Practice Problems

Bruno Salcedo∗

Winter 2025

1. There are two cars, one red and one green. There are two people called Anna and
Bob. Each of them would like to have one car. They need to decide who gets
the red car, and who gets the green car. Their values for each of the two cars are
summarized in Table 1.

(a) What is the efficient outcome?

(b) Find the VCG transfers for this problem. Suppose that both cars are always
available to society.
(c) Is there an efficient mechanism for this problem which never runs a deficit?
(d) Repeat parts (b) and (c) assuming that Anna originally owns the red car and
Bob originally owns the green car. Hence, in the VCG transfer counterfactu-
als, the red car is only available if Anna is part of society.

Red Green

Anna vAR vAG

Bob vBR vBG

Table 1 – Preferences over cars

2. Suppose that the drilling rights for a specific location are being auctioned. There
are two bidders. Suppose that the value of the oil field is either high (v = 100)
or low (v = 0), with each of these values being equally likely. Moreover, suppose
that each bidder observes a signal xi that could be promising or discouraging.
∗
Department of Economics, Western University · brunosalcedo.com · [email protected]
Creative Commons Attribution-NonCommercial-ShareAlike 3.0 Unported license cbna.

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 Signals are noisy. Conditional on the value of the field being high, the probability
of an optimistic signal is 3/4. Conditional on the value of the field being low, the
probability of an optimistic signal is 1/4.

(a) What is the expected value of the field for a bidder who observes a high
signal? [hint: use Bayes rule]
(b) What is the expected value of the field for a bidder who observes a high
signal, and realizes that the other bidder received a pessimistic signal?
(c) Suppose that the drilling rights are auctioned via a sealed-bid second-price
auction, and the two bidders are rational. Would the bidders bid a number
greater than, less than, or equal to their expected value for the field?

3. The mechanism designer must allocate 10 identical objects. There is no cost asso-
ciated with allocating the objects. There are more than 10 individuals interested
in receiving an object. Each individual i would like to receive at most one object.
The utility of individual i is given by

ui = vi qi − ti ,

where vi ≥ 0 is i’s private value for receiving an object, and qi = 1 if i receives an

object and qi = 0 otherwise.

(a) Find all Pareto efficient outcomes.

(b) Find the VCG mechanism for this problem.
(c) Does the VCG mechanism run a deficit?

4. Consider the setting from the Problem 3. Suppose the objects are paintings that
need to be painted by Anna the artist. Anna incurs a cost of $100 per painting
and can paint up to 10 paintings. Her utility is

uA = −100n − tA ,

where n is the number of paintings she paints.

(a) Find all Pareto efficient outcomes.

(b) Find the VCG mechanism for this problem.
(c) Does the VCG mechanism run a deficit?

5. Suppose an object is to be allocated to either Bob, Charlie, or David. Whoever

receives the object, it will generate consumption externalities for the other indi-
viduals in accordance with Table 2.

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 B C D

vB (a) vB −2 −1

vC (a) −5 vC −5

vD (a) −1 −2 vD

Table 2 – Negative consumption externality

(a) What is the efficient outcome?

(b) Find the VCG transfers for this problem.
(c) Is there an efficient mechanism for this problem which never runs a deficit?

6. Bob the Buyer and Susan the Seller must choose whether to trade or not, If they
trade, the seller incurs a cost equal to c and the buyer obtains a payoff equal to
v. It is common knowledge that c ∈ [0, 8] and v ∈ [2, 10]. However, only the seller
knows the specific value of c and only the buyer knows the specific value of v.
Both the buyer and the seller have quasi-linear preferences over money.

(a) Draw a graph illustrating when it is Pareto efficient to trade.

(b) Find the VCG mechanism for this problem.
(c) Is the VCG mechanism PE? IC? BB? IR?
(d) Consider a variation of the VCG mechanism in which the seller always re-
ceives a payment equal to v in addition to the VCG transfers you found in
part (b). Is this mechanism PE? IC? BB? IR?
(e) Consider the following mechanism. The seller reports whether her cost is
less than 4 and the buyer reports whether his value is greater than 6. Trade
takes place if and only if v > 6 and c < 4. If trade takes place, the buyer
pays $6 to the mechanism designer, and the mechanism designer pays $4 to
the seller. Is this mechanism PE? IC? BB? IR?
(f) Find a mechanism that is IC, IR, and BB that is better tjan the mechanism
from part (e). [Hint: draw the trade region of the mechanism.]

7. Anna and Bob own large plots of private land. There is an opportunity to use
some of that land for a public project that would benefit both Bob and Anna. Let
xA ∈ [0, 1] and xB ∈ [0, 1] denote the proportions of Anna’s land and Bob’s land
that are used for the public project. Anna’s and Bob’s utility functions are:

uA = (xA + xB ) − (1 + vA )x2A ,

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 uB = (xA + xB ) − (1 + vB )x2B ,

where the first term represents the total amount of land used for the public good,
and the second term represents the foregone private value of the share of their pri-
vate land used for the project. The parameters vi ∈ [0, 1] are private information.

(a) Find the Pareto efficient land donations from Anna and Bob. You can as-
sume monetary transfers are possible and Anna and Bob have quasi-linear
preferences over money.
(b) Suppose that Anna and Bob choose independently and simultaneously how
much of their land to donate. Find the rational land donations in this volun-
tary contributions game.
(c) Find the VCG transfers for this problem assuming that vA = 1 and vB = 1.
(d) Is the VCG mechanism for this problem individually rational?
(e) Is there a first best mechanism for this problem?

8. Consider the roommate problem from the lecture notes and the following alloca-
tion rule. Gary and Frank simultaneously announce whether their value for the ma-
chine is very low (vi < 250), low (250 ≤ vi < 500), intermediate (500 ≤ vi < 750),
high (750 ≤ vi < 1, 000), or very high (vi ≥ 1, 000). They buy the machine if (i)
at least one roomate reports a very high value, (ii) at least one roomate reports a
high value and no roomate reports a very low value, or (iii) both roomates report
an intermediate value or higher.

(a) Graph the proposed allocation rule.

(b) Is the proposed allocation rule efficient?
(c) Find a transfer rule that combined with the proposed allocation rule would
be budget balanced and individually rational. Is it incentive compatible?
(d) Find a transfer rule that combined with the proposed allocation rule would
be incentive compatible and individually rational. Is it budget balanced?

9. Consider the roommate problem from the lecture notes. For each of the follow-
ing mechanisms, indicate whether it is incentive compatible for Gary, incentive
compatible for Frank, budget balanced and/or Pareto efficient.

(a) First, Gary reports how much he is willing to pay (v̂G ). Then, after hearing
Bob’s report, Frank announces how much he is willing to pay (v̂F ). They
buy the machine if and only if v̂F + v̂G ≥ 1000. If they but the machine,
Frank pays 1000 − v̂G , and Gary pays v̂G .

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 (b) Frank and Gary simultaneously report their values. Each pays 500, regardless
of the reports, and regardless of whether they buy the machine. They buy
the machine if and only if v̂F + v̂G ≥ 1000.
(c) They buy the machine and Frank pays 1000, if Frank’s value is greater or
equal than 1000. Otherwise, they do not buy the machine and nobody pays
anything.
(d) Frank and Gary simultaneously announce their values. They buy the machine
if v̂F · v̂G ≥ 250000. If they buy the machine, Gary pays 250, 000/v̂F and
Frank pays 250, 000/v̂G .
(e) Frank and Gary simultaneously announce their values. They buy the machine
if (v̂F − 800)2 + (v̂G − 800)2 ≤ 40000. If they buy the machine, each pays
q
ti = 800 − 40000 − (v̂i − 800)2

[hint: draw a picture of this mechanism]

10. Consider a firm with cost function C(q) = 2500 + 10q. The individual demand
from each consumer equals Di (p) = 30 − 2p.

(a) Find the optimal two-part tariff scheme for the monopolist.
(b) How many consumers does the firm need to break even (total profit exactly
equal to zero).

11. Consider a small town with two shop owners (Anna and Bob). The city govern-
ment must decide whether and where to undertake a small public project. The
project can be built either close to Anna’s shop or close to Bob’s shop. Regardless
of its location the project would result in a benefit of $50 thousand dollars for
each owner. During the construction phase, the nearest business will be affected
and suffer a loss of ci ≥ 0. The amount of this loss is known by the business
owners but not by the government. The total payoff of each business owner i us
thus given by

−t if the project is not built
 i



ui = 50 − c − ti
i if the project is built in location i .


50 − t

if the project is built in location − i
i

(a) Find the efficient outcome as a function of the losses cA and cB .

(b) Find the VCG transfer rule.
(c) Is the VCG mechanism for this problem budget balanced?

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 (d) Can you find a first best mechanism for this problem? [A first best mechanism
is a mechanism that is efficient, incentive compatible, individually rational,
and budget balanced].

12. Consider a generic social choice problem with two individuals and three alterna-
tives. For each of the following mechanisms to choose a social alternative, deter-
mine whether it is efficient and whether it is incentive compatible.

(a) Individuals simultaneously report their rankings of the alternatives. The

social outcome is chosen using Borda’s rule. In case of a draw, an alternative
is chosen at random among those alternatives with the highest Borda sores.
(b) Individuals simultaneously report their rankings of the alternatives. Then,
an individual is selected randomly by the flip of a coin. The alternative
ranked top by the selected individual is chosen.
(c) The first of the three alternatives is never chosen. The individuals simulta-
neously and independently for one of the remaining two alternatives. If an
alternative receives two votes, then it is chosen. Otherwise, an alternative is
chosen at random by the flip of a coin.

13. Consider a firm with constant marginal costs that operates on two different mar-
kets. The demand functions are given by

2000 30
D1 (p1 ) = and D2 (p2 ) = .
p21 p5

(a) Suppose that the firm can set a different price in each market. In which
market would the monopolist charge a higher price?
(b) Suppose a new regulation forces the firm to charge the same price in both
markets. What will happen to consumer surplus in each of the two markets?

14. Consider a market operated by a single firm with cost function C(q) = q 2 /6000.
There are two types of consumers. There are 1,000 consumers of type 1 and 1,000
consumers of type 2. The individual demand functions for each consumer of type
1 and for each consumer of type 2 are given by

D1 (p) = max {0, 16 − 2p} and D2 (p) = max{0, 20 − p},

respectively. The monopolist can use non-linear pricing, but must treat all con-
sumers equally.

(a) Find the optimal two-part tariff.

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 (b) Suppose that the government offers to pay the firm a subsidy for each con-
sumer that buys a positive amount. The subsidies can differ for type 1 and
type 2 consumers. Is there any subsidy that would increase total market
surplus? Remember to take into account the government surplus or deficit.
(c) [Harder] Suppose that the government imposes a sales tax of $t per unit in
order to cover the cost of the subsidy. Is there a value of $t that would allow
the government to break even without running a deficit?

15. There are two markets for a given commodity. The market demand in each of
these two markets is given by:

D1 (p1 ) = 60 − 3p1

and

D2 (p2 ) = 20 − p2 ,

respectively. All the consumers within each market are homogeneous. All the
firms have the same cost function. There are no fixed costs, and the marginal cost
is constant and equal to 5. Firms receive a subsidy of 2 dollars per unit sold.
For each of the following institutional arrangements, find the consumer surplus
and dead-weight loss.

(a) Both markets are perfectly competitive.

(b) Both markets are operated by a monopolist that cannot price discriminate
in any way (it must set the same fixed-price mechanism for both markets).
(c) Both markets are operated by a monopolist that must use fixed-price mech-
anisms but can charge a different price in each market.
(d) Both markets are operated by a monopolist that can use two-part tariffs but
must use the same two-part tariff in both markets
(e) Price discrimination is not possible, and there are two firms, j = 1, 2. Each
firm j chooses a quantity qj . Quantities are chosen simultaneously and in-
dependently. The market price is determined by the total inverse demand
function.
(f) Which arrangement is better for the consumers of each market?

16. Consider a monopolist with the cost function:

C(q) = 10q.

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The monopolist operates on two different markets with the demand functions:

D1 (p1 ) = 60 − p1 /2,
D2 (p2 ) = 40 − p2 /2.

The government is evaluating different proposed policies. Find the equilibrium

quantity and price for each of the following arrangements.

(a) Allow the firm to continue operating as a monopolist that cannot price dis-
criminate.
(b) Allow the firm to continue operating as a monopolist that cannot price dis-
criminate, and offer a subsidy of 90 per unit sold.
(c) Allow the monopolist to price discriminate based only on market segment,
that is, let it charge a different posted price in each market.
(d) Allow the monopolist to price discriminate based only on quantity, that is
let it use the same nonlinear pricing scheme for both markets.
(e) Split the monopolist into two firms that will compete in quantities a la
Cournot, without any form of price discrimination.
(f) Rank the proposed policies in terms of total market surplus.

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