Correlation and full surplus extraction

Debasis Mishra

April 8, 2020
Optimal auction design

Cremer, J. and McLean, R.P., 1988. Full extraction of the surplus

in Bayesian and dominant strategy auctions. Econometrica,
pp.1247-1257.
Why correlation?

Myerson’s analysis assume types are independently drawn.

This may not be a good assumption if agents have access to the

same information source.

For selling a oil well, bidders conduct their own tests on the field to
estimate value. Quite likely the test results will be correlated.

Does the presence of correlation in types significantly change

Myerson’s result?
Optimal auction design with correlated types

A seller is selling a single object – she has no value for the object.

What mechanism maximizes the expected revenue of the seller if

the types of buyers are correlated?

In complete information: seller extracts full surplus by asking

highest buyer payment ≡ value.

With incomplete information, possible to do so if information is

correlated in a particular way.
Cremer-McLean (CM) lotteries

The seller can always do a Vickrey auction and get expected

second highest value as revenue.

CM question: Can the seller get expected highest value as revenue?

CM solution: participation fee for the Vickrey auction.

Participation fee equal to n1 of difference of expected highest and

expected second highest value can alway allow to extract surplus
without destroying incentive constraints.

Trick is to charge participation fees to maintain IR constraints.

Cremer-McLean (CM) lotteries

When reporting its types, a buyer does not know how much she
has to pay for participation.

Key: design participation fee such that expected participation fee

equals expected payoff of buyer in the auction.

Can we do this for independence too!!! NO.

Participation fee depends on others types.
Expected participation fee independent of type.
Expected payoff will depend on type.

Interim IR will be impossible to satisfy.

The model
n buyers: N is the set of buyers.

Each buyer i’s type is her value vi , which is drawn from some finite
set Vi .

Usual notations: V := V1 × . . . × Vn and V−i = ×j6=i Vj .

Probability that type profile v ≡ (v1 , . . . , vn ) is given by π(v )

(jointly distributed).

Conditional probability: probability that others have types v−i

when i has type vi

π(vi , v−i )
π(v−i |vi ) = P 0
v 0 π(vi , v−i )
−i
DSIC mechanisms
A mechanism (Q, P) is pair where Q Pi : V → [0, 1] is allocation rule
of buyer i with the restriction that j∈N Qj (v ) ≤ 1 for all v ∈ V
and Pi : V → R is the payment rule of buyer i.

A mechanism (Q, P) is dominant strategy incentive compatible

(DSIC) if for every i ∈ N, every v−i ∈ V−i and for every vi , vi0 ∈ Vi ,

vi Qi (vi , v−i ) − Pi (vi , v−i ) ≥ vi Qi (vi0 , v−i ) − Pi (vi0 , v−i ).

A mechanism (Q, P) satisfies interim IR (IIR) if for every i ∈ N

and for every vi ∈ Vi ,
X h i
vi Qi (vi , v−i ) − Pi (vi , v−i ) π(v−i |vi ) ≥ 0.
v−i ∈V−i
Full surplus extraction

An information structure is a pair (V , π): type space and prior on

the type space.

Definition
An information structure (V , π) admits full surplus extraction if
there exists a DSIC and IIR mechanism (Q, P) such that
X X  X
π(v ) Pi (v ) = π(v ) max vi
i∈N
v ∈V i∈N v ∈V

Expected payment of buyers must equal expected highest value

(expected maximum surplus).
Question and answer

What information structures admit full surplus extraction?

What kind of mechanisms allow for full surplus extraction?

Finite type space and a sufficient condition on correlation (“full

rank” condition).

Vickrey auction with a participation fee which depends on the type

of others.
Efficiency is required

Given that we want to achieve full surplus, we must allocate the

object to the highest valued buyer at every type profile.

Given the incentive compatibility is DSIC, we can use some form of

Groves mechanism.

Remind Groves payments: for every i and every (vi , v−i )

pigg (vi , v−i ) = hi (v−i ) −

X
vj Qj∗ (vi , v−i ),
j6=i

where Q ∗ is the efficient allocation.

Efficiency is required
Using ri (v−i ) := hi (v−i ) − maxj6=i vj , we rewrite it as:

pigg (vi , v−i ) = ri (v−i ) + max vj −

X
vj Qj∗ (vi , v−i ),
j6=i
j6=i

So, if i is the highest valued-agent (winner), she pays

ri (v−i ) + max vj
j6=i

If i is not the winner, she pays

ri (v−i )

Interpret ri (v−i ) as a conditional participation fee: buyer i agrees

to pay this once other agents report their types.
Farkas Lemma

Theorem
Let aij and bi be real numbers for each i ∈ {1, . . . , m} and for
each j ∈ {1, . . . , n}. Consider the following two sets.

n
X
F = {x ∈ Rn+ : aij xj = bi ∀ i ∈ {1, . . . , m}}
j=1
m
X m
X
G = {y ∈ Rm : aij yi ≥ 0 ∀ j ∈ {1, . . . , n}, bi yi < 0}.
i=1 i=1

Then, F 6= ∅ if and only if G = ∅. The claim continues to hold if x

is not restricted to be non-negative in F if we make corresponding
constraints in G equality.
Proof: using separating hyperplane theorem.
Example of Farkas Lemma

x1 + x2 + x3 = 2
2x1 − x2 + x3 = 4
x1 − 2x2 − 2x3 = −5
x1 + 3x2 − 4x3 = 3.

Farkas alternative:

2y1 + 4y2 − 5y3 + 3y4 < 0

y1 + 2y2 + y3 + y4 = 0
y1 − y2 − 2y3 + 3y4 = 0
y1 + y2 − 2y3 − 4y4 = 0.
CM Full surplus extraction theorem

Theorem (Cremer-McLean, 1988)

An information structure (V , π) admits full surplus extraction if for
all i ∈ N, there exists no ρi : Vi → R with ρ(vi ) 6= 0 for some
vi ∈ Vi such that
X
ρi (vi )π(v−i |vi ) = 0 ∀ v−i ∈ V−i .
vi ∈Vi

Note: Independent priors cannot satisfy this.

π(v−i |vi ) is independent of vi .
P
So, equation reduces to vi ∈Vi ρi (vi ) = 0.
A ρi which satisfies this can be trivially constructed.
Proof of theorem

Consider Vickrey auction (Q ∗ , P ∗ ). Denote by

Xh i
Ui∗ (vi ) := Qi∗ (vi , v−i )vi − Pi∗ (vi , v−i ) π(v−i |vi ).
v−i

P 0 )= π(v )
Denoting π(vi ) := 0
v−i π(vi , v−i π(v−i |vi ) , we write
X Xh i
Ui∗ (vi )π(vi ) = Qi∗ (v )vi − Pi∗ (v ) π(v ).
vi ∈Vi v ∈V
Proof of theorem

Using the property of Vickrey auction

X X X
π(v ) max vi = π(v ) Qi∗ (vi , v−i )vi
i∈N
v ∈V v ∈V i∈N
Xh X X i
= Ui∗ (vi )π(vi ) + Pi∗ (v )π(v ) .
i∈N vi ∈Vi v ∈V

Full surplus extraction is possible if and only if there exists a DSIC

and IIR mechanism (Q, P) such that
X X Xh X X i
π(v ) Pi (v ) = Ui∗ (vi )π(vi ) + Pi∗ (v )π(v ) .
v ∈V i∈N i∈N vi ∈Vi v ∈V
(1)
Proof of theorem
We now construct the new Groves mechanism by specifying ri
maps. In particular, for every i ∈ N if ri : V−i → R is constructed
as:

X
ri (v−i )π(v−i |vi ) = Ui∗ (vi ) ∀ vi ∈ Vi .
v−i

The sufficient condition in the theorem guarantees such a ri can be

constructed. To see, construct Farkas alternative:
X
ρi (vi )Ui∗ (vi ) < 0 (2)
vi ∈Vi
X
ρi (vi )π(v−i |vi ) = 0 ∀ v−i ∈ V−i . (3)
vi ∈Vi

By our sufficient condition, the only way Equations (3) can be

satisfied if ρ(i)(vi ) = 0 for all vi . But that will mean Equation (2)
cannot hold.
Proof of theorem
Clearly, the new Groves mechanism is DSIC. Since the payment of
agent i at (vi , v−i ) is Vickrey payment and ri (v−i ), its expected
payoff is X
U ∗ (vi ) − ri (v−i )π(v−i |vi ) = 0.
v−i

So, interim IR holds — interim expected utility of each agent is

zero.
Also, for satisfying Equation (1),
X X X X
π(v ) Pi (v ) = π(v ) ri (v−i ) + Pi∗ (v )]
v ∈V i∈N v ∈V i∈N
Xh X X i
= Ui∗ (vi )π(vi ) + Pi∗ (v )π(v ) ,
i∈N vi ∈Vi v ∈V

Hence, full surplus extraction is possible.

Two agents

Suppose two agents with V1 = V2 = X . Then, the CM condition

is there should exist no ρ : X → R with ρ(z) 6= 0 for some z ∈ X
such that
X
ρ(x)π(x|y ) = 0 ∀ y ∈ X.
x∈X

This is equivalent to requiring that the conditional probability

matrix π(x|y ) has full rank.
Comments

CM theorem is for finite type spaces. See McAfee and Reny (1992)
for an infinite type space version.

CM theorem uses DSIC as the solution concept. If we use BIC as

the solution concept, weaker sufficient conditions can be given –
see Cremer and McLean (1988).

The conditional participation fee can be higher than value for some
agents who do not win. So, CM mechanism fails ex-post IR.
However, interim utility is exactly equal to zero.
Comments

The sufficient condition requires priors to be correlated. But

condition is quite synthetic.

Difficult to say how “generic” this class of priors are and what
exact kinds of correlations they allow.

Optimal mechanism design for classes of priors which fail the CM

sufficient conditions is challenging – Myerson’s techniques break
down.

CM mechanism is prior-heavy – constructing participation fees

which are solutions to equations involving priors.

CM full surplus extraction theorem is a benchmark result in

mechanism design.