Mechanism Design

Mechanism Design

Overview

Design better institutions - decide here are a set of actions people can take and the payoffs.

Two problems to overcome:

1. Hidden actions - can't see what people are doing
2. Hidden information - can't figure out information about people

Applied Mechanism Design

• Auctions
• Public Goods

Assume people are rational. And later on extend the model to account for psychological model of people and rules-based model of people.

Hidden Action and Hidden Information

We are designing incentive structures to induce people to take the right kinds of effort.

Hidden Action - you're an employer, how do you know if people put in the right amount of effort.
Also known as moral hazard problem.

The model:

• Action: effort = 0,1
• Outcome = {Good, Bad}
• Prob(Good|effort=1) = 1
• Prob(Good|effort=0) = p
• Cost effort =c

Incentive compatible - Makes sense to put in effort.

Comparative Statics - given a model, try and get some understanding of what happens when variables changes in value.

Auctions

Objective of seller is to get as much money as possible.
Types of Auctions: Ascending price, Second price, Sealed bid.

Roger Myerson developed a Nobel Prize-winning Theorem that with rational bidders, a wide class of auction mechanisms including Ascending price, Second price and Sealed bid produce identical outcomes i.e. the highest bidder wins and pays the price of the second highest bidder.

It doesn't matter which auction mechanism is used if all players are rational.

Clarke-Groves-Vickery Pivot Mechanism

Pay the marginal amount you'd have to contribute for the project to be viable.
However, this mechanism is not balanced i.e.the combined contribution may not be sufficient to pay for the public good.