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Market Design and the Economics of Asymmetric Information

  • Teacher(s):   O.Strimbu   R.Hakimov  
  • Course given in: English
  • ECTS Credits: 6 credits
  • Schedule: Spring Semester 2019-2020, 4.0h. course (weekly average)
  •  sessions
  • Related programmes:
    Bachelor (BSc) in Economic Sciences

    Bachelor of Science (BSc) in Economics

 

Objectives

Hakimov

The class aims to introduce students to one of the most applied areas of microeconomics - market design. This class is about how to design mechanisms to allocate scarce resources and how to create successful marketplaces and platforms. Different marketplaces have different tasks to accomplish. Practical market design that aims to design marketplaces that will be adopted, implemented, and maintained can be thought of as a kind of economic engineering. A market is an institution where goods and services are exchanged or traded, and its role is to determine who gets what. Some markets, like commodity markets, typically function without any effort of the designer, while demand and supply are the primary designers for them. Thus, in these markets prices decide who gets what. This is not the case however for a variety of other cases. Sometimes money cannot be used for one reason or another (for instance in case of allocating seats in public elementary schools), or sometimes the market is not thick enough to easily determine the price and ensure the transaction (for instance, if you want to sell a painting of Picasso). We will study these markets. Our primary tool will be economic theory. In most classes, we will start with a class of problems and develop a theoretical model that helps us identify what a “good” solution to the problem is, what are the incentive problems that might arise and whether some mechanisms or designs might lead to a good solution. Then we will consider applications where we think about a particular setting and compare what is done in practice to the theory. Often we will look at empirical and experimental evidence to see whether the theoretical solutions are supported by the outcomes in the real applications or controlled experimental settings. At the end of each class, we will have a practice exercise session to get more familiarity with the studied solutions.

The class divides roughly into two main parts: matching and auctions. The first part of the class is on auctions. Asymmetric information is an essential part of auctions, as potential buyers might have limited knowledge about the value of the asset or rights for sale. Here we start with the simplest case of a seller who wants to allocate a single item (a house, a company, a painting, or the rights to a natural resource such as oil or timber), and look at how different types of auctions work in theory and practice. Then we will consider complex allocation problems where a seller wants to allocate goods and bidders may want to buy more than one thing. We will look at the auctions used to allocate multiple items, auctions that are used to allocate rights to mineral resources, online ads, and others. William Vickrey received Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel in 1996 for, among the others, his seminal contribution to the auction theory.

In the second part, we are going to study matching markets, i.e., markets where there’s no money and no prices. Instead, the designer asks people what they want and try to satisfy their preferences subject to the scarcity of resources. Examples include problems such as assigning students to schools in large cities where families can ask to be placed outside their neighborhood school, placing doctors in residency positions, matching couples on dating websites, centralized college admissions or assigning donated kidneys to transplant patients. We will study a set of algorithms that have desirable theoretical properties and are often used in practice to solve these problems. Matching is one of the most recent and fast-developing field of economics, which provides the solution to the allocation problems across the globe, and the contribution of economists to this area was awarded Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel to Alvin Roth and Lloyd Shapley in 2012.

Finally, in the last lecture, we will consider high-frequency trading markets and the adverse effects of the continuous allocation systems of the possibility of the black market development. In these markets, some undesirable effects can arise due to some players having the speed advantage over the other players. Independent of the presence of prices in these markets, the insights from matching market design solutions can be used to solve these problems.

An important goal in this class is to introduce the areas of economic theory such as game theory and mechanism design and connect this theory to practical applications. The hope is that once students get familiar with the ideas, they will be able to read academic papers or browse the internet and see lots of examples where this theory is relevant and useful.

Strimbu

The goal of this part of the course is to introduce students to the economics of asymmetric information. At the end of this part of the course students should know that informational asymmetries can lead to market failures and that there exist decentralized solutions (e.g., signaling and screening) and centralized solutions (e.g., mandatory insurance) that can reduce or prevent these market failures. Students should also know that informational asymmetries can cause welfare losses in contractual relationships not mediated by a market and that contract theory shows us how to reduce or prevent these welfare losses.

Contents

Hakimov

The course outline is preliminary and subject to changes.

1. Introduction to market design and

simple auctions

1.1 General description of the course

1.2 Introduction to market design

1.3 Simple auctions - theory

1.4 Empirical evidence on simple auctions

1.5 Application: eBay

2. Other auctions

2.1 VCG auction

• Case study: Keywords auctions

2.2 Common value auctions

• Case study: US treasury bills auctions and IPO

2.3 Exercise for simple auctions

3. Two-sided matching: Marriage market

3.1 Two-sided matching: Marriage market model

3.2 Application: Medical match

3.3 Exercises for other auctions

4. Assignment problem and kidney

exchange

4.1 One-sided matching: Assignment problem

4.2 Application 1: On-campus housing

4.3 Application 2: Kidney exchange

4.4 Exercises for the marriage market

5. School choice and centralized college

admissions

5.1 One-sided many-to-one assignment model: School choice

model

5.2 Application 1: School choice programs in US

5.3 Application 2: Centralised college admissions

5.4 Exercises for assignment problems and kidney exchange

6. High-frequency trading and black markets in first-come-first-served systems

6.1 Trading: current system, problem, and solutions

6.2 Booking appointment systems: model, experimental test, and

recommendations

6.3 Exercises for school choice

6.4 Exercise for current lecture

6.5 Overview of exam structure

7. Midterm exam

Strimbu

1. Introduction

1.1 The Economics of Asymmetric Information

1.2 Hidden Information (or Private Information)

1.3 Two Kinds of Hidden Information: Hidden Characteristics and Hidden Actions

1.4 Two Kinds of Problems Caused by Asymmetric Information: Adverse Selection and Moral Hazard

2. Review of Basic Game Theory Concepts

2.1 Nash Equilibrium

2.2 Backward Induction

2.3 Subgame Perfect Nash Equilibrium (SPNE)

2.4 Perfect/Imperfect vs Complete/Incomplete Information

3. Perfect Bayesian Equilibrium (PBE)

3.1 PBE in Dynamic Games of Complete Information

3.2 PBE in Dynamic Games of Incomplete Information

3.3 The Notion of Type and Strategy

3.4 Bayesian Updating

3.5 Separating Equilibrium

3.6 Pooling Equilibrium

3.7 The One-Shot-Deviation Principle

4. Hidden Characteristics and Adverse Selection

4.1 Hidden Characteristics: Definition and Examples

4.2 What is Adverse Selection?

4.3 Example 1: Adverse Selection in the Used Car Market

4.4 Akerlof's (1970) "Market for Lemons"

4.5 Example 2: Adverse Selection in Insurance Markets

4.6 How do Insurance Firms Protect themselves against Adverse Selection?

5. Decentralized Solutions to the Adverse Selection Problem: Signaling

5.1 Spence's (1973) "Job Market Signaling"

5.2 Leland and Pyle's (1977) "Equity Signaling"

6. Decentralized Solutions to the Adverse Selection Problem: Screening

6.1 Rostchild and Stiglitz's (1976) "Screening in Insurance Markets"

7. Centralized Solutions to the Adverse Selection Problem: Mandatory Insurance

8. Hidden Actions and Moral Hazard

8.1 Hidden Actions: Definition and Examples

8.2 What is Moral Hazard?

8.3 Example 1: Moral Hazard in Insurance Markets

8.4 How do Insurance Companies Protect themselves against Moral Hazard?

8.5 Example 2: Moral Hazard in Principal-Agent Relationships

9. Solutions to the Moral Hazard Problem in Principal-Agent Relationships

9.1 The Principal-Agent Model

9.2 Bonuses and Other Forms of Incentives, Monitoring, and Auditing

9.3 Definition of contract, participation constraint, and incentive constraints

9.4 Holmström’s (1979) “Moral Hazard and Observability”

9.5 The “Informativeness Principle”

9.6 Grossman and Hart’s (1983) “Principal-Agent Problem”

9 .7 Holmström and Milgrom (1987)

References

Hakimov

Textbooks:

1. Two-Sided Matching: A Study in Game Theoretic Modeling and Analysis by Alvin Roth and Marilda Sotomayor published by Econometric Society. The textbook is optional and supplemental to the slides covered in class.

2. Market Design by Guillaume Haeringer. The textbook is optional and supplemental to the slides covered in class.

Strimbu

Textbooks:

1. The Economics of Asymmetric Information by Brian Hillier

2. The Economics of Contracts: A Primer by Bernard Salanié

3. The Theory of Incentives: The Principal-Agent Model, by Laffont and Martimort.

Pre-requisites

Microeconomic Theory (Analyse économique: Microéconomie)

Evaluation

First attempt

Exam:
Written 2 hours
Documentation:
Allowed
Calculator:
Allowed
Evaluation:

Hakimov

The grade of the course is 100% midterm exam. The exam is open-book. The midterm exam will be run online, on 22 April, 14-15. Zoom session with instructions for the exam will start 20 minute before the exam. Students are expected to be able to solve the allocation task, know the properties of the different allocation mechanisms, and also be aware of the main theoretical and empirical results on each of the topics. Students are expected to know the proofs of the main results if given in the class.

Strimbu

Your grade in this part of the course will be determined on the basis of an end-of-term exam (100%) that will take place during the June examination session. The projected date is June 10th. The exam will be organised online and will be open-book. It will last between 1 and 2 hours.

Final Grade

Your final grade at the course is 50% of your grade in Hakimov and 50% of your grade in Strimbu.

Retake

Exam:
Written 3 hours
Documentation:
Not allowed
Calculator:
Not allowed
Evaluation:

If you fail the course you will have to take a final exam. The final exam is written and closed-book. The duration of the final exam is 3 hours. In case of a retake, the retake exam determines 100% of your final grade.



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