Market design is a branch of economics that focuses on establishing rules of exchange, meaning who gets allocated what and by what procedure, in order to achieve efficient and equitable outcomes.[Milgrom Nemmers Prize Presentation Slides, 2008] Roth, Alvin E. "The economist as engineer: Game theory, experimentation, and computation as tools for design economics." Econometrica 70.4 (2002): 1341-1378. It is closely related to mechanism design and auction theory. Market design is concerned with the workings of particular markets in order to fix them when they are broken or to build markets when they are missing.Alvin Roth (2007), The Art of Designing Markets, Harvard Business Review, https://hbr.org/2007/10/the-art-of-designing-markets Practical applications of market design theory, pioneered by scholars like Alvin Roth, have included labor market matching (e.g. the national residency match program), organ transplantation, school choice, and university admissions.
Auction theory
Early research on auctions focused on two special cases: common value auctions in which buyers have private signals of an items true value and private value auctions in which values are identically and independently distributed. Milgrom and Weber (1982) present a much more general theory of auctions with positively related values. Each of n buyers receives a private signal . Buyer i’s value is strictly increasing in and is an increasing symmetric function of . If signals are independently and identically distributed, then buyer i’s expected value is independent of the other buyers’ signals. Thus, the buyers’ expected values are independently and identically distributed. This is the standard private value auction. For such auctions the revenue equivalence theorem holds. That is, expected revenue is the same in the sealed first-price and second-price auctions.
Milgrom and Weber assumed instead that the private signals are “affiliated”. With two buyers, the random variables and with probability density function are affiliated if , for all and all . Applying Bayes’ Rule it follows that , for all and all .
Rearranging this inequality and integrating with respect to it follows that , for all and all. (1) It is this implication of affiliation that is critical in the discussion below.
For more than two symmetrically distributed random variables, let be a set of random variables that are continuously distributed with joint probability density function f(v) . The n random variables are affiliated if for all and in where .
Revenue Ranking Theorem (Milgrom and Weber) Suppose each of n buyers receives a private signal . Buyer i’s value is strictly increasing in and is an increasing symmetric function of . If signals are affiliated, the equilibrium bid function in a sealed first-price auction is smaller than the equilibrium expected payment in the sealed second price auction.Milgrom, Paul and Robert Weber (1982). "A Theory of Auctions and Competitive Bidding". Econometrica (Econometrica, Vol. 50, No. 5) 50 (5): 1089–1122
The intuition for this result is as follows: In the sealed second-price auction the expected payment of a winning bidder with value v is based on their own information. By the revenue equivalence theorem if all buyers had the same beliefs, there would be revenue equivalence. However, if values are affiliated, a buyer with value v knows that buyers with lower values have more pessimistic beliefs about the distribution of values. In the sealed high-bid auction such low value buyers therefore bid lower than they would if they had the same beliefs. Thus the buyer with value v does not have to compete so hard and bids lower as well. Thus the informational effect lowers the equilibrium payment of the winning bidder in the sealed first-price auction.
Equilibrium bidding in the sealed first- and second-price auctions We consider here the simplest case in which there are two buyers and each buyer’s value depends only on his own signal. Then the buyers’ values are private and affiliated. In the sealed second-price (or Vickrey auction), it is a dominant strategy for each buyer to bid his value. If both buyers do so, then a buyer with value v has an expected payment of (2) .
In the sealed first-price auction, the increasing bid function B(v) is an equilibrium if bidding strategies are mutual best responses. That is, if buyer 1 has value v, their best response is to bid b = B(v) if they believes that their opponent is using this same bidding function. Suppose buyer 1 deviates and bids b = B(z) rather than B(v). Let U(z) be their resulting payoff. For B(v) to be an equilibrium bid function, U(z) must take on its maximum at x = v. With a bid of b = B(z) buyer 1 wins if , that is, if . The win probability is then so that buyer 1's expected payoff is . Taking logs and differentiating by z, . (3) The first term on the right hand side is the proportional increase in the win probability as the buyer raises his bid from to . The second term is the proportional drop in the payoff if the buyer wins. We have argued that, for equilibrium, U(z) must take on its maximum at z = v . Substituting for z in (3) and setting the derivative equal to zero yields the following necessary condition. . (4)
Proof of the revenue ranking theorem
Buyer 1 with value x has conditional p.d.f. . Suppose that he naively believes that all other buyers have the same beliefs. In the sealed high bid auction he computes the equilibrium bid function using these naive beliefs. Arguing as above, condition (3) becomes . (3’) Since x > v it follows by affiliation (see condition (1)) that the proportional gain to bidding higher is bigger under the naive beliefs that place higher mass on higher values. Arguing as before, a necessary condition for equilibrium is that (3’) must be zero at x = v. Therefore, the equilibrium bid function satisfies the following differential equation. . (5) Appealing to the revenue equivalence theorem, if all buyers have values that are independent draws from the same distribution then the expected payment of the winner is the same in the two auctions. Therefore, . Thus, to complete the proof we need to establish that . Appealing to (1), it follows from (4) and (5) that for all v < x.
Therefore, for any v in the interval [0,x] . Suppose that . Since the equilibrium bid of a buyer with value 0 is zero, there must be some y < x such that and . But this is impossible since we have just shown that over such an interval, is decreasing. Since it follows that the winner bidder's expected payment is lower in the sealed high-bid auction.
Ascending auctions with package bidding
Milgrom has also contributed to the understanding of combinatorial auctions. In work with Larry Ausubel (Ausubel and Milgrom, 2002), auctions of multiple items, which may be substitutes or complements, are considered. They define a mechanism, the “ascending proxy auction,” constructed as follows. Each bidder reports his values to a proxy agent for all packages that the bidder is interested in. Budget constraints can also be reported. The proxy agent then bids in an ascending auction with package bidding on behalf of the real bidder, iteratively submitting the allowable bid that, if accepted, would maximize the real bidder's profit (value minus price), based on the reported values. The auction is conducted with negligibly small bid increments. After each round, provisionally winning bids are determined that maximize the total revenue from feasible combinations of bids. All of a bidder's bids are kept live throughout the auction and are treated as mutually exclusive. The auction ends after a round occurs with no new bids. The ascending proxy auction may be viewed either as a compact representation of a dynamic combinatorial auction or as a practical direct mechanism, the first example of what Milgrom would later call a “core selecting auction.”
They prove that, with respect to any reported set of values, the ascending proxy auction always generates a core outcome, i.e. an outcome that is feasible and unblocked. Moreover, if bidders’ values satisfy the substitutes condition, then truthful bidding is a Nash equilibrium of the ascending proxy auction and yields the same outcome as the Vickrey–Clarke–Groves (VCG) mechanism. However, the substitutes condition is robustly a necessary as well as a sufficient condition: if just one bidder's values violate the substitutes condition, then with appropriate choice of three other bidders with additively-separable values, the outcome of the VCG mechanism lies outside the core; and so the ascending proxy auction cannot coincide with the VCG mechanism and truthful bidding cannot be a Nash equilibrium. They also provide a complete characterization of substitutes preferences: Goods are substitutes if and only if the indirect utility function is submodular.
Ausubel and Milgrom (2006a, 2006b) exposit and elaborate on these ideas. The first of these articles, entitled "The Lovely but Lonely Vickrey Auction", made an important point in market design. The VCG mechanism, while highly attractive in theory, suffers from a number of possible weaknesses when the substitutes condition is violated, making it a poor candidate for empirical applications. In particular, the VCG mechanism may exhibit: low (or zero) seller revenues; non-monotonicity of the seller's revenues in the set of bidders and the amounts bid; vulnerability to collusion by a coalition of losing bidders; and vulnerability to the use of multiple bidding identities by a single bidder. This may explain why the VCG auction design, while so lovely in theory, is so lonely in practice.
Additional work in this area by Milgrom together with Larry Ausubel and Peter Cramton has been particularly influential in practical market design. Ausubel, Cramton and Milgrom (2006) together proposed a new auction format that is now called the combinatorial clock auction (CCA), which consists of a clock auction stage followed by a sealed-bid supplementary round. All of the bids are interpreted as package bids; and the final auction outcome is determined using a core selecting mechanism. The CCA was first used in the United Kingdom's 10–40 GHz spectrum auction of 2008. Since then, it has become a new standard for spectrum auctions: it has been utilized for major spectrum auctions in Austria, Denmark, Ireland, the Netherlands, Switzerland and the UK; and it is slated to be used in forthcoming auctions in Australia and Canada.
At the 2008 Nemmers Prize conference, Penn State University economist Vijay KrishnaKrishna's Nemmers Presentation, 2008 and Larry AusubelAusubel's Nemmers Presentation, 2008 highlighted Milgrom's contributions to auction theory and their subsequent impact on auction design.
Matching theory
According to economic theory, under certain conditions, the voluntary exchanges of all economic agents will lead to the maximum welfare of those engaged in the exchanges. In reality, however, the situation is different; We usually face market failures, and of course, we sometimes face conditions or constraints such as congested markets, repugnant markets, and unsafe markets. This is where market designers try to create interactive platforms with specific rules and constraints to achieve optimal situations. It is claimed that such platforms provide maximum efficiency and benefit to society.
Matching refers to the idea of establishing a proper relationship between the two sides of the market, the demanders of a good or service and its suppliers. This theory explores who achieves what in economic interactions. The idea for the matching emerged in the form of theoretical efforts by mathematicians such as Shapley and Gale. It matured with the efforts of economists such as Roth, and now market design and matching are of the most important branches of microeconomics and game theory.