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You are on page 1of 25

Helmut Bester and Roland Strausz April 24, 1998

3

3y

Abstract

This paper extends the revelation principle to environments in which the mechanism designer cannot fully commit to the outcome induced by the mechanism. We show that he may optimally use a

direct mechanism under which truthful revelation is an optimal strategy for the agent. In contrast with the conventional revelation principle, however, the agent may not use this strategy with probability one. Our results provide a basic tool for studying dynamic contracting problems between a principal and a single agent. Also, we indicate

that the revelation principle cannot be extended to a framework with multiple agents and limited commitment.

Keywords:

revelation principle, mechanism design, limited commit-

ment, asymmetric information;

JEL Classication No.: D82, C72

**3 Free University Berlin, Dept. of Economics, Boltzmannstr.20, D-14195 Berlin (Germany); Email addresses: respectively. paper.
**

hbester@wiwiss.fu-berlin.de and strausz@wiwiss.fu-berlin.de,

y We wish to thank Hans Haller for his assistance in proving the main result of our

2

1

Introduction

This paper provides a modied version of the revelation principle for environments in which the party in the role of the mechanism designer cannot fully commit to the outcome induced by the mechanism. The revelation principle, which has been shown by Gibbard (1973), Green and Laont (1977), Dasgupta et. al. (1979) and Myerson (1979), is the guiding principle for the theory of implementation and mechanism design under imperfect information. It states that the range of implementable outcomes is simply the set of outcomes that give no incentive to the agents to misrepresent their type. This eectively reduces the problem of nding an optimal mechanism within the set of all conceivable mechanisms to a straightforward maximization problem subject to so-called incentive compatibility constraints. Even though the conventional revelation principle holds in a wide array of incentive problems, its applicability is restricted by the requirement that the mechanism designer must be able to credibly commit to the outcome of the mechanism. This requirement has implications, which may be unrealistic for many contractual relationships. First, in a long-term relationship the mechanism designer has to specify a contract that covers the entire time horizon of the relationship. Second, he must be able to resist renegotiating away ex post ineciencies. This is a serious problem because under asymmetric information the ex ante optimal contract typically exhibits ex post inecient outcomes. To assume that such contracts will not be renegotiated somehow runs against the central postulate of contract theory that all benets from trade will be exploited. Third, any action that the mechanism designer may take must be veriable so that it can be specied as part of the mechanism. If any of these conditions is not met, the argument of the conventional revelation principle fails for a simple reason: Suppose that, in accordance with truthful revelation, the agents reveal their types. Then the mechanism designer is practically fully informed. Clearly, he will exploit this information

3 for all those decisions to which he is not committed by the mechanism. Since the agents anticipate this, they may realize that truthfully reporting their private information is disadvantageous for them. Therefore, the standard revelation principle fails with imperfect commitment. Nonetheless, our Theorem in Section 3 shows that essential features of the revelation principle extend to situations with imperfect commitment. Thus, our Theorem provides a basic tool for studying mechanism design problems that involve sequential contracting, renegotiation or contractual incompleteness. Indeed, in line with the conventional revelation principle we prove that the mechanism designer may optimally choose a direct mechanism, in which the agent's message space is simply the set of his types. Further, under this mechanism it is an optimal strategy for the agent to reveal his type truthfully and he will use this strategy with positive probability. As an important consequence, also in the presence of imperfect commitment the outcome of an optimal mechanism can still be found in the set of incentive compatible outcomes. In contrast with the full commitment case, however, incentive compatibility is no longer sucient for implementation. In fact, typically the agent has to be kept indierent between truthfully revealing his information and cheating, which may occur with positive probability. In comparison with the proof of the conventional revelation principle, the proof of our Theorem is complicated by the fact that the mechanism designer's beliefs about the agent's type determine his behavior. Thus, when we replace an arbitrary mechanism by a direct mechanism, we have to ensure that the agent's messages induce the same posterior beliefs as under the original mechanism. Actually, this is possible only as long as the mechanism designer faces a single agent. Section 4 of this paper presents an example which demonstrates that the Theorem of Section 3 fails in an environment with multiple agents. While this paper provides an extension of the revelation principle for the single agent case, it also points to the limitations of this principle in situations with imperfect commitment and several agents.

4

Our Theorem is relevant for the large part of contract theory that studies contracting problems between a principal and a single agent. In this area, the analysis of limited commitment has become a major direction of research. This research is generally well aware of the unfortunate gap in implementation theory that arises because the derivation of optimal contracts cannot appeal to the conventional revelation principle. Filling this gap is the main purpose of this paper. In many cases, the literature on contracting with limited commitment simply sidesteps this problem by imposing articial restrictions on the form of contracts. This approach is not fully satisfactory as the `optimal' contract under these restrictions may not be fully optimal within the set of all conceivable contracts. In Freixas, Guesnerie, and Tirole (1988), for instance, the principal is constrained to linear contracts and cannot use a revelation mechanism. Similarly, Dewatripont's (1989) analysis of renegotiation-proof labor contracts simply imposes incentive compatibility restrictions without justifying them. A justication for this procedure is given in this paper.1 In their study of regulatory dynamics without commitment, Laont and Tirole (1993, chapter 9) focus on the two-type case and restrict the regulator to oering a menu of two contracts. They acknowledge that they \did not nd any argument to exclude generally menus with more than two contracts" (p. 390). This paper provides an argument for why their approach involves no loss of generality. Only a small part of the literature explicitly allows for general mechanisms to derive optimal contracts (Hart and Tirole (1988), Laont and Tirole (1990)). These papers, however, do not present a generalizable concept to characterize the structure of optimal contracts. Rather, they derive for a particular setting some specic form of the general result established here.

1 At the same time, however, Dewatripont (1989) does not allow the informed party to

randomize. Given our results, this seems restrictive.

5

Hart and Tirole (1988) consider a seller-buyer relationship which lasts for T periods. The seller seeks to rent or sell a durable good to the buyer, whose valuation is private information. His commitment is limited in the sense that, in each period, he cannot resist to renegotiate away ineciencies. Hart and Tirole characterize the optimal renegotiation-proof contract and show that it uses at most two messages in each period. Since the buyer's valuation is either high or low, this number coincides with the number of dierent types. Laont and Tirole (1990) analyze procurement contracts in a two-period model with renegotiation. In a setting, where the agent's cost takes two possible values, they prove that the number of messages in the optimal renegotiation-proof contract may, without loss of generality, be set to two. Section 2 of this paper describes a general framework of contracting under imperfect commitment. In Section 3 we establish an extension of the revelation principle for this framework. Section 4 presents an example showing that the result of the previous Section cannot be expected to hold in settings with multiple agents. Finally, Section 5 contains concluding remarks.

2

The Revelation Game

We consider a revelation game between a principal and a single agent. The equilibrium of this game determines an allocation z = (x; y ) 2 Z = X 2 Y : An allocation consists of two types of decision variables: By X we denote the set of all those decisions to which the principal can contractually commit himself. In contrast, the set Y consists of all those decisions that are not contractible and are chosen at the principal's discretion. We allow for the possibility that the decision x restricts the principal's feasible choices in Y : This is described by the correspondence F : X ) Y : Thus, the principal has to select y 2 F (x) Y when he is committed to the decision x 2 X:

6 The principal has no private information. The agent, however, is privately informed about his type t 2 T = ft1 ; :::; ti ; :::; tm g: The principal only knows the probability distribution = ( 1 ; :::; i ; :::; m ) of the agent's type, with P i > 0; i = 1; :::; m; and i i = 1: The payos of both players depend on the allocation (x; y ) and the agent's type: When the agent is of type ti ; the principal's payo from (x; y) is Vi (x; y ): The agent's payo in this situation is Ui (x; y): As part of the game, the agent can send some message m 2 M = fm1; :::; mh ; :::; mng to the principal. The principal can commit himself to a decision function x3 : M ! X: The interpretation is that, once the principal has committed himself to the decision function x3(1); the agent can enforce the decision x3(m) by sending the message m: A mechanism or contract 0 = (M; x3 ) species a message space M in combination with a decision function x3(1): For a given mechanism 0; the revelation game proceeds as follows: First, the agent selects some message m 2 M: This determines the contractually specied decision x3(m) 2 X: The principal uses the agent's message to update his beliefs about the agent's type and chooses some decision y 2 F (x3 (m)): We are interested in the Perfect Bayesian Equilibria of this game. More formally, the agent's strategy is a mapping q : T ! Q; where P Q = fq 2 I n j h qh = 1g is the set of probability distributions over M: R+ Thus, if the agent of type ti adopts the strategy q(ti ); the message mh is selected with probability qh (ti ): The principal's strategy y : M ! F (x3(m)) describes his choice y (m) as a function of the observed message m: We denote the principal's posterior belief by the mapping p : M ! P; where P P = fp 2 I m j i pi = 1g is the set of probability distributions over T: Thus, R+ after receiving some message m; the principal believes that the agent is of type ti with probability pi (m):

7 Given a mechanism 0; the functions (q3 ; y 3; p3) constitute a Perfect Bayesian Equilibrium of the revelation game if three conditions are satised: First, the principal's strategy has to be optimal given his beliefs about the agent's type. This means that, for all m 2 M; it has to be the case that

y 3 (m) 2 argmax

y 2F (x3 (m)) i

X p3(m)V (x3(m); y):

i i

(1)

Second, the agent anticipates the principal's behavior y 3 and chooses q to maximize his payo. Thus, for each ti 2 T; q 3 has to satisfy

q3 (ti ) 2 argmax

q2Q

X q U (x3(m ); y3(m )):

h h i h h

(2)

Finally, for all messages that occur in equilibrium with positive probability, the principal's posterior beliefs have to be consistent with Bayes' rule. That is, for all mh 2 M and all ti 2 T; it is required that

p3 (mh ) = i

i P
i
qjhq(3t()tj ) j

3

h

whenever

X q3 (t ) > 0:

j h j

(3)

We denote a Perfect Bayesian Equilibrium for a given mechanism 0 by (q3 ; y3 ; p3j0): In this equilibrium the principal receives the expected payo V 3 (q3 ; y3 ; p3j0) and the ti 0type agent's expected payo is Ui3 (q3 ; y3 ; p3j0): To make the generality of our framework understood, we emphasize that the set Y may contain decisions of arbitrary complexity. In some applications of our model, the principal's decision y 2 Y may indeed represent another mechanism. In this case, Vi (1; y ) and Ui (1; y ) are to be interpreted as the payos that the players receive in the equilibrium of the mechanism y 2 Y: This interpretation allows us to view also dynamic contracting games as special cases of our framework. We conclude this Section by some examples which illustrate the general applicability of the environment described above.

8

Unobservable actions

The principal's decision y may not be contractible because it is not publicly observable. Suppose for instance that there is a veriable noisy signal about the agent's type. In this case the contract x will typically be conditioned on this signal. Upon observing the agent's message, the principal may be able to aect the informativeness of the signal by his inspection eort y; which is unobservable and hence not contractible.

Short-term contracts

Imperfect commitment arises in a multi-period environment when the time horizon of the contractual agreement x is limited. After the contract x expires, the principal oers a new contract y for the remaining periods. As we indicated above, the new contract y may be another mechanism involving further messages by the agent.

Renegotiation

When the principal receives the message m; he may realize that the contract x3 (m) is ex-post inecient. He will then propose a new contract or mechanism y; which the agent can either accept or reject. Since the agent can insist on the original contract x3 (m); this imposes a restriction F (x3 (m)) on the set of contracts Y that the principal can achieve through renegotiation.

Cheap talk

When Z = Y; the principal faces no commitment.2 The agent's message m has no direct impact on the allocation. It can only play a role when it aects the principal's decision via his beliefs about the agent's type. In this situation the revelation game reduces to a cheap talk game.

3

Direct Mechanisms

2 Strategic

The mechanism 0 = (M; x3 ) is said to be a direct mechanism if M = T: With a direct mechanism the message space is the agent's type space and in

information revelation in such a setting has rst been studied by Crawford and Sobel (1982).

9 the direct-revelation game the agent simply announces some type. As a special case of the environment described in the previous Section, the principal may be able to commit himself to all relevant decisions. This is the case when Z = X: Then equilibrium conditions (1) and (3) are redundant. For a given 0; condition (2) denes an optimal reporting strategy (q 3j0) of the agent. In this situation, it is well-known that the following important observation applies:3

Revelation Principle

(q 3j0) be an optimal reporting strategy of the agent for a given mechanism 0: Then there exists a direct d 3 mechanism 0 and an optimal reporting strategy (^j0 ) such that V (^j0 ) = q d q d V 3 (q3 j0) and Ui3 (^j0d ) = Ui3 (q 3j0) for al l ti 2 T: Moreover, qi (ti ) = 1 for al l q ^

Assume

Z = X:

Let

ti

2 T:

The revelation principle greatly simplies the principal's problem of designing an optimal mechanism. It tells us that he can restrict himself to an allocation function z 3 : T ! Z which gives the agent no incentive to misrepresent his type. Thus, for each ti 2 T; the function z 3 has to satisfy the incentive compatibility conditions

Ui (z 3 (ti )) Ui (z 3 (tj )) for all tj

2 T:

(4)

The incentive compatibility conditions eectively summarize the restrictions that the principal faces because he is uninformed about the agent's type. At least, this is true when he can commit himself to the entire allocation z 3: Under imperfect commitment, the agent may not be willing to reveal himself because the principal might exploit this information to the agent's disadvantage. Because of this problem, it is a priori not even obvious that using a direct mechanism is optimal for the principal.

standard revelation principle requires that the principal can commit to probabilistic decisions. Therefore, the following statement assumes that X represents the set of probability distributions over deterministic decisions.

3 The

10 While the revelation principle in its standard form fails under imperfect commitment, the main result of this paper is to show that a modied version of this principle still holds in this case.

Theorem

0d

Let

(q 3 ; y 3 ; p3 j0)

be a Perfect Bayesian Equilibrium of the revela-

tion game for a given mechanism

**q ^ ^ (^; y; pj0d ) such that V 3 (^; y; pj0d ) q ^ ^ 3 3 3 3 3 d ) = U 3 (q3 ; y3 ; p3 j0) for al l t 2 T: Moreover, V (q ; y ; p j0) and Ui (^; y; pj0 q ^ ^ i i qi (ti ) > 0 for all ti 2 T: ^
**

and a Perfect Bayesian Equilibrium

0:

Then there exists a direct mechanism

We prove our Theorem by a series of Lemmas. For these Lemmas we dene, for each mh 2 M and each ti 2 T;

h 3 h h !i (q 3 ) qh (ti ) and ! h (q 3) (!1 (q 3); :::; !ih (q 3); :::; !m (q 3)):

(5)

In Lemma 1 we show that whenever there are `redundant' messages, which are not used in equilibrium, one can delete these messages and obtain a new, smaller mechanism with a Perfect Bayesian Equilibrium that is payoequivalent to the original equilibrium. Lemma 2 then shows that if a mechanism induces a Perfect Bayesian Equilibrium in which the vectors ! h (q 3); h = 1; :::; n; are linearly dependent, then there is another Perfect Bayesian Equilibrium for the same mechanism, in which the principal receives at least the same payo and the agent's types get exactly the same payo. Moreover, some message is not used in this equilibrium so that it can be deleted according to Lemma 1. Lemma 3 is an immediate implication of Lemmas 2 and 1: It states that the message space of any mechanism 0 can be reduced to a message space in which the number of messages does not exceed the number of the agent's types, without aecting the agent's payo and without making the principal worse o. This observation provides the basis for applying the classical `marriage theorem', which is stated as Lemma 4. Lemma 5 shows how the marriage theorem can be used to associate with each message a type of the

11 agent in such a way that each type selects the message assigned to him with positive probability. The nal step of our argument is presented in Lemma 6, which employs the previous Lemma to construct a direct mechanism satisfying the properties of our Theorem.

Lemma 1 Let (q3 ; y 3; p3j(M; x3 )) be a Perfect Bayesian Equilibrium with

! h (q3 ) = 0 for some mh 2 M . Consider the mechanism 00 = (M 0 ; x0 ) with M 0 fmh 2 M j! h (q3 ) 6= 0g and x0(mh ) = x3(mh ) for all mh 2 M 0. Then 00 has a Perfect Bayesian Equilibrium (q0 ; y 0 ; p0 j00 ) which is payo-equivalent to the Perfect Bayesian Equilibrium (q3 ; y3 ; p3 j0).

0 3 Proof: Set qh (ti ) = qh (ti ), y 0 (mh ) = y3 (mh ), and p0(mh ) = p3 (mh ) for all h

such that mh 2 M 0 . It is easily veried that the combination (q 0; y 0; p0) satises conditions (1), (2), and (3). The combination therefore constitutes a Perfect Bayesian Equilibrium. Furthermore, V 3 (q0 ; y0 ; p0 j00 ) = V 3(q 3; y 3 ; p3 j0) and Ui3 (q0 ; y0 ; p0 j00 ) = Ui3 (q 3 ; y 3 ; p3 j0) for all ti 2 T: Q.E.D. The previous Lemma has the practical implication that, when solving the problem of nding an optimal mechanism, the principal does not need to consider mechanisms in which some messages are not sent in equilibrium. Out-of-equilibrium beliefs cannot be used to support additional equilibrium outcomes.

Lemma 2 Consider a mechanism 0 = (M; x3) and a Perfect Bayesian Equi-

librium (q3 ; y3 ; p3 j0) with ! h (q3 ) 6= 0 for every mh 2 M: If the vectors ! h (q3 ), h = 1; :::; n are linearly dependent, then there exists another Perfect Bayesian Equilibrium (q 0 ; y 3 ; p3 j0) with ! h (q 0) = 0 for some mh 2 M , and V 3(q 0; y 3; p3 j0) V 3 (q 3; y 3; p3j0) and Ui3(q 0; y 3; p3j0) = Ui3(q 3; y 3 ; p3 j0) for all ti 2 T:

Proof: If the vectors ! h (q 3); h = 1; :::; n are linearly dependent, then there

12 is a = (1 ; :::; h ; :::; n ) 2 I n nf0g such that R

X ! h(q3) = 0:

h h

(6)

**We now x and dene
**

t

0 min1

h h

;

b

1 0 max

h h

(7)

**Since ! h (q3 ) 0 and ! h (q3 ) 6= 0; it follows from (6) that minh h < 0 and maxh h > 0: Therefore, t and b satisfy
**

b < 0 < t:

(8)

**Dene a strategy q for the agent by
**

3 qh (ti ) (1 + h )qh (ti ) with 2 [b ; t ]: Note that by (7) qh (ti ) 0: Furthermore, (6) implies h h !i (q3 )] = 1: Therefore q (ti ) 2 Q for all ti 2 T:

P

h qh (ti )

=

P [q3 (ti)+

h h

(9)

We now show that, since (q3 ; y 3 ; p3 ) is an equilibrium under the mechanism 0; also (q ; y3 ; p3 ) is an equilibrium under the mechanism 0: Indeed, q induces the posterior belief

p (mh ) = i

3 whenever (1 + h ) j qh (tj ) > 0: This immediately implies that (q ; y3 ; p3 ) satises equilibrium conditions (1) and (3). In addition, qh (ti ) > 0 implies 3 that qh (ti ) > 0: Therefore, also equilibrium condition (2) is satised.

P

+ h i P
i
(1(1 + )hq)hq(3t()tj ) = p3(mh) i j

3

j

h

(10)

**Because any message mh 2 M results in the same allocation (x3(mh ); y 3(mh )) for both equilibria we have
**

Ui3 (q ; y3 ; p3 j0) = Ui3 (q3 ; y 3; p3j0) for all ti

2 T:

(11)

**13 The principal's equilibrium payo
**

V 3(q ; y 3 ; p3 j0) =

i i

X
X q(t )V (x3(m ); y3(m ))

h h i i h h

(12)

**is linear in : Therefore, it is maximized over the range [b ; t] by some 3 2 fb ; t g: Since q = q 3 if = 0; this implies
**

V 3 (q ; y3 ; p3 j0) V 3 (q3 ; y3 ; p3 j0):

3

(13)

mh 2 M such that ! h (q ) = 0: The proof is therefore complete if we set 3 q0 = q . Q.E.D.

As 3

2 fb; tg; (7) 3and (9) imply that there is at least one message

By applying Lemmas 2 and 1 repeatedly, we can restrict ourselves to mechanisms that support equilibria in which the vectors ! h (q3 ); h = 1; :::; n; are linearly independent. In such mechanisms the number of messages is not larger than the number of the agent's types. This is formalized in the following Lemma.

Lemma 3 Let 0 = (M; x3 ) be a mechanism and (q 3 ; y 3 ; p3 j0) a Perfect

Bayesian Equilibrium. Then there exists a mechanism 00 = (M 0 ; x0) and a Perfect Bayesian Equilibrium (q 0; y 0 ; p0 j00) such that the vectors ! h (q 0); h = 1; :::; jM 0 j; are linearly independent and jM 0 j jT j. Also, V 3 (q0 ; y0 ; p0 j00 ) V 3(q3; y3; p3j0) and Ui3(q0; y0; p0j00) = Ui3(q3; y3; p3j0) for all ti 2 T:

Proof: If the vectors ! h (q3 ) are linearly independent, then necessarily jM j

jT j.

The Lemma is trivially fullled by dening 00 = 0, x0 = x3, and (q0 ; y0 ; p0 ) = (q 3 ; y 3 ; p3 ). If the vectors ! h (q3 ) are linearly dependent, then by repeatedly using Lemma 2 and 1 we can delete messages as long as the vectors ! h (:) of the underlying equilibrium are linearly dependent. Note that as long as a mechanism 0 = (M; x3 ) exhibits jM j > jT j, the number of vectors ! h (:) is larger than their dimension. From the rank theorem it then follows that the vectors ! h (:) are linearly dependent. Consequently, the

14 procedure does not stop before jM j jT j. Q.E.D.

At this point we have eectively proven the rst part of our Theorem. Since the principal cannot gain by using a larger message space, he may as well use a direct mechanism. To complete our proof, it remains to show that there is a direct mechanism which induces each type of the agent to reveal himself with positive probability. An important tool for this part of our proof is the classical marriage theorem, which we restate in the next Lemma. This theorem in its denitive form was rst stated and shown in Hall (1935) and Maak (1936). Weyl (1949) introduced the term `marriage theorem'.4 We rely on a statement and a proof found in Jacobs (1969, pp. 105-106).

Lemma 4 Let H be a nite non-empty set and K be a non-empty set, pos-

sibly innite. Further, let D : H ) K be a correspondence and for any set P H dene [ D(h): D (P ) = Then there exists a mapping d : H ! K such that (i) d(h) = d(k ) implies h = k; and (ii) d(h) 2 D(h) for all h 2 H; if and only if jD (P )j jP j for all P H . The following Lemma applies the marriage theorem to our context.5

interpretation of Lemma 4 as the marriage theorem identies H with a set of men, where each man h has some acquaintances D(h) in the set of women K: The mapping d represents a marriage which by (i) respects monogamy and by (ii) associates each man only with one of his acquaintances. 5 We are grateful to Hans Haller for informing us about the marriage theorem and for providing a straightforward proof of Lemma 5.

4 The

h2P

15

Lemma 5 Let

= [!ih ] be an m 2 n matrix with column vectors ! h ; h =

1; :::; n; and row vectors !i ; i = 1; :::; m: Denote H f1; :::; ng and K f1; :::; mg: The n column vectors are linearly independent and satisfy !h 0 P and h ! h >> 0: Then there exists a mapping c : K ! H such that (a) for each i 2 K; one has !ic(i) > 0; and (b) for each h 2 H; there is an i 2 K with h = c(i):

> 0g. It follows that D (P ) = [h2P D (h) = f j 0; h 2 P g. We rst show that jD(P )j jP j for all P H . Fix P H and construct the m 2 jP j matrix

P = [! h ]h2P .

**Proof: Dene the correspondence D (h)
**

h i !i >

fij!ih

**Since the original matrix
**

consists of linearly independent column vectors, this also holds for

P . Consequently, Rank(

P ) = jP j. Note further, that the matrix

P has only jD (P )j non-null row vectors. This implies that Rank(

P ) jD (P )j. Hence, it follows that jD (P )j jP j. We now construct the mapping c : K ! H . Since jD (P )j jP j; Lemma 4 implies that a mapping d : H ! K exists such that (i) d(h) = d(k ) implies h = k and (ii) d(h) 2 D(h) for all h 2 H: Due to (i) the mapping d is invertible. Set c(d(h)) = h for each h 2 H . So far the mapping c(1) assigns exactly one element from fd(h)jh 2 H g K to each element in H . Moreover, for each i 2 fd(h)jh 2 H g one has !ic(i) > 0: Hence, condition (b) of the Lemma is satised and condition (a) is satised for all i 2 fd(h)jh 2 H g: In order to satisfy condition (a) for all i 2 K; it suces to assign to each remaining h h i 2 K nfd(h)jh 2 H g an element h 2 H such that !i > 0. Since !i 0 and Ph ! h > 0 there exists for each i 2 K nfd(h)jh 2 H g an h 2 H such that i h !i > 0. We can therefore specify for each i 2 K nfd(h)jh 2 H g a c(i) 2 H such that condition (a) is satised. Q.E.D. The following Lemma concludes the proof of our Theorem.

Lemma 6 Consider a mechanism 0 = (M; x3 ) with a Perfect Bayesian

Equilibrium (q3 ; y 3; p3j0): If the vectors ! h (q3 ); h = 1; :::; n; are linearly in-

16 dependent, then there exists a direct mechanism 0d and a Perfect Bayesian Equilibrium (^; y ; pj0d ) which is payo equivalent to (q3 ; y3 ; p3j0) and satises q ^ ^ qi (ti ) > 0 for all ti 2 T . ^ Dene an m 2 n matrix

= [!ih (q3 )] with column vectors ! h ; h = 1; :::; n; and row vectors !i ; i = 1; :::; m: Clearly, the matrix

satises the conditions of Lemma 5. Obviously, n = jM j jT j = m; because the column vectors ! h ; h = 1; :::; n; are linearly independent.

Proof:

By Lemma 5 we can associate with each ti 2 T a message mc(i) 2 M such that !ic(i) > 0 and S (h) fijh = c(i)g 6= ; for all mh 2 M: Now we replace the mechanism 0 = (M; x3 ) by a direct mechanism 0d = (T; xd ) with xd (tj ) x3 (mc(j ) ) for all tj 2 T: Dene (^; y ; p) by q ^ ^

qj (ti ) !i ^

c(j )

=jS (c(j ))j;

y (tj ) y 3 mc(j ) ; ^

p(tj ) p3 mc(j ) : ^

(14)

Note that qi (ti ) > 0 for all ti 2 T: Thus, to complete the proof, it is sucient ^ to show that (^; y ; pj0d ) constitutes an equilibrium which is payo-equivalent q ^ ^ 3 ; y3 ; p3 j0): to (q

3 By (14), qj (ti ) = qh (ti )=jS (h)j for all j 2 S (h): Therefore, ^

m X j =1

qj (ti ) = ^

n X X h=1 j 2S (h)

3 qh (ti )=jS (h)j =

n X h=1

3 qh (ti ) = 1;

(15)

so that q(ti ) 2 Q: Since (xd (tj ); y(tj )) = (x3 (mc(j ) ); y 3 (mc(j ))); any allocation ^ ^ that the agent induces by some message tj 2 T under the mechanism 0d ; he can also induce by the message mc(j ) 2 M under the mechanism 0: Conversely, as for each mh 2 M there is a ti 2 T such that mh = mc(i) ; anything that he can induce under 0 he can also induce under 0d : Thus, the agent must be indierent between (^; y ; pj0d ) and (q3 ; y3 ; p3 j0): Moreover, qj (ti ) > 0 if q ^ ^ ^ 3 (t ) > 0: Therefore, q satises equilibrium condition (2). and only if qc(j ) i ^

17 Given q; by (14) the agent's message tj ^

**2 T generates the posterior belief
**

(16)

3 i qc(j ) (ti ) i qj (ti ) ^ =P = p3 mc(j ) : pi (tj ) = P ^ i 3 ^ k k qj (tk ) k k qc(j )(tk )

Accordingly, after observing the message tj 2 T under the mechanism the principal holds the same belief as after observing mc(j ) 2 M under the mechanism 0: Thus his choice y(tj ) = y 3(mc(j ) ) is optimal and (^; y ; p) ^ q ^ ^ satises equilibrium conditions (2) and (3). Finally, under the mechanism 0 the ti 0type agent induces the allocation (x3 (mh ); y 3 (mh )) with probability 3 qh (ti ): Under the mechanism 0d he induces the same allocation with probaP 3 ^ bility j 2S (h) qj (ti ) = qh (ti ): Therefore, the principal receives the same payo under (^; y ; pj0d ) and (q3 ; y3 ; p3 j0): q ^ ^ Q.E.D. 0d , Our Theorem maintains the essential features of the standard revelation principle. First, it states that with a direct mechanism the principal can get at least the same payo as with any other mechanism. In this sense, using a direct mechanism 0d = (T; x) is optimal for the principal. Second, truthfully ^ reporting his type is an optimal strategy for the agent { even though he may not choose this strategy with probability one. In the equilibrium (^; y ; pj0d ) q ^ ^ ^ x he induces the allocation z (ti ) (^(ti ); y (ti )) by reporting type ti : Since ^ qi (ti ) > 0; the allocation function z has to satisfy the incentive compatibility ^ ^ conditions (4). Thus, the principal is restricted to incentive compatible allocations, independently of whether he can fully commit himself or not. Yet, when the principal cannot fully commit himself, he faces further restrictions that go beyond incentive compatibility. In addition to satisfying (4), the allocation function z has to support (^; y ; p) so that the conditions ^ q ^ ^ (1) - (3) for a Perfect Bayesian Equilibrium are fullled. These additional constraints re ect the principal's inability to commit himself to a decision y 2 Y: Also, because of these constraints one cannot guarantee that the agent reports his type truthfully with probability one. Instead, he may have to cheat with positive probability.

18 Our procedure of replacing the mechanism 0 by a direct mechanism 0d may necessitate changing the equilibrium probability distribution of the allocation z: As we have shown, this can always be done in such a way that the principal does not lose while the agent's payo remains unchanged. We demonstrate in Section 4 that this may no longer be possible when the principal deals with more than one agent. Apparently, the theory of mechanism design with multiple agents cannot appeal to the useful tool of the revelation principle when there is imperfect commitment on the part of the principal.6

4

Multiple Agents

In this Section we will show that the Theorem of Section 3 cannot be extended to a revelation game with more than one agent. We consider an example where the principal faces two agents. Agent 1 is privately informed about his type; he is equally likely to be either of type t1 or of type t2: There is no uncertainty about agent 2: For simplicity, the players' payos do not depend on any contractible decisions so that Z = Y: In this case, a mechanism 0 merely species a message space M for agent 1: After receiving some message m 2 M from agent 1; the principal chooses y 2 Y = [0; 2]: The principal's payo Vi (y) depends on agent 1's type ti and the decision y according to

V1 (y ) = 0y 2; V2 (y ) = 0(2 0 y )2:

(17)

**The payo of type ti of agent 1 is Ui (y ); where
**

U1 (y) = 0(0:5 0 y)2 ;

6 With

U2(y ) = 0(1:5 0 y )2 :

(18)

full commitment it is well-known that the revelation principle applies when the

solution concept for the agents' message game is either the dominant strategy equilibrium or the Bayesian Nash equilibrium.

**19 Agent 2's payo is
**

W (y ) = 010(1 0 y)2 :

(19)

Note that, if the principal believes that agent 1 is of type t1 with probability p1 ; he will choose y(p1 ) to maximize p1 V1 (y) + (1 0 p1 )V2 (y ): This yields ^

y(p1) = 2(1 0 p1 ): ^

(20)

Our argument proceeds as follows: We rst construct a Perfect Bayesian Equilibrium for a message space M = fm1; m2 ; m3 g with three messages. Then we show that one of the players must become worse o in comparison with this equilibrium when M is replaced by the direct mechanism M d = ft1; t2 g: When M = fm1 ; m2 ; m3g; the revelation game has a Perfect Bayesian Equilibrium (q 3; y 3; p3 ) where agent 1's strategy is

3 3 3 q1 (t1 ) = 0:5; q2 (t1) = 0:5; q3 (t1 ) = 0; 3 3 3 q1 (t2 ) = 0; q2 (t2 ) = 0:5; q3 (t2 ) = 0:5:

(21)

**The principal's beliefs and strategy are given by
**

p3 (m1) = 1; p3 (m2 ) = 0:5; p3(m3 ) = 0; 1 1 1 y3 (m1) = 0; y 3 (m2 ) = 1; y 3(m3 )

(22)

= 2:

Indeed, using (20), it is easily veried that p3 and y 3 satisfy equilibrium conditions (1) and (3). The agent's behavior q 3 satises condition (2) because

U2 ( (m2)) = U2 ( (m3)) = 00:25 U2 ( (m1)) = 02:25: y3 y3 y3 U1 (y3 (m1)) = U1 (y3 (m2)) = 00:25 U1(y 3 (m3 )) = 02:25

(23)

3 3 The expected equilibrium payo for either type of agent 1 is U1 = U2 = 00:25: The principal's expected equilibrium payo is

V 3 = 0:25[V1 (y3 (m1)) + V1 (y 3 (m2 )) +

V2 (y 3(m2 )) + V2 (y3 (m3))] = 00:5;

(24)

**20 and agent 2 gets
**

W 3 = 0:25[W (y 3 (m1 )) + W (y3 (m2 )) + W (y3 (m2)) + W (y 3(m3 ))] = 05:

(25)

We now characterize the Perfect Bayesian Equilibria that can be supported by a direct mechanism M d = ft1 ; t2 g: This is done in three steps.

Step 1:

that

**Given the mechanism M d ; there is an equilibrium (q3 ; y3 ; p3 ) such
**

3 3 q1 (t1) = 1; q2 (t1 ) = 0; 3 3 q1 (t2) = 0; q2 (t2 ) = 1;

(26)

p3 (t1) = 1; p3 (t2 ) = 0; 1 1 y 3(t1 ) = 0; y3 (t2) = 2:

In this equilibrium, each type ti reveals himself and by (20) the principal responds optimally. Revealing his type is optimal for agent 1 because

U2 (y3 (t2)) = 00:25 02:25 = U2 (y3 (t1)): U1 (y3 (t1)) = 00:25 02:25 = U1 (y3 (t2 ))

(27) (28)

3 3 The payo for either type of agent 1 is U1 = U2 = 00:25: The principal's and the agent 2's expected equilibrium payos are

W 3 = 0:5[W (y3 (t1)) + W (y 3(t2 ))] = 010:

V 3 = 0:5[V1(y 3 (t1 )) + V2 (y 3(t2 ))] = 0;

(29)

Note that, by ignoring the presence of agent 2; the equilibrium described by (26) can be viewed as an example of our Theorem: The principal's equilibrium payo under the direct mechanism M d is increased in comparison with the equilibrium in (21) - (22) under the mechanism M: Also, agent 1's payo

**21 is the same in both equilibria.
**

Step 2: We now show that for any

such that

**2 [0; 1] there is an equilibrium (q3; y3; p3)
**

3 q2 (t1 ) = 1 0 ; 3 q2 (t2 ) = 1 0 ; p3 (t2 ) = 0:5; 1 y 3 (t2 ) = 1:

3 q1 (t1 ) = ; 3 q1 (t2 ) = ; p3 (t1 ) = 0:5; 1 y 3(t1 ) = 1;

(30)

This equilibrium entails no information revelation and so the principal takes the same decision after each of the two messages. Agent 1; therefore, is indierent between announcing t1 and t2 : Also in this equilibrium he receives 3 3 the payo U1 = U2 = 00:25: Because y3 (t1) = y 3(t2 ) = 1 and V1(1) = V2 (1) = 01; the principal and agent 2 realize the payos

V 3 = 01; W 3 = 0:

(31)

Step 3: Consider an equilibrium where one type of agent 1 employs a mixed

reporting strategy. We will show that then the other type must mimic this 3 strategy. Assume for instance that type t1's behavior is given by q1 (t1 ) = 2 (0; 1): Note that this requires U1(y 3(t1 )) = U1 (y 3(t2 )):

3 First consider the possibility that type t2 chooses the pure strategy q2 (t2 ) = 1: Then Bayesian updating yields p3(t1 ) = 1 > 0:5 > p3 (t2 ): By (20), 1 1 with these beliefs the principal chooses y3 (t1) = 0 and y 3(t2 ) > 1: However, U1 (0) = U1 (y3 (t1 )) = U1(y 3 (t2 )) implies that either y 3 (t2 ) = 0 or y 3 (t2 ) = 1: 3 Thus it cannot happen in equilibrium that q2 (t2 ) = 1: The same argument 3 eliminates the possibility that q1 (t2 ) = 1 in equilibrium.

We are thus left with the possibility that also type t2 chooses a mixed 3 strategy q1 (t2) = 2 (0; 1); which is optimal only if U2 (y3 (t1)) = U2 (y3 (t2)):

22 This equality in combination with U1(y 3(t1 )) = U1 (y3 (t2)) yields y3 (t1) = y 3(t2 ): By (20) the principal's beliefs therefore must satisfy p3(t1 ) = p3 (t2): This is consistent with Bayes' rule only if = : We therefore conclude that the equilibrium described by (30) is the only one in which some type of agent 1 uses a mixed strategy. In summary, the example of this Section shows that with a direct mechanism there are exactly two equilibrium constellations. Either the equilibrium is fully revealing as the one described by (26), or pooling occurs as in (30). Both outcomes dier from the equilibrium in (21)-(22), which can be realized when the message space contains three elements. Even more signicant is a comparison of the equilibrium payos in (24)-(25), (29) and (31): In any Perfect Bayesian Equilibrium of the game with the direct mechanism either the principal or agent 2 is worse o relative to the Perfect Bayesian Equilibrium of the game with three messages. This demonstrates that the Theorem of Section 3 for the single agent case does not apply in an environment with multiple agents.

5

Concluding Remarks

The main contribution of this paper is an extension of the revelation principle to contracting problems with limited commitment. Our Theorem provides a useful starting point for the study of dynamic contracting problems between a principal and a single agent. As it shows, the optimal contract may be constructed from the subset of incentive compatible allocations that support a Perfect Bayesian Equilibrium of a direct revelation game. Our analysis also reveals that this procedure cannot be applied to contracting problems with several agents. It remains an open question to what extent one can characterize optimal mechanisms in settings with limited commitment and multiple agents. Green and Laont (1987) make a step in this direction by studying `posterior implementable' rules, which represent the

23 outcomes of a two-stage game. In the rst stage, communication takes place but no binding commitments can be made. The second stage consists of ratifying the agreement obtained at the rst stage. Green and Laont focus on a two-person problem with two-sided asymmetric information and two possible decisions. They show that the optimal contract involves message spaces that are far smaller than each individual agent's private information, which is represented by a continuum of types.

24

6

References

Crawford, V. and J. Sobel (1982): \Strategic Information Transmission," Econometrica 50, 1431-1451. Dasgupta, P., P. Hammond and E. Maskin (1979): \The Implementation of Social Choice Rules," Review of Economic Studies 46, 185-216. Dewatripont, M. (1989): \Renegotiation and Information Revelation over Time: The Case of Optimal Labor Contracts," Quarterly Journal of Economics 104, 589-619. Freixas, X., R. Guesnerie and J. Tirole (1985): \Planning under Incomplete Information and the Ratchet Eect," Review of Economic Studies 52, 173-191. Gibbard, A. (1973): \Manipulation for Voting Schemes," Econometrica 41, 587-601. Green, J. and J.-J. Laont (1977): \Characterization of Satisfactory Mechanisms for the Revelation of Preferences," Econometrica 45, 427-438. Green, J. and J.-J. Laont (1987): \Posterior Implementability in a TwoPerson Decision Problem," Econometrica 55, 69-94. Hart, O. and J. Tirole (1988): \Contract Renegotiation and Coasian Dynamics," Review of Economic Studies 55, 509-540. Hall, Ph. (1935): \On Representatives of Subsets," Journal of the London Mathematical Society 10, 26-30. Jacobs, K. (1969): Selecta Mathematica I, HTB 49, Springer-Verlag: Berlin, Heidelberg, New York. Laont, J.-J. and J. Tirole (1990): \Adverse Selection and Renegotiation in Procurement," Review of Economic Studies 57, 579-625.

25 Laont, J.-J. and J. Tirole (1993): A Theory of Incentives in Procurement and Regulation, MIT Press: Cambridge - Massachusetts, London. Maak, W. (1936): \Eine neue Denition der fastperiodischen Funktionen," Abhandlungen aus dem Mathematischen Seminar Hamburg 11, 240244. Myerson, R. (1979): \Incentive Compatibility and the Bargaining Problem," Econometrica 47, 61-73. Weyl, H. (1949): \Almost Periodic Invariant Vector Sets in a Metric Vector Space," American Journal of Mathematics 71, 178-205.

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