INFORMATION ECONOMICS AND ITS APPLICATIONS

UNIT –I
Information economics Introduction
Information economics or the economics of information is the branch of
microeconomics that studies how information and information systems affect an
economy and economic decisions.

The information economics generally refers to a branch of information

that indicates how efficiency and profit can be received by new communication
technologies.

Information economics or the economics of information is the branch

of microeconomics that studies how information and information systems affect
an economy and economic decisions.

One application considers information embodied in certain types

of commodities that are "expensive to produce but cheap to reproduce."
Examples include computer software (e.g., Microsoft Windows), pharmaceuticals,
and technical books.

There are several subfields of information economics. Information as signal has

been described as a kind of negative measure of uncertainty.
It includes complete and scientific knowledge as special cases. The first insights in
information economics related to the economics of information goods.
In recent decades, there have been influential advances in the study of information
asymmetries and their implications for contract theory, including market failure as
a possibility.

Information economics is formally related to game theory as two different types of

games that may apply, including games with perfect information, complete
information, and incomplete information. Experimental and game-theory methods
have been developed to model and test theories of information
economics, including potential public-policy applications such as mechanism
design to elicit information-sharing and otherwise welfare-enhancing behavior.
An example of game theory in practice would be if two potential employees are
going for the same promotion at work and are conversing with their employee
about the job. However, one employee may have more information about what the
role would entail then the other. Whilst the less informed employee may be willing
to accept a lower pay rise for the new job, the other may have more knowledge on
what the role's hours and commitment would take and would expect a higher pay.
This is a clear use of incomplete information to give one person the advantage in a
given scenario. If they talk about the promotion with each other in a process called
colluding there may be the expectation that both will have equally informed
knowledge about the job. However the employee with more information may mis-
inform the other one about the value of the job for the work that is involved and
make the promotion appear less appealing and hence not worth it. This brings into
action the incentives behind information economics and highlights non-cooperative
games.

Value of information

The starting point for economic analysis is the observation that information
has economic value because it allows individuals to make choices that yield higher
expected payoffs or expected utility than they would obtain from choices made in
the absence of information. Data valuation is an emerging discipline that seeks to
understand and measure the economic characteristics of information and data.

Principal-Agent Problem

What Is the Principal-Agent Problem?

The principal-agent problem is a conflict in priorities between a person or group
and the representative authorized to act on their behalf. An agent may act in a way
that is contrary to the best interests of the principal.

The principal-agent problem is as varied as the possible roles of a principal and

agent. It can occur in any situation in which the ownership of an asset, or a
principal, delegates direct control over that asset to another party, or agent.

Understanding the Principal-Agent Problem

The principal-agent problem has become a standard factor in political science and
economics. The theory was developed in the 1970s by Michael Jensen of Harvard
Business School and William Meckling of the University of Rochester.
In a paper published in 1976, they outlined a theory of an ownership structure
designed to avoid what they defined as agency cost and its cause, which they
identified as the separation of ownership and control.

This separation of control occurs when a principal hires an agent. The principal
delegates a degree of control and the right to make decisions to the agent. But the
principal retains ownership of the assets and the liability for any losses.

For example, a company's stock investors, as part-owners, are principals who rely
on the company's chief executive officer (CEO) as their agent to carry out a
strategy in their best interests.

That is, they want the stock to increase in price or pay a dividend, or both. If the
CEO opts instead to plow all the profits into expansion or pay big bonuses to
managers, the principals may feel they have been let down by their agent.

There are a number of remedies for the principal-agent problem, and many of them
involve clarifying expectations and monitoring results. The principal is generally
the only party who can or will correct the problem.

What Causes the Principal-Agent Problem?

Agency Costs

Logically, the principal cannot constantly monitor the agent’s actions. The risk that
the agent will shirk a responsibility, make a poor decision, or otherwise act in a
way that is contrary to the principal’s best interest can be defined as agency costs.
Additional agency costs can be incurred while dealing with problems that arise
from an agent's actions. Agency costs are viewed as a part of transaction costs.

Agency costs may also include the expenses of setting up financial or other
incentives to encourage the agent to act in a particular way. Principals are willing
to bear these additional costs as long as the expected increase in the return on the
investment from hiring the agent is greater than the cost of hiring the agent,
including the agency costs.

Solutions to the Principal-Agent Problem

There are ways to resolve the principal-agent problem. The onus is on the principal
to create incentives for the agent to act as the principal wants. Consider the first
example, the relationship between shareholders and a CEO.
Contract Design

The shareholders can take action before and after hiring a manager to overcome
some risks. First, they can write the manager's contract in a way that aligns the
incentives of the manager with the incentives of the shareholders. The principals
can require the agent to regularly report results to them. They can hire outside
monitors or auditors to track information. In the worst case, they can replace the
manager.

Designing a contract involves linking the interests of the principal and agent by
tackling issues such as misaligned information, setting methods to monitor the
agents, and incentivizing the agent to act in the best way possible for the principal.

Performance Evaluation and Compensation

Compensation is always a motivating factor and a high priority for an agent.

Linking compensation to certain criteria, such as a performance evaluation, can
ensure that the agent performs at a high level if their compensation depends on it.
This is almost a surefire way to align the interests of both the principal and the
agent.

Methods of agent compensation include stock options, deferred-compensation

plans, and profit-sharing. In these methods, if the agent performs well, they will
see a direct benefit; if they do not, they will be hurt financially.

At its root, it's the same principle as tipping for good service. Theoretically, tipping
aligns the interests of the customer-the principal, and the agent- the waiter. Their
priorities are now aligned and are focused on good service.

Examples of the Principal-Agent Problem

The principal-agent problem can crop up in many day-to-day situations beyond the
financial world.

A client who hires a lawyer may worry that the lawyer will wrack up more billable
hours than are necessary.

A homeowner may disapprove of the City Council's use of taxpayer funds.

A home buyer may suspect that a realtor is more interested in a commission than in
the buyer's concerns.
In all of these cases, the principal has little choice in the matter. An agent is
necessary to get the job done.

What Is a Principal-Agent Problem Example?

A common example of the principal-agent problem is that of C-level managers and
shareholders. C-level managers may make decisions in their best interest that are
not in the best interest of shareholders. This could involve enacting certain
policies, making deals with politicians, and so on, that may hurt the company but
benefit the manager. Tying the C-level manager's compensation to the performance
of the company would be a way to overcome this conflict.

What Causes the Principal-Agent Problem?

The primary cause of the principal-agent problem is agency costs. These costs arise
due to the inability of the principal to constantly monitor the work of the agent,
which could result in the agent avoiding responsibilities, making poor decisions, or
acting in a way contrary to the benefit of the principal.

What Is a Good Way to Overcome the Principal-Agent Problem?

A good way to overcome the principal-agent problem is by aligning the interests of
both the principal and the agent and removing any conflict of interest. One of the
best ways to do this is by aligning the compensation of the agent to a performance
evaluation. If the agent performs well, they will see a direct financial benefit; if
they perform poorly, the opposite will be true. Methods to achieve a link between
performance and compensation are stock options, deferred-compensation plans,
and profit sharing.

Information asymmetry
Information asymmetry means that the parties in the interaction have different
information, e.g. one party has more or better information than the other.
Expecting the other side to have better information can lead to a change in
behavior.

The less informed party may try to prevent the other from taking advantage of him.
This change in behavior may cause inefficiency.
Examples of this problem are selection (adverse or advantageous) and moral
hazard.

Hidden Action( Moral Hazard)

Hidden Action is related to moral hazard problem of the Asymmetric information.

Here the principal cannot monitor or does not have full knowledge regarding the
agent's action or activities.
An example will be the Principal Agent problem, where the Agent can shirk the
duties and principal may be unaware of this action.

Moral hazard refers to hidden actions because, in such cases, the informed side
may take the 'wrong' action.

Hidden actions and moral hazard – Medical care, doctor visits. – Employment
– shirking – Insurance: risky driving, car rental.

UNIT –II

Adverse selection (Hidden Information)

Hidden Information is related to adverse selection problem. Here one party does
not have the same level of information as that of the other party in a transaction.
An example will be the Lemon's problem, where the buyers do not know which a
plum (good quality car) is and which is a lemon (bad quality car).
Adverse selection occurs when one side of the partnership has information the
other does not and this can occur deliberately or by accident due to poor
communication.

For example, George Akerlof's The Market for Lemons.

Lemon Problem

The most common example of the Lemons Market is in the automobile industry.
As suggested by Akerlof, there are four car types that a buyer could consider. This
includes choosing either a new or used car, and choosing a good or bad car, or
Lemon as it is more commonly known.
When considering the market options there is possibility of purchasing a new
lemon car as there is a used good car.

The uncertainty that arises from the probably of purchasing a lemon due to
asymmetric information can cause the buyer to have doubts about the car's quality
and inherent outcome when purchased.

This same dilemma exists in a multitude of markets where sellers have an

incentive to not disclose information about their product if it is poor quality due to
knowledge that the average standard across the industry from good products
existing will boost their selling power.

The asymmetrical information known about the car's quality can lead to a
breakdown in the autombile industry's overall efficiency.

This is due to two reasons. Firstly, uncertainty between the buyers and sellers and
secondly in the broader market where only sellers with below average vehicles will
be willing to sell due to the reduced quality being represented.

There are two primary solutions for adverse selection; signaling and
screening.

Moral hazard includes a partnership between a principal and agent and occurs
when the agent may change their behaviour or actions after a contract has been
finalised which can cause adverse consequences for the principal.
Moral hazard is present when there is a change in the agents behavior after taking
out insurance cover to protect them.

For example, if someone purchased car insurance for their vehicle and afterwards
held their responsibility to a lower standard by going over the speed limit for
example or generally driving recklessly.

For moral hazard, contracting between principal and agent may be describable as
a second best solution where payoffs alone are observable with information
asymmetry.

Insurance covers will often include a waiting period clause to refrain agents from
changing their attitude.

Signaling

Michael Spence originally proposed the idea of signaling.

He proposed that in a situation with information asymmetry, it is possible for
people to signal their type, thus credibly transferring information to the other party
and resolving the asymmetry.

This idea was originally studied in the context of looking for a job. An employer is
interested in hiring a new employee who is skilled in learning. Of course, all
prospective employees will claim to be skilled at learning, but only they know if
they really are. This is an information asymmetry.

Spence proposed that going to college can function as a credible signal of an

ability to learn. Assuming that people who are skilled in learning can finish college
more easily than people who are unskilled, then by attending college the skilled
people signal their skill to prospective employers.

This is true even if they didn't learn anything in school, and school was there solely
as a signal. This works because the action they took (going to school) was easier
for people who possessed the skill that they were trying to signal (a capacity for
learning).

Screening

Joseph E. Stiglitz pioneered the theory of screening.

Screening refers to the actions of an uninformed party to push the informed party
to reveal private information. Often there are inefficiencies in markets that are
caused by asymmetric information.
Screening helps the market become more efficient by making information
available to everyone involved in a transaction.

In this way the under informed party can induce the other party to reveal their
information. They can provide a menu of choices in such a way that the optimal
choice of the other party depends on their private information.
By making a particular choice, the other party reveals that he has information that
makes that choice optimal.

For example, an amusement park wants to sell more expensive tickets to customers
who value their time more and money less than other customers.
Asking customers their willingness to pay will not work - everyone will claim to
have low willingness to pay.
But the park can offer a menu of priority and regular tickets, where priority allows
skipping the line at rides and is more expensive.
This will induce the customers with a higher value of time to buy the priority ticket
and thereby reveal their type.
Screening Examples
There are many screening examples. Let's consider an auto insurance company as a
screening example.

Take, for instance, a company that deals in auto insurance. The company aims to
charge cheap premium deals to those drivers who have a lower risk of getting into
an accident and charge higher premiums to those drivers who have a higher risk of
getting into an accident. How does the company measure the risk of a person
getting into an accident?

Instead of taking the driver's word for it, the insurance company conducts
extensive research on the driver's background and the amount and types of
accidents they've had in the past. In this way, it determines the risk that the driver
has of getting into an accident. The process of doing the background check for the
driver and estimating a risk associated with them is known as screening.
The screening process then enables the company to differentiate between drivers
and offer insurance packages accordingly. Screening allows the company to
increase its profit and reduce costs.

If the driver is risky, in the event of an accident, they may already have paid the
insurance company enough to cover the expense. However, if it wasn't for
screening, and the insurance company had no idea of the risk associated with the
driver, it would have resulted in a much higher cost for the company.

Risk and Uncertainty of Information

Fluctuations in the availability and accuracy of information can induce some level
of risk and uncertainty.

Difference between Risk and Uncertainty

Risk is defined by the circumstances under which the probability of every outcome
is known by the decision-making individual and that, among all possible outcomes,
it is not fully certain which will occur.
In contrast, uncertainty refers to the situation whereby the probability of every
outcome is unknown and cannot be accurately estimated thus, individuals will
often lack sufficient economic information to make an informed decision.

Risk Attitudes

Risk attitude directly influences the behavior of economic agents during decision-
making under uncertainty by altering the individuals’ perception towards the
valuation and reliability of information within the market.
Stakeholders, particularly managers, will often demonstrate different risk attitudes
which dictate their decision-making towards a variety of investments.
Risk attitude is classified under three main categories: risk aversion, risk
neutrality and risk-seeking dispositions.
Risk-averse managers have a tendency to prefer investments with a low degree of
uncertainty that generates relatively lower expected returns, as opposed to those
with a high degree of uncertainty that generates relatively higher expected returns.
They are more likely to choose a decision with a guaranteed outcome that has
minimal risk, even if that meant foregoing a payoff that is potentially higher.
Risk-neutral managers primarily focus on maximizing the expected outcome
irrespective of the level of risk. This indifference fuels their inclination to pursue
risky investment decisions only if the potential payoff was greater than the
potential losses.

While, risk-seeking managers have the tendency to prefer investments with the
highest potential return, even if that decision meant undertaking a higher degree of
risk.

Information goods

Buying and selling information is not the same as buying and selling most other
goods. There are three factors that make the economics of buying and selling
information different from solid goods:

First of all, information is non-rivalrous, which means consuming information

does not exclude someone else from also consuming it.

A related characteristic that alters information markets is that information has

almost zero marginal cost. This means that once the first copy exists, it costs
nothing or almost nothing to make a second copy. This makes it easy to sell over
and over. However, it makes classic marginal cost pricing completely infeasible.

Second, exclusion is not a natural property of information goods, though it is

possible to construct exclusion artificially. However, the nature of information is
that if it is known, it is difficult to exclude others from its use.

Since information is likely to be both non-rivalrous and non-excludable, it is

frequently considered an example of a public good.

Third is that the information market does not exhibit high degrees of
transparency. That is, to evaluate the information, the information must be
known, so you have to invest in learning it to evaluate it.
To evaluate a bit of software you have to learn to use it; to evaluate a movie you
have to watch it.

Network effects
Carl Shapiro and Hal Varian described Network effect (also called network
externalities) as products gaining additional value from each additional user of that
good or service.
Network effects are externalities in which they provide an immediate benefit
when an additional user joins the network, increasing the network size.

The total value of the network depends upon the total adopters but carries only a
marginal benefit for new users. This leads to a direct network effect for each user's
adoption of the good, with an increased incentive for adoption as other user's adopt
and join the network.
The indirect network effect occurs as a complementary goods benefit from the
adoption of the initial product.

The growth of data is constantly expanding and growing at an exponential rate,

however, the application of this data is far lower than the creation of it.

New data brings about a potential increase in misleading or inaccurate information

which can crowd out the correct information. This increase in unverified
information is due to the easy and free nature of creating online data, disrupting
potential for users from finding sourced and verified data.

Positive and Negative Network Externalities

The importance of network externalities is also due to the complementary nature of

a network’s components. Therefore, depending on the nature of the network effect,
externalities can be two types: positive and negative network externalities.

Positive network externalities:

When individuals, consumer base, or network expects the value of goods and
services to be determined by whom else utilizes them, it is known as positive
network externalities. It exists when the benefits or marginal utility increase as the
number of other users increases. These externalities create a tangibly positive and
desirable influence of the number of consumers on the quality of the goods.

Negative network externality:

Negative network externalities emerge when the advantages decrease as the
number of other users increases. Direct physical consequences are not a part of
indirect network externalities. However, it also depends on the number of users,
same as positive externalities except in a different way. The impact or influence as
a consequence of an event’s occurrence is negative here. It results in an
undesirable outcome.

Example
Given below are two network externalities examples:

Suppose a company, xyz launched a product, a tablet. The tablet comes with the
latest technology and a cool feature that can transfer charge within a few seconds
to another device of the same specification. People who are into gaming will have
their devices charged frequently. When this feature comes, they can easily charge
without missing out on the game. It’s design was to make people’s life easier and
safer. This feature will increase the number of people who buy the phone. As new
users come in, innovations to existing devices take place. This is an example
of positive network externalities.

Similarly, if xyz stocks are listed on the securities exchange market and another
company, its competitor, listed its shares bearing the news of high tax dividends
given to their shareholders. Naturally, there will be a shift in investors happening.
The share prices of xyz are most likely to fall as there is a high chance of investors
selling their shares to invest in the other company that is more profitable in the
current scenario. This is a negative externality.

Critical mass

As new networks are developed, early adopters form the social dynamics of the
greater population and develop product maturity known as Critical mass.

Product maturity is when they become self-sustaining and is more likely to occur
when there are positive cash flows, consistent revenue flows, customer retention
and brand engagement.
To form a following, low initial prices need to be offered, along with widespread
marketing to help create the snowball effect.
Types of Equilibrium
•A pooling equilibrium is an equilibrium in which all types of sender send the
same message.
• A separating equilibrium is an equilibrium in which all types of sender send
different messages.
• A partially separating/pooling equilibrium is an equilibrium in which some types
of sender send the same message, while some others sends some other messages.

A pooling equilibrium in game theory is an equilibrium result of a signaling

game.
In a signaling game, players send actions called "signals" to other players in the
game.

Signaling actions are chosen based on privately held information (not known by
other players in the game). These actions do not reveal a player's "type" to other
players in the game, and other players will choose strategies accordingly. Under
this equilibrium, all types of a given sender will send the same signal, some
representing their true type, some correctly mimicking the type of others, as they
have no incentive to differentiate themselves.

The receiver therefore acts like having received no information/message

maximizing his/her utility according to his/her prior belief.

In signaling games, a separating equilibrium is a type of perfect Bayesian

equilibrium where agents with different characteristics choose different actions.

Cheap Talk

In game theory, cheap talk is communication between players that does not directly
affect the payoffs of the game. Providing and receiving information is free. This is
in contrast to signaling in which sending certain messages may be costly for the
sender depending on the state of the world.
This basic setting set by Vincent Crawford and Joel Sobel has given rise to a
variety of variants.
To give a formal definition, cheap talk is communication that is:

1. costless to transmit and receive

 2. non-binding (i.e. does not limit strategic choices by either party)
3. unverifiable (i.e. cannot be verified by a third party like a court)
Therefore, an agent engaging in cheap talk could lie with impunity, but may
choose in equilibrium not to do so.
 UNIT –III
Price Discrimination

A pricing strategy that charges consumers different prices for the

identical good or service

What is Price Discrimination?

Price discrimination refers to a pricing strategy that charges consumers different

prices for identical goods or services.

Different Types of Price Discrimination

1. First Degree Price Discrimination

Also known as perfect price discrimination, first-degree price discrimination

involves charging consumers the maximum price that they are willing to pay for a
good or service. Here, consumer surplus is entirely captured by the firm. In
practice, a consumer’s maximum willingness to pay is difficult to determine.
Therefore, such a pricing strategy is rarely employed.

2. Second Degree Price Discrimination

Second-degree price discrimination involves charging consumers a different price

for the amount or quantity consumed. Examples include:
 A phone plan that charges a higher rate after a determined amount of
minutes are used
 Reward cards that provide frequent shoppers with a discount on future
products
 Quantity discounts for consumers that purchase a specified number of more
of a certain good

3. Third Degree Price Discrimination

Also known as group price discrimination, third-degree price discrimination
involves charging different prices depending on a particular market segment or
consumer group. It is commonly seen in the entertainment industry.

For example, when an individual wants to see a movie, prices for the same
screening are different depending on if you are a minor, adult, or senior.

Primary Requirements for a Successful Price Discrimination

For a firm to employ this pricing strategy, there are certain conditions that must be
met:

#1 Imperfect competition
The firm must be a price maker (i.e., operate in a market with imperfect
competition). There must be a degree of monopoly power to be able to employ
price discrimination. If the company is operating in a market with perfect
competition, this pricing strategy would not be possible, as there would not be
sufficient ability to influence prices.

#2 Prevention of resale
The firm must be able to prevent resale. In other words, consumers who already
purchased a good or service at a lower price must not be able to re-sell it to other
consumers who would’ve otherwise paid a higher price for the same good or
service.

#3 Elasticity of demand

Consumer groups must demonstrate varying elasticities of demand (i.e., low-

income individuals being more elastic to airplane tickets compared to business
travelers). If consumers all show the same elasticity of demand, this pricing
strategy will not work.

Example of Price Discrimination: Cineplex

The Canadian entertainment company, Cineplex, is a classic example of a firm
using the price discrimination strategy. Depending on the age demographic, tickets
for the same movie are sold at different prices. In addition, Cineplex charges
different prices on different days (Tuesday being the cheapest and weekends being
the most expensive). The following is a diagram from Cineplex for a movie
screening on a Monday.

As indicated in the diagram above, different age demographics face different prices
for the same screening. This is an example of third-degree price discrimination.

Price Discrimination in Increasing a Firm’s Profitability

Consider a firm that charges a single price for an apple: $5. In such a case, it would
lead to one sale and total revenue of $5:

Now, consider a firm that is able to charge a different price to each customer. For
example:

 $5 for the first consumer

 $4 for the second consumer
 $3 for the third consumer, and so on.

In such a situation, the firm is able to increase its revenues by selling to customers
who were originally not going to purchase, by offering price = each customer’s
willingness to pay. This leads to five sales and total revenue of $5+$4+$3+$2+1 =
$15.
As indicated above, price discrimination allows a firm to reap additional profits
and convert consumer surplus into producer surplus.

Advantages of Price Discrimination

Advantages of this pricing strategy can be viewed from the perspective of both the
firm and the consumer:

The Firm
 Profit maximization: The firm is able to turn consumer surplus into
producer surplus. In a first-degree price discrimination strategy, all
consumer surplus is turned into producer surplus. It also ties into
survivability, as smaller firms are able to better survive if they are able to
offer different prices in times of greater and lower demand.
 Economies of scale: By charging different prices, sales volume is likely to
increase. As a result, firms can benefit from increasing their production
towards capacity and utilizing economies of scale.
The Consumer
 Lower prices: Although not all consumers are winners, consumers that
are highly elastic may gain consumer surplus from the lower prices, due
to price discrimination. For example, at a movie theatre, tickets for
seniors and children are typically priced at a discount to adult tickets.

Disadvantages of Price Discrimination

 Higher prices: As indicated above, some consumers will face lower prices
while others will face higher prices. Consumers that face higher prices (i.e.,
consumers who purchase airline tickets during peak season) are
disadvantaged.
 Reduction in consumer surplus: The pricing strategy reduces consumer
surplus and transfers money from consumers to producers, leading to
inequality.

Screening

Screening in economics refers to a strategy of combating adverse selection – one of

the potential decision-making complications in cases of asymmetric information –
by the agent(s) with less information.
For the purposes of screening, asymmetric information cases assume two economic
agents, with agents attempting to engage in some sort of transaction. There often
exists a long-term relationship between the two agents, though that qualifier is not
necessary. Fundamentally, the strategy involved with screening comprises the
“screener” (the agent with less information) attempting to gain further insight or
knowledge into private information that the other economic agent possesses which
is initially unknown to the screener before the transaction takes place.
In gathering such information, the information asymmetry between the two agents
is reduced, meaning that the screening agent can then make more informed
decisions when partaking in the transaction.
Industries that utilize screening are able to filter out useful information from false
information in order to get a clearer picture of the informed party. This is important
when addressing problems such as adverse selection and moral hazard.
Moreover, screening allows for efficiency as it enhances the flow of information
between agents as typically asymmetric information causes inefficiency.
Screening is applied in a number of industries and markets.
The exact type of information intended to be revealed by the screener ranges
widely; the actual screening process implemented depends on the nature of the
transaction taking place.
Often it is closely connected with the future relationship between the two agents.
Both economic agents can benefit through the notion of screening, for example in
job markets, when employers screen future employees through the job interview,
they are able to identify the areas the employee needs further training on.
This benefits both parties as it allows for the employer to maximize from
employing the individual and the individual benefits from furthering their skill set.
The concept of screening was first developed by Michael Spence (1973). It should
be distinguished from signaling – a strategy of combating adverse selection
undertaken by the agent(s) with more information.
Examples
Labor market
Screening techniques are employed within the labor market during the hiring
and recruitment stage of a job application process. In brief, the hiring party (agent
with less information) attempts to reveal more about the characteristics of potential
job candidates (agents with more information) so as to make the most optimal
choice in recruiting a worker for the role.

Interviews are a key screening technique used by hiring parties in a job recruitment
process.
Screening techniques include:

 Application review – the hiring party initially screens applicants by

undertaking a review of their application submission and any responses
received, including an evaluation of their resume and cover letter to reveal
education, experience and fit for the role
 Aptitude testing and assessment – the hiring party may require applicants to
undertake a range of testing exercises (either online or in-person) to reveal
academic or practical abilities
 Interviews – candidates are often required to undertake an interview with a
representative(s) from the hiring party to reveal a range of factors such as
personality traits, verbal communication ability and confidence level
Insurance market
The process of screening customers is highly applicable in the market
for insurance. In general, parties providing insurance perform such activities to
reveal the overall risk level of a customer, and as such, the likelihood that they will
file for a claim. When in possession of this information, the insuring party can
ensure a suitable form of cover (i.e. commensurate with the customer’s risk level)
is provided.
In particular, Michael Rothschild and Joseph Stiglitz conducted research on the
insurance market and how individuals can improve their position in the market
when presented with asymmetric information. Rothschild and Stiglitz found that
individuals (uninformed party) are able to initiate action by extracting information
through screening in order to better position themselves in the market. Insurance
companies (uninformed party) had lacked information on the risk level of
consumers (informed party). Through screening, insurance companies were able to
gain information on the risk level of their consumers, this had been done by
offering incentives to policyholders in order to disclose such information on
customers. This allowed insurance companies to create a range of risk classes in
which their consumers were allocated. Moreover, this allowed insurance
companies to create policy contracts for higher deductibles in exchange for lower
premiums.
Screening techniques include:
 Background check – the party providing insurance obtains information
about the customer such as their criminal history, credit rating and previous
employment to reveal past behaviors

 Provision of demographic information – the party providing insurance

obtains information about the customer such as their age, gender and ethnicity
to reveal their type. For example, a young male has a higher risk of being in a
car accident than a middle-aged woman
Other information gathered by insurance parties during a screening process is
usually specific to the type of insurance the customer is seeking. For example, car
insurance will require provision of accident history, health insurance will require
provision of health condition and previous illnesses, and so on.

Moral hazard:
Moral hazard take place when one party engages in actions that harm the other
party. The chance of moral hazard can occur especially in insurance
companies,[8] in which one party takes part in risky behaviour as they have
insurance coverage and therefore will benefit from being compensated by the
insurance company. In this case, the insurance company is the uninformed party,
however, through screening processes such as historic behaviour, therefore,
insurance companies are able to identify those individuals in order to offer a
different insurance plan.
Product market
Businesses apply screening techniques when generating and adapting a new
product idea.[9] Once businesses have developed product ideas, screening
processes are used in order to determine how well the product will do in the
market. In this scenario, businesses are the uninformed party whilst consumers are
the informed party, however, in order to understand what consumers are looking
for in products, businesses deploy screening techniques to get a detailed idea.
Screening techniques include:
 Research and development - businesses take feedback from consumers based
on prior products or products similar to one currently being developed to find
what areas to improve on as well as how to create a point of difference to
establish an innovative product that yields high return. Moreover, this allows
businesses to identify consumer needs, the profitability of the idea and where
the product fits in the market.
 Test marketing - the party providing the product obtains information from a
group of individuals that represent the product market in order to understand
how well the product will do in the market as well as how much individuals
value the product. This screening process allows businesses to further
understand how to market the product to appeal to individuals as well as gain
information on the product market.
 Product launch - product launching is a screening process as it allows
businesses to gain further information on how the product will do in the market
as the product launch stage is the beginning of the product life cycle. Moreover,
based on how the product does in the market as well as the feedback provided
 by consumers, businesses are able to gain further information on what areas of
the product need to be improved.
Other techniques
Second-degree price discrimination is also an example of screening, whereby a
seller offers a menu of options and the buyer's choice reveals their private
information. Specifically, such a strategy attempts to reveal more information
about a buyer’s willingness to pay. For example, an airline offering economy,
premium economy, business and first class tickets reveals information regarding
the amount the customer is willing to spend on their airfare. With such
information, firms can capture a greater portion of total market surplus.
Incorrect Screening
One downfall of deploying screening techniques is the information gathered may
be incorrect, this can therefore lead to inefficiency. For example, an unproductive
employee may perform well in screening exams such as aptitude testing. However,
as the employer is the uninformed party, they will not be able to notice these
aspects until the individual has been employed, and therefore, the time and effort
put into the employee causes inefficiency. Hence, it is important for industries to
understand the biases involved when utilising screening techniques.
Incorrect Screening in the Insurance Market
Typical screening processes in the insurance market involve looking at historic
data and demographic information, however, these screening processes may lead to
incorrect conclusions. For example, a young male would typically be seen as high
risk however, this may not truly be reflected as they could be a safe driver.
Therefore, insurance companies need to ensure that further information is gathered
prior to concluding what category individuals suit.
Contract theory
In contract theory, the terms "screening models" and "adverse selection models"
are often used interchangeably.
An agent has private information about his type (e.g., his costs or his valuation of
a good) before the principal makes a contract offer. The principal will then offer
a menu of contracts in order to separate the different types. Typically, the best type
will trade the same amount as in the first-best benchmark solution (which would be
attained under complete information), a property known as "no distortion at the
top". All other types typically trade less than in the first-best solution (i.e., there is
a "downward distortion" of the trade level).
Optimal auction design (more generally known as Bayesian mechanism design)
can be seen as a multi-agent version of the basic screening model. Contract-
theoretic screening models have been pioneered by Roger Myerson and Eric
Maskin.
They have been extended in various directions. For example, it has been shown
that, in the context of patent licensing, optimal screening contracts may actually
yield too much trade compared to the first-best solution. Applications of screening
models include regulation, public procurement, and monopolistic price
discrimination.
Contract-theoretic screening models have been successfully tested in laboratory
experiments and using field data.

What Is a Monopoly?

A monopoly is a market structure where a single seller or producer assumes a

dominant position in an industry or a sector. Monopolies are discouraged in free-
market economies as they stifle competition and limit substitutes for consumers.

In the United States, antitrust legislation is in place to restrict monopolies, ensuring

that one business cannot control a market and use that control to exploit its
customers.

KEY TAKEAWAYS
 A monopoly is a market structure that consists of only one seller or
producer.
 A monopoly limits available substitutes for its product and creates barriers
for competitors to enter the marketplace.
 Monopolies can lead to unfair consumer practices.
 Some monopolies such as those in the utility sector are government
regulated.

What's a Monopoly?

Understanding a Monopoly
A monopoly is a business that is characterized by a lack of competition within a
market and unavailable substitutes for its product. Monopolies can dictate price
changes and create barriers for competitors to enter the marketplace.

Companies become monopolies by controlling the entire supply chain, from

production to sales through vertical integration, or buying competing companies in
the market through horizontal integration, becoming the sole producer.

Monopolies typically reap the benefit of economies of scale, the ability to produce
mass quantities at lower costs per unit.

Types of Monopolies
The Pure Monopoly
A pure monopoly is a single seller in a market or sector with high barriers to entry
such as significant startup costs whose product has no substitutes.

Microsoft Corporation was the first company to hold a pure monopoly position on
personal computer operating systems. As of 2022, its desktop Windows software
still held a market share of 75%.

Monopolistic Competition
Multiple sellers in an industry sector with similar substitutes are defined as
having monopolistic competition. Barriers to entry are low, and the competing
companies differentiate themselves through pricing and marketing efforts.

Their offerings are not perfect substitutes, such as Visa and MasterCard. Other
examples of monopolistic competition include retail stores, restaurants, and hair
salons.

The Natural Monopoly

A natural monopoly develops in reliance on unique raw materials, technology, or
specialization. Companies that have patents or extensive research and development
costs such as pharmaceutical companies are considered natural monopolies.

Public Monopolies
Public monopolies provide essential services and goods, such as
the utility industry as only one company commonly supplies energy or water to a
region. The monopoly is allowed and heavily regulated by government
municipalities and rates and rate increases are controlled.
Pros and Cons of a Monopoly
Without competition, monopolies can set prices and keep pricing consistent and
reliable for consumers. Monopolies enjoy economies of scale, often able to
produce mass quantities at lower costs per unit. Standing alone as a monopoly
allows a company to securely invest in innovation without fear of competition.

Conversely, a company that dominates a sector or industry can use its advantage to
create artificial scarcities, fix prices, and provide low-quality products. Consumers
must trust that a monopoly operates ethically due to limited or unavailable
substitutes in the market.

What Companies Have Faced Antitrust Violations as a Monopoly?

In 1994, Microsoft was accused of using its significant market share in the
personal computer operating systems business to prevent competition and maintain
a monopoly. Using Antitrust legislation, Microsoft was accused of "using
exclusionary and anticompetitive contracts to market its personal computer
operating system software. By these contracts, Microsoft has unlawfully
maintained its monopoly of personal computer operating systems and has an
unreasonably restrained trade."

A federal district judge ruled in 1998 that Microsoft was to be broken into two
technology companies, but the decision was later reversed on appeal by a higher
court. Microsoft was free to maintain its operating system, application
development, and marketing methods.

What Is Price Fixing?

Price fixing is an agreement among competitors to raise, lower, maintain, or
stabilize prices or price levels. Antitrust laws require that each company establish
prices and other competitive terms on its own, without agreeing with a competitor.
Consumers make choices about what products and services to buy and expect that
the price has been determined based on supply and demand, not by an agreement
among competitors.

How Do Antitrust Laws Protect Consumers?

Antitrust cases can be prosecuted by state or federal governments. Consumers who
suspect a company is violating antitrust laws can contact the Antitrust Division or
Federal Trade Commission at the federal level. A local company operating within
one state can be investigated by the Attorney General of the state.

The Bottom Line

A monopoly is defined as a single seller or producer that excludes competition
from providing the same product. A monopoly can dictate price changes and
creates barriers for competitors to enter the marketplace. Antitrust legislation is in
place to restrict monopolies, ensuring that one business cannot control a market
and use that control to exploit its customers.
 UNIT –IV

What Is Mechanism Design Theory?

Mechanism design theory is an economic theory that seeks to study the
mechanisms by which a particular outcome or result can be achieved.

KEY TAKEAWAYS
 Mechanism design theory is an economic framework for understanding how
businesses can achieve optimal outcomes when individual self-interest and
incomplete information may get in the way.
 The theory is derived from game theory and accounts for individual
incentives and motivations, and how these can work for the benefit of a
company.
 The theory's creators were awarded the Nobel Memorial Prize in Economic
Sciences in 2007.

Understanding Mechanism Design Theory

Mechanism design is a branch of microeconomics that explores how businesses
and institutions can achieve desirable social or economic outcomes given the
constraints of individuals' self-interest and incomplete information. When
individuals act in their own self-interest, they may not be motivated to provide
accurate information, creating principal-agent problems.

In particular, mechanism design theory allows economists to analyze, compare,

and potentially regulate certain mechanisms associated with the achievement of
particular outcomes that focuses on how businesses and institutions can achieve
desirable social or economic outcomes given the constraints of individuals' self-
interest and incomplete information.

Mechanism design takes private information and incentives into account to

enhance economists' comprehension of market mechanisms and shows how the
right incentives (money) can induce participants to reveal their private information
and create an optimal outcome.

Mechanism design theory is thus used in economics to study the processes and
mechanisms involved with a particular outcome. The concept of mechanism design
theory was broadly popularized by Eric Maskin, Leonid Hurwicz, and Roger
Myerson. The three researchers received a Nobel Memorial Prize in Economic
Sciences in 2007 for their work on the mechanism design theory and were branded
as foundational leaders on the subject.

Revelation Principle
The revelation principle of economics is that truth-telling, direct revelation
mechanisms can generally be designed to achieve the Bayesian Nash equilibrium
outcome of other mechanisms; this can be proven in a large category of mechanism
design cases. Put into other words, the revelation principle holds that there is a
payoff-equivalent revelation mechanism that possesses an equilibrium in which
players truthfully report their types to any Bayesian game.

Game Theory: Bayesian Games and Nash Equilibrium

A Bayesian game has the most relevance in the study of economic game theory,
which is essentially the study of strategic decision-making. A Bayesian game in
one in which the information about the characteristics of the players, otherwise
known as the player's payoffs, is incomplete. This incompleteness of information
means that in a Bayesian game; at least one of the players is uncertain of the type
of another player or players.

In a non-Bayesian game, a strategic model is considered an if every strategy in that

profile is the best response or the strategy that produces the most favorable
outcome, to every other strategy in the profile. Or in other words, a strategic model
is considered a Nash equilibrium if there exists no other strategy that a player
could employ that would produce a better payoff given all the strategies are chosen
by the other players.

Bayesian Nash equilibrium, then, extends the principles of the Nash equilibrium to
the context of a Bayesian game which has incomplete information. In a Bayesian
game, Bayesian Nash equilibrium is found when each type of player employs a
strategy that maximizes the expected payoff given the actions of all the types of
other players and that player's beliefs about the types of the other players. Let's see
how the revelation principle plays into these concepts.

Revelation Principle in Bayesian Modelling

The revelation principle is relevant to a modeling (that is, theoretical) context when
there exists:
  two players (usually firms)
 a third party (usually the government) managing a mechanism to achieve a
desirable social outcome
 incomplete information (in particular, the players have types that are hidden
from the other player and from the government)

Generally, a direct revelation mechanism (in which telling the truth is a Nash
equilibrium outcome) can be proven to exist and be equivalent to any other
mechanism available to the government. In this context, a direct revelation
mechanism is one in which the strategies are just the types a player can reveal
about himself. And is it the fact that this outcome can exist and be equivalent to
other mechanisms that comprise the revelation principle. The revelation principle
is used most often to prove something about the whole class of mechanism
equilibrium, by selecting the simple direct revelation mechanism, proving a result
about that, and applying the revelation principle to assert that the result is true for
all mechanisms in that context.

Applicability of Mechanism Design Theory in auctions

All participants of the interview want to reach the best outcome. However, it needs
to be mentioned that two interviewees made an exception and claimed whether an
actual win-win situation is at the end possible, even if a buyer is trying to
accomplish it. At this point, it already needs to be mentioned that it is dependent on
the relationship a buyer is targeting. Beyond that, the interviewees were
distinguishing among two different forms of application of the Mechanism Design.
The first one, the so-called dirty mechanism, is all about a very subjective-driven
and price only focus in which the main target is to get the best price out of the
auction without paying attention to all criteria.

Evident from the interview is that 3 out of 8 interviewees claimed that there has to
be a minimum of two suppliers in the auction to apply a game mechanism. Beyond
that, interviewee 1 and interviewee 3 stated clearly that the ideal number for using
a mechanism such as Bonus-Malus in an auction. Interestingly, all interviewees use
the Mechanism Design Theory for various commodity groups and argue differently
why they do so. For instance, interviewee 2 and 4 claim that they purchase items
on a whole price scale and it depends on what the client wishes to purchase, but do
not give a clear explanation why. Interviewee 3 elaborated it in more detail. She
has claimed that mechanistic approaches are applied in every price-class auction in
her firm, mainly for strategic items. Her reason accordingly is that her firm is a
very established one in the automotive market.

The intermittent nature of renewable energy resources creates extra challenges in

the operation and control of the electricity grid. Demand flexibility markets can
help in dealing with these challenges by introducing incentives for customers to
modify their demand.

Market-based demand-side management (DSM) have garnered serious attention

lately due to its promising capability of maintaining the balance between supply
and demand, while also keeping customer satisfaction at its highest levels.

The use of mechanism design theory seeks to regulate and control the
information available to participants in order to achieve the desired result of
an orderly market. Generally, this requires the monitoring of information and
activity at various levels for exchanges, market makers, buyers, and sellers.

Bidding Behavior
Bid behavior is an analysis of how a demand-side platform (DSP) or a
certain programmatic buyer reacts to bid requests from supply-side platforms
(SSPs). KPIs will include bid rate, bid price, and win rate. Bidding behavior can
give clues as to why a buyer might not be spending as expected and help to
troubleshoot issues.

Auctions
When most people hear the word “auction,” they think of the open-outcry,
ascending-bid (or English) auction. But this kind of auction is only one of many.
Fundamentally, an auction is an economic mechanism whose purpose is the
allocation of goods and the formation of prices for those goods via a process
known as bidding. Depending on the properties of the bidders and the nature of the
items to be auctioned, various auction structures may be either more efficient or
more profitable to the seller than others. Like all well-designed economic
mechanisms, the designer assumes that individuals will act strategically and may
hold private information relevant to the decision at hand. Auction design is a
careful balance of encouraging bidders to reveal valuations, discouraging cheating
or collusion, and maximizing revenues.
William Vickrey first established the taxonomy of auctions based on the order in
which the auctioneer quotes prices and the bidders tender their bids. He established
four major (one-sided) auction types:

(1) the ascending-bid (open, oral, or English) auction;

(2) the descending-bid (Dutch) auction;

(3) the first-price, sealed-bid auction; and

(4) the second-price, sealed-bid (Vickrey) auction.

The Four Basic Auction Types

The most common type of auction, the English auction, is often used to sell art,
wine, antiques, and other goods. In it, the auctioneer opens the bidding at a reserve
price (which may be zero), the lowest price he is willing to accept for the item.
Once a bidder has announced interest at that price, the auctioneer solicits further
bids, usually raising the price by a predetermined bid increment. This continues
until no one is willing to increase the bid any further, at which point the auction is
closed and the final bidder receives the item at his bid price. Because the winner
pays his bid, this type of auction is known as a first-price auction.

The Dutch auction, also a first-price auction, is descending. That is, the
auctioneer begins at a high price, higher than he believes the item will fetch, then
decreases the price until a bidder finally calls out, “Mine!” The bidder then
receives the item at the price at which he made the call. If multiple items are
offered, the process continues until all items are sold. One of the primary
advantages of Dutch auctions is speed. Since there are never more bids than there
are items being auctioned, the process takes relatively little time. This is one reason
they are used in places such as flower markets in Holland (hence the name
“Dutch”).

In the English and Dutch auctions, bidders receive information as others bid (or
refrain from bidding). However, in the third type of auction, known as the first-
price, sealed-bid auction, this is not the case. In this mechanism, each bidder
submits a single bid in a sealed envelope. Then, all of the envelopes are opened
and the highest bidder is announced, and he receives the item at his bid price. This
type of auction is most often used for refinancing credit and foreign exchange,
among other (primarily financial) venues.
The fourth type is the second-price, sealed-bid auction, otherwise known as the
Vickrey auction. As in the first-price, sealed-bid auction, bidders submit sealed
envelopes in one round of bid submission. The highest bidder wins the item, but at
the price offered by the second-highest bidder (or, in a multiple-item case, the
highest unsuccessful bid). This type of auction is rarely used aside from setting the
foreign exchange rates in some African countries.

First Price Sealed-Bid Auction

In a first-price sealed-bid auction, each bidder submits a sealed bid to the seller
(that is hidden from other bidders). The high bidder wins and pays his bid for the
good. Generally, a sealed-bid format has two distinct parts--a bidding period in
which participants submit their bids, and a resolution phase in which the bids are
opened and the winner determined.

When multiple units are being auctioned, the first-price sealed-bid auction is
refered to as a "discriminatory" auction because not all winning bidders pay the
same amount. It works as follows. In a discriminatory auction (more than one unit
for sale), sealed bids are sorted from high to low, and items awarded at highest bid
price until the supply is exhausted. The most important point to remember is that
winning bidders can (and usually do) pay different prices.

Bidding

It is obvious that in a first-price sealed-bid auction, a bidder always bids below her
valuation for the item. If she bids at or above her value, then her payment equals or
exceeds her value if she wins the auction, and therefore her expected profit will be
zero or negative. Since bids are below bidders' values, the first-price sealed bid
auction is not a demand revealing mechanism.

In a first-price sealed-bid auction, there is no sequential interaction among bidders.

Bidders submit the bids only once. Bidders are trading between bidding high and
winning more often, and bidding low and benefiting more if the bid wins. It can be
shown that a symmetric Bayesian Nash Equilibrium in the first-price sealed-bid
auction with risk neutral bidders is that every bidder bids the expected highest
value among their rivals, conditional on the bidder's own value being higher than
all of the rivals' values.
The first price auction is strategically equivalent to the Dutch auction. Unlike in
the second-price and English auctions, it is not a dominant strategy in a first-price
auction to bid your value. However, the theoretically optimal bidding strategy in
both first-price and Dutch auctions is the same for any given bidder.

In a first-price sealed-bid auction, it is advantageous for a bidder to gather

information about the competing bids before deciding on his own bid. Therefore,
the "privacy" issue is essential in this auction format.

Uses

This type of auction is used for refinancing credit and foreign exchange. The U.S.
Treasury uses the discriminatory auction to sell most of the treasury bills, notes,
and bonds that finance the national debt of the United States.

The first-price sealed-bid auction has been used in Japan to sell dried fish. It works
as follows: Bidders deposit their bids in a box which is then handed to an
auctioneer. After some agreed-upon time interval has expired, the auctioneer
announces the winner.

The first-price sealed-bid auction is also used to award construction contracts.

However, there is a difference. In a sealed-bid. There auction awarding a
construction contract, the bidders are sellers rather than buyers before, the winning
bid is the lowest bid. Please see procurement auction.

The Swiss auction is a variation of the first-price sealed-bid auction. What is

unusual about the Swiss auction is that though the bid itself may not be modified,
the winner can choose whether to accept or refuse the item. The name "Swiss
auction" comes from the use of this auction by the Swiss construction industry to
award contracts. Architects argue in favor of this auction technique because
timetables and specifications nearly always require modification and there is no
point in working with a contractor who doesn't want a certain job.

Second-Price Sealed-Bid Auction

In a second-price sealed bid auction, each bidder submits a sealed bid to the seller.
The high bidder wins and pays the second-highest bid for the good. The second-
price auction is a special case of a Vickrey auction. As in other Vickrey auctions, it
is a dominant strategy in a second-price auction for a bidder to bid their true value.

Bidding in second-price sealed-bid auctions

It can be shown that in a second-price sealed bid auction, it is a dominant strategy

for a bidder to bid her true value. The argment is as follows: say there is a bidder
Susie, and Susie's valuation for the item is v. Suppose the highest competing bid is
p. If v is greater than p, then Susie wins the item and earns v-p if she bids her own
value v. No other bids can give Susie better earning. If Susie's value v is less than
p, then the best Susie can do is to bid below p and earn zero dollar. Susie earns
exactly zero dollar by bidding v. Over all, to bid v is the best choice for Susie.
Therefore, sometimes the second-price auction is also called demand revealing
mechanism.

Comparing to the first-price sealed-bid auction and the English auction, the
second-price sealed-bid auction has its comparative advantages. In an English
auction, bidders' bidding strategies are severely affected by closing method.
Whether the auction is run during a fixed time interval plays a key role in the
auction (please see "soft close" vs "hard close"). However, in the sealed-bid
auction, bidders' bidding strategies are not affected by closing method. In a first-
price auction, bidders bid below their values, and therefore the first-price auction is
not a demand revealing mechanism. However, as we mentioned, the second-price
auction is a demand revealing mechanism.

The English auction is strategically equivalent (in theory) to the second-price

auction. While the format of the English auction is quite different, it is also
a dominant strategy in that format for a bidder to bid (up to) their true value before
dropping out. Experimental economists have examined whether this equivalence
(or isomorphism) holds in practice.

One type of cheating in the second-price sealed-bid auction is that the seller spies
on the bids and then inserts a fake bid in order to increase the payment of the
winning bidder. This possibility was pointed out as early as Vickrey's seminal
paper that introduced this type of auction (Please see readings).

Uses
 In the 1970's, U.S. Treasury Department experimented with this type of auction to
sell the national debt.

What is an English Auction?

English auction refers to the process or method of the sale of a single quantity of a
product where the bidding starts with the starting price, which is set by the seller of
the product and increases with the continuous bidding from the different buyers
until the price is reached at a level above which there is no further bidding. This
price will be the selling price of the product under the auction.
Table of contents

 What is an English Auction?

o Explanation
o Features
o Example of English Auction
o Variations
o English Auction Bidding Strategy
o English Auction vs. Dutch Auction
o Drawbacks
o Recommended Articles

Key Takeaways
 English auction means the procedure of a product’s single quantity where
the bidding starts with the starting price fixed by the product’s seller and increases
with the continuous bidding from the different buyers. It increases until the price is
reached above without further bidding. It is the product’s selling price under the
auction.
 The variations of the English auction are English clock variations and time
interval auctions.
 Price step bidding, a higher price or lighthouse bidding, bid cutting, and
bidding by head actions are the strategies of this auction bidding.

Explanation
English auction is the process under which one quantity of a product is listed for
sale. Under this method, all the bidders are aware of each other, and the bids are
placed openly in front of everyone. The process starts with the declaration of the
 opening bid or the reserve price, which the product seller sets. After this, the
interested bidders start placing their respective bids in an ascending order, i.e., the
next bid should be higher than the previous bidder’s price. This process continues
until there is a bid above which any other buyer is not interested in buying the
item. It is the highest bid and the selling price of the product.

Features
 English auction is an open and transparent auction with different bidders,
and each bidder’s value is known to others.
 All the bids should be in ascending order, and the next bidder can place the
bid with an amount higher than the previous bid amount.
 The seller of the product sets the reserve price or the opening bid. So, the bid
below such price is allowed.
 The auction houses set the mechanism of the bid price increment.

Example of English Auction

Mr. A defaulted on the loan taken from the bank. On his inability to repay the loan,
the bank decided to sell off the security attached to the loan, i.e., Mr. A’s house.
So, the bank decided to recover the loan by selling the house through the bidding
process. Bank arranged the auction and advertised the auction so that many bidders
 could come and bid. The bank’s initial price was $ 250,000, which was the current
market value of the house prevailing at the time of auction.

The bidding process started by the host of the bid program declared the initial set
price as $ 250,000 to all the bidders at the auction and asked them to bid further.
One of the bidders placed the bid at $ 265,000, and further bid increased to $
275,000 and then to $ 300,000. After which, no further bid was received. So, the
house was sold to the person who bidded for $ 300,000, and with this, the host
announced the completion of the auction. It is an example of an English auction.

Variations
 First Variation in an English clock auction where the auction completes in a
single day only by arranging the bidding and inviting the bidders to the auction
place. In this type of auction, the bid starts with the lower amount and completes at
the higher amount, and in the end, the winner is announced, and the host
announces the completion of the bid.
 The other type of English auction is time interval auction, which is not
completed in a single day, and it takes a few days to complete the auction. The
auction may be in physical form or online form. The bidders are given the time
frame within which the bid is to be submitted, and then the host will announce the
winner, who is the highest bidder. An example is tendered, contract bidding,
government bidding, etc.

English Auction Bidding Strategy

1. Price Step Bidding – In the price step bidding, the bidding starts with the
lower amount, and slowly and gradually, it increases without any big gap between
the two biddings.
2. Higher Price or Lighthouse Bidding – In this type of bidding, the bidding
starts with the lower amount, and suddenly the buyer bids for the much higher
amount and the small bidders get eliminated.
3. Bid Cutting – In bid cutting, the bid starts as normal, and the same gets
increased mistakenly by one of the bidders. After that, the bidder wants to correct
the bid, so he asks to forbid cutting and bid higher than the previous bid value.
Only the bidder can cut the bidding if the host permits him to do so.
4. Bidding by Head Actions – If the bidder nods the head, it is considered he
is still in bidding, and if he shakes his head, it means he declares by his actions that
he can’t bid further.
 English Auction vs. Dutch auction
 English auction is a type of auction where the bid starts from the lower value
and reaches the highest value. In contrast, in a Dutch auction, the bidding starts
from the highest value and reaches the lower value but not less than the minimum
amount set.
 One can bid from minimum to maximum in English bidding, whereas in
Dutch bidding, one can bid from maximum to minimum.
 The highest price is not set in an English auction, whereas the Dutch
auction is the highest price.

Dutch Auction Meaning

Dutch auction in finance is the process of finding the optimum price at which the
government agency or company wants to sell its assets or securities. The seller
establishes an opening price that steadily decreases until a bid (quantity and cost) is
placed. Unlike typical initial public offerings (IPOs), the Dutch auction
strategy work without underwriters or investment banks.
The auctioneer reduces the asking price until collecting all bids to sell the total
shares in this method, also known as descending or uniform price auction.
Following the submission of all bids, the price with the most bidders becomes the
new offering price for the entire offering. After the price reaches an optimal level,
the remaining bidders must purchase securities at that rate.

Key Takeaways
 In finance, a Dutch auction is a process of determining the best price for a
government agency or firm to sell its assets or securities. Companies frequently
utilize this strategy to go public but do not want underwriters to set the rules.
 The seller chooses the number of shares to be sold and the opening price,
while the bidders determine the selling price.
 The auctioneer begins at the highest offering price and works their way
down until all bids (quantity and cost) have been submitted and all shares have
been sold.
 Unlike traditional IPOs, this technique does not necessitate underwriters or
investment banks.

How Does Dutch Auction Work?

The Dutch auction method allows public and private entities to sell their assets or
securities on their terms, and it is common in initial public offerings (IPOs). It is
often used by a firm that wants to go public but does not wish underwriters to
define its rules. It enables companies to make their IPOs accessible to individual
investors, allowing them to keep an eye on the price fall and submit bids at a
reasonable price.

The seller determines the quantity and opening price of shares to be sold, while the
bidders determine the selling price. First, investors submit bids for their number
and specified price of shares they want to buy and pay. After that, the auction starts
at the highest bid price and goes down until all bids (quantity and cost) are placed,
and all shares are sold. Finally, the auction closes with the last bidder accepting the
going price.

The last or lowest bid becomes the offering price for all shares, which all investors
must pay. As a result, even buyers who bid higher prices for the shares will be able
to purchase the appropriate number of shares for lower per-unit rates.

For example, if investor A places a bid for 10,000 shares at $65 each and investor
B places a bid for 20,000 shares at $50 each, the firm will choose the latter as the
profit would be more by selling more shares at a lower unit price.
The Dutch auction allows individual investors to find the best traditional
offerings. As a result, they benefit more and more by buying shares at lower prices
 and selling them at higher bid prices. Likewise, the U.S. Treasury sells its Treasury
Bills (T-Bills), notes (T-notes), and bonds (T-bonds) using this auction.
Dutch Auction vs Traditional IPO
In the traditional IPO, an investment bank or underwriter determines the price of
shares. These intermediaries define multiple parameters for evaluations and consult
potential investors to decide on the IPO pricing. In contrast, the Dutch auction
helps the entity find the right price in an IPO auction to maintain the supply and
demand balance. That is why it is a more efficient way of going public through
traditional IPOs rather than choosing blank check companies or Special Purpose
Acquisition Companies (SPACs).
Examples

Let us consider the following Dutch auction examples to get a better insight into
the concept:

Example #1
A public entity wants to sell 1 million shares to investors, and hence, it opens the
bids for them. Here are the bids placed:

 Investor A for 100,000 at $65 each

 Investor B for 200,000 at $60 each
 Investor C for 400,000 at $50 each
 Investor D for 100,000 at $70 each
 Investor E for 200,000 at $60 each

The entity chooses the lowest bid with the highest number of shares and finalizes
selling the shares at $50 each. As a result, the shares become available to all
investors at the lowest rate even though they have placed higher bids.

Example #2
In 2004, Google sold approximately 20 million shares with at least five bids. The
aim was to enjoy short-term gains from trading securities. In addition, it allowed its
loyal customers some ownership as part of its reward program. Another reason
behind the Google Dutch auction was to build a strong shareholder base.
Revenue Equivalence Theorem

During last class we studied first and second price auctions in the symmetric
Bayesian setting, and we showed that the revenue and expected payments are
identical in both auctions at the equilibrium. In fact, this is not just a coincidence
but is instead a consequence of the revenue equivalence principle that we will state
below.
In general, consider a direct revelation auction A for a single item and suppose
that A assigns the item to the highest bidder. Then it can be shown that revenue at
equilibrium is the same in all such auctions.
Let us consider two further examples.
• Third price auction: in third price auction, the item is allocated to the highest
bidder who is then charged third highest bid (it is left to the reader as an exercise to
prove that such auction is not truthful). Although this auction is not used in
practice, it is an interesting exercise to study it.
• All-pay auction: again, the item is awarded to the highest bidder. However, each
bidder pays his/her bid even if he/she does not win the item. This type of auction is
used to model lobbying kind of activities where costs/bids are sunk costs.
Revenue Equivalence for One-sided Markets

A question commonly addressed in the economic analysis of auctions is whether

any two auction mechanisms are "revenue equivalent". Two auctions are said to
be "revenue equivalent" if they result in the same expected sales price.

This is an important issue to a seller who wants to hold an auction to sell her item
for the highest possible price. If one type of auction is found to generate higher
average sales revenue, then that auction type will obviously be preferred by the
seller.

The revenue equivalence theorem states that,if all bidders are risk-neutral
bidder and have independent private value for the auctioned items, then all four of
the standard single unit auctions have the same expected sales price (or seller's
revenue).The four standard single unit auctions are the English auction, the Dutch
auction,first-price sealed-bid auction,and the second-price sealed-bid auction.

A more formal description of revenue equivalence

Paul Klemperer gives the following more formal statement (and a complete
treatment in Appendix A) in his paper "Auction Theory: A Guide to the
Literature". (Journal of Economic Surveys v13, n3 (July 1999): 227-86):

Assume each of a given number of risk-neutral potential buyers of an object has a

privately-known signal independently drawn from a common strictly-increasing,
atomless distribution. Then any auction mechanism in which

1. the object always goes to the buyer with the highest signal, and
2. any bidder with the lowest-feasible signal expects zero surplus

yields the same expected revenue (and results in each bidder making the same
expected payment as a function of her signal).

The theorem applies very broadly to auction types, beyond the English, Dutch,
First- and Second-Price auctions, to include nearly any "reasonable" auction
mechanism, and even some peculiar mechanisms such as the All-Pay auction.

Klemperer also points out that the theorem can apply in common value auctions
when the bidders' signals are independent, and that, "The theorem extends to the
case of k > 1 indivisible objects being sold, provided bidders want no more than
one object each; all auctions that give the objects to the k highest-value bidders
are revenue equivalent."

research focus on the issue of revenue equivalence

Tests of the revenue equivalence theorem involve two separate issues. The more
basic issue concerns the strategic equivalence (or isomorphism) of (a) the first-
price and Dutch auctions and (b) the second-price and English auctions. Strategic
equivalence of the auctions in the pair(s)have the same revenue irrespective of
bidders' risk attitudes.Assuming that strategic equivalence is satisfied for both
auction pairs, a second issue concerns the possible revenue equivalence between
auction pairs (a) and (b)
CREDIT RATIONING

Credit rationing – a situation in which lenders are unwilling to advance additional

funds to borrowers at the prevailing market interest rate – is now widely
recognized as a problem arising because of information and control limitations in
financial markets.
This method restricts the flow of credit in undesirable sector & diverts it into the
most desirable sector.

For example: The central bank has raise the maximum ceiling on agriculture
sector to promote the flow of credit in rural sector, this is done to encourage
the activity in agriculture sector.

Credit rationing by definition is limiting the lenders of the supply of

additional credit to borrowers who demand funds at a set quoted rate by the
financial institution.

It is an example of market failure, as the price mechanism fails to bring

about equilibrium in the market. It should not be confused with cases where credit
is simply "too expensive" for some borrowers, that is, situations where the interest
rate is deemed too high.

With credit rationing, the borrower would like to acquire the funds at the current
rates, and the imperfection is the absence of supply from the financial institutions,
despite willing borrowers.

In other words, at the prevailing market interest rate, demand exceeds supply, but
lenders are willing neither to lend enough additional funds to satisfy demand, nor
to raise the interest rate they charge borrowers because they are already
maximizing profits, or are using a cautious approach to continuing to meet their
capital reserve requirements.