1 - Dynamic Mechanism Design: Robustness and Endogenous Types

Summary

This article was prepared for an invited session at the 2015 World Congress of the Econometric Society. Through a unifying framework, I survey recent developments in the dynamic mechanism design literature and then introduce two new areas that I expect will draw attention in the years to come: robustness and endogenous types.

INTRODUCTION

Long-term contracting plays an important role in a variety of economic problems including trade, employment, regulation, taxation, and finance. Most long-term relationships take place in a “changing world,” that is, in an environment that evolves (stochastically) over time. Think, for example, of (a) the provision of private and public goods to agents whose valuations evolve over time, as the result of shocks to their preferences or learning and experimentation, (b) the design of multi-period procurement auctions when firms’ costs evolve as the result of past investments, (c) the design of optimal tax codes when workers’ productivity evolves over time as the result of changes in technology or because of learning-by-doing, (d) the matching of agents whose values and attractiveness is learned gradually over time through private interactions.

Changes to the environment (either due to exogenous shocks, or to the gradual resolution of uncertainty about constant, but unknown, payoffs) are often anticipated at the time of initial contracting, albeit rarely jointly observed by the parties. By implication, optimal long-term contracts must be flexible to accommodate such changes, while at the same time provide the parties with incentives to share the information they receive over time.

Understanding the properties of optimal long-term contracts is important both for positive and for normative analysis. It permits one to address questions such as: How does the provision of quantity/quality evolve over time under profit-maximizing contracts? How do the dynamics of the allocations under profit maximization compare to their counterparts under welfare maximization? In particular, when do distortions due to profit maximization decrease over time and vanish in the long run? In what environments does the private observability of the “shocks” (i.e., the changes to the environment subsequent to the signing of the initial contract) play no role? When is the nature of the shocks (i.e., whether they are transitory or permanent) relevant for the dynamics of the decisions under optimal contracts?