Lecture 7: Introduction to Auctions

Auction example – Auction for different types of offices. Sealed bid auction where everyone pays
their bid. This is called a discriminatory Auction because people pay a different amount for the same
thing.

The person who wins suffers from ‘Winners Curse’ because they pay more than others and would
have benefited from shading their bid. It was used at google, but leads to strategic gaming and is
difficult to play.

A uniform price auction is where everyone pays the same and the price you bid is not the price you
pay. In the example, there are y people and x top offices, the x+1 highest bid is paid by the top x
people who get the window offices. It is an optimal bidding strategy to bid your wiliness to pay –
equivalent to second price auction.

This is even under uncertainty – you don’t know others bids. You can’t gain from reporting a false
bid: You either have no change or your hurt yourself.

Auction Essentials

Auctions are a price discovery mechanism if you don’t know what the right price is because there
isn’t a huge market.

When auctions are relevant:

- You don’t know the right price

- There is scarcity – like a painting (no market forces)
- The quality and quantity of the good changes frequently – eg fish or electricity – lots of
dimensions to take into account
- Transaction frequency is low

*Helps the buyer and the seller to get the right price.

What is an auction?

Defining an auction -

1. Bidding format rules: how bids can be submitted and what they include – price and quantity,
construction etc
2. Bidding process rules: Closing times, rules for bid, ticking size, available information
3. Price and allocation rules: Final price – how it is determined, who wins and what do they
pay?

It is a market mechanism / price discovery mechanism.

Close to a competitive equilibrium in normal market economy: Uniform price auction is the same.

*There are behavioural factors that can come into an auction – even though we model them
theoretical: Auction fever, auctioneers taking advantage of people.

Valuations

Each bidder gets a signal about their valuation: The highest willingness to pay.
Private value: Everyone gets a precise signal (no noise) about their own valuation of the item and its
different for each person, but it doesn’t depend on others valuations. This is the private value
model.

Common Value: Each buyers valuation of the good depends on the valuation of others. Very
complicated. Eg: Oil tract underground – All trying to figure out the common value, which comes
from what others think too.

Interdependent: Mix of both. This is when the bidders signals are correlated – this is the
interdependent or common value model.

Common value: In this case the signal is noisy but the true valuation is the same.

Interdependent value: The valuation is the sum of a private and common part.

**This means the auction format is very important!

We are looking at private valuations: IPV – Independent Private Valuations

Incentive issues – Do I bid my value or not?

Payoff = (value – bid) if you win

(0) If you lose.

In the case where price = bid, I prefer to win than lose.

Efficiency: When the social surplus is maximised.

Social surplus = sellers surplus + winners surplus + losers surplus = p + (v-p) + (n-1)x0 = v

If the winner with the highest valuation wins, then the auction is efficient (as above). Efficiency =~
revenue maximisation.

Ideally the winner with the highest surplus wins the auction, but that is not always the case.

Auction Types

Ascending auctions: Price goes from low to high.

English outcry auction: Like you see on TV, house auctions – Bidders announce the prices

o Jump bids are allowed – which can change payoffs etc

o May be a minimum tick price
o Stops due to time limit or no further bids
o Speed matters – you can’t bid at the same time. *Dynamic game
o The winner pays their final announced price: It seems like first price auction, but it’s
closer to second price because it’s not the maximum willingness to pay for the
winner.
English Auction: Auctioneer announces the prices and it gradually increases by a ticking
price. This is the standard ascending auction.
 o Price announced and bidders say if they accept or drop out. Only one person needs
to stay in for auction to continue to next step.
o Stops when there is one bidder left who is the winner and pays the amount
announced in the previous step (which has been accepted by the winner and no one
else)
o Tie: Everyone drops out at the same time – random draw decides. Theoretically
doesn’t happen as we use continuous distributions.
o AKA: Japanese button auction Let go of you button when you want to drop out.

What is a bid in English Auction: You have a price target you know you will stop pressing the button
(or drop out) and you only “bid” once.

Bid in an English outcry auction: A price. You may make several bids, up until the auction goes past
your price.

English Auction Strategy: Describes an agents actions based on any possible bidding history (who
bid, how much etc) and then says what they will do as a result. A strategy is dominant if it
outperforms any other strategy.

Truthful bidding is a dominant strategy in the English auction.

Proof:

- If I bid greater than my value and lose: Payoff = 0 - No change

- If I bid greater than my value and win: Payoff is negative (value – price*) – Negative outcome
- If I bid less than my value and lose: I get nothing, but may have missed the chance to win:
Payoff: 0 – Worse or the same outcome
- If I bid less than my value and win: I would have won anyway – No change.

In an English auction, the auctioneer learns the valuations of all the bidders except for the winner.
This helps for price discovery.

English Outcry Auction Strategy: Not the same!

Example Grinch and Santa: If someone has a weird strategy to bid up the price in between certain
price ranges, it may be a dominant strategy to do jump bids. So as a result there is no dominant
strategy. This shows us that design of auctions matter a lot.

How to design a mechanism that achieves this but is a static game and the timing doesn’t matter?
For real life applications this can be important – like dispute resolution, you don’t want the people
there. Or online auctions – turn it into a one shot game.

Vickery Auction: Second Price Sealed Bid Auction

Instead collect sealed bids asynchronously and the winner pays the second highest bid. In the English
auction, the winner pays their final bid, but this is the highest bid of the loser plus the ticking price.

Static one shot game – equivalent to Japanese button auction. (But we just theoretically ignore the
ticking price). We also find that again truthful bidding is a dominant strategy by the same logic.
Vickrey Vs English Auction

They are strategically equivalent: The same strategy (bid your true value), payoffs and the same
revenue and outcomes.

However – Vickrey is strategic form game (one shot) and English is extensive form game (dynamic).

That means the strategy is more complex in English auction because you have to have a range of
actions based on the actions of others and all possible histories.

*Well almost the same: The ticking price means that the payoff and price in the English auction may
be slightly higher. But we ignore it theoretically.

Assumptions

- Bidders are rational

- Perfectly know their valuations
- Valuations are private

In this case, the Vickrey and English auction are the same. (However in real life, these don’t actually
apply. The podcast about the auctions showed how behavioural factors can have an effect. People
can end up paying above the price they had in mind. This would make a second price auction result
in less possible)

Equilibrium of Auction Games

Model:

We have n bidders with valuation vi.

Bidders know their valuations vi.

The utility/payoff for each n depends on their bid, the others bids and their valuation:

μi ( v i , bi , b¿ i)=v i−Price(b i , b¿ i)if i wins ; 0 if not .

Two Information Assumptions: Complete and Incomplete Information

Complete: All valuations are common knowledge. Truth telling is weakly dominant strategy BUT not
the only nash equilibrium *see below. (Unrealistic but easier to solve)

Incomplete: Bidders values are private. The distribution of values is common knowledge – which
makes this a Bayesian Nash Equilibrium (you do the best given the information available).
Complete Information Example: Second Price Auction

N = 3, vi=30, v2=40, v3=50

Complete information – Second Price Auction. Tie Break: Highest valuation gets it.

Strategies in a static game are just the bid prices.

Strategy Profile: (b1, b2, b3)

Example (b1=30, b2=40, b3=50) Usual NE Dominant strategy: truth telling

(30, 45, 50) – Winner is 3, pays 45 Nash equilibrium – No profitable deviations

(30, 42, 42) – Winner is 3, pays 42 Nash equilibrium

(30, 35, 35) – Not an equilibrium because player 2 can bid 36 and win

Any situation where player 2 can win in a Nash equilibrium? Yes…

(30, 50, 30) – Winner is 2, pays 30 Nash equilibrium because no profitable deviations,
player 3 could bid 50 too, but their payoff is still 0.

Any situation where player 1 wins? Yes…

(50, 20, 20) – Winner is 1, pays 20 This is a nash equilibrium because no profitable
deviations from 2 or 3: 3 could win but payoff is 0.

But these weird equilibriums are unusual – they show evidence of collusion. There is some kind of
cooperation. The players might bid low to help the winner eg (20, 20, 40) or (0, 0, 40). This can
happen in repeated games: if you are always competing against the same people, you can let each
other have some parts of the market to maximise profits and share.

BUT the most sensible equilibrium is when everyone truthfully bids their valuation – which we
assume for comparison.

Incomplete Information Exercise

Is truth telling still dominant? Yes - but there are alternative equilibrium as well.

Dominant strategy: Means that no matter what everyone else is doing, this is the best thing for you
to do. In the Bayesian setting, you don’t know the others strategies, but your best response it still to
tell the truth.

Dutch Auctions…

First price auction: Example

Compete information: Get insights and then apply to incomplete information

N=3, v1=30, v2=40, v3=50

Complete information – First price auction

(30, 40, 50) Winner is 3, pays 50 Not a NE because 3 can reduce their bid to 40.
 (30, 40, 40) Winner is 3, pays 40 Usual Nash equilibrium – no profitable deviation
(same outcome as SPA)

(30, 45, 45) Winner is 3, pays 45 Nash equilibrium since no unilateral improvements

(30, x, x) where x is <=50 & =>40 Is a NE. Also 30 could be y<=x.

In SPA we saw collusion as a NE where player 1 can win. Can that ever happen in this setting? No.
The most any agent will rationally bid is their value because they have to pay it, so it’s easy for any
player with a higher value to bid above and get a positive payoff.

FPA: Truth telling is not an equilibrium: It is a dominated strategy. If you bid your valuation, your
payoff is always 0. You might lose by shading your bid, but you will never get a positive payoff if you
don’t. So the agents are trying to match the value is of the next highest bidder in the incomplete
information setting.

You can see from the two mechansims that the revenue is the same: Revenue equivalence theorem.
In both auctions, the winner pays the value of the next highest bidder (40).

Lecture 8: Auction Essentials

Recap: Complete Information Equilibriums: (v3>v2>v1)

Second Price Auction: (V1, v2, v3) bid your value: truth telling is a dominant strategy

First Price Auction: (b1<v1, v2, v2) The highest value bidder shades their bid to gain a positive
payoff.

Due to the strategic behaviour, people underbid and therefore the revenue that accrues to the seller
is equivalent.

Incomplete information: Calculate Bayesian Nash Equilibrium bidding functions.

First price auction under incomplete information

Prob(b) is the probability of winning the auction with bid = b, ie: b is the highest bid. Valuation = v.

Expected payoff = Probability of winning x winning payoff + probability of losing x losing payoff (0)

μi ( v i , b , b¿ ) =Prob ( b ) ( v i−b ) + ( 1−Prob ( b ) ) ( 0 )=Prob ( b ) ( v i−b )

i

A trade off occurs between submitting a higher bid with a greater likelihood of winning and
therefore a lower expected payoff. We need to maximise the payoff function with respect to the bid
to find the best bid function.

Optimal strategy: Choose b to maximise payoff.

More about Bayesian Games:…

A strategy of a bidder maps a valuation to a bid v ⟶ s (v)

For example I might bid half of my value, then s(v) = v/2

Assumptions:
 (1) Strategies are symmetric, so that if two agents have the same valuation, their bid will be
the same. (However, if the distribution of bids is continuous then no one will have the
same value).
(2) Bidders strategies are strictly increasing in v.
(3) For each bidder i, s(vi) <= vi : You never bid more than your value.

Assumptions imply = The person with the highest value will win with the highest bid.

Notation: s(v) = β(v)

Optimal bidding in first price auction incomplete information:

With n bidders and private independent valuations on a uniform distribution from [0, X] and bidding
strategies according to assumptions 1- 3: Then the optimal bidding strategy is:

( n−1)
β (v )= v
n
Derivation: Method 1 – Conjecture an equilibrium strategy

Assume n bidders, v i .i . d U {0,1 } (values are iid and uniformly distributed between 0 and 1.)

F (v )onuniform dist [a , b]=

[ ( v−a)
(b−a) ]
= Pr [V random < v]∧f (v )=
1
b−a

v i .i . d U {0,1 }⟹ F( v )=v=Pr [V random < v ]

On a uniform distribution, conjecture a linear solution and guess and verify.

Conjecture: b=β ( v )=αv +k

μi (v i , bi , b¿ i)=(v −b) Pr [b> max {b1 , b2 ... b n−1 }]

μi (v i , bi , b¿ i)=(v −b) Pr [b> max {β ( v 1 ) , β ( v 2 ) ... β ( v n−1 ) }]

μi (v i , bi , b¿ i)=(v −b) Pr [b> max {α v 1+ k , α v 2 +k ... α v n−1 + k }]

μi (v i , bi , b¿ i)=(v −b) Pr [ ( b−kα )> max {v , v ... v

1 2 n−1 }]

( )
n−1
b−k
μi (v i , bi , b¿ i)=(v −b) .
α
Maximise wrt b

( ) ( ) ( 1α )=0
n−1 n−2
∂ μ ( ) b−k b−k
= −1 + ( v −b ) ( n−1 )
∂b α α
n−1 n −1
(b−k ) α
⟹ n−2
=( v−b)(n−1) n −1
(b−k ) α
⟹ b−k=(v−b)(n−1)
⟹ b(1+(n−1))=v( n−1)+k

⟹ b∗¿ v ( n−1
n ) k
+ where α =
n
n−1
n
k
∧k= =0
n

So β ( v ) = v (
n )
n−1

Derivation Method 2: General Method – Not a uniform distribution

F
Assume n bidders, v i .i . d v , v } where the distribution function = F(v)
{
b=β (v )∴ β is differentiable
μi (v i , bi , b¿ i)=(v −b) Pr [b> max {β ( v 1 ) , β ( v 2 ) ... β ( v n−1 ) }]
−1
μi (v i , bi , b¿ i)=(v −b) Pr [ β (b)>max {v 1 , v 2. .. v n−1 }]

Let’s define Y = max of (n-1) random variables

CDF :G( y)=Prob [Y < y ]=F n−1 ( y )

−1
μi (v i , bi , b¿ i)=(v −b) . Pr [ β (b)> Y ]
−1
μi (v i , bi , b¿ i)=(v −b) .G( β (b))

Maximise wrt b

∂μ 1
=(−1 ) . G ( β−1 ( b ) ) + ( v −b ) G' ( β −1 ( b ) ) =0
∂b β ' ( β¿ ¿−1 ( b )) ¿
∂ −1 1
Remember f (x )=
∂x −1
f '(f ( x ))

⟹ G ( β ( b )) β '( β ¿¿−1 ( b ) )+ b G ( β ( b ) ) =v G ( β ( b ) ) ¿
−1 ' −1 ' −1

Substitute in b=β (v )⟹ ( β ( β (v) ) ) =v

−1

⟹ G ( v ) β '( v)+ β (v) G' ( v )=v G ' ( v )

Integration by parts
v v
⟹∫ G ( v ) β ' (v)+ β ( v)G ( v ) dv =∫ v G ( v ) dv
' '

v v

v
⟹ G ( v ) β (v)−G ( v ) β (v)=∫ y G ( y ) dy + c
'

Find the integration constant by substituting in the lowest valuation v into left hand side, G(v) = 0
(probability of winning if you have the lowest value) so left hand side is 0, which means the constant
must equal 0.
 v
1
⟹ β ( v )= ∫
G(v) v
y G' ( y ) dy =E [ Y |Y < v ]

Observe that the bidding function is a conditional expectation: The expected value of (n-1) random
variables conditional that you have the highest bid.

The steps in the 2nd method include: 1. Derive the equilibrium bidding function. 2. Calculate the
expected payment of any one bidder. 3. Calculate expected revenue of the seller.

Dutch Auction

Descending price auction: You bid when you want to buy the product. The price starts high and goes
low. Bidding your true value is not a dominant strategy.

Strategically the same as the first price auction – except this is a dynamic game. You will bid at your
expectation of the second highest bid conditional on your bid being the highest.

- Bidders use the same strategies and the same payoffs. Sellers get the same revenues.

Revenue Equivalence Theorem

So English = Second Price and Dutch = First Price auction, BUT the revenue is the same due to the
revenue equivalence theorem.

Any efficient auctions that gives the object to the highest valuation bidder and which gives the
lowest value bidder a payoff of 0, always generates exactly the same revenue.

Key Point – Even though different auctions have different bidding functions, the expected payment
for bidders and the expected revenue for the seller is the same.

Theorem:

There are n bidders with private valuations that are iid on a strictly increasing cumulative probability
distribution F(v) between [v, v ]. A standard auction which has the following properties as a
minimum:

- The winner is always the person with the highest valuation

- The bidder with the lowest valuation [v] has a zero expected payoff

In equilibrium will yield the same expected revenue for the seller and the expected price for any
buyer (average price) is the same (M I ). Expected payoff of each buyer is the same.

EXAM 1.21.39 Useful beyond just equivalence: “If I give you an arbitrary auction that satisfies the
properties of the theorem, you don’t need to calculate the revenue for that auction, you can invoke
the revenue equivalence theorem and know the revenue is the same as the first price auction or the
second price auction. You can derive the optimal bidding function under the new auction using
revenue equivalence, so if I give you an auction (eg all pay – item awarded to the highest but
everyone pays their bid). Then calculate expected payoff under a standard auction like first price
auction, then write down the equation for the expected payoff under the new auction (all pay) with
the unknown bidding function, equate the two and solve for the unknown bidding function.”

eg All pay auction with one winner, if you need to derive the optimal bidding function from this
auction
Proof:

Any auction that meets the two characteristics above, in Equilibrium the optimal strategy is a
function of valuation.

FPA: β (v )=E (2 nd highest price∨v is the highest valuation)

SPA: β (v )=v

Reserve Prices

Lowers the efficiency but increases the revenue.

Optimal level of the reserve price – make it as close as possible to the highest valuation. But there is
a risk you set it too high and don’t sell the item.

Virtual valuation: Set equal to zero to find reserve price that will maximise revenue.

Example – Uniform distribution between 0 – 100, 1 bidder. R= reserve price, v = value

Expected revenue = Prob(sell) x r + Prob(no sell) x 0

= Prob(v >= r) x r

= (1 – Prob(r < v)) x r

= r x (1 – r/100)

Maximise expected revenue to get r = 50

Theorem (Bulow and Klemperer): Show that having an extra bidder is actually a better outcome than
having a reserve price.

Lecture 9: Ebay and Online Auctions

How to run an online auction?

Two key questions: What will the price be? And what information will we share with participants?
We need to appeal to the layman because people know the English outcry auction from movies and
tv.

- An issue is that people are not at the same location at the same time.

First price auction – English Auction ? Submit and pay your bid. But online people aren’t there at the
same time, you can’t see the bids at the same time. You will shade your bid to get some kind of
surplus but you don’t know by how much and you don’t know if you’ve been outbid if you’re not
there. If buyers enter their highest bid and get no surplus, they won’t come back because there’s no
payoff.

Due to the time period and the fact that people place bids at different times, it’s not a good way to
achieve the English auction.

Second price auction? What should be displayed? If you display all the bids, you don’t encourage
people who are in the middle to bid and then the second price is actually much lower than it might
have been. The solution is to display only the second highest bid, encouraging people to bid above it
even if their bid won’t win.

The ebay auction is called a California Auction:

- 2nd price auction where the price is the 2 nd highest bid: The 2nd highest bid is shown, which
encourages other people to bid.
- Dynamic auction: It takes place over time and you can revise your bid

One feature of this auction on ebay is that people can update their preferences. But also that there
is ‘proxy bidding’ – Ebay asks people to enter a maximum price and they bid on their behalf using the
ticking price as the increment. It doesn’t display these maximum values. This means people don’t
have to physically watch the auction.

But not many people are aware of it. It means you don’t lose at the last minute by last minute
snipping.

It can quickly rum through the bidding behaviour that may have occurred offline – ie the current
price is $20, my max price is $30 and someone else puts $40, ebay automatically adjusts to $31,
rather than a long bidding war.

What does ebay show bidders?

- The current bid which is the second highest bid (the price the winner will pay if the auction
ends now) OR starting price/reservation price if no bids
- The minimum bid required to participate = current price + increment.

It doesn’t show you the maximum bid – so ‘current price + increment’ may be immediately outbid.

Minimum bid = Starting bid if first bid

Current bid + increment if not first bid

New current bid = Minimum/reserve price if first bid

b2 + increment if b2 + increment < highest bid

highest bid if b2 + increment > highest bid

In a second price auction, it is dominant strategy to bid your value. In practice in the ebay auction
(California auction), it is no longer dominant strategy to bid your value – because people can change
their values and they don’t really understand what’s happening in the algorithm. Also when values
are interdependent, the auction can be used to gain information about the true value of a good.

- Therefore snipping and hard deadline make this not dominant strategy to bid your value.

If people don’t understand the system, they think someone is having a bidding war with them.

Someone bidding at the last minute can steal the item away if others are not using the proxy bidding
function. People get the wrong idea because they might put in the minimum bid and end up getting
the item so they think it is an English auction (first price / pay your bid).

Last minute snipping

Amazon comparison:

- English ascending auction – pay your bid and the price goes up – with proxy bidding (so like a
2nd price auction)
- Soft deadline is the difference, so the time limit is extended when someone makes a bid near
then end. (On ebay the deadline is hard) This allows people to have more time to keep
bidding and therefore make more money

Studies on what behaviour this induced…

They found that on ebay – there was a lot of crazy action in the last 30 minutes. Buyers complained
that their bids were not getting processed and sellers were complaining that their revenue might be
less if some buyers were not able to bid.

Proxy bidding allows protection against snipping: No one can steal via a last-minute bid if you’ve put
your max value up. BUT:

Strategic reasons for late biding: Experienced buyers use last minute bidding to avoid inducing a
bidding war with inexperienced/incremental bidders who just put in their minimum amount and
don’t understand the proxy bidding. If an experienced buyer put their max value in early, that can
result in the price being bid up. If they do it at the last minute, there isn’t enough time for
inexperienced buyers to come in and increase the price.

Also if the item’s value is interdependent (bidders update their values as they see how much others
want it) then late bidding can also be a way for buyers to protect their personal information about
the value of the good. For example, a well-known antique collector knows more about the value of a
good and doesn’t want to reveal so others will bid up the price.

So empirical analysis into ebay and amazon auctions, with different ending times, can help
determine if bidding late is strategic. If it is, we should see a difference between bid timing on ebay
and amazon – more late bidding on ebay.
Study:

Computers vs Antiques

Computer – private value, prices easily available, bids don’t convey information

Antiques – interdependent value, price not well known, valuations signals are noisy, expert opinion
means bids convey information

Researchers looked at the last minute bidding for each good in each auction.

The results showed that there was significantly more last minute bidding for both goods on ebay,
with the effect even more significant for antiques. This confirmed the hypothesis that late bidding is
strategic. For antiques, they are bidding late to conceal information about their own valuation.

People blatantly admit to using strategic behaviour on ebay – there are still youtube videos about
this.

Ebay is a Vickery auction – it is not a dominant strategy to bid your value straight away because of
the hard deadline. The effect is more pronounced when there are more experienced bidders or the
value is interdependent.
VCG Auction

Used when you have sets of items to be sold. When bidders would like to bid on more items than
needed but only want to buy what’s needed.

Each bid is for a subset of the items being sold. The value is for whatever is in the subset. Number of
values to give = 2^S where S is number of items.

The vickery outcome takes the bids and maximises the social value of the allocation. Bidders pay the
externality they impose on others.

Basically the outcome of the VCG is to charge buyers the difference between the positive externality
and the negative externality they impose of the rest of the group.

Rules of the assignment:

- Each item can only be assigned to one bidder if x ∈ μ(i)⟹ ∄ j ≠ i st x ∈ μ( j)

- The assignment is chosen to maximise the social value overall.

Why do this? To get to the efficient allocation.

In a standard auction, v is the social surplus and is maximised when the bidder with the highest
valuation gets the item.

Prices:

Determine the economy with and without the winning bidder. (negative – positive externality)

Negative externality = The value received by the other bidders if bidder i was not present at all.
Recalculate the best allocation without bidder i.

Minus positive externality = The value received by the other bidders in the current allocation (but
without bidder i’s value. *Use the existing allocation and add up the value of all the other people.

Why do we do this? To have good incentive properties – dominant strategy implementation

properties. Truthfully revealing your bid vector is dominant strategy.

VCG = 2nd price auction with 2 bidders and 1 good

Theoretically – This auction is efficient because the goods maximise the social value.
When you are truthful, you’re helping the society find the best allocation. Private incentives and
aligned with social incentives and therefore the auction is strategy proof – dominant strategy
implementation.

Facebook is an example of VCG auction, but not much used in real life.

Difficulties: Because when there are lots of different items, the possible assignments could be a
huge number of different options. And asking agents to give a valuation over every subset of items
can also add up to thousands of valuations eg 10 items = 2^10 valuations = 1024.

If there are then lots of bidders for lots of items, the number of possible assignments to find the
optimal one can be huge eg 10 items, 10 bidders, assignments = 10! = 3.6million then this has to be
done for each agent – 40 million calculations!! Not solvable in reasonable time.

Facebook – they use the auction only on a few items 3 or 4, so its possible to compute.

Another problem is that its not great for the sellers- the revenue is actually lower than other
options, even though it has nice properties of efficiency and strategy proofness.

Key Word Search: Google

Charge based on clicks – Google wants to charge just for appearance of ads, Advertiser wants to only
pay when a sale gets made. What happens is you pay for clicks.

Auction for the position on sponsored ad: Why? There are millions of key words, supply and demand
is changing based on trends, you need price discovery method to maximise revenues.

- Advertisers submit a $ bid per click. Not based on which position you are on the list of
sponsored ads, just the click price. (Facebooks uses price per impression or conversation for
other advertisers).
- Separate auction for every query: Every time a click happens, google runs auction runs for
the sponsored links and returns the positions in order of the bids. A generalised second price
auction format is used. Started with a discriminatory auction, but now 2 nd price.
- Features: Google is a targeted search – people are definitely interested in buying the
product, so google can maximise their revenue with an auction. Bidders only submit one bid
even though there are multiple positions.

Quality weighting: Google also care about the likelihood of people clicking on the link so that they
can maximise revenue – if you offer to pay a lot per click but no one clicks, google loses.

Old System- Pay your bid: Instable – because there is a bidding war up to the second highest bid, but
if there are 2 positions, the second highest wants to pay the third highest, which means the top
highest also wants to pay the third highest not the second highest, but they can keep bidding and
dropping back.

New system: Efficiency – Set the price so that supply = demand and the market planner(seller)
achieves the efficient outcome.
The VCG auction is efficient but among the prices it is seller pessimal price combination. We want to
do better!

Google uses GSP = Generalise second price auction: Efficient but not dominant strategy proof. But in
the case that it is a dominant strategy to bid your true value, then the GSP leads to higher revenue
than VCG. Also what we care about is what the mechanism implements, rather than the strategies
used to get there – so this is a good mechanism that implements an equilibrium. (In practice you can
game the system, but the NE outcomes (if they are locally envy free) are efficient so it’s ok).

There is a bidder optimal equilibrium and seller optimal – bidder optimal = VCG. So any GSP
equilibrium generates at least as much revenue than VCG. So even though VCG is strategy proof, the
seller will get a better outcome using GSP and that’s why google uses it.

On the other hand, facebook uses VCG because they want return custom from advertisers, so they
are using the buyer optimal equilibrium.
School choice

Measurements of school choice mechanisms

No justified envy: μ eliminates justified envy if μ ( r 1 ) ≻r μ ( r 2 ) ⟹ r 1 ⊳ μ (r ) r 2 ∀ r ∈ R .

2 1

Individual Rationality: μ ( r ) ≽ r Φ ∀ r ∈ R .
' '
Pareto Efficiency: ∄ μ' ∈ A such that μ ≽r μ ∀ r ∈ R and μ ≻s μ for some s ∈ R , where A is the set of
all allocations.

Strategy Proofness/Incentive Compatible: An allocation μ is incentive compatible if

μ ( ≻r ) ≽ r μ ( ≻r , ≻¿r ) ∀ r ∈ R where ≻ r are true preferences and ≻ r are misreported preferences

Non-wastefulness: An allocation is non-wasteful if no agent prefers an available item to their

assignment. An allocationis non−wasteful if ∨μ(b)∨¿ qb ⟹ μ (r ) ≽r b ∀ r ∈ R∧∀ b ∈ B

- Substitutability and complementarity: Show a proof of complementarity

School choice week 6

Stability and efficiency

Stability: Fairness, no justified envy

DA – gives stable outcome but not efficient. Pareto dominants any other stable
matching/mechanism.

If schools are worries about parent’s lawsuits, then go with stability. But it is inefficient.

Serial dictatorship is always pareto efficient, but you don’t want to use a dictatorship to determine
school choice.

The DA algorithm pareto dominates any other mechanism, so if a stable and efficient match exists
then DA will find it.

TTC for school choice – differences from housing market:

- Schools have many places

- Students have priority at multiple schools.
Adapt TTC by allowing students with highest priority to point to their favourite school and schools
point to students at the top of their priority, then identify cycles, reduce school slots and go again.

TTC interprets priority differently – you can trade it, it’s not as important for stability.

TTC is pareto efficient, it is strategy proof, BUT it is not stable due to justified envy. Same as priority
line mechanism being unfair.

Stability: IR, non-wastefulness, no justified envy /no blocking pairs.

Choice functions in school matching

Schools might want to achieve objectives about the composition of the school body.

No capacity constraints, the allocation is based on the choice function.

~ ~
Ch c ( S)=chosen students out the set S by school c
Responsive choice rule: Choose the highest ranked students up to the capacity you have. This is the
usual choice function we have been using for making school choices out of a set. A responsive choice
rule is substitutable. (Linear priorities)

Preference-based choice rule: Each subset is ranked in a different order, depending on who else is
available to be chosen at the time. There’s no capacity constraint, just sets of students who are
ranked according to preference.

Stability for Choice

- Individual rationality: for students - μ( s)≻s s , ∀ s and for schools - Ch c ( μ(c ))=μ (c) ∀ c
- No blocking pair – No (s,c) pair such that c ≻s μ(s)∧s ∈Chc ( μ( c)∪ s)

Accommodating choice in the DA

- Schools tentatively accept anyone in the choice function and permanently reject all other,
then the students go to propose to their next choice.

In this case, there might not be a stable matching. There may be complementarities, which causes an
externality. Same as the couples problem – couples have complementarity in their preferences.

We need to rule out complementarity in order to find a stable matching.

Linear order was only one dimensional – so they automatically meet substitution. The intuition is
that no students should be accepted because of another student’s submission.
~
Formally Chis substitutable if s ∈Ch( S)∧s ≠ s ' ⟹Ch c ¿

If a student is chosen in a larger set, they should still be chosen in the smaller set. If you remove
some students, those who were previously chosen and are still in the set should still be chosen.

When the choice rule is substitutable, the deferred acceptance outcome is stable.

EXAM: Some examples of substitutability or complementarity in choice rules.

The Law of Aggregate Demand

LAD says weakly more students should be chosen from a larger set. This is a simple monotonicity
~
requirement. ¿ Chc (S)∨≥∨Chc ¿
Group strategy proofness: Stronger requirement than strategy proofness – means no group of
students can get together and deviate from truth telling to bet a better outcome.

If choice rules satisfy LAD and substitutability then student proposing DA is group strategy proof for
students.

Rural Hospital Theorem: If choice rules satisfy LAD and substitutability, each agent gets the same
number of partners in any stable matching.

Reform of the Boston program – using TTC in school choice was not used because people didn’t like
the idea of being able to trade priorities, esp if you have priority for siblings. Also the impact on
transport – if you want people to stay local DA is better.

Chinese College Admissions

Centralised matching. Two classes of mechanism:

1. Sequential mechanism (like Boston)

2. Parallel Mechanism: Hybrid between Boston and DA. You have choice bands – so you get 3
top choices in the first round. They do DA on the first 3 choices. Then at the end of top 3
choices, the results are made final.

The difference comes from how many choices you are allowed to put in each round – notation = e.

Sequential – Boston mechanism

Parallel – You get a certain number of choices and then positions are made permanent. The same
number of choices (e) is allowed in each round.

Partial Parallel – You get a different number of choices in each round – maybe 2 in the first round
then 3 in the next round etc.

These are called ‘proposal rejection algorithms’

Within the class of these mechanisms:

- Only one is pareto efficient wrt reported preferences: Boston mechanism. However, due to
manipulability, we don’t know if reported preferences are true – so the outcome might not
be efficient anyway.
- One is strategy proof: DA or e = infinity. All the others are manipulable, but they become
more manipulable as e is lower. With Boston the most manipulable.
- One is fair: DA or e = infinity. With the others you can still end up with justified envy because
of the way preferences are listed.

Metrics to Assess School Choice: Manipulability and Welfare (Choice accommodation)

Manipulation Incentives

There are shades of manipulability, it may be difficult to find the way to manipulate. As we increase
e, the manipulation opportunities are reduced but not eliminated.
Definition of manipulability:
A mechanism A is manipulable at problem( Ri , R¿i )if ∃ a report R ' i s . t . Ai ( R ' i , R¿i ) ≽i A i (Ri , R ¿i )
Within the class, Boston is the most manipulable.

Definition of being more manipulable: A is more manipulable than B if an agent can manipulate the
same problem in mechanism B, then they can always manipulate at A. However, being able to
manipulate at A doesn’t always mean they can manipulate at B. *It doesn’t have to be the same
person. (Try do an example where the same student manipulates in both mechanisms)

When working out: It’s either the same person who can manipulate or the person who is misplaced
by the earlier manipulating person (when testing less manipulable example first – eg Shanghai then
Boston).

Welfare-Incentives

First Choice Accommodation: Mechanisms with higher (e) – closer to DA – assign fewer people to
their first choice. The lower the e, the more people assigned to their first choice. For some this is an
important metric.

General-Choice Accommodation: Mechanisms with lower (e) assign more students to one of their
first e-choices than a mechanism with a higher e. Eg: Shanghai assigns more students to their top 2
choices than e = 3. (However, take with a grain of salt because people won’t be reporting their true
preferences, so the results don’t really count).

Stability or Efficiency?

Problemwise comparison for stability: DA is most stable. Shanghai is more stable than Boston – and
can be shown in a similar example to the manipulability. Manipulability implies there is instability.
BUT the e parameters don’t work in the same way – the e values must be multiples of each other.

The NE of Boston is stable.

Theory is black and white, but in practice you want to see the degree of manipulability or efficiency
or welfare loss. And know the frequency of these errors – which are seen through lab and field
experiments.