we have a problem with truth-telling since agent i exerts an externality on −i

when they lie. That is, they can change the allocation but do not pay the price.
A proportional mechanism
P
• Suppose we build the bridge if θ̃i > c and everyone pays an amount proportional to their
claim,
θ
ti = P c
θ̃i
• Will we get truth-telling? Why or why not?
Is there any mechanism that implements the first-best in dominant strategies? In a Vickery-Clarke-
Groves (VCG) mechanism
• Allocation: p∗ (θ̃) = 1 iff

P
i θ̃i >c
23
• Transfers: Let  
X
ti (θ̃) = hi (θ̃−i ) −  θ̃j − c p∗ (θ̃)
j6=i
where hi (·) is an arbitrary function. That is, agent i wins a transfer equal to everyone else’s
utility plus a constant that does not depend on i’s report. Intuitively, when i chooses his
report he then maximizes the sum of everyone’s utility.
Proposition 6. The VCG mechanism implements the efficient outcome in dominant strategies.
Moreover, if a mechanism implements the efficient outcome in dominant strategies, then it must be
VCG.
Proof (⇒)
• We wish to show that agent have a dominant strategy to tell the truth in a VCG mechanism.
• Given other’s reports θ̃−i , agent i chooses θ̃i to maximize

 
X
ui (θi , θ̃) = θi + θ̃j − c p∗ (θ̃i , θ̃−i ) − hi (θ̃−i )
j6=i
where we can ignore the hi term since it only depends on other’s reports.
• Recall that p∗ (θ̃i , θ̃−i ) is chosen to maximize surplus,

 
X
θ̃i + θ̃j − c p(θ̃i , θ̃−i )
j6=i
Thus agent i’s utility is maximized by telling the truth.
• Intuitively, agent i’s utility coincides with social surplus. Since the planner is maximizing
surplus, misreporting will only mess up the planner’s choice of project and lower i’s surplus.
Put differently, the change in i’s transfer fully internalizes the externality he has on the other
agents by misreporting.
Proof (⇐)
• See Green and Laffont (1979) or MWG, Prop 23.C.5.
Special case: The pivot mechanism

hP i
• A special case of the VCG mechanism is where we set hi (θ̃−i ) = ∗
j6=i θ̃j − c p−i (θ̃−i ) equal
to the welfare in a world without i, where p∗−i (θ̃−i ) = 1 if j6=i θj > c.
P
24
• In the pivot mechanism agent i’s payment is then

 
X h i
ti (θ̃) =  θ̃j − c p∗−i (θ̃−i ) − p∗ (θ̃)
j6=i
which is i’s externality on the other agents. That is, if i’s existence does not change the
outcome of the project then they pay nothing. However, if i’s report causes the project to be
P
built then they pay c − j6=i θj to the planner, which equals the amount the other agent fell
short of building the bridge.
• The pivot mechanism is individually rational (an agent can always opt out),
• The pivot mechanism will lose money. To see this, suppose there are two agents and that
neither can build the project on their own. That is
θ1 , θ2 < c < θ1 + θ2
Then both agents’ utilities coincide with social surplus: u1 = θ1 − t1 = θ1 + θ2 − c, and

similarly, u2 = θ1 + θ2 − c. However, there is only one social surplus to split between them;
hence the planner loses money.
Remark: We could have defined the pivot mechanism slightly differently (see MWG Example 23.C.1)
• Define i’s utility to include their share of the cost of the project, ui = ηi p−ti , where ηi = θi − Nc .
P
• First-best says we build the project if i ηi > 0.
• We can again define a pivot mechanism as i’s externality on the other agents,
 
X
η̃j  p∗−i (η̃−i ) − p∗ (η̃)

ti (η̃) = 
j6=i
• This version makes money for the planner since ti ≥ 0.
• It is individually rational in the sense that agent i obtains at least as much utility as under
allocation p∗−i . However, this may mean they have low value θi and still have to pay c/N to
build the road, and thus get negative utility.
Special case: Second price auctions
• In the context of an auction, a pivot mechanism coincides with a second-price auction
• When i wins they prevent the agent with the second highest value from having the good.
Hence this is their externality on the other agents. The second-price auction says the winning
agent should pay this externality.
25
If we weaken dominant strategy requirement to Bayesian implementation, then we can use the
expected externality mechanism.
• Given everyone else tells the truth, let i’s payment be

  
X
ti (θ̃i , θ−i ) = hi (θ−i ) − E−i  θj − c p∗ (θ̃i , θ−i )
j6=i
Hence i obtains the expected utility of other agents (rather than the realized utility, as in
VCG). It is straightforward to show that truth-telling is Bayesian IC.
P
• With dominant strategy implementation, it is impossible to satisfy budget balance, i ti (θ) =
c, for all θ (see MWG, Prop 23.C.6). However, with Bayesian implementation there is a
function hi (θ̃−i ) that attains budget balance for all θ (see MWG, Section 23.D).
• In the next section we study how participation constraints can make it impossible to implement
efficient outcomes.
The idea of VCG and pivot mechanisms can be extended to dynamic models (see Bergemann and
Valamaki, Ecta, 2010)
• For example, suppose I am selling a house, and bidders arrive over time. If I sell it today then
I cannot sell it tomorrow. The dynamic pivot mechanism would say that the buyer should
pay the maximum expected discounted value of agents entering in the future.
• Or, suppose I am selling many airline tickets for a flight that leaves in a month. If I sell a
ticket today the externality is the sum of values of people who are awarded tickets minus the
values of people who would have been allocated a ticket had I not sold one ticket today. Thus,
the externality is not just the value of the person who would have purchased that particular
ticket.
3.3 Trade
• Myerson and Satterthwaite (JET, 1983)
Model
• A seller can make one unit of a good. She has cost c ∼ G[c, c]. This is private information.
• A buyer would like the good. He has value v ∼ F [v, v]. This is private information.
• To make the model non-trivial, assume some buyer’s values exceed some seller’s costs.
A mechanism is a triple (p, tB , tS )
26
• A probability the object is traded p(ṽ, c̃)
• A payment made by the buyer tB (ṽ, c̃)
• A payment received by the seller tS (ṽ, c̃)
• This formulation allows the social planner (who we will call the “middleman”) to inject money
tS > tB .
Payoffs
• The seller obtains uS = tS − cp
• The buyer obtains uB = vp − tB
• First-best: Trade should occur if the buyer’s value exceeds the seller’s cost, p(v, c) = 1v>c .
• Let uB (v, ṽ) = Ec [vp(ṽ, c) − tB (ṽ, c)] be the buyer’s interim expected utility given report ṽ,
and UB (v) = uB (v, v) be his utility under truth-telling. Similarly, define uS (c, c̃) and US (c).
Incentive compatibility
• A mechanism is incentive compatible for the buyer if p(v, c) is increasing in v and UB (v) =
hR i
v
Ec v p(s, c)ds + UB (v).
• A mechanism is incentive compatible for the seller if p(v, c) is decreasing in c and US (c) =
hR i
c
Ev c p(v, s)ds + US (c).
Consider the problem of the middleman.

Their payoff is
Π = Ev,c [tB − tS ]
= Ev,c [(v − c)p(v, c) − UB (v) − US (c)]
= Ev,c [(M R(v) − M C(c))p(v, c)] − UB (v) − US (c) (5)
where
1 − F (v) G(c)
M R(v) = v − and M C(c) = c +
f (v) g(c)
Equation (5) gives us the middleman’s profit-maximizing mechanism. This result is of interest to
internet platforms like Uber and AirBnB, and to financial brokers.
Proposition 7. The middleman’s payoff is maximized if trade takes place iff M R(v) > M C(c).
Thus, we get too little trade.
Example: v, c ∼ U [0, 1]
27
• Efficient trade occurs if v > c. This occurs with probability 1/2.
• With a profit-maximizing middleman, trade occurs if 2v − 1 > 2c. That is v − c > 1/2. This
occurs with probability 1/8.
We next ask: Is efficient trade possible?
Proposition 8. Assume that costs and values are overlapping, c > v. Any efficient mechanism
loses money for the middleman.
Remark
• The “overlapping supports” is necessary. Suppose v ∼ F [3, 4] and c ∼ G[0, 1]. Then just set a
price of p = 2.
• The key problem is that trade is not always efficient, and agents on the margin have an
incentive to lie.
Proof: Brute force
• Insert p(v, c) = 1v>c into equation (5) we get

Z v Z min{v,c}
Π= [M R(v) − M C(c)] dG(c)dF (v)
v c
Z v Z min{v,c} Z v Z min{v,c}
= [vf (v) − (1 − F (v))] dG(c)dv − (cg(c) + G(c))dcdF (v)
v c v c
• Integrating by parts,
Z min{v,c} Z min{v,c}
cg(c)dc = [cG(c)]min{v,c}
c − G(c)dc
c c
• Substituting in and rearranging,

Z v Z v
Π= [vf (v) − (1 − F (v))] G(min{v, c})dv − min{vG(v), c}dF (v)
v v
Z c Z v
=− (1 − F (v))G(v)dv + [vf (v) − cf (v) − (1 − F (v))] dv
v c
Z c
=− (1 − F (v))G(v)dv
v
Rv
The second line considers two cases: whether v is above or below c. Integrating c [vf (v) −
cf (v)]dv by parts, one can then show that the second term is zero.
Proof: VCG approach
28
• Payoff equivalence tells us that an agent’s utility is purely determined by the utility of the
lowest type and the allocation function. One particular payment scheme is the VCG payment.
• Under VCG payments an agent pays their externality on others. That is, the buyer pays his
externality on the seller (i.e. the seller’s cost), and the seller is paid her externality on the
buyer (i.e. the buyer’s value).
• If the supports of the buyer’s value and seller’s cost are the same, then we can set tB = c1v>c
and tS = v1v>c . The middleman’s profit is then
Π = E[(c − v)1v>c ] < 0
Intuitively, truthtelling implies we must give both parties the social surplus (v −c) to get them
to report truthfully. But there is only one surplus, meaning the middleman loses (v − c). This
is reminiscent of Holmstrom’s team problem.
• The rest of the proof extends this to when the supports are different. Suppose that we
implement the efficient allocation p(v, c) = 1v>c and choose payments:
tB = max{c, v}1v>c
tS = min{v, c}1v>c
One can check that
– These payments give lowest types no utility. That is, a buyer of type v always pays at
least v. And a seller of type c receives at most c.
– Reporting truthfully is a weakly dominant strategy. Fix a buyer with value v. If c > v,
there is no trade and no payment. The agent would regret winning at price c, so truth-
telling is optimal. If c ∈ [v, v], there is trade and at price c. If the agent lowered his
report below c he would regret losing, so truth-telling is optimal.
• We now wish to show that the middleman loses money whenever trade takes place. Recall
that the middleman receives max{c, v} and pays min{v, c}. There are two cases:
– Suppose c < v, so the middleman receives v. By the assumption of the theorem, c > v,
so min{v, c} > v.
– Suppose c > v, so the middleman receives c. Since trade is efficient, v > c, so min{v, c} >
c.
Why does this matter?
• It tells us that efficient trade inherently conflicts with private information.
29
– Formally, the following are inconsistent: Efficiency, Interim IC, Interim IR, Ex-ante
Budget Balance.
• This formalizes the notion of “transactions costs” in the Coase Theorem.
• At the start of the class we mentioned that there are three types of market failures: market
power, externalities and information. But one might say that information is the only real
problem.
– If a monopolist sells to many buyers, the outcome is efficient if she knows their values.
As we saw in the last notes, when she doesn’t know their values, her optimal mechanism
is classic monopoly pricing.
– If a polluter is emitting harmful pollution, then (i) if there is a single person suffering,
they can pay the polluter not to pollute, or (ii) if there are many people suffering, they
can set up a Lindahl pricing mechanism. However, neither of these will work if there is
imperfect information about the polluter’s cost of reducing her pollution, or the harm
suffered by the victims.
30
4 Dynamics
In this section we consider dynamics with and without commitment.
4.1 Sequential Screening
• This is a two period version of the nonlinear pricing problem. See Courty and Li (RES, 2000)
and Pavan, Segal and Toikka (Ecta, 2014).
Model
• A single seller faces a buyer with unknown value.
• At t = 1, the agent sees their type σ ∼ F (σ) with support [σ, σ], and signs a contract. This
type is not his value for the good, but is a signal about his actual valuation.
• At t = 2, the agent sees his actual value θ ∼ G(θ|σ) with support [θ, θ].
• If the agent buys quality q at price t, his utility is u = θq − t.
• If the principal sells quality q at price t, her profits are π = t − c(q).
A mechanism
• Agents report their types σ̃ and θ̃ in periods t = 1, 2.
• Allocation q(θ̃, σ̃) ∈ <+
• Transfer t(θ̃, σ̃) ∈ <.
Incentive compatibility in period t = 2.
• Given some period 1 report σ̃, the agent’s utility is
u(θ, θ̃; σ̃) = θq(θ̃, σ̃) − t(θ̃, σ̃)
where θ is the agent’s value and θ̃ is their report. Let U (θ; σ̃) = u(θ, θ; σ̃). Observe that the
actual period 1 signal σ is irrelevant once we know θ.
• Truth-telling is incentive compatible iff
– The agent’s period 2 utility is

Z θ
U (θ; σ̃) = q(s, σ̃)ds + U (θ; σ̃) (ICF OCθ )
θ
This follow from the envelope theorem.
31
– The allocation is monotone,
q(θ, σ̃) is increasing in θ (M ONθ )
• The proofs are the same as the one-period version.
Incentive compatibility in period t = 1.
• At time t = 1, the agent’s expected lifetime utility given signal σ and report σ̃ is

1 − G(θ|σ)
v(σ, σ̃) = Eθ [U (θ; σ̃)] = Eθ q(θ, σ̃) + Eθ [U (θ; σ̃)]
g(θ|σ)
where we have integrated by parts. Let V (σ) = v(σ, σ).
• Truth-telling is incentive compatible iff
– The agent’s period 1 utility is

Z σ
−∂G(θ|s)/∂σ
V (σ) = Eθ q(θ, s) ds + V (σ) (ICF OC)
σ g(θ|s)
−∂G(θ|σ)/∂σ
This follows from the envelope theorem. We can interpret I(θ, σ) := g(θ|σ) as the
impulse response; this measures how the distribution of θ changes when σ changes.
– Utility v(σ, σ̃) is supermodular in (σ, σ̃). That is,

−∂G(θ|σ)/∂σ
Eθ q(θ, σ̃) is increasing in σ̃ (M ONσ )
g(θ|σ)
• The proofs are the same as the one-period version.
The principal’s problem
• The principal wishes to maximize her ex-ante profit
Π = Eσ,θ [t(θ, σ) − c(t(θ, σ))]
subject to IC and IR.
• To solve the relaxed problem, ignoring (M ONσ ) and (M ONθ ), we follow the usual three steps.
• Step 1: Observe that profits equal welfare minus utility,
Π = E[θq(θ, σ) − c(q(θ, σ)) − V (σ)]

1 − F (σ)
E[V (σ)] = Eθ,σ q(θ, s)I(θ, σ)
f (σ)
32
• Step 3: Substitute in expected utility into the profit equation. We thus wish to maximize
Π = E [m(θ, σ)q(θ) − c(q(θ))] − V (σ) (6)
subject to (IRθ ), where

1 − F (σ)
m(θ, σ) = θ − I(θ, σ)
f (σ)
We can now solve for the optimal quality.
Proposition 9. Suppose a higher signal σ raises the distribution of values θ in the sense of first-
order stochastic dominance. Assume that m(θ, σ) increasing in both σ and θ. Then the optimal
quality satisfies
m(θ, σ) = c0 (q(θ, σ)) (7)
Proof:
−∂G(θ|σ)/∂σ
• First observe that the FOSD assumption means that I(θ, σ) = g(θ|σ) > 0. Hence all
qualities are downward distorted.
• Differentiating profits (6) with respect to q(θ) we obtain (7).
• We have to verify monotonicity in both periods.
– At t = 1, the fact that m(θ, σ) is increasing in σ means that q(θ, σ) is increasing in σ.

Since I(θ, σ) > 0, (M ONσ ) holds.
– At t = 2, the fact that m(θ, σ) is increasing in θ means that q(θ, σ) is increasing in σ,
and hence (M ONθ ) holds.
Interpretation
1−F (σ)
• If f (σ) is decreasing in σ, then agents who receive higher signals σ receive higher quality for
the same realized value θ. Intuitively, we distort down the quality of pessimistic agents (σL )
to stop optimistic agents (σH ) from copying them.
• The amount of distortion is increasing in the impulse response I(θ, σ). The more informative
σ is about θ, the more the distortion.
• Special case 1: If the signal is fully informative, σ = θ, then it coincides with the usual
formula,4
1 − F (θ)
θ− = c0 (q(θ))
f (θ)
There is no difference between this problem and the one period model.
4
This is tricky to see from the I(θ, σ) formula since the distribution is degenerate. But the answer is immediate
since there is no difference between t = 1 and t = 2.
33
• Special case 2: If the signal is completely uninformative, then I(θ, σ) = 0, and there is no
distortion
θ = c0 (q(θ))
Intuitively, if the agent has no information when he signs the contract, the principal can
implement the first best, and then extract the agent’s rents E[U (θ)] via an up-front payment.
Technically, it is as if the problem is interim IC and ex-ante IR; In the static problem, the
interim IR is needed for the agent to earn rents in equilibrium.
• Special case 3: If the process is AR(1), i.e. θ = ασ + , where α > 0 and is IID then the
impulse response is I(θ, σ) = α.5
4.2 Coase Conjecture (and the Problem of Commitment)
Model:
• Seller has mass 1 of a good (e.g. land). She has cost 0.
• There is mass 1 of buyers who have values θ ∼ U [0, 1].
• Time discrete, t = {0, 1, 2, . . .}. Discount factor δ.
• Each period t ≥ 1, the seller names a price pt , buyer accepts if value exceeds a cutoff θt , where
θ0 := 1.
• Payoffs: If trade happens at time t, buyer gets u = δ t (θ − pt ), and seller gets π = δ t pt .
• Benchmarks: Competitive outcome: p = 0, q = 1. Monopoly outcome: p = 1/2, q = 1/2.
– The optimal dynamic mechanism is pt = 1/2 for all t, i.e. monopoly pricing. See Example
3 in the nonlinear pricing notes.
Why does this matter?
• Consider the government owns a large swathe of land. Can they use their monopoly power
to raise prices about the competitive price? This requires the government commit to restrict
sales. But how can they commit? They will always be tempted to sell a little more. More
generally, this model helps us understand the market for durable goods (e.g. cars) and durable
experiences (e.g. movies). The key issue is that sales tomorrow substitute for sales today. This
means the seller is competing with future versions of herself.
hR i
5 ∂ ∂ ασ+
To see this, (ICF OCθ ) implies ∂σ
v(σ, σ̃) = E
∂σ −∞
q(s, σ̃)ds = E [αq(θ, σ̃)].
34
• Mechanism design assumes the principal can commit to a contract. This is the canonical
example in which the principal cannot commit.
• Literature: Coase (1972) conjectured that if the seller could change her price frequently the
price would drop to zero “in the twinkling of the eye”. This was proved by Gul, Sonnenschein
and Wilson (1987). The version we do here is from Example 1 in Gul et al, and in Sutton
(1986).
Recursive structure
• At each time t, suppose the firm sets a price pt and people with values exceeding θt purchase
(if they have not already done so).
• At the start of time t = 1, customers have values θ ∼ [0, 1], and the firm will set price p1
inducing cutoff θ1 . Let θ1 = γ represent how much the cutoff shrinks over a period, and
p1 = βθ1 be the discount relative to the cutoff.
• At the start of time t, customers have values θ ∼ [0, θt−1 ]. This is identical to the initial
problem, except scales by θt−1 . Thus, we look for an equilibrium in which θt = γθt−1 and
pt = βθt . Thus the cutoff shrinks by γ each period as does the price, pt = γpt−1 . Since
quantity and prices shrink by γ, continuation profits shrink by γ 2 , Π(θt−1 ) = γ 2 Π(θt−2 ).6
Buyer’s problem
• The cutoff type θt who is indifferent between buying today and tomorrow.
(θt − pt ) = δ(θt − pt+1 )
• Fix γ, which is the fraction prices drop each period pt+1 = γpt . We can use this to determine
the relationship between the cutoff and prices,
1−δ
pt = θt =: βθt
1 − δγ
Intuitively, if the seller wishes to lower θt by then she needs to lower pt by more than since
the buyer will anticipate lower prices tomorrow.
Seller’s problem
• The seller chooses the period t cutoff to maximize profits,
Π(θt−1 ) = max(θt−1 − θt )pt + δΠ(θt )

θt
6
To see this, observe that this property is maintained by the Bellman equation, Π(θt−1 ) = (θt−1 −θt )×pt +δΠ(θt ) =
γ(θt−2 − θt−1 ) × γpt−1 + δγ 2 Π(θt−1 ) = γ 2 Π(θt−2 ).
35
Solving the seller’s problem: Approach #1
• Using pt = βθt , the seller’s problem is thus
Π(θt−1 ) = max(θt−1 − θt )βθt + δΠ(θt ) (8)

θt
• Step 1: Use the envelope theorem
Π0 (θt−1 ) = βθt∗ = γβθt−1 (9)
where θt∗ is the optimal choice of θt .
• Step 2: Differentiate the Bellman equation (8) w.r.t θt ,
(θt−1 − 2θt )β + δΠ0 (θt ) = 0
Using Π0 (θt ) = γβθt ,

(θt−1 − 2θt )β + δγβθt = 0
Thus θt is linear in θt−1 as originally conjectured.
• What is γ? Using θt = γθt−1 and canceling,
(1 − 2γ) + δγ 2 = 0 (10)
Solving this quadratic yields √

1− 1−δ
γ= <1
δ
√
which implies that β = 1 − δ.
• One can then derive profits. Integrating up (9) using Π(0) = 0 yields
γ 2
Π(θ) = βθ (11)
2
Solving the seller’s problem: Approach #2
• Step 1: Calculate profits on-path (and hence continuation profits). In equilibrium we know
that θt = γθt−1 , pt = γpt−1 and thus Π(θt ) = γ 2 Π(θt−1 ). Using the Bellman equation,
Π(θt−1 ) = (θt−1 − γθt−1 )γβθt−1 + δγ 2 Π(θt−1 )
Note that γ is a choice variable (lowering γ leads to more sales today, a lower price today, and
lower profits tomorrow). But β is not since this represents the buyer’s expectation of prices
tomorrow, which the seller cannot control today.
36
• Rearranging
(1 − γ)γ 2
Π(θt−1 ) = βθ (12)
1 − δγ 2 t−1
• Step 2: Differentiating (12) with respect to γ gives you (10). Note that it is important not to
differentiate with respect to the γ buried in β, since β reflects beliefs about tomorrow’s prices,
and cannot be chosen by the seller.
• We can verify that (12) is consistent with (11). Using the quadratic (10) to substitute for δγ 2 ,
(1 − γ)γ 2 (1 − γ)γ γ
Π(θ) = 2
βθ = βθ2 = βθ2
1 − δγ 1 − (2γ − 1) 2
Remarks about solving the problem
• There is even a third way of solving the problem. Substitute profits (12) into the Bellman.
Then differentiate with respect to θt . This gives the FOC
(1 − γ)γ
(θt−1 − 2θt )β + 2δ βθt = 0
1 − δγ 2
Using θt = γθt−1 , and rearranging yields the same quadratic (10) .
• Sutton (1986) considers the bargaining variant of this problem where the seller has one object
to sell. There is one buyer who has unknown value θ ∼ U [0, 1]. The price and cutoffs are the
same, but the continuation profit is conditional on having a unit to sell and is thus proportional
2 .
to θt−1 rather than θt−1
What happens when then seller can change her price frequently?
• Let h be the length of a period in a unit interval “real time” [0, 1], so there are 1/h discrete
periods per unit time.
• If δ is the amount of discounting over [0, 1] then there is δ h discounting each discrete period.
√
1− 1−δ h
Correspondingly, the seller sells to fraction γ(h) = δh of the buyers each period.
Proposition 10 (Coase Conjecture). As the time between periods shrinks, h → 0, then: (a) The
seller’s profits converge to those she would get in the competitive equilibrium, Π(1) → 0; (b) All
sales take place “in the twinkling of an eye”.
Proof:
• Part (a): Π(1) → 0. To see this, just let δ → 1 in equation (11).

γ
lim Π(1) = lim β=0
h→0 δ→1 2
since γ → 1, while β → 0.
37
• Part (b): All sales take place “in the twinkling of an eye”. The customers remaining after the
first discrete period equal γ, so the customers left after “real time” [0, T ] equals
h √ iT /h
1− 1 − δh
lim γ(h)T /h = lim =0
h→0 h→0 δT
To calculate the limit of the numerator, take logs and apply L’hopital’s rule.
Conversely, what happens if the seller has a lot of commitment power? That is h → ∞.
• The initial cutoff equals the monopoly level,

1
lim θ1 = lim γ(h) =
h→∞ h→∞ 2
• The initial price equals the monopoly level,

p 1
lim p1 = lim 1 − δ h θ1 =
h→∞ h→∞ 2
• Initial profits converge to monopoly profits,

γ 1
lim Π(1) = lim β=
h→∞ h→∞ 2 4
• Thus the problem collapses to the standard monopoly problem.
Remarks on the model, and the literature.
• Suppose values are distributed θ ∼ U [θ, θ], and the seller has value θ0 . There are two cases.
• Case 1 (the “gap case”): θ > θ0 . There is a unique equilibrium. The game ends in finite time,
and can be computed via backwards induction. The equilibrium satisfies the Coase conjecture.
• Case 2 (the “no gap case”): θ ≤ θ0 . There are two types of equilibria
– There is a unique Markov equilibrium, where the state variable is the current cutoff, θt .
This satisfies the Coase conjecture.
– There are non-Markovian equilibria that do not satisfy the Coase property. They look
as follows: The price is close to monopoly, slowly dropping over time; if the seller cuts
prices faster, then buyers believe that she will switch to the Markov equilibrium. Hence
if the seller does drop her price, buyers expect future prices to be even lower and don’t
buy, meaning the seller doesn’t have an incentive to drop her price. See Ausubel and
Deneckere (1989).
38
• What if the seller could post a mechanism at each point in time, rather than just a posted price?
That is, the seller can commit to one-period mechanisms but not multi-period mechanisms.
The optimal mechanism consists of posted prices. See Skreta (2006).
• How can the seller solve the commitment problem? Rental contracts (Bulow, 1979). Best-price
provisions (Butz, 1990).
4.3 Commitment Failures Elsewhere
• There are two types of commitment failure:
– No commitment. The principal is free to choose whatever they like each period.
– Renegotiation proofness. The principal and agent agree to a long-term contract but
cannot commit not to renegotiate. For example, in the moral hazard model the principal
exposes the agent to risk in order to provide incentives. But after the agent has chosen
her effort, the two can renegotiate towards something more efficient by shifting risk back
to the principal. See Fudenberg and Tirole (1990).
• Commitment problems in non-linear pricing. Suppose we repeat the static non-linear pricing
problem twice, and types are persistent. After the first period, the principal is tempted to
raise the price to high-value agents, and fully extract from them. Anticipating this, they under
report in the first period. See Laffont and Tirole (1988).
• Commitment problems with auctions.
– Suppose we run a second-price auction, where i and j have values $100 and $80. If people
bid truthfully, the seller realizes that i values the good at $100 but only pays $80. The
auctioneer is tempted to introduce fake bids. It can also be politically problematic. See
McMillan (1994, JEP).
– If we run a first-price auction, can the seller credibly commit to refuse counter offers?
For example, suppose i has a value of $100 and bids $50, while j has a value of $80 and
bids $40. After the auction ends, and i is announced the winner, what happens if j offers
$55?
– Like the Coase conjecture, can an auctioneer commit to a reserve price?
39
5 Competition: Private Values
We first consider two models of competing principals with private values. The general lesson is that
market with private values generally work well (at least as well as those in Econ 101). In the next
section, we will see that it’s a different story with common values.
5.1 Nonlinear Pricing
Model
• Two firms who sell an identical range of products.
• Firm i chooses price schedule Ti (q).
• An agent of type θ ∼ F [θ, θ] wants one good. He chooses the product q and firm i to maximize
he utility, u = θq − Ti (q)
• When a firm sells a good of quality q, they get π = T (q) − c(q).
Proposition 11 (Bertrand). There is a unique Nash equilibrium in which both firms choose Ti (q) =
c(q).
Proof:
• Suppose firm j wins more than half the customers and makes positive profits. Then firm i
can choose Ti (q) = min{Ti (q), Tj (q)} − .7
• This deviation will win all the customers and thus makes profit Πi + Πj − .
• Thus equilibrium profits are zero. A firm will never be willing to lose money on a product, so
prices must equal costs.
Remarks
• This simple example shows that private information does not really change competition rel-
ative to Econ 101. For example, one can view Hotelling as competition where one does not
know the horizontal preference of the buyer.
7
This assumes j uses a pure strategy. If i and j used mixed strategies then the maximum price for a given quality
would make no sales, giving rise to another deviation.
40
5.2 Competition among Auctioneers
Model
• There is a continuum of buyers and sellers.
• There is mass 1 of buyers in the market. Each would like one unit.
• There are an unlimited number of potential sellers. It costs k for a seller to enter the market
(you can think of this as a production cost). The seller has no use for the good other than
selling it.
Timing
• Sellers simultaneously choose whether to enter.
• Entering sellers simultaneously post auction mechanisms.
• Buyers look at all the auctions and independently choose which to enter. They can only enter
one.
• After entering, the buyers see who else has entered and discover their value, θ ∼ F [θ, θ]. These
are IID.
• The buyers play a BNE in the chosen mechanism.
Remarks
• There is a coordination problem: Sometimes lots of buyers may turn up a single seller. Oth-
erwise, how efficient is the market?
• What auctions will sellers post?
• Will enough sellers enter (they cannot capture consumer surplus) or too many (business steal-
ing)?
• This is also related to macro models of directed search.
We first characterize seller’s optimal mechanisms. See McAfee and McMillan (1987) or Levin and
Smith (1994).
Proposition 12. It is optimal for each seller to post a SPA (or FPA) with reserve price r = 0.
Proof:
41
• The basic idea is simple: From one seller’s perspective, agents’ rents are pinned down by
free entry, so the seller wishes to maximize welfare. A SPA is a VCG mechanism, so an agent
receives his marginal contribution to social surplus. Thus entry into an auction with no reserve
price is efficient.
• Let’s be more formal. There are a large number of sellers, so agent’s rents are independent of
what one seller does. Denote these rents by u∗ .
• The seller’s revenue equals welfare minus rents. The latter is fixed, equal to u∗ , so the seller’s
profits equal
n
" #
X
∗
Π(λ) = Eλ pi (θ)θi − nu (13)
i=1
where n is the (random) number of agents who enter the auction. Since agents make in-
dependent entry decisions, n is distributed according to a Poisson distribution with mean
λ.8
• We have to determine two numbers: the allocation and the mean number of bidders λ. This
is analogies to how in the usual auction problem we determine the allocation and the utility
of the lowest type.
• The allocation follows from (13). Conditional on n, the seller wishes to allocate the good to
the agent with the highest value.
• We now turn to the number of bidders. A seller’s profit (13) thus equals
Eλ [θ1:n − nu∗ ] (14)
where θ1:n is the highest order-statistic of n. When a seller thinks about increasing λ to λ + ,
this leads to zero additional bidders turning up with probability 1 − + o(), 1 additional
bidder with probability + o() and more bidders with probability o().9 At the optimal
choice of λ, the seller must be indifferent about raising λ a little. Let
Π(λ + ) = Eλ [θ1:n+1 ] + (1 − )Eλ [θ1:n ] − (λ + )u∗
then
d
Π(λ + )|=0 = 0 ⇒ Eλ [θ1:n+1 − θ1:n ] − u∗ = 0
d
They would thus like a buyer to enter if the increase in welfare E[θ1:n ] exceeds the (opportu-
nity) cost of entry u∗ .
8
This is called the “law of rare events”. See https://en.wikipedia.org/wiki/Poisson_limit_theorem
9
This property is one way of defining a Poisson process. It comes from the fact that every bidder turns up
independently.
42
• In a SPA, a bidder gains E[θ1:n+1 − θ1:n ]. Thus if we set r = 0 bidders will enter up to the
point that E[θ1:n+1 − θ1:n ] = u∗ , as required.
We next turn to the seller’s entry problem
• They have to pay cost k to enter.
• One might think that there is inefficient entry since the seller only captures the second highest
value, whereas the welfare gain is the highest. However they exert a negative externality on
other sellers by stealing business. These effects exactly cancel out. See Albrecht, Gautier and
Vroman (AER, 2014).
Proposition 13. The entry of sellers into the market is efficient.
Proof:
• The idea is simple but subtle. Suppose a seller enters the market. What is the impact on all
the other participants?
– They steal buyers from other sellers. But since those buyers get their marginal contri-
bution to those auctions, this does not affect the payoff of the other sellers.
– The agents enter the new auction until they get rent u∗ , so buyers get the same utility
as before.
– The entering seller thus exerts no externalities on the other parties, so her entry decision
is efficient.
• Let’s be more formal. From the planner’s perspective, total surplus from mass m of sellers is
1
S(λ) = Eλ [θ1:n − k]
λ
where λ = 1/m is the average number of buyers per seller. Suppose we lower m a little or,
equivalently, raise λ by . Social surplus is
1
S(λ + ) = [Eλ [θ1:n+1 ] + (1 − )Eλ [θ1:n ] − k]
λ+
Differentiating,
d
S(λ + )|=0 = 0 ⇒ Eλ [θ1:n − k] − λEλ [θ1:n+1 − θ1:n ] = 0
d
This says the planner equates the welfare from each new seller to the lower welfare from all
the old sellers.
43
• Now consider a new seller. Using (14), free entry tells us that
Eλ [θ1:n ] − λu∗ = k
Given that agent’s rents coincide with their impact on other sellers, u∗ = Eλ [θ1:n+1 − θ1:n ],
this coincides with the planner’s solution.
5.3 Taxonomy of “Competing Principals” Models
There is a literature on “competing principals”. We have looked at two such examples. Here are
some of the dimensions along which such models differ:
• How are firms differentiated?
– Vertical differentiation, as in the nonlinear pricing.
– Horizontal differentiation, as in Hotelling.
– Search fictions, as in random search models.
• How many people can a buyer purchase from?
– Exclusive: Agent only purchases from one principal.
– Delegated: Agent can choose subset of principals.
– Intrinsic: Agent must deal with all principals, e.g. A bank must deal with the Federal
Reserve and the SEC.
• What can contracts be written on?
– Private: Price of i can only depend on the agent’s choice qi
– Public: Price of i can depend on both the agent’s choice of qi and qj . E.g. Intel charges
more if Dell buys some processors from AMD.
– Contractible contracts: e.g., “I’ll charge monopoly price if you choose the same contract;
else I’ll set price equal to cost”. This is analogous to price-match guarantees.
44
6 Competition: Common Values
In this section we consider settings where the principal directly cares about the type of the agent
(not just via the mechanism, as in nonlinear pricing). For example,
• A principal considers buying a good of unknown quality
• A principal considers insuring an agent of unknown risk
Above, we discussed how this affects mechanism design with a single principal (see Exercise 2, and
HW5 Q2). The importance of common values really comes out when we look at markets.
6.1 Akerlof ’s Lemons
• A competitive market of principals wishes to acquire an asset off a party with private infor-
mation. The key issue is that the higher the price, the better the selection.
• Originally due to Akerlof (1970). We’ll follow MWG, Chap 13.B.
Applications
• Finance, e.g. mortgage backed securities.
• Industrial organization, e.g. trade of cars
• Labor economics, e.g. hiring workers of unknown quality.
Model
• An agent is of productivity θ ∼ F [θ, θ]. This is privately known by the agent.
• There are two identical firms (principals). We could have more, but two is enough for perfect
competition, a la Bertrand.
• The firms post wages wi .
• The agent decides whether or work for either firm, or work for neither.
• We look for a PBE of the game.
Payoffs
• If a firm pays wage w, she receives profit π = θ − w.
• If the agent accepts, he receives u = w − r(θ), where r(θ) is his reserve value.
• We assume r(θ) is increasing and r(θ) ≤ θ, so that trade is always efficient.
45
Figure 6.1: Akerlof ’s Lemons.
46
Proposition 14. A PBE exists, and the equilibrium wage satisfies
w = E[θ|r(θ) ≤ w] (15)
and agent types Θ = {θ : r(θ) ≤ w} trade. Generically, the equilibrium wage is unique and is the
highest w satisfying equation (15).
Proof (existence)
• This is a Bertrand game between the two firms.
• Both firms must break even. If firm 1 makes profits at wage w then firm 2 can pay more.
This will cost her at most since the selection of workers will improve.
• Given the price w, agents will sell if r(θ) ≤ w.10 Hence the zero profit points are determined
by the fixed point (15).
• Does a fixed point exist?
– Let Γ(w) = E[θ|r(θ) ≤ w] be the firm’s expected productivity given a wage of w. Define
this on the domain w ∈ [r(θ), Eθ]
– If w = r(θ) then only the lowest type trades. Since Γ(θ) = θ ≥ r(θ) = w, we start weakly
above the 45o line.
– If w = Eθ then Γ(θ) ≤ Eθ ≤ w, and so we are weakly below the 45o line.
– The function Γ(w) is increasing so a fixed point exists.
Proof (uniqueness)
• If there is one fixed point, the equilibrium is unique. See Figure 6.1(a)
• What if there are multiple crossing-points?
– See Figure 6.1(d). At points A or B, a deviation to wage w̃ is profitable.
• Uniqueness of the equilibrium wage can only fail if the highest fixed point is a tangency point.
This is non-generic.
Remarks
• There is too little trade. The adverse selection means that the marginal agent does not capture
their full productivity. In comparison, low productivity agents are over-paid. See Figure 6.1.
10
We’ve broken ties in favor of trading. If the distribution is continuous, this doesn’t matter. If the distribution
has atoms, there will be existence issues if we let Θ = {θ : r(θ) < p}.
47
• There can be full unraveling. See Figure 6.1(b). For this we need r(θ) = θ.
• There can be full trade. See Figure 6.1(c). For this we need r(θ) < Eθ.
• MWG present a “competitive equilibrium” approach to the lemons problem. A competitive

equilibrium is a wage w and a set of trading types Θ that are consistent with each other. Any
wage that satisfies equation (15) constitutes such an equilibrium. When there are multiple
competitive equilibria, as in Figure 6.1(d), they are Pareto ranked with the highest wage
equilibrium being best. To see this observe that firms make zero profits in all equilibria, while
agents prefer higher prices.
• MWG also argue that the highest fixed point is constrained Pareto optimal. Formally, this is
a mechanism design problem with the constraint that the principal breaks even. Intuitively,
in any mechanism, types [θ, θ∗ ] trade for some θ∗ . The highest equilibrium corresponds to
the highest θ∗ that is consistent with break-even. The only thing the principal could do is to
subsidize no-traders, but this would lower the amount of trade and welfare, or tax no-traders,
but this would make no-traders worse off.
Example 1
• Suppose θ ∼ U [0, 1] and r(θ) = θ − 1/4.
• Given a price w, the marginal type is

1
θ∗ = r−1 (w) = w +
4
• The firm’s productivity is then

1 w 1
Γ(w) = E[θ|θ ≤ θ∗ ] = θ∗ = +
2 2 8
• The fixed point (15) then yields w = 1/4, which means that half of the sellers trade.
Example 2
• Suppose θ ∼ U [0, 1] and r(θ) = αθ. Given a price p, the marginal type is
w
θ∗ = r−1 (w) =
α
• The firm’s productivity is then

1 w
Γ(w) = E[θ|θ ≤ θ∗ ] = θ∗ =
2 2α
48
• If α > 1/2, then the willingness to pay is always less than the price, E[θ|r(θ) ≤ w] < w for
any w > 0. Thus the unique PBE exhibits no trade. See Figure 6.1(b)
• If α < 1/2, then the willingness to pay is always greater than the price, E[θ|r(θ) ≤ w] > w
for any w > 0. Thus the unique PBE exhibits full trade. See Figure 6.1(c)
6.2 No Trade Theorem
In Akerlof there is no trade if r(θ) = θ. This is a special case of a more general result. Consider the
following extension of the Akerlof model.
• A seller owns an asset; a buyer, B, contemplates purchasing it.
• The asset will pay off dividends v in the future. Both agents only value the asset for its
dividends.
• Each agent i ∈ {B, S} has a (nontrivial) private, independent signal θi ∈ < of the value v,
such that E[v|θi ] is increasing in θi .
The game:
• Fix a price p
• Both parties simultaneously announce “trade” or “no trade”.
Proposition 15. Trade takes place with probability zero in any BNE.
Proof
∗ , and the seller will sell iff θ ≤ θ ∗ .

• The buyer will purchase iff θB ≥ θB S S
• The buyer will announce “trade” if E[v|θB , θS ≤ θS∗ ] ≥ p. This implies that when he receives
the worst “trade” signal
∗
E[v|θB , θS ≤ θS∗ ] ≥ p
∗ , θ ] ≤ p. This implies that when she receives

• The seller will announce “trade” if E[v|θB ≥ θB S
the worst signal

∗
E[v|θB ≥ θB , θS∗ ] ≤ p
• These formulas yield a contradiction:
∗
p ≤ E[v|θB , θS ≤ θS∗ ] < E[v|θB ≥ θB
∗
, θS ≤ θS∗ ] < E[v|θB ≥ θB
∗
, θS∗ ] ≤ p
as required.
49
A more general result (advanced)
• We don’t need to assume anything about the signal structure (e.g. independence).
• The more general proof is as follows. Suppose there is a set of states Ω that determine the
value v and the signals {θB , θS }. The probability distribution is common knowledge.
• Let Hi (ω) ∈ Ω be the states that i thinks are possible in state ω. Define
TB = {ω ∈ Ω : E[v|HB (ω) ∩ TS ] ≥ p}
TS = {ω ∈ Ω : E[v|HS (ω) ∩ TB ] ≤ p}
That is, TS is the event S will announce “trade” given she knows the state is in HS (ω) and B
is willing to trade.
• Suppose the agents trade. The S knows that TS occurred and believes with probability 1 that
TB occurred. Thus each believes with probability one that T = TS ∩ TB occurred. The seller
trades if E[v|T ] ≤ p, while the buyer trades if E[v|T ] ≥ p. But both of these cannot occur
unless signals are trivial.
6.3 Competition in Screening Contracts
• This comes from the paper of Rothschild and Stiglitz (1978).
• That paper studied the insurance industry. We’ll follow MWG 13.D in studying a Spencian
education model. The economics is identical, but the Spence structure is easier.
Model
• Workers have productivity θ ∈ {θL , θH }, where Pr(θ = θL ) = α. These are privately known.
• A job consists of a wage w and an effort level e.
• Agent θ gets utility u = w − c(e, θ), where the cost function is increasing in e, submodular in
(e, θ),11 and satisfies c(0, θ) = 0. The outside option is zero.
• A firm employing agent θ get profit π = θ.
• Effort is entirely wasteful. It is useful since high types don’t mind effort as much as low-types
(“single-crossing”).
• First-best: If the type were observable then equilibrium would yield (w, e) = (θ, 0).
11
That is ceθ (e, θ) < 0. This implies “single-crossing”.
50
Game
• Two firms (principals) simultaneously post a finite set of contracts (w, e).
• Agents choose their favorite contract.
• We look for a pure PBE.
• As in signaling models an equilibrium is “pooling” if both types choose the same contract and
“separating” if these choose different contracts.
Step 1: All equilibria are zero profit. See Figure 6.2(a).
• If not, the firm making less profits should offer the current contracts that are offered and pay
more.
• If the industry were making profits Π, then this firm will make Π − .
• Note that this doesn’t affect which contract the agents choose (i.e., the IC constraints).
Step 2: There is no pooling equilibrium. See Figure 6.2(b).
• Suppose there were, then one firm can pick off the high types.
Step 3: The lowest type exerts zero effort. See Figure 6.2(c).
• If not, a zero effort contract is a profitable deviation
Step 4: The only pure PBE is the least-cost separating equilibrium. See Figure 6.2(d).
• Suppose the θH were exerting more effort than necessary, then there is a profitable deviation.
To summarize:
Proposition 16. If a pure PBE exists, it is the least-cost separting equilibrium. See Figure 6.2(e).
But, does an equilibrium exist?
• If there are lots of high-types then a pooling equilibrium is a profitable deviation from the
least-cost separating equilibrium. See Figure 6.2(f).
• Is this a problem: It tells us a separating equilibrium may not exist exactly when it is Pareto
dominated by a pooling equilibrium.
What does this teach us about insurance?
• Consider a model with a risky type (the “low type” here) and a safe type (the “high type”
here). The risky-agent wants more insurance giving rise to a single-crossing condition.
51
Figure 6.2: Rothschild-Stiglitz. This plots the indifference curves for workers under different contracts.
52
• In the least-cost separating equilibrium the risky type gets full insurance, while the safe type
get partial insurance.
• This tells us that asymmetric information undermined insurance markets (in addition to the
problems of limited commitment, and moral hazard).
What happened subsequently?
• If we allow for mixed strategies, there exists a unique equilibrium (Luz, 2017).
• If we look for a competitive equilibrium of insurance pools, rather than letting insurance
companies post contract, then the least-cost separating equilibrium is the unique equilibrium
(Dubey and Geanakopolis, 2002).
• If firms can only employ one person, and this is determined by “direct search” then the least-
cost separating equilibrium is unique. Intuitively, the low productivity agent gains more from
the pooling contract than the high-productivity agent, leading to negative selection (Guerreri,
Shimer, Wright, 2014).
53

Asymmetric Information Models in Economics

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Asymmetric Information Models in Economics

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Econ 201c, UCLA Simon Board

• Information structure (single-agent model)

• Information structure (auctions)

∗ Values may be independent or correlated.

• Type of implementation (multi-agent models)

A guide to this class:

• These notes: Single-agent models.

– Multi-period mechanism design

– Private values - Competing auctioneers

1 Revelation and Taxation Principle

1.1 Nonlinear Pricing

• There is one agent with unknown value θ ∼ F [θ, θ].

• Equivalently, there is continuum of agents with IID values θ ∼ F [θ, θ].

• Principal has increasing, convex cost c(q) of supplying quality q.

• Suppose the firm charges price schedule T (q).

• Suppose we start with a DRM hq(θ), t(θ)i.

1.2 Revelation Principle for Bayesian Implementation

• There are N agents have types θ = (θ1 , . . . , θN ) ∈ ×i Θi . Denote the distribution by F .

• There is an allocation y ∈ Y , e.g. with nonlinear pricing, y = (q, t).

• Agent i reports a message mi ∈ Mi . Let M = (M1 , . . . MN )

• The principal implements allocation g : M → Y .

• We look for a BNE m∗ (θ) = (m∗1 (θ1 ), . . . m∗N (θN )).

Acceptance of the mechanism is WLOG

• We can always include a null message m0 in Mi such that g(m0 ) = ∅.

Direct revelation mechanism

• Agent i’s message space is her type space, Mi = Θi .

Proposition 1. Truth-telling is a BNE of the direct revelation mechanism

E−i [ui (ḡ(θ), θ)] = E−i [ui (g(m∗ (θ)), θ)]

2 Single Agent Problems

• The firm’s problem is to choose a direct mechanism hq(θ), t(θ)i to solve:

max Π = E[t(θ) − c(q(θ))]

s.t. (IR) u(θ, θ) ≥ 0 ∀θ

Pointwise maximization gives rise to the FOC

2.1 Nonlinear Pricing: Two Types

max Π = (1 − α)[tH − c(qH )] + α[tL − c(qL )]

Claim 1. (IRH ) can be ignored.

• (ICH ) and (IRL ) imply (IRH ) . Formally, θH qH − tH ≥ θH qL − tL ≥ θL qL − tL ≥ 0.

• (ICL ) and (ICH ) imply that θH (qH − qL ) ≥ tH − tL ≥ θL (qH − qL ).

Claim 3. (IRL ) binds

Claim 4. (ICH ) binds

Claim 5. If qH ≥ qL then (ICL ) can be ignored.

• If (ICH ) binds and qH ≥ qL then tH − tL = θH (qH − qL ) ≥ θL (qH − qL ) and so (ICL ) holds.

Solving the problem

• Given these claims, the principal’s problem becomes

max Π = (1 − α)[tH − c(qH )] + α[tL − c(qL )]

• The FOCs are then

• Transfers can then be derived from (IRL ) and (ICH ).

The Wilson approach. There is an alternative way to interpret this problem.

2.2 Nonlinear Pricing: Continuous Types

• This is a lot of constraints! Fortunately, we can characterize incentive compatible allocations

qL qL* qH=qH* q qL qL* qH=qH* q

Lemma 1. Mechanism (q, t) is incentive compatible iff

(ii) Quality q(θ) is weakly increasing in θ

[⇐] Pick θH > θL . Part (i) implies that

= U (θL ) + (θH − θL )q(θL ) = u(θH , θL )

max Π = E[t(θ) − c(q(θ))]

s.t. (IRθ ) U (θ) ≥ 0

• Step 1: Observe that profits equal surplus minus utility,

Π = E[θq(θ) − c(q(θ)) − U (θ)]

• Step 2: Calculate the expected utility of the agent.

Π = E [M R(θ)q(θ) − c(q(θ))] − U (θ) (2)

subject to (IRθ ), where

Proposition 2. Assume M R(θ) is increasing. The optimal quality q(θ) is given by