Chai Ng

694300

Utility Function

Summarizes what an individual likes/dislikes, underlying preferences.

If preferences over bundles of goods satisfy the following assumptions, then there exists
a continuous utility function u(x ) that represent these preferences.
1. Completeness: any two bundles can be compared
2. Transitivity: if x> y and y > z , then x> z
a. Also depends on an appropriately defined choice set
3. Continuity: if bundle x is better than bundle y, and bundle z is sufficiently close
to y, then x is better than z (or if z is closer to y than x , then youd still
prefer x ; cant be breaks or unexpected changes in preferences)
4. Strict monotonicity: if bundle x contains at least as much as bundle y of every
good, and strictly more of at least one good, then consumer would strictly prefer x
to y
a. Generally, goods providing positive payoffs is not an issue (need to check)
b. Allows the assumption of p1 q 1 + p 2 q 2=Y instead of
5. Convexity: marginally diminishing utility in consumption, therefore consumer
would [strictly] prefer bundle z= x + ( 1 ) y , for any 0< <1
a. Strict convexity will provide a unique solution to maximization problem (if
not there is an interval of solutions)
b. Generally, diminishing utility with consumption not an issue (need to
check)
Limitations:
Some preferences cannot be represented by a continuous utility function (does
not satisfy assumptions)
The utility function is not unique and has varying functions that represent the
same preferences (with any positive monotonic transformation, e.g. logs,
squares)
Example Money Giving Utility Functions:

x=money kept ; y=money given ; 0< <1

1. Cares about own payoff and the differences in payoff:

FS

'

( x , y )=x ( x y )

u FS ( x , y ) =x |x y|

or

2. Cares about own payoff and his/her share of the payoff:

uBO ( x , y ) =x

x
1

x+ y 2

3. Cares about moral cost of deviating from social norms:

u ( x )=x ( xx e )

Constrained Optimisation
Given a constraint (typically a budget set), we are able to solve a utility maximization
problem
Assume that utility functions are differential (FOC, SOC)
Constrained maximization (find the maximum possible utility that satisfies the constraint)
Lagrange method
Uses to identify the

u with a unit increase in

max L ( q1 , q2 , ) =u ( q1 , q2 ) + (Y p1 q1 p 2 q 2)

Y :

q 1 , q2

Steps to solve:
1. Take the FOC and equal to zero
2. Simultaneously solve for q1 and
Limitations:

ECOM30010 Microeconomics

q 2 (usually a function of Y

and

pi )

Chai Ng
694300
1. Not aware that you can consume negative quantities (if impossible, corner
solution)
Marshallian (uncompensated) demand
Turns Lagrange solutions as functions where

q1 ( p1 , p 2 , Y ) and q 2( p1 , p 2 , Y )

Compensation (Expenditure Minimisation problem)

How to compensate the consumer to maintain the same level of utility? What is the
minimum amount of money the agent needs to guarantee u

min p 1 q 1+ p 2 q 2
q1 ,q2

subject u ( q 1 ,q 2 )=u

Steps to solve:
1. Solve for

q1 and q 2 through the Lagrange method where

L= p1 q1 + p2 q2 + ( u u ( q 1 ,q 2 ))

2. Calculate the utility and income required (prior price change)

3. Calculate income required from new consumption (given the price change)
Hicksian (compensated) demand
What bundle a consumer needs to buy to get herself utility
way?
From Marshallian (uncompensated demand)

u in the cheapest possible

qi ( p1 , p2 , Y )=qi ( p1 , p2 , E ( p 1 , p2 , u ) )=hi ( p1 , p2 , u ) .
)= p1 h1 ( p 1 , p2 , u ) + p 2 h2 ( p1 , p 2 , u ) .
Where E ( p1 . p2 , u
h ( p1 ,q 1 , u ) =( h1 ( p1 , q1 , u ) , h2 ( p 1 , q 1 , u ) )
Slutsky equation (Income/Substitution Effects)

qi ( p1 , p 2 , E ( p1 , p2 , u ) )

qi ( p1 , p2 , E ( p 1 , p2 , u ) )=
hi ( p1 , p2 , u )
q 1 ( p1 , p2 , E ( p 1 , p2 , u ) )
p1
p1
E
hi
1.
is the substitution effect: holding utility constant at u
, how does
p1
quantity change as the prices change (budget line slope changes)
2.

qi
q
E 1

is the income effect: holding the price constant (slope of the budget

line), how does quantity respond to the change in income?

Types of Goods
Good can change their properties depending on particular prices and income

Normal good:

Luxury good:

qi
> 0 (individual consumes more as income increases)
Y
qi p 2 q2 ( p1 , p2 , Y )

>1 (individual spends a larger share of her

Y
Y

income on the good as income rises)

Inferior good:
o

qi
< 0 (individual consumes less as income increases)
Y

Often larger impact when the price is lower (since they consumed more
units to begin with)

Giffen good:
increases)

q1 ( p 1 , p2 ,Y )
p1

ECOM30010 Microeconomics

>0

(individual consumes more as price of good

Chai Ng
694300
o

Often has constraints/conditions for the demand to exhibit Giffen

properties

Giffen Goods
Where to search for a good with Giffen property? When nutrition is a real concern and
they are in the subsistence zone where they need to meet minimum nutrition levels.
There are two types of goods:
Basic good: if households are so impoverished that they consume only the staple
good then they are in the calorie-deprived zone (steep indifference curves
Fancy good

Game Theory
Strategic interaction: my best choice of action depends on what I expect you to do and
vice versa
How to write a game
Strategic form game:
1. Specify players: i=1,2 N
2. Specify what each player can do:

s i= { s a , sb , } , resulting in a vector of

strategies s=(s 1 ,.. , s n) that describes what each player has done to determine
the outcome of the game
si is the strategy profile that excludes i ' s pure strategy, therefore
a.

s=(s i , si )
3. Specify payoffs/utility functions for each players and their strategies
Simultaneous-move (strategic or normal form) games
In the example of Penalty Kicks
If the strategy isnt guaranteed to score, the probabilities of scoring is used as a
payoff
Sometimes players dont want to deviate from the expectation of others
Payoff Matrix
Player 1 \ Player 2

s 1,b
s 1,b

s 2,a
s 2,b
u1 ( s 1,a , s 2,a ) ,u 2 ( s1, a , s2, a ) u1 ( s 1,a , s 2,b ) ,u 2 ( s1, a , s2,b )
u1 ( s 1,b , s 2,a ) ,u 2 ( s1, b , s2, a ) u1 ( s 1,b , s 2,b ) ,u 2 ( s1, b , s2,b )

Sequential-move (extensive form or dynamic) games

Game tree strategies: provides additional information in the definition for who moves
when and the histories of the game
Game Tree Diagram: How to label information sets, payoffs, strategies and players (in 3 stages)

Strategy in a sequential game is a complete contingent plan of action for each player. At
equilibrium, we do not need to distinguish what A thinks B will do, and what B will
actually do, because they must be the same. Strategy profile notation, has to write in
each stage and branch what the players best response is (even if that branch is unlikely
to be played out):

( s1, stage1.1 , ( s 1,stage 3.1 , s1, stage3.2 ) ) , ( s 2,stage 2.1 , s2, stage2.2 )

ECOM30010 Microeconomics

Chai Ng
694300
Backward induction: beginning from the final branches; prune them until the root
(moving the payoffs as you go along) to reach the expected outcome
There are NEs that are not from backward induction through non-credible threats
(deviating from the best response to force player to play a different strategy)
o If threatening player can revise action: require players to play NE in every
subgame, instead of only in the overall game
o If threatening player cannot revise action: NE is the appropriate solution
concept
Subgame: Includes two stages or one action from each player (not a single branch
where only one player makes an action!)
Information sets: set of nodes where the same player moves; the player who moves
has the same set of actions available; a player cannot distinguish histories of the game
(will know in what stage, but not which branch)
Subgames cannot break information sets (should behave as it is a new separate
game)
Becomes a game with some elements of simultaneous and sequential
Cannot be at terminal nodes (doesnt make a difference since no one moves after)
Strategy profile notation doesnt need contingency plans for sequential games!

Types of Strategies

Strictly dominant strategy: A strategy that gives player i (strictly) higher payoff
than any other of i' s strategies, for any strategy of the opponent
Strictly dominated strategy: A strategy that gives player i lower payoff than some
other strategy s^i of i , for any strategy of the opponent, is called strictly dominated
(eliminate before calculations!)

Pure Strategy Nash Equilibrium (PSNE): A strategy profile s S is a PSNE if no

player can gain by using some other strategy, where the inequality holds (no incentive to
deviate / higher payoff):

ui ( si , si ) ui ( si , si
)

Every player is happy to use their expected strategy, where si denotes the
strategy of other players.
Nash equilibrium need not be efficient! (Expectations can result in a less efficient
NE)
Assumption: players do not communicate when they deviate
If additional strategies/options give lower payoff, it will not be chosen (however,
this changes the expectations of the other players strategies)
Systematic way to identify PSNE:
1. Find the best response (or responses) for each player i and each strategy of
the opponent, which strategy will provide the highest payoff. B R1 ( s2, x )=s1, x
2. Find where the best responses match each others (fixed point):
every player i

s i=BR( si ) for

Mixed Strategy Nash Equilibrium (MSNE): A strategy profile m S is a MSNE if for

each player i , and every mixed strategy m i of player i , the following inequality
holds:

ui (mi , mi
) u i ( mi , mi )
Where m is a vector of probabilities that tell us how often players will play each

strategy where the strategies provide the same expected payoff, players are indifferent
between the strategies.

ECOM30010 Microeconomics

Chai Ng
694300

Probs.
Player 1 \ Player 2

s 1,b
s 1,b

1
s 2,a
s 2,b
u1 ( s 1,a , s 2,a ) ,u 2 ( s1, a , s2, a ) u1 ( s 1,a , s 2,b ) ,u 2 ( s1, a , s2,b )
u1 ( s 1,b , s 2,a ) ,u 2 ( s1, b , s2, a ) u1 ( s 1,b , s 2,b ) ,u 2 ( s1, b , s2,b )

Systematic way to identify MSNE:

1. Calculate the expected utilities for each strategy of player
probability or
u1 ( s 1,a , ) = u1 ( s1,a , s 2,a ) + ( 1 ) u1 ( s1, a , s2,b ) and

i , assume

u1 ( s 1,b , ) = u1 ( s1,b , s 2,a ) +(1 )u1 ( s1,b , s 2,b )

2. Solve for where expected utilities for each strategy equals, for probability

u1 ( s1,a , s 2,a ) + ( 1 ) u1 ( s 1,a , s 2,b ) = u1 ( s 1,b , s 2,a ) + ( 1 ) u1 ( s 1,b , s 2,b )
u 1 ( s1, a , s2,b ) u1 ( s 1,b , s 2,b )
=
u1 ( s 1,b , s 2,a ) u1 ( s1, b , s2, b ) +u1 ( s 1,a , s2, b )u 1 ( s1, a , s2,a )

Subgame perfect Nash Equilibrium (SPNE): A game that starts at any non-terminal
node; A strategy profile is SPNE if it is a NE in the overall game and in each of the
subgame.
Any SPNE is a PSNE/NE of the overall game
Not all NE is an SPNE

Congestion Games
A game with infinitely many players; when players interact with an obvious solution, or
provided with an additional option, it changes the agents strategy resulting in a less
efficient outcome.
Common payoffs of players: negative of how many minutes they travel (where
y are the proportion of people using a particular route)

and

ui ( s i , xsi )=function of minutes by x

How do we find the equilibrium? Where the utilities of the options available equal each
other, and no player wants to deviate.
1. Establish general utility functions of the player, for each available route option (as
a function of minutes and proportion)
2. Eliminate any strictly dominated routes
3. Set both equations to equal each other and solve for x and total travel time.

Political Competition

1. Players: political parties i={1,2, n }

2. Strategies: political positioning, as a number in the [0, 1] interval (essentially the
same as how parties win voters support)
a. The parties immediately know who wins (or the probability of winning)
3. How to determine winners? Voters know parties positions and has own
positions on [0, 1] interval and generally prefers a party that is closest to ones
own position (assume voters vote simultaneously, an SPNE)
Voters: Infinitely many voters, spread evenly across the whole interval [0, 1]
(exactly (ba) fraction of all voters located between points a and b ,
a<b .
Voter utility: ui ( a )= ai , the smaller the distance between the own
position, i , and the position of the party, a , the better it is for the voter

ECOM30010 Microeconomics

Chai Ng
694300

Voter strategy: Therefore

( a+b2 )

vote for

a ,

(1 a+2 b )

vote for

b . Nash equilibrium as no voter can change the outcome and has no

incentive to deviate (solution to some non-specified smallest subgame of
political positioning):

a if |ai|< bi b if |ai|> bi ab if |ai|= bi

Vote for

Outcome: Assume that parties have probability of of winning each, and

parties decide to locate at a=b , each party gets equal number of votes
and ties

The winner party is

a if a>1b
b if a<1b
ab if a=1b

Styles
o Deterministic: party positions determine the winner
o Probabilistic: uncertain (only the probability) as party leadership can tilt
election in an unpredictable way
4. Payoffs: What the winner cares about?
a. About being elected -> losing provides payoff of zero
b. About the position of the elected party -> payoff is the same as if it were
elected if the winning party is the same position (where x is the position of
the winning party)
i. Party 0 (a): u0 ( x ) =x
ii. Party 1 (b):

u1 ( x )=(1x)

Four Scenarios
Winning
DW
PW

Deterministic voting
Probabilistic voting

Position
DP
PP

DW: (, ) is a NE because it is both parties best response to each others strategies

(no incentive to deviate)

a<

Best response: where

share of votes than
party)

1
, B R b ( a ) (a ,1a) as b will have a larger
2

(essentially to be in the interval of the opposing

PW: (, ) is an NE because its where

B R a ( b )=a

and

B R b ( a )=b

1
, B R b ( a )=a+ 0.01 to maximize its
2
1
probabilities of winning (or if a>
, B R b ( a )=a0.01 )
2
Best response: where

a<

DP: (, ) is an NE, as no party as incentives to deviate because it loses the election.

Best responses

1
1
a< , B R 0 ( a )=1a0.01 and if a> , B R 0 ( a )=lose
2
2
1
1
For party 0, if b> , B R 1 ( b )=1b+ 0.01 and if b< , B R 1 ( b )=lose
2
2
For party 1, if

ECOM30010 Microeconomics

Chai Ng
694300
PP: (0, 1) is the NE as it is the strictly dominant strategies where parties care about their
positions and voting is probabilistic. Identifying best responses require setting up a
maximization problem (as it becomes expected utility from winning/losing). Best
responses:

max E u0 ( a , b )=(a )
a

( a+b2 )+ (b ) (1 a+b2 )

b 2a 2
b
2

Party 0 cant control b, therefore, for any b,

Similarly for Party 1, for any a,

B R 0 ( b )=0

B R1 ( a ) =1

Median voter theorem: parties locate at the position of the median voter (assumes
that voters are distributed uniformly on [0, 1]). However, this invalidates the conclusion:
Not everyone has to vote (more important to get people to vote)
Elections are structured as multiple contests (median voter may not apply to
the whole country)

Standard Auctions
Two key areas of auction theory:
1. Bidding strategies: How should bidders bid to maximize their expected payoffs?
a.
bi ( v) is the bidding function that tells you what you should bid for every
possible valuation

vi

(may depend on your best guess about the

distribution of others F j (v ) , as well as the number of other bidders)

b. Assume that other players are playing a random (mixed) strategy
c. Payoffs are assumed to be v i bi , and zero if bidder left the auction
2. Auction design: How should sellers design the auction to maximize their
expected revenues? (or efficiency in a government example)
a. Simplicity sake, we assume that the distribution is uniform on [0, 1], for
second-highest order statistics (

for sample :

n1
), the expected
n+1

revenue of the auctioneer is:

2
3
4
5
6
1/3

3/5
2/3
5/7
b. Preference for second-price auction for single unit private value auctions is
because the strategy is easier to understand and explain that bi ( v )=v
c. Governments care about efficiency above all else (because if item is
allocated to a company that does not have the best use for the asset, the
money or potential gain is lost forever
Environments:
Standard: Private values, you have your own valuation that is unaffected by others (e.g.
computers)
Each bidder i' s valuation is a random, independent draw from some
distribution with cumulative density function Fi (v) that represents the
bidders and auctioneers best guess about the valuations. v is the actual
amount willing to pay for the object after seeing it. Different distributions for
different bidders.
Results in Revenue Equivalence Theorem: if bidders are risk neutral and their
valuations are independent, the sellers expected revenues are the same in these
four standard private-value auctions
o Distribution of revenues and bidding strategies are different, which the
seller may care about

ECOM30010 Microeconomics

Chai Ng
694300

More likely to receive low revenue form the second-price auction

than from the first price auction, but chances to have higher
revenues (higher variance)
Seller will never get more than 2/3 in the first price auction

Common Values: The value of the item is the same for you as others (details matter,
e.g. selling a painting/antiques)
Winners curse: incorrect conditioning of his expected value will often result in the
winner overpaying because:
o The winning bid exceeds the value of the auctioned asset such that the
winner is worse off in absolute terms
o The value of the asset is less than the bidder anticipated, so that the
bidder as a net gain but will be worse off than expected (winning has a
negative signal that your valuation is too high)
How to confirm this? E(v i whenbi >r )
o Expected (true) valuation (assume
best response):

( probability of valuation )(average of valuations) for all scenarios

Expected payoff: ( probability of occuring )( payoff ) of all scenarios

Difficult to calculate the optimal bid, but bidding changes when:

o There are more bidders, you must bid less aggressively (more likely to lose
the object, but less likely to get a lemon)
o There is a famous expert, you must bid less aggressively (same as above)
Ways to overcome this and considerations:
o How valuable the information is for others?
o How easy it is to obtain information?

Open vs. Sealed bids: Ascending price auction (open): more difficult to signal own
bidding strategy to the other bidder and pay back to combat inefficiencies in common
value auction
Early vs. Late bids: Only important in a sealed-bid style environment where there is
an advantage in concealing superior information.
Bidding early results in the standard second-price auction.
Bidding late means rival has no time to respond, but bid will be accepted with
only probability

b2 wins
b2 loses
2
b1 wins
( 1 )

b1 loses
( 1 )
( 1 )2
How to compare? Identify E ( u1 (late ) ) E ( u1 ( early ) ) , where
E ( u )= probability of winning(v i price)

Higher valuation bidders would prefer to bid early and get the object with high
probability

Formats:
English (ascending): bidders submit their bids sequentially as open outcries, with the
highest bidder winning
Where r is the current highest bid, a bidder i can bid bi=r +0.01 or
leave the auction, the best response (and weakly dominant strategy) is:

ECOM30010 Microeconomics

Chai Ng
694300

bid b i=r +0.01 if v i >r + 0.01

leave the auctionif v i <r +0.01
either bidleave if vi =r +0.01

Ascending clock auction: Price is announced, and bidders can either accept (price
p+increment is announced) or leave the auction; if there is no more bidders at the new
increment, object is allocated randomly among bidders (accepted price); if there is one
bidder, she gets the object; if more than one bidder, the process repeats
Provides additional information (signals) while the auction is run; able to revise
your bid
Auctioneers revenues are higher in ascending price because the information of
others is revealed and they are able to bid more aggressively
More efficient than second-price auction, combat inefficiencies in common value
auction
Similar to Amazon (additional 10 mins for each extra bids so that others would
have a chance to react), resulting in no major difference in the bidding strategies
of common value and private value goods as bidders have no incentive to
hide their information
Second-price sealed-bid: Bidders submit their bids simultaneously, with the highest
bidder winning and paying the second highest bid
Weakly dominant strategy to submit a bid bi=v i as payoff is v i r , where
r is unknown
o If i loses the auction, any other strategy would either make i lose
the auction, or lose money if i wins the auction
o If i wins the auction, any other strategy would either give i the same
payoff, or make i lose the auction (because i pays the secondhighest price)
o Bidding bi=v i gives i at least the same payoff as any other strategy
and sometimes a higher payoff (consider the scenarios of where

v i >< =r

Therefore, the bidder with the highest valuation wins and auctioneer receives the

n1
n+1

expected revenue of

eBay as bidders can jump the bid up at the very last second, so that others
cannot react (also bidders prefer to gamble and get the object at a lower price
at a lower probability, than to get the object at a very high price with a high
probability)

Dutch (descending): Auctioneer starts with a high price and reduces the price, with the
first bidder who accepts a price winning

( 1n ) v

bi ( v )= 1

similar to first-price sealed-bid is the ideal bidding strategy

Once price is below your valuation, waiting increases your payoff (if you win) but
lowers the probability that you win

First-price sealed-bid: Bidders submit their bids simultaneously, with the highest
bidder winning and paying the second highest bid

NE is where
o

bi ( v )=

v
2

for 2 players

Require a maximization problem setup: what is the probability of winning

with bid

x ? Or what is the probability that

ECOM30010 Microeconomics

is higher than

b2=

v2
2
9

Chai Ng
694300
(uniform distribution of [0, 1]), therefore the probability is

2 x , where x

1
2

(to ensure probability is not larger than 1)

max [2 x ( v 1x ) ]
x

Take the FOC and set to zero results in

Bidders best response strategy, as the number of players increase,

following the pattern of

v1
2

( 1n ) v

bi ( v )= 1

(the more bidders there are,

the more aggressively they bid

Auctioneer gets the expectation of the highest-order statistic (

n
)and plug that expected valuation into the bidding function
n+1
n
1 n1
1 =
n+1
n n+ 1

for sample :

( )

Multi-unit Auctions: Spectrum Auction, Treasury Auctions, coal or offshore petroleum

exploration rights.
Assume two identical units, and three bidders (know their own valuation but not
the valuation of others)
Assume using the second-price sealed-bid auction
If bidders demand more than one unit, weakly dominant strategy for the first unit,
but incentive to bid lower on additional units
Complements/substitutes: difficult to efficiently allocate multi-unit goods. Package
bidding allow bidding on both individual items, as well as a collection of lots (more
efficient, but may discourage small bidders to participate).
There are n bidders, each interested in buying 2 units of good at price $1, with n
units for sale (but demand for 2 n ). n highest bids determine the allocation and
n+1 -highest bid determines the price.
Zero-revenue NE: Each bidder bids $1 for unit 1 and $0 for unit 2. Payoffs:
$1/bidder, $0 for seller. No incentive to deviate as if bidder bids $1 for the second
unit, the n+1 -th bid is now $1 (new price) and the payoff is zero regardless if
the bidder gets the object or not.
Good NE: Each bidder bids $1 for both units. Payoffs: $0/bidder, $1 for seller. No
incentive to deviate as they cant change the price ( n+1 -st bid of $1)
Sequential multi-unit auction: Auction unit 1 first, then unit 2 next. In the last
auction, everyone should bid true valuation. However:
Highest bidder would not necessarily leave after the first round (prefer to let
second-highest bidder win first round and leave, and compete with lower bidders,
but everyone is making these calculations so hard to compete optimal bidding
strategy in second round)
Difficult to expand
Simultaneous multi-unit auction:
Separate auctions for each unit: Difficult because bidders can either win both
units (doesnt want both), or have an unallocated unit, or receive low revenues, or
have bidders revaluating their strategy to bid lower (NZ Auction)
Each bidder pays the next bidders bid: if b1 >b 2> b3 , then bidder 1 pays b2
and bidder 2 pays b3 (Bidder 1 will consider bidding lower than b2 and pay

b3

instead), as the advantage of second-price auction is lost:

ECOM30010 Microeconomics

10

Chai Ng
694300
Higher bid (higher probability of winning) vs. Lower bid (lower expected
price)
Each winner pays the same price: bidder 1 and 2 pays b3 . Bidders changing
their bid will change whether they win and when they win, but does not change
the price paid (similar to single-unit second-price auction, uncertain effects on
revenue)
o
n highest bidders get n object and pay n+1 -st highest price
Simultaneous ascending auction (open): bidding occurs over many rounds
o only stops when no license receives a new bid (allows bidders to switch to
other licenses if the license they are bidding for becomes too expensive)
o if bidders bid too little, they are restricted from bidding in the next round
(forces bidders to bid, instead of waiting out and bidding late)
o

Non-standard auctions
Where there are no fixed seller or buyer, and no money changing hands.
American football: How do we get both teams to be indifferent in how the coin lands
(determining who wins the possession)

We want to find where p ( x )=q ( x ) where

probability of team A winning is the same
whether A or B gets the ball, and likewise for
team B who will not care

p(x) the probability of A winning if A

has possession (probability of B winning,
if A has possession is 1 p(x ) )

q( x) the probability of A winning if B

has possession (probability of B winning,
if B has possession is 1q ( x )

x yardage for team As end-zone

Descending distance auction: Assume NE when x=x

where neither team wants
the ball and there is coin flip (indifferent); however unrealistic to assume that teams
know each others probability of winning ( p(x) and q( x) )
Becomes similar to a common value auction, where teams that havent dropped
out signals that own valuation is too low/high
Average-distance sealed-bid auction: Winner is lower bidder, with starting distance
being the average of the two; how do we know if the teams will bid close to their own
true valuation?
Team As utility from winning the possession pushes the bid up:

p ( x ) u A ( Win the game ) + ( 1 p ( x ) ) u A ( Lose the game)

Team Bs utility from losing and the other teams possession pushes the bid down:

( 1 p ( x ) ) u B ( Winthe game )+ p ( x ) uB ( Lose the game)

Bilateral Trade
Assume that seller also has a valuation for the item and is unwilling to sell if

bi < v s (no

v s< v B )
p ( v S , v B )= price (if transaction

auction/possible mechanism to induce efficient trade where

Pricing function (utility/revenue/payoff function):

happens)

Myerson and Satterthwaite Impossibility Result:

1. Seller cant sell an item that they dont have (physical constraints)
2. Information constraints can also prevent the sale of an item

ECOM30010 Microeconomics

11

Chai Ng
694300
a. Seller/buyer can pretend they have a valuation different from their true
valuation (seller wants higher; buyer wants lower)
uS B ( What SB say|Who SB really is
b.
c. Cannot guarantee all efficient trades will happen if no truthful reporting
Individual rationality constraints/conditions (because trade is voluntary):
p ( v s , v B ) v s , otherwise seller wont sell

p ( v s , v B ) v B , otherwise buyer wont buy

p ( v s , v B )=0 , trade shouldnt happen in this case

Incentive compatibility constraint: What if the sellers/buyers pretended they had

different valuation? (1) Find expected utility if the scenarios if they pretended/if they
hadnt (2) set true valuation to pretend valuation utility (3) calculate pricing
functions for the ones you know
For the seller p ( 0,1 ) 0.8 , but for the buyer p ( 0,1 ) 0.2
We need incentive compatibility for players to report truthfully
Mechanism 1: Seller makes an offer
If sellers valuation is either v s=0 or

v s=0.9 , likewise buyer valuation is either

v B=0.1 or v B=1 . NE: Both v S=0 and v S=0.9 will offer p=1 (only sell
where v B=1 ) which provides the highest expected revenue
Mechanism 2: Seller makes two offers
In equilibrium p1> p 2 , every buyer will reject the first offer and wait for
in Mechanism 1 principles
Mechanism 3: Buyer makes an offer
Similar to Mechanism 1, Buyer is better off buying at
payoffs

p=0

p2 , resulting

with higher expected

Mechanism 4: Second-price auction

Simultaneous naming of valuation, if v B >v S

then trade happens where pB =v S and

pS =v B (but where would the difference in money come from? Sometimes government

is interested in efficient trade)

Can get money from agents themselves, before they know their own valuations
(signing a contract before that to put money into escrow account)
Better to contract before parties have their information

Adverse Selection
Assume that only one side has information, but this information is relevant for the other
party (buyer does not know his valuation for the object but the seller will)
Hostile takeover: Company knows better than acquirer their valuation. What price
should the company set?
Investors value function v I =ap , therefore willing to buy only when

v I =aE ( p ) =p

E( p) is the expected price/value of the company

lower bound + p
which is often
)
2
Company will not offer p , if it is worth more than p and the investor knows
(where

this; understanding that the expected value on a random variable distribution is

now p/2 from [0, p ]
If investor knows more information, narrows the band of valuation and investor is
more willing to pay a higher price

ECOM30010 Microeconomics

12

Chai Ng
694300
Insurance: Customer knows better about her health/driving habits that will determine
the cost to the insurance company
Each agent comes with v i which is the expected value of insurance claims
(cost to insurers) distributed uniformly on [0, 1] and value the policy at 1.2 v i
(risk adverse)
Only agents whose 1.2 v i p will buy insurance
Total cost to insurer is the cost/person * # of people insured (
E ( v i )Fraction of insured people ; Total revenue is
pFraction of insured people ; Total profit is the revenue cost (insurer will
price when its profitable)
o Only a small fraction of people are insured, as only high-cost agents are
willing to sign for insurance driving up the price
Solution? Forcing desirable customers to sign up
Unobservable quality: such as internal damage of a car that affects the quality of the
car
Solutions:
1. Forcing desirable customers into the market
2. Signaling: High-quality market will be efficient
a. E.g. Warranty for a car, cheap for a high-quality item but expensive for
a low-quality item; resulting in only high-quality cars coming in with
warranty

Random Thoughts

Every model has its setup, assumptions (that are able to be tested) and is able to
make predictions; should not always conform to reality
Know his model types and know the assumptions/understanding which will be
tested
Math Notation: Bold letters will always stand for a vector (e.g. x=( x 1 , x 2 ) and

y=( y 1 , y 2 ) will represent in the bundle x=(1,3) , there is 1 unit of good 1

and 3 units of good 2)
Experiments/Situations: invented environments/situations to test the validity of
models
o Utility prediction: (1) set assumptions/limits, (2) FOC=0, (3) interpret
relating back to (1) assumptions and limitations
Selfish behavior: okay to assume because most of the time it provides
accurate/simple predictions
Proof by contradiction: proofing technique that assumes the statement is wrong,
then prove that the condition of the theorem is not satisfied
Simplified problems are used when the initial problem is too hard (assuming it
satisfies the same constraints)
Consumer theory informs about details of field experiments, who to target, how to
design, etc.
In exam, dont try and find MSNE for 3x3 (or more) game, you can be sure to rule
out strictly dominated strategies before beginning calculations
If something doesnt work in a simple environment, it wont work in a more
complicated environment
xstartpoint
2

Probability of winning on a uniform distribution is

In second-price auction, if both ties, they pay their bids (which is equal anyways)
Expected price of the rival on a uniform distribution is the midpoint
Designing auctions in non-money environments
o What is the object being allocated and how? (allocation rule)

ECOM30010 Microeconomics

13

Chai Ng
694300
o

Is there a variable that can serve the role of money (payment rule) that is
(noted as p(v s , v B ) )
(1) sufficiently divisible?
(2) sufficient range to make participants wish not to win the
auction?

ECOM30010 Microeconomics

14