ECON-602

Problem Set 3 - Solutions

1. Fudenberg and Tirole 7.8

(a) Under full information the monopolists problem is

cq 2
max t
t,q 2
To ensure the agent purchase any quantity it must be that u1 0, which implies the
constraint t = q. Substituting this into the monopolists objective gives

cq 2
max q
q 2
2
The first order condition from this maximization gives q = c and t = c .

(b) We can construct a mechanism in which type purchases quantity q with a transfer t and
type purchases quantity q with a transfer of t. The monopolists problem is

q2 q2
max p(t c ) + p(t c )
2 2

s.t.[IR1 ] q t 0
[IR2 ] q t 0
[IC1 ] q t q t
[IC2 ] q t q t

Together, IR1 and IC2 imply IR2 as q t q t 0. We will ignore the IC1 constraint
for now and show that it is satisfied by the solution to the problem without it.

From the IR1 constraint binding we have t = q. From the IC2 constraint, t = t+(q q).
Substituting these back into the objective function, we have

q2 q2
max p(q c ) + p(q + (q q) c )
2 2
The first order conditions differentiating w.r.t. q and q are

1
 p pcq = 0

and

p pcq + p( ) = 0.

From the first we see q = c , and from the second we have q = c p()
pc . Note that the
solution for q is efficient, that is, it matches the solution under full information in part
(a), but the same is not true for the solution to q.

Finally we verify that the IC1 constraint that we ignored is indeed satisfied. Since IC2
holds with equality,

(q q) = (t t)

Since q q, we have

(q q) = (t t)

so q t > q t as desired.

The utility of the type buyer is 0. The utility of the type is

S = q t = q (q + (q q))
()(p)
= pc .

(c) If the consumer buys the alternative technology, he then chooses q to solve

q2
max q c f.
2
This gives

q=
c
2
u= f
2c
2
Given the tariff from part (b) with f < 2c S, the type prefers producing himself
to buying the bundle the monopolist offers which gives utility S. Therefore only type
consumers will buy from the monopolist. Clearly the monopolist could do better if he is
able to sell to the types with another tariff.

In the optimization problem, we must now add another constraint,

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 2
[IR2 ] q t f
2c
Suppose initially f is set so that this constraint just binds at the solution to the original
problem, i.e

2
f= S
2c
As f decreases, the monopolist must keep the new IR20 constraint satisfied by increasing
q or decreasing t. Any change which has the same effect on q t has the same effect on
profits. Each has the same marginal cost as cq = . Because of the second order effect, the
monopolist initially prefers to decrease t. However, eventually this would cause the IC1
constraint to bind as the low consumer would find the type bundle more attractive.
At this point, raising q instead of lowering t has less of an effect on the IC1 constraint
and is preferred.

2. Mas-Collel 23.E.5

(a) The ex-post efficient trading rule will have all the highest valuation agents owning a unit
of the good. i.e., we may have only buyers, only sellers or a mixture of both ending up
with the good, as long as there is some such that all agents with have one unit
of the good and all others do not. The total amount of good is given by the continuum
[1 , 1 ].
(b) Define the following competitive social choice function as follows: Let qS and qD denote
market supply and demand, and be defined as:


2 2 for p 2
qD = 2 p for 2 p 2

0 for p 2

0 for p 1
qS = p 1 for 1 p 1

1 1 for p 1

The market equilibrium price p will cause efficient trade, and will lead to the efficient
outcome described in (a) above. There will be no need for announcements, so that it is
incentive compatible and it is individually rational since a buyer will buy if and only if
p 2 , and a seller will sell if and only if p 1 . This example concludes that for a
continuum of buyers and sellers the Myerson-Satterthwaite Theorem no longer holds.

Mas-Collel 23.F.2
Think of the buyer as the agent, and the monopolist as the principal, in the setting of example
23.F.1. The agents utility is given by u1 (, x, t) = v(x)t (so that a higher results in a higher

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utility level and a higher marginal utility - the latter is the single crossing condition). The
sellers utility is given by u0 (, x, t) = t cx. Using the revelation principle we can concentrate
on a direct mechanism (x(), t()) which solves the sellers problem:

max E[t() cx()]

x(),t()

s.t. (x(), t()) is Bayesian incentive

compatible and individually rational

We now follow the analysis of linear utility in section 23.D [with k = x, and v() = v(x())].
Letting U1 () = v(x())t() denote the utility of type from truth-telling, proposition 23.D.2
implies that the principals problem is equivalent to (recall that v 0 () > 0 so that constraint (i)
can be written as shown below):

max E[v(x()) U () cx()]

x(),U ()

s.t. (i) x() is non-decreasing

Z
(ii) U () = U () + v(x(s))ds for all [, ]

(iii) U () 0 for all [, ]

Following the same steps as in example 23.F.1 the problem becomes:

Z
max [v(x()) cx()]()d U ()
x(),U ()

s.t. (i) x() is non-decreasing

(ii) U () 0

Clearly (ii) will bind at a solution, and using integration by parts the problem becomes:

   
1 ()
Z
max v(x()) cx() ()d
x() ()
s.t. x() is non-decreasing

Ignoring the constraint, and assuming an interior solution we get that the function x() which
solves the problem must satisfy the FOC:

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0 1 ()
v (x()) c = 0 for all [, ]
()

To see that the solution x() is indeed non-decreasing, the same argument as in example 23.F.1
applies here as well. The SOC is satisfied since v 00 () < 0. Note that the highest valuation
consumer is set at the first-best level since we get v 0 (x()) c = 0, but all other consumer
types are distorted (this is a common result in mechanism design problems).

Mas-Collel 23.F.6
Let x = (p, T ) where p is the price and T is the total revenue given to the firm, T = px (p) + t.
Then, ui (x, ) = [x(p)] + T ,and using the notation on page 887 of the text book we obtain
that ui (x, ) = vi (k) + ti , which in turn is equal to v i (k).
(a) The Proposition 23.D.2 tells us that [p(), T ()] is implementable if and only if,
(i) x(p()) is non-decreasing, i.e. p() is non-decreasing,
(ii)
Z
u() = u() + v i (s)ds

Z
= u() x(p(s))ds

Z
= u() x(p(s))ds

(b) The regulator wants to choose [p(), T ()],or equivalently, [p(), u()], to maximize,
" Z ! #
Z
x(s)ds t() + u() ()d,
p()

subject to u() 0 for all , and the two conditions given in part (a) above. Since
u() = T () x(p()) the objective function can be rewritten as

" Z ! #
Z
x(s)ds [u() + x(p()) p()x(p())] + u() ()d
p()
" Z ! #
Z
= x(s)ds [p() ]x(p()) (1 )u() ()d.
p()

Using integration by parts we have,

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 Z Z

u()()d = [u()()] u0 ()()d

Z
=u() + x(p())()d.

Substituting, we want to choose [p(), u()] to solve,

" Z ! #
Z
()
max x(s)ds [p() ]x(p()) (1 )x(p()) ()d
p() ()

s.t. (i) u() 0 (which implies u() 0 for all )

(ii) p() is non-decreasing

Start by setting u() = 0, and lets ignore constraint (ii). Taking the FOC w.r.t p() we
get,

()
x(p()) + x(p()) + (p() )x0 (p()) (1 )x0 (p()) =0
()

rearranging and dividing by x0 (p()) we get,

()
p() = + (1 ) . (1)
()
(
So, () nondecreasing and (1 ) > 0 implies that constraint (ii) is satisfied, and (1) is
the regulators optimal price rule. If = 1 then we want p() = . If, however, > 1, then
we have no solution: for any transfer function t(), we can increase welfare by rasing it
to t() + for > 0.

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