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EC537 Microeconomic Theory for Research Students,

Part II: Lecture 1

Leonardo Felli

CLM.G.4

8 November 2011
Course Outline

Topics in Contract Theory

Lecture 1: Contracts what are they? The Coase Theorem, Hidden


Information, Bilateral trading.

Lecture 2: Hidden Action, Multi-Tasking, Informed Principal,


Intertemporal Incentives.

Lecture 3: Implementation and the Foundations of Contracting with


Unverifiable Information.

Lecture 4: Transaction Costs.

Lecture 5: Hold-Up Problem, Specific Investments and Competition.

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Admin

My coordinates: S.478, x7525, lfelli@econ.lse.ac.uk

PA: Elizabeth Mirhady, S.686, e.mirhady@lse.ac.uk.

Office Hours:
Wednesday 3:30-4:30 p.m.
or by appointment (e-mail lfelli@econ.lse.ac.uk).

Course Material: available at:


http://econ.lse.ac.uk/staff/lfelli/teaching

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References: Contract Theory

Oliver Hart, Firms Contracts and Financial Structure, Oxford: Oxford


University Press, 1995.

Jean-Jacques Laffont and David Martimort, The Theory of


Inncentives: The Principal-Agent Model, Princeton and Oxford:
Princeton University Press, 2002.

Patrick Bolton and Mathias Dewatripont, Contract Theory,


Cambridge: M.I.T. Press, 2004.

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The Contract

The first natural question that needs to be answered is:

What is a contract?

Definition
A contract is the ruling of an economic transaction: the description of the
performance that the contracting parties agree to complete at a (possibly
future) date.

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Example: a contract for the purchase of a specific item, say a meal. It
specifies:

the restaurant’s performance (number of courses, quality of food,


cooking details, etc. . . ),

the customer’s performance (payment in full upon completion).

Contracts involve not only the contracting parties, but also outsiders
(enforcing authority: Court or Enforcer).

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We distinguish between implicit and explicit contracts.

A contract is implicit or self-enforcing whenever the environment in


which the contracting parties operate corresponds to the extensive
form of a game whose (unique) subgame perfect Nash equilibrium
(PBE) exactly corresponds to the outcome the parties would like to
implement.

If you believe in SPE or PBE then there is no need for explicit


communication. The two rational individuals will behave in the way
required.

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If the outcome the parties would like to implement is not the
subgame perfect Nash equilibrium of the environment in which they
operate the parties might want to modify the environment.

This is accomplished through an explicit contract.

An explicit contract is a commitment device requiring:

an explicit agreement between the parties,

the intervention of a third party: the enforcer.

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The role of the enforcer is to force the parties to behave in a way that
differs from the one that would arise in the absence of any agreement.

An explicit contract therefore specifies a new extensive form


corresponding to a new game for the parties.

The usual way for the enforcer to guarantee that the parties operate
in this new environment is by modifying the parties’ payoffs, when
necessary.

By agreeing to bring in an enforcer in the game the parties commit to


play a game that differs from the initial one they were in.

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To see how the presence of an enforcer may work consider the
following example: (Kreps, 1984)

A buyer B and a seller S wish to trade an indivisible item at date 1.

The buyer’s valuation: v ,

The seller’s delivery cost: c.

Let
v >c
In other words, trade is socially efficient.

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Let p be a reasonable price level (we abstract for the moment from
bargaining) such that:
v > p > c.

B’s and S’s situation may be described by the following normal form:

deliver not deliver


pay p v − p, p − c −p, p
not pay p v , −c 0, 0

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The unique Nash equilibrium (dominant solvable) is:

(B does not pay, S does not deliver).

This is clearly an inefficient outcome: no trade.

The situation does not change if any of the following two extensive
forms are played.

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The unique SPE of the following game is:

{B does not pay, S does not deliver at both nodes}.

Bb
@
pay p @ not pay p
@
@
S @S
q @q
L L
L L
deliver L not deliver L not
L L
L deliver L deliver
L L
q Lq q Lq
(v − p, p − c) (−p, p) (v , −c) (0, 0)

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The unique SPE of the following game is:

{S does not deliver, B does not pay at both nodes, }.

Sb
@
deliver @
@not deliver
@
B @B
q @q
L L
L L
pay p L not pay p L not
L pay p L pay p
L L
L L
q Lq q Lq
(p − c, v − p) (−c, v ) (p, −p) (0, 0)

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Solution: to this inefficiency is an explicit contract enforced by a third
party (enforcer).

It specifies:

the payment p that B is supposed to make contingent on S delivering


the item,

the punishment FB > p (implicit in the legal system) imposed by the


enforcer on B in the event that S delivers and B does not pay,

the punishment FS > c (implicit in the legal system) imposed by the


enforcer on S in the event that B pays but S does not deliver.

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In this case the normal form describing the contracting parties
problem once the contract is in place is:

deliver not deliver


pay p v − p, p − c FS − p, p − FS
not pay p v − FB , FB − c 0, 0

The unique Nash equilibrium is now:

(B pays p, S delivers).

This particular contract is budget balanced off-the-equilibrium-path


(renegotiation proof). The latter property does not always hold.

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Consider now an environment in which when a party goes to the
enforcer (goes to court) detection is costly (κ) and is successful only
with probability π.

The payoffs associated with (not pay p, deliver) are:

v − π (FB + κ), π FB − (1 − π)κ − c

The payoffs associated with (pay p, not deliver) are:

π FS − (1 − π)κ − p, p − π (FS + κ)

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Notice that as deterrence goes: the detection probability (policing,
monitoring) π and the size of the punishment, FB and FS , are
substitutes (Becker 1968).

The game, below, assumes that the enforcer’s costs κ are paid by the
loosing party (British system):

deliver not deliver


π FS − (1 − π)κ − p,
pay p v − p, p − c
p − π (FS + κ)
v − π (FB + κ),
not pay p 0, 0
π FB − (1 − π)κ − c

If court’s costs κ are too high the game has multiple Nash equilibria:
(pay p, deliver) and (not pay p, not deliver).

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This example clearly shows the need for an enforcement mechanism.

This mechanism may be due to:

the parties being involved in a repeated relationship


relationship/implicit contracting, (multiplicity might be a problem).

the presence of a legal system that enforces the parties agreement


(explicit contracting).

Notice that according to this interpretation the enforcer is essentially


a commitment device available to the parties that can be used when
the parties agree to call it in.

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An alternative interpretation is that the enforcer itself is one of the
players of the game.

It should therefore be endowed with a payoff function and an action


space and should be explicitly considered in the analysis of the
contractual situation (we will come back to this).

It should be mentioned that using this line of argument one could


obtain a rather extreme interpretation of a contract (a law) (Mailath,
Morris and Postlewaite 2000).

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The view is that enforcement/punishment is the only relevant activity.

A contract (a law) can at best be interpreted as cheap talk that allows


the parties to coordinate on a particular equilibrium of the game.

No new equilibrium is introduced by the parties agreeing on a


contract or by the parliament passing a law.

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From now on we will assume that the two (or more) parties involved
in the contractual relationship operate in a market economy with a
well functioning legal system.

Whatever contract the parties agree to, it will be enforced by the


court.

The penalties for breaching the contract will be assumed to be


sufficiently severe that no contracting party will ever consider the
possibility of not honoring the contract.

We will abstract from explicitly specifying these penalties.

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Coase Theorem:

Once we have established what a contract is and how it works the


next natural question is:

What could parties achieve in an economic environment in which they


can costlessly negotiate a contractual agreement?

The answer to this question is the celebrated Coase Theorem.

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Theorem (Coase Theorem: Coase (1960))
In an economy where ownership rights are well defined and transacting is
costless gains from trade will be exploited (a contract will be agreed upon)
and efficiency achieved whatever the distribution of entitlements.

That is rational agents write contracts that are individually rational and
Pareto efficient.

A contract is individually rational if each contracting party is not worse off


by deciding to sign the contract rather then choosing not to sign it.

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This is the reflection of an other basic principle of a well functioning
legal system known as: freedom of contract.

This is equivalent to assume that the action space of the contracting


parties always contains the option not to sign the contract.

A contract is Pareto efficient if there does not exists an other feasible


contract that makes at least one of the contracting party strictly
better off without making any other contracting party worse off.

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Consider the following simple model of a production externality.

Consider two parties, labelled A and B.

Party A generates revenue RA (eA ) (strictly concave) by choosing the


input eA at a linear cost c eA (c > 0).

A’s payoff function is then:

ΠA (eA ) = RA (eA ) − c eA

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Party B generates revenue RB (eB ) (strictly concave) by choosing the
input eB at the linear cost c eB (c > 0).

Party B also suffers from an externality γ eA (γ > 0) imposed by A on


B.

B’s payoff function is then:

ΠB (eB ) − γ eA = RB (eB ) − c eB − γ eA

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Assume first that the parties choose the amounts of input eA and eB
simultaneously and independently without any prior agreement.

Party A’s problem:


max ΠA (eA )
eA

Party B’s problem:


max ΠB (eB ) − γ eA
eB

In equilibrium the inputs chosen (êA , êB ) are:

RA0 (êA ) = c, RB0 (êB ) = c

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Consider now the social efficient amounts of input eA∗ and eB∗ .

These solve the problem:

max ΠA (eA ) + ΠB (eB ) − γ eA


eA ,eB

In other words (eA∗ , eB∗ ) are such that:

RA0 (eA∗ ) = c + γ

RB0 (eB∗ ) = c

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Comparing (êA , êB ) and (eA∗ , eB∗ ) we obtain using concavity of RA (·):

eB∗ = êB , eA∗ < êA

In other words:

ΠA (eA∗ ) + ΠB (eB∗ ) − γ eA∗ − [ΠA (êA ) + ΠB (êB ) − γ êA ] =

= [ΠA (eA∗ ) − ΠA (êA )] + γ (êA − eA∗ ) > 0

The joint surplus is reduced by the inefficiency generated by the


externality.

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Assume now that the two contracting parties have the opportunity to
get together and agree on a contract before the amounts of input are
chosen.

There exists strictly positive gains from trade.

A reduction in the amount of input eA from êA to eA∗ will generate:

a decrease in the net revenues from A’s technology:

ΠA (eA∗ ) < ΠA (êA )

reduction in the negative externality

γ eA∗ < γ êA

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The former effect is more than compensated by the latter one. This
may create room for negotiation.

Normalize for simplicity the total size of the surplus that is available
to share between the two contracting parties to have size 1 (simple
normalization).

To establish a well defined negotiation ownership rights need to be


specified.

Entitlements/ownership rights define the outside option of each party


to the contract.

In other words they define the payoff each party is entitled to without
need for the other party to agree.

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Denote wA and wB the entitlements of party A, respectively B where:

wA + wB < 1.

We assume the following extensive form for the costless negotiation


between the two parties:

Infinite horizon, alternating offers bargaining game with discounting


and outside options.

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Denote:

δ the parties’ common discount factor,

x the share of the pie to party A,

(1 − x) the share of the pie to party B.

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Extensive Form:

Odd periods:

Stage I : A makes an offer xA to B,

Stage II : B observes the offer and has three alternatives:

he can accept the offer, then x = xA and the game


terminates;

he can reject the offer and take his outside option wB


and the game terminates;

he can reject the offer and do not take his outside


option, then the game moves to Stage I of the following
period.

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Even periods:

Stage I : B makes an offer xB to A,

Stage II : A observes the offer and ha three alternative choices:

he can accept the offer, then x = xB and the game


terminates;

he can reject the offer and take his outside option wA


and the game terminates;

he can reject the offer and do not take his outside


option, then the game moves to Stage I of the following
period.

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Payoffs:

If parties agree on x in period n + 1:

πA (σA , σB ) = δ n x, πB (σA , σB ) = δ n (1 − x),

If they do not agree and either party takes his outside option in period
n + 1:
πA (σA , σB ) = δ n wA , πB (σA , σB ) = δ n wB .

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Theorem (Deal Me Out)
For any discount factor δ < 1, and any pair (wA , wB ), wA + wB < 1, the
bargaining game has a unique subgame perfect equilibrium.

Agreement between the parties is immediate and the outside options are
never exercised.

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Proof: (sketch)

Denote xiH , respectively xiL , i ∈ {A, B}, the highest, respectively the
lowest, possible share that A can receive in a subgame that starts
with i making the offer.

We then have that:


 
xBH ≤ max{wA , δ xAH }, 1 − xAL ≤ max{wB , δ 1 − xBL }

Moreover:
 
xBL ≥ max{wA , δ xAL }, 1 − xAH ≤ max{wB , δ 1 − xBH }

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Solving these inequalities we obtain:

xAH = xAL = xA , xBH = xBL = xB

We also obtain that:

If
δ δ
wA ≤ , wB ≤
1+δ 1+δ
then
1 δ
xA = , xB =
1+δ 1+δ

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If
δ
wA ≥ , wB ≤ δ(1 − wA )
1+δ
then
xA = 1 − δ(1 − wA ), xB = wA

If
δ
wA ≤ δ(1 − wB ), wB ≥
1+δ
then
xA = 1 − wB , xB = δ(1 − wB )

If
wA ≥ δ(1 − wB ), wB ≥ δ(1 − wA )
then
xA = 1 − wB , xB = wA

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These offers characterize a pair of strategies (σA , σB ).

It is easy to show that these strategies constitute the unique subgame


perfect equilibrium of the bargaining game.

Notice that an efficient agreement is reached independently of the


size of the entitlements.

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In particular if each party is entitle to the choice of his input, then:

ΠA (êA )
wA =
ΠA (eA∗ ) + ΠB (eB∗ ) − γ eA∗

ΠB (êB ) − γ êA
wB =
ΠA (eA∗ ) + ΠB (eB∗ ) − γ eA∗

If instead party B is entitled to preclude party A from operating his


technology, then:

ΠB (êB )
wA = 0, wB =
ΠA (eA∗ ) + ΠB (eB∗ ) − γ eA∗

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In either case the result above implies that we would get the efficient
outcome: (eA∗ , eB∗ ).

However, the share that accrues to each party depends on the


entitlements wA and wB .

The equilibrium contract specifies a transfer between the two parties


and A’s choice of input eA∗ .

Also the transfer depend on the entitlements wA and wB .

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From now on we are going to focus on models in which the Coase
Theorem fails.

The classic cause for the failure of the Coase Theorem is the presence
of asymmetric information between the parties.

This is a situation in which each party has private information on his


own preferences (hidden information model).

Recall that a game of incomplete information (a player does not know


the preferences of one opponent) can always be recast as a game of
imperfect information (a player does not know the history of the
game) (Harsanyi 1967).

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Asymmetric Information:

We are going to consider first a very simple model of bargaining


under bilateral asymmetric information (a specific extensive form)
with no externalities.

We will show that in this situation efficiency cannot be achieved.

Recall that the Coase Theorem implies efficiency even in the presence
of externalities therefore if inefficiency arises in the absence of
externalities we can conclude that the Theorem fails.

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Notice however that this does not imply that we cannot find an
extensive form that will achieve efficiency.

Fortunately an other fundamental principle of contract theory will


help in this case: Revelation Principle.

Using the revelation principle we will be able to conclude that


efficiency cannot be achieved whatever extensive form governs the
bargaining between the two parties under bilateral asymmetric
information.

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Consider the following simple model of bilateral trade (double
auction) (Chatterjee and Samuelson, 1983).

Two players, a buyer and a seller: N = {b, s}.

The seller names an asking price: ps .

The buyer names an offer price: pb .

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The action spaces:

As = {ps ≥ 0}, Ab = {pb ≥ 0}.

The seller owns and attaches value vs to an indivisible unit of a good.

The buyer attaches value vb to the unit of the good and is willing to
pay up to vb for it.

The valuations for the unit of the good of the seller and the buyer are
their private information of each player.

Player i ∈ {b, s} believes that the valuation of the opponent v−i


takes values in the unit interval.

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The type spaces:

Ts = {0 ≤ vs ≤ 1}, Tb = {0 ≤ vb ≤ 1}

Player i ∈ {b, s} also believes that the valuation of the opponent is


uniformly distributed on [0, 1]:

µs = 1, µb = 1.

The extensive form of the game is such that:


If pb ≥ ps then they trade at the average price:

(ps + pb )
p= .
2

If pb < ps then no trade occurs.

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The payoffs to both the seller and the buyer are then:

 (ps + pb )
if pb ≥ ps
us (ps , pb ; vs , vb ) =
 v 2 if pb < ps
s

and 
(ps + pb )
vb − if pb ≥ ps

ub (ps , pb ; vs , vb ) = 2
 0 if pb < ps

Players’ strategies: ps (vs ) and pb (vb ). We consider strictly monotonic


and differentiable strategies.

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Consider now the seller’s best reply.

This is defined by the following maximization problem:

max Evb {us (ps , pb ; vs , vb ) | vs , pb (vb )}


ps

Consider now the seller’s payoff, substituting pb (vb ) we have:



 (ps + pb (vb ))
if pb (vb ) ≥ ps
us = 2
 v if pb (vb ) < ps
s

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or 
 (ps + pb (vb ))
if vb ≥ pb−1 (ps )
us = 2
 v
s if vb < pb−1 (ps )

The seller’s maximization problem is then:


Z pb−1 (ps ) Z 1
(ps + pb (vb )
max vs dvb + dvb
ps vb =0 vb =pb−1 (ps ) 2

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Recall that by Leibniz’s rule:
!
Z β(y )

G (x, y )dx =
∂y α(y )

= G (β(y ), y ) β 0 (y ) − G (α(y ), y )α0 (y ) +

Z β(y )
∂G (x, y )
+ dx
α(y ) ∂y

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Therefore the first order conditions are:
dpb−1 (ps ) 1   dpb−1 (ps )
vs − ps + pb (pb−1 (ps )) +
dps 2 dps
Z 1
1
+ dvb = 0
pb−1 (ps ) 2

or from ps = pb (pb−1 (ps )):

dpb−1 (ps ) 1  1
(vs − ps ) + vb p−1 (ps ) = 0
dps 2 b

which gives:

dpb−1 (ps ) 1 
1 − pb−1 (ps ) = 0

(vs − ps ) +
dps 2

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The buyer’s best reply is instead defined by:

max Evs {ub (ps , pb ; vs , vb ) | vb , ps (vs )}


pb

Consider now the buyer’s payoff obtained substituting ps (vs ):



(ps (vs ) + pb )
vb − if vs ≤ ps−1 (pb )

ub = 2
 0 if vs > ps−1 (pb )

we then get
Z ps−1 (pb )  
(ps (vs ) + pb )
max vb − dvs
pb vs =0 2

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Therefore the first order conditions are:
(ps (ps−1 (pb )) + pb ) dps−1 (pb )
 
vb − +
2 dpb
Z ps−1 (pb )
1
− dvs = 0
2 vs =0

or
dps−1 (pb ) 1  ps−1 (pb )
[vb − pb ] − vs 0 =0
dpb 2
which gives:

dps−1 (pb ) 1 −1
(vb − pb ) − ps (pb ) = 0
dpb 2

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To simplify notation we re-write pb−1 (·) = qb (·) and ps−1 (·) = qs (·).

The two differential equations that define the best reply of the seller
and the buyer are then:
1
[qs (ps ) − ps ] qb0 (ps ) − [1 − qb (ps )] = 0
2

1
[qb (pb ) − pb ] qs0 (pb ) − qs (pb ) = 0
2

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 58 / 79
Solving the second equation for qb (pb ) and differentiating yields:

qs (pb )qs00 (pb )


 
0 1
qb (pb ) = 3−
2 [qs0 (pb )]2

Substituting this expression into the first differential equation we get:

qs (ps )qs00 (ps )


   
qs (ps )
[qs (ps ) − ps ] 3 − − 1 − ps − 0 =0
[qs0 (ps )]2 qs (ps )

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 59 / 79
This is a second-order differential equation in qs (·) that has a
two-parameter family of solutions.

The simplest family of solution takes the form:

qs (ps ) = α ps + β

Then the values α = 3/2 and β = −3/8 solve the second-order


differential equation.

The definition of qs (·) and qb (·) imply that:


2 1 2 1
ps = vs + , pb = vb +
3 4 3 12

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 60 / 79
This is the (unique) Bayesian Nash equilibrium of this game.

Notice now that it is efficient to trade whenever:

vb ≥ vs

However in this double auction game trade occurs whenever:

pb ≥ ps

or
2 1 2 1
vb + ≥ vs +
3 12 3 4

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 61 / 79
In other words, in equilibrium trade occurs whenever:
1
vb ≥ vs +
4

vb 6
vs = vb
1 .................................................................
..
..
Trade ..
..
..
..
..
..
.
vb = vs + 4 .... 1
..
..
p 6 .. -
(0, 0) vs
1

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 62 / 79
Revelation Principle:

The obvious question is now: how can we make sure that there does
not exists an alternative way for the parties to achieve efficiency?

The tool that allows us to give an answer to this question is:


Revelation Principle

The Revelation Principle (Green and Laffont 1977, Myerson 1979,


Harris and Townsend 1981, Dasgupta, Hammond and Maskin 1979)
greatly simplify the set of feasible mechanisms for the parties.

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 63 / 79
This Revelation principle says that there is no loss in generality in
restricting attention to direct revelation mechanisms that satisfy
truth-telling constraints.

Recall:

the indirect mechanism is the one in which parties agree to a trade, set
prices etc. . .

the direct mechanism is the one in which parties report their private
information to a mechanism designer who according to the reports
enforces the mechanism.

Looking for the truth-telling equilibrium of the direct mechanism that


maximizes the principal’s utility is the way to identify the best
possible indirect mechanism from the principal’s view point.

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 64 / 79
Since every BNE of every indirect mechanism has an associated
truth-telling BNE of a direct mechanism if we find the truth-telling
BNE of the direct mechanism that maximizes the principal’s utility
there cannot exist any BNE of the indirect mechanism that is better
for the principal.

Notice that this way to proceed does not require us to specify the
space of all possible indirect mechanisms.

It is critical that the principal can commit to the mechanism in


advance: renegotiation may lead to a failure of the revelation
mechanisms (Dewatripont, 1989).

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 65 / 79
Bilateral Trade (Myerson and Satterthwaite 1983)

In our setting there is no principal, but the two parties at an ex-ante


stage — before they learn their private information — will commit to
a mechanism via the contract.

They will choose their contract in a way that maximizes their ex-ante
welfare.

Assume further that this is a pure bilateral contract transfers cannot


involve a third party.

In jargon the contract has to be budget balancing.

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 66 / 79
A seller and a buyer trade a single unit of a good.

The seller’s cost of delivering is c and it is the seller’s private


information:
c ∼ PS (c), c ∈ [c, c]

The buyer’s valuation is v and it is the buyer’s private information:

v ∼ PB (v ), v ∈ [v , v ]

A contract in this environment is a pair (φ, t) where


φ is the probability of trade,
t is the transfer from the buyer to the seller.

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 67 / 79
By revelation principle restrict attention to truth-telling direct
mechanisms.

The seller’s indirect utility is then:

US (ĉ, v |c) = t(ĉ, v ) − φ(ĉ, v ) c

The buyer’s indirect utility is instead:

UB (c, v̂ |v ) = φ(c, v̂ ) v − t(c, v̂ )

Denote:

US (ĉ) = Ev [t(ĉ, v ) − φ(ĉ, v ) c] = t(ĉ) − φ(ĉ) c

UB (v̂ ) = Ec [φ(c, v̂ ) v − t(c, v̂ )] = φ(v̂ ) v − t(v̂ )

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 68 / 79
Therefore every truth-telling BNE direct mechanism has to satisfy the
following set of incentive compatibility constraints (IC):

US (c) ≥ t(ĉ) − φ(ĉ) c ∀c, ĉ ∈ [c, c]

UB (v ) ≥ φ(v̂ ) v − t(v̂ ) ∀v , v̂ ∈ [v , v ]

Since once again we insist on freedom of contract we also require the


following individual rationality constraints (IR) to be satisfied:

US (c) ≥ 0, ∀c, ĉ ∈ [c, c]

UB (v ) ≥ 0, ∀v , v̂ ∈ [v , v ]

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 69 / 79
Notice now that both parties’ preferences satisfy the Spence-Mirrlees
single crossing conditions:
 
∂ ∂UB /∂t
− >0
∂v ∂UB /∂φ

The following result helps us to write (IC) and (IR) constraints in a


manageable form.

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 70 / 79
Theorem (Myerson and Satterthwaite 1983)
For any probability φ(c, v ) there exists a transfer function t(c, v ) that
satisfies (IR) and (IC) if and only if:

Ec,v [φ(c, v ) (JB (v ) − JS (c))] ≥ 0

where

   
1 − PB (v ) PS (c)
JB (v ) = v − , JS (c) = c +
pB (v ) pS (c)

and
dφ(c) dφ(v )
≤ 0, ≥0
dc dv

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 71 / 79
Proof:
From the (IC) constraints since for every v̂ > v we must have:

UB (v ) ≥ φ(v̂ ) v − t(v̂ ) = UB (v̂ ) − (v̂ − v ) φ(v̂ ),

UB (v̂ ) ≥ φ(v ) v̂ − t(v ) = UB (v ) − (v − v̂ ) φ(v ),

Summing the two inequalities we get:

(v̂ − v ) φ(v̂ ) ≥ (v̂ − v ) φ(v )

Dividing by (v̂ − v ) and letting v̂ tend to v we obtain:

UB0 (v ) = φ(v )

Since φ(v , c) ∈ [0, 1] we obtain for every v ∈ [v , v ]:

UB (v ) ≥ UB (v )

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 72 / 79
We therefore conclude that the only relevant (IR) constraint is:

UB (v ) ≥ 0

Notice that since for every v̂ > v we have:

(v̂ − v ) φ(v̂ ) ≥ (v̂ − v ) φ(v )

we also obtain that:


dφ(v )
≥0
dv
Symmetrically for the seller we can prove that (IC) constraint implies:

dφ(c)
≤0
dc
Consider now the differential equation obtained above:

UB0 (v ) = φ(v )

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 73 / 79
Integrating it we obtain:
Z v
UB (v ) = UB (v ) + φ(ν)dν
v

and symmetrically for the seller we obtain:


Z c
US (c) = US (c) + φ(γ)dγ
c

By budget balancing we now get:

0 = Ec [t(c)] − Ev [t(v )] =
Z c Z c 
= φ(c) c + φ(γ)dγ pS (c) dc + US (c) +
c c

Z v Z v 
+ φ(ν)dν − v φ(v ) pB (v )dv + UB (v )
v v

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 74 / 79
Integrating by parts we get:

US (c) + UB (v ) =
Z c 
PS (c)
= − c+ φ(c) pS (c) dc +
c pS (c)

v  
1 − PB (v )
Z
+ v− φ(v ) pB (v )dv
v pB (v )

or
US (c) + UB (v ) = Ec,v [φ(c, v ) (JB (v ) − JS (c))]

Since (IR) is such that US (c) ≥ 0 and UB (v ) ≥ 0 then:

Ec,v [φ(c, v ) (JB (v ) − JS (c))] ≥ 0

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 75 / 79
Sufficiency is a bit more complex to prove it requires us to solve the
partial differential equation that is represented by the FOC of the (IC)
constraints.

The parties’ ex-ante problem is now:

max Ec,v [φ(c, v ) (v − c)]


φi

s.t. Ec,v [φ(c, v ) (JB (v ) − JS (c))] ≥ 0

dφ(c) dφ(v )
≤ 0, ≥0
dc dv

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 76 / 79
Ignoring monotonicity conditions and denoting µ the lagrange
multiplier of the remaining constraint we get a lagrangian function
that is linear in φi :
   
µ 1 − PB (v ) PS (c)
Ec,v φ(c, v ) (v − c) − −
1−µ pB (v ) pS (c)

The solution is to set φ = 1 if and only if the term in brackets is


strictly positive.

In other words trade occurs if and only if, for µ ≥ 0:


   
µ 1 − PB (v ) µ PS (c)
v− ≥c+
1−µ pB (v ) 1 − µ pS (c)

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 77 / 79
This φ(c, v ) is weakly monotonic in:
 
µ 1 − PB (v )
v−
1−µ pB (v )

and  
µ PS (c)
c+
1−µ pS (c)

Then MHRP implies that both monotonicity conditions are satisfied


and hence local and global (IC) holds.

Clearly if µ > 0 there will be inefficiencies in trade.

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 78 / 79
Theorem (Myerson and Satterthwaite 1983)
If c > v and v > c then necessarily µ > 0.

Proof: Immediate by substituting the efficient probabilities φi into the


constraint of the parties problem and showing that is violated.

Clearly with bilateral asymmetric information the Coase Theorem fails in a


very relevant sense: efficiency is no longer guaranteed by the use of
contracts.

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part8II:
November
Lecture 12011 79 / 79