LONDON SCHOOL OF ECONOMICS Andrew Ellis

Department of Economics

Problems for Lecture 10

EC202 Microeconomic Principles II

1. Consider dividing an indivisible object. Suppose that buyer 1 values

a good at v1 while buyer 2 values the good at v2 but incurs a cost of 3
utils if buyer 1 gets the good. Both v1 and v2 are distributed uniformly
on [0, 10].
(a) Suppose the object is allocated via a second price auction (with
no reserve price). Does buyer 2 have a weakly dominant strat-
egy? Explain.
Answer: Yes, but it is not to bid her valuation. She bids v2 + 3.
The logic is the same as the 2nd price auction, except losing
gives a payoff of −3, not zero. Hence she would rather pay
b1 ∈ (v2 , v2 + 3) than lose, since v2 − b1 > −3.
(b) What is the efficient allocation rule?
Answer: Give to 1 if v1 − 3 > v2 . Otherwise give to 2
(c) Find the VCG mechanism discussed in class. Verify that it is
incentive compatible.
Answer: The allocation rule x is such that x(v̂1 , v̂1 ) = 1 if v1 −
3 > v2 and otherwise x(v̂1 , v̂2 ) = 2. The transfer is ti (v̂1 , v̂2 ) =
W−i (v̂1 , v̂2 ) − W (v̂−i , 0).
If x(v̂1 , v̂2 ) = 1 (i.e. we give to 1), them W−1 (v̂1 , v̂2 ) = −3 and
W (0, v̂2 ) = v̂2 , so t1 (v̂1 , v̂2 ) = v̂2 − 3. For person 2, W−2 (v̂1 , v̂2 ) =
v̂1 and W (v̂1 , 0) = max(v̂1 − 3, 0) = v̂1 − 3, so t2 = 3.
If x(v̂1 , v̂2 ) = 2 (i.e. we give to 2), then W−2 (v̂1 , v̂2 ) = 0 and
W (v̂1 , 0) = max(v̂1 − 3, 0), so t2 (v̂1 , v̂2 ) = − max(v̂1 − 3, 0). For
person 1, W−1 (v̂1 , v̂2 ) = W (0, v̂2 ) = v̂2 , so t1 (v̂1 , v̂2 ) = 0.
To see it is incentive compatible, note that

v2 (x(v̂1 , v̂2 )) + t2 (v̂1 , v̂2 ) = v2 − max(v̂1 − 3, 0)

when v̂1 − 3 < v̂2 and 3 − 3 = 0 otherwise. Hence 2’s payoff

is constant in v̂2 until it falls below v1 − 3. Hence it is weakly

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 dominant to report v2 for the same reasons as in a second price
auction. If v2 > max(v̂1 − 3, 0), increasing v̂2 does not change
payoff, while decreasing it can hurt. If v2 < max(v̂1 − 3, 0), de-
creasing v̂2 does does not change payoff, while increasing it can
only hurt by sending the payoff from 0 to something negative.
For 1,
v1 (x(v̂1 , v̂2 )) + t1 (v̂1 , v̂2 ) = v1 − v̂2 − 3
when v̂1 > v̂2 − 3 and 0 otherwise. Hence, reporting v1 is weakly
dominant for the same reason as in a second price auction.

2. Recall the Espresso machine problem from lecture. There are two
roommates with values v1 and v2 , distributed independtly. v1 is uni-
formly distributed on the interval [0, 100]. v2 is uniformly distributed
on the interval [10, 110]. The espresso machine costs c = 60.

(a) What is the efficient allocation rule?

Answer: Purchase if v1 + v2 ≥ c
(b) Consider the split-the-cost rule: each roommate says y or n.
The espresso machine is purchased if and only if both say y,
in which case roommate i gets vi − c/2; if not purchased, each
roommate gets 0. Show that the strategy: “y if vi ≥ c/2, other-
wise n” is a weakly dominant strategy.
Answer: If i is expected to play y, then payoff is positive for
some strategies of j (such as y for any value of vj ) and otherwise
0. Deviating to n makes i’s utility identically zero. Similarly, if
i expected to play n, then her utility is zero. Since vi < c2 ,
switching to y can only decrease her utility.
(c) In the split-the-cost rule above, what is the probability that it is
efficient to buy the machine but the machine is not purchased?
Answer: It is efficient to buy the machine if v1 + v2 > c. The
machine is not purchased if v1 < p = c/2 or v2 < p. We can find

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 this probability by computing

P r(v1 < p&v2 ≥ c + v1 ) + P r(v2 < p&v1 ≥ c + v2 )

Z p Z 110 Z p Z 100
= f1 (x) f2 (y)dydx + f2 (x) f1 (y)dydx
0 2p−x 10 2p−x
Z p Z p
(110 − 2p + x) (100 − 2p + x)
= 2
dx + dx
0 100 0 1002
1 1 1
= 2
[(110 − 2p)x + x2 ]px=0 + [(100 − 2p)x + x2 ]px=10
100 2 2
2
p(220 − 4p) + p − 850
=
1000
for p = 30, this is 315/1000
(d) Find the split-the-cost rule that maximizes the probability that
the machine is purchased.
Answer: The machine is purchased if v1 ≥ p1 and v2 ≥ p2 .
Clearly, p2 should exceed 10, the minimum value of v2 . Given
p2 ≥ 10,
100 − p1 110 − p2
P r(v1 ≥ p1 &v2 ≥ p2 ) = .
100 100
Moreover, p1 +p2 = 60 (or else we can increase the probability of
purchase by lower one of the prices). Substituting that in yields

11000 − 100(60 − p1 ) − 110p1 + p1 (60 − p1 ).

Taking the FOC and setting it equal to zero gives p1 = 25 and

p2 = 35. This gives a 9/16 chance that the machine is pur-
chased.
(e) Find the probability it is efficient to purchase the machine. (Op-
tional; Googling “convolution” may be helpful.)
Answer: It is efficient to purchase the machine if v1 + v2 ≥ 60.
We can compute the distribution of v1 + v2 using the convolution
formula:
Z 110
P r(v1 + v2 ≤ x) = f2 (y)F1 (x − y)dy
10

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 For 10 < x < 100:
Z x
f2 (y)F1 (x − y)dy
Z10x
1
= F1 (x − y)dy
100
Z10x
1 (x − y)
= dy
10 100 100
 
1 1 2x
= [(xy − y ]10
10000 2
 
1 1 2
= x − 10x + 50
10000 2

For x = 60, there is a 18 chance that it is inefficient to purchase,

or a 87 chance it is. This is a strictly higher chance than the best
split-the-cost rule, so even the best split-the-cost rule is far away
from efficiency.
(f) Find the VCG mechanism.
Answer: Purchase if and only if v1 + v2 ≥ c. If v1 + v2 < c,
then transfers are 0. The transfer that 1 pays is W−i (v1 , v2 ) −
W (v−i , 0). Then, W−i (v1 , v2 ) = v−i −c and W (v−i , 0) = max{v−i −
c, 0}. Combining, ti (v1 , v2 ) = max{c − v−i , 0}. That is, i pays the
minimum amount needed to fund the coffee machine given the
other’s report. The problem is that the total transfers do not
cover the cost; if both valuations are above c, then t1 = t2 = 0!
So the mechanism runs a deficit. This is bad because it means
someone has to provide a subsidy to make the mechanism run
correctly.
3. A seller has a cost c that equals 0 and 1 with equal probability. A
buyer values the good at v, which equals 21 and 32 with equal prob-
ability. Values and costs are independently distributed. The social
alternatives are X = {trade, don0 t} and both have quasi-linear pref-
erences.
(a) What is the utilitarian alternative for each (c, v) pair?
Answer: Trade if and only v ≥ c.

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 (b) Find the VCG mechanism discussed in class. Verify that it is
incentive compatible.
Answer: Seller reports ĉ as 0 or 1. Buyer reports v̂ 12 or 32 . Then,
if ĉ < v̂, x(ĉ, v̂) = trade. Otherwise, x(ĉ, v̂) = not. We need to
know the value to others. The “worst” type of S is c = 1. The
“worst” type of B is v = 12 . So we use the values to calculate
the alternatives. x∗∗ 3
−S (v̂) = trade when v = 2 ; otherwise not.
x∗∗
−B (ĉ) = trade when c = 0; otherwise not. so:

tS (c, v) = vB (x(c, v)) − V (v, 0)

1
tB (c, v) = vS (x(c, v)) − V ( , c)
2
Let 1E be the indicator function of the set E. then,

tS (ĉ, v) − c1ĉ<v = 1ĉ<v (v − c) − V (v, 1)

so it is a best response for her to report her cost truthfully. Sim-

ilarly,
1
v1v̂>c + tB (c, v̂) = 1v̂>c (v − c) − V ( , c)
2
so it is a best response to report her value.
(c) Calculate the total expected transfers. Does the mechanism run
a surplus or a deficit?
Answer: Plugging in:
3 3 1
tS (1, ) = − = 1
2 2 2
3 3 1
tS (0, ) = − = 1
2 2 2
1
tS (1, ) = 0 − 0 = 0
2
1 1 1
tS (0, ) = − 0 =
2 2 2

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 and for buyer
3
tB (1, ) = −1 − 0 = −1
2
3 1 1
tB (0, ) = −0 − = −
2 2 2
1
tB (1, ) = 0 − 0 = 0
2
1 1 1
tB (0, ) = −0 − = −
2 2 2

The transfers cancel out except in (0, 32 ). There, they total 21 , so

the mechanism runs a deficit. It expects to lose 14 in expectation.
(d) Suppose that the buyer learns her value and then makes a take-
it-or-leave-it offer to the seller. After seeing the offer, the seller
learns her cost and then decides whether to accept or reject it.
Is there a (subgame perfect) equilibrium where trade happens
whenever it is efficient?
Answer: clearly she should only offer 0 or 1, the two possible
values of the seller’s cost. With v = 21 , the only possiblity is 0.
For v = 23 , it’s more interesting. If she offers 1, she gets a payoff
of 32 − 1 = 12 . If she offers 0, she gets a payoff of 23 one half the
time. This has an expected value of 43 , so she prefers it. This is
unique and trade breaks down half the time.
This is a toy version of Myerson-Satterthwaite’s Bilateral trade.
There is no efficient mechanism (IR and IC) that induces the
efficient outcome and is budget balanced. This holds whenever
there is not common knowledge of gains from trade. Here, when
v = 12 and c = 1, both types think it might or might not be efficient
to trade. For instance, the seller thinks c may equal 0 (gains from
trade) or 1 (not efficient to trade).

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