Exam 2007

Questions
1. Consider the following all-pay auction with two symmetric bidders. The
valuation of each bidder is uniformly distributed on the interval [0; 1] and
it is stochastically independent from the valuation of the other bidder.
Each bidder i simultaneously submits a bid bi . The object is awarded to
the bidder with the higher bid (disregard ties). Each bidder i pays his
own bid bi whether he wins the object or not.
(a) Characterize the symmetric Bayesian equilibrium of this auction.
(b) In such equilibrium, what is the expected revenue of the auction?
2. Consider two towns, 1 and 2, and a planner. The planner could build a
road between the two towns at a given cost c > 0. The benet to town i of
having a road is a random variable vi , distributed on [0; 1) with density
function f (vi ). The variables v1 and v2 are identically and independently
distributed. The planner can impose a transfer ti (positive or negative)
on each town i.
Let x = 0 if the road is not built and x = 1 if it is built. Town is payo
is xvi + ti . The planners payo is x (v1 + v2 c) t1 t2 . The planner
knows c but vi is private information of town i.
(a) Characterize the set of Groves mechanisms that implement the allocation that maximizes the planners payo.
(b) Within the set in (a), describe a mechanism in which the two towns
are treated symmetrically (ex ante) and the expected cost to the
planner E [t1 + t2 + xc] is equal to zero.
3. You open a restaurant. The quality of your food can be good or bad and
it is denoted with q 2 f0; 1g with Pr [q = 1] = 21 . Suppose that there is
one potential customer who will visit your restaurant at most once.
Your restaurant oers a starter at price p and an entree at the same price
p. The price is exogenously given at level p > 14 . The utility of the
customer is:
0
q
2q

if he does not eat at your restaurant

if he only eats the starter
if he eats both courses

Before the customer chooses whether to enter your restaurant, you can engage in non-informative advertising. You can choose to spend any amount
m 0 on money burning, which is observable by the customer.
Then, the customer decides whether to enter your restaurant (in which
case he must order the starter). If he does enter your restaurant, he can
also order the entree after he has tasted the starter.
1

(a) Find a threshold p, such that, if and only if p

p there exists a
Bayesian equilibrium in which no money burning occurs and the customer enters the restaurant.
(b) For what values of p p can you nd a perfect Bayesian equilibrium
where money burning occurs in equilibrium?
(c) For what values of p < p can you nd a perfect Bayesian equilibrium
where money burning occurs in equilibrium?

Solutions
1. Answers:
(a) The expected utility of a bidder with valuation vi who bids bi (r) is
i

= Pr [b

(v i )

bi (r)] vi

bi (r)

In a symmetric equilibrium
i

= Pr [v

r] vi

bi (r) = rvi

bi (r)

with foc
b0i (r) = vi
evaluated at r = vi ,
Hence
bi (vi ) =

b0i (vi ) = vi
1
2

vi

x2 dx =

1 2
v + k;
2 i

but it is easy to see that k = 0. Hence bi (vi ) = 12 vi2

(b) The expected revenue of the seller is simply given by
2E [bi (vi )] = E

vi2

vi2 dx =

1
3

(full points for computing the revenue through the Revenue Equivalence Theorem and the expected revenue of the second-price auction).
2. Answers:
(a) There is a dierence between the set-up of this question and the
one presented in lecture. In lecture, we would have written that
the payo of the principal is simply the cost, (t1 + t2 + xc), and
we would have mazimized the sum of all the playerspayos, namely:
x (v1 + v2 c). Here, we write that the principals payo is x (v1 + v2
t1 t2 and we are asked to maximize the principals payo. Still, the
allocation that maximizes the planners payo is the e cient one,
namely build the road if and only if v1 + v2
c. The transfers t1
and t2 are added to the payo generated by that allocation. So, the
two set-ups ask the same question: implement the allocation that
maximizes x (v1 + v2 c).
The dierent set-up generated some understandable confusion among
students. Some thought that they should maximize the sum of the
payos of all players, namely, xv1 + xv2 + x (v1 + v2 c). While this
is an incorrect interpretation of the question, I would not detract
more than ve points from answers that followed this route.
3

c)

First, describe the allocation that maximizes the planners payo:

x = 1 if only if v1 + v2 c.
Second, write down externality transfers:
v^

ti (^
v1 ; v^2 ) =

c+
i
(^
v i)

(^
v i)

if v^1 + v^2 c
if v^1 + v^2 < c

(b) The cost to the planner is

t1 + t2 + xc

=
=

v2

c+
(v
1
2) +

(v2 ) + v1
2 (v1 )

c+

v1 + v2 c + 1 (v2 ) +
1 (v2 ) + 2 (v1 )

(v1 ) + c

(v1 )

if x = 1
if x = 0

if x = 1
if x = 0

The expected cost is then

E [t1 + t2 + xc]

= E [ 1 (v2 ) +
+ Pr [v1 + v2
= E [ 1 (v2 ) +

(v1 )]
c] E [v1 + v2
2 (v1 )] + g (c) ;
2

cjv1 + v2

c]

where
g (c)

Pr [v1 + v2

c] E [v1 + v2

cjv1 + v2

c]

Then, in a symmetric mechanim with zero expected cost,

E[

(v i )] =

1
g (c) :
2

In particular, one can choose the constant function

yielding
ti (^
v1 ; v^2 ) =

v^

c
i
1
g
(c)
2

1
2 g (c)

(v i ) =

1
2 g (c),

if v^1 + v^2 c
if v^1 + v^2 < c

One cannot invoke Myerson-Satterthwaite theorem to argue that a

zero-expected cost mechanism does not exist. Myerson-Satterthwaite
show that there does not exist a mechanism that achieves ex post
budget balance, while here we are only requiring budget balance in
expected value. This point was discussed in the lecture notes before
presenting Myerson-Satterthwaite.
3. Answers:
(a) The threshold is p = 23 . To see this, consider an equilibrium without
money burning where the customer always visits the resataurant.
The customers payo is p if q = 0 and 2 2p if q = 1. His
expected payo is
1
1
( p) + (2
2
2

2p) = 1

which is non-negative if and only if p

4

2
3.

3
p;
2

(b) For every p 23 , there exists a PBE with money burning.

To see this, let (m) = Pr [q = gjm] denote the consumers belief
after he observes m.
Suppose there exists a separating equilibrium where a high type burns
m . It is clear that the low type will burn m = 0. In such an
equilibrium, (m ) = 1 and (0) = 0.
S. If m = m the customer enters the restaurant and buys a starter;
if q = 1 he also buys an entree: the restaurants payo is 2p m
if q = 1 and p m if it q = 0. If m = 0, the restaurants payo is
zero. If instead p > 1, the customer never enters the restaurant.
Then, for every m 2 [p; 2p] there exists a separating equilibrium in
which m = m i q = 1.
(c) The equilibrium in (b) also exists for every p 2 14 ; 23 by the same
exact argument used in (b). The fact that there is also a pooling
equilibrium is inconsequential.