Reference Dependent

Mechanism Design
Eisenhuth (2018)
Reference Dependent Utility
• Kanheman and Tversky (1979)
• Rabin (2007): reference point is endogenous
Eisenhuth (2018)
• Revenue maximizing mechanisms in the presence of agents who are
loss averse.
• Two models of reference dependence:
• One-dimensional (wide bracketing): agents evaluate gains and losses over the
entire risk neutral payoff.
• Two-dimensional (narrow bracketing): agents consider gains and losses
separately, in terms of receiving the object (allocation) and payment.
• Choice Acclimating Personal Equilibrium (CPE): The reference point is
determined endogenously as an equilibrium object and depends on
the mechanism played.
Model
• Preferences
• The narrowly bracketed specification of agents’ preferences
𝑢2 𝑐 𝑔 , 𝑐 𝑚 𝑟 𝑔 , 𝑟 𝑚 , 𝜃 = 𝜃𝑐 𝑔 + 𝑐 𝑚 + 𝜂 𝑔 𝜇 𝑔 𝜃 𝑐 𝑔 − 𝑟 𝑔 + 𝜂𝑚 𝜇𝑚 𝑐 𝑚 − 𝑟 𝑚

Intrinsic utility Gain loss utility

𝑐 𝑔 , 𝑟 𝑔 ∈ {0,1} denote the good dimension

𝑐 𝑚 , 𝑟 𝑚 ∈ ℝ denote the money dimension
𝑐 𝑙 is the agent’s actual consumption and 𝑟 𝑙 is the reference level of
consumption for 𝑙 ∈ {𝑔, 𝑚}
𝜂 𝑙 > 0 denotes the weight attached to the gain loss utility in dimension 𝑙
𝜃 ≥ 0 denotes the agent’s private type
• 𝜇𝑙 𝑥 = 𝑥, 𝑖𝑓 𝑥 ≥ 0
𝜆𝑙 𝑥 𝑖𝑓 𝑥 < 0

Where 𝜆𝑙 > 1, 𝑙 ∈ {𝑔, 𝑚}

• Widely-bracketed specification of preferences

𝑢1 𝑐 𝑔 , 𝑐 𝑚 𝑟 𝑔 , 𝑟 𝑚 , 𝜃 = 𝜃𝑐 𝑔 + 𝑐 𝑚 + 𝜂𝜇 𝜃𝑐 𝑔 + 𝑐 𝑚 − 𝜃𝑟 𝑔 + 𝑟 𝑚

Intrinsic utility Gain-loss utility

• 𝜇 𝑥 = 𝑥, 𝑖𝑓 𝑥 ≥ 0
𝜆𝑥 𝑖𝑓 𝑥 < 0
Where 𝜆 > 1
Types and Information
• Loss averse agents 𝑁 ≥ 2 who share the same 𝜂𝑙 and 𝜆𝑙 where 𝑙 ∈
{𝑔, 𝑚}
• Agents types {𝜃𝑖 }𝑁 𝑖=1 are the realizations of 𝑁 independent draws from
the continuous distribution function, 𝐹: Θ ⟶ [0,1] where Θ =
𝜃𝑚𝑖𝑛 , 𝜃𝑚𝑎𝑥 with strictly positive density 𝑓 everywhere.
• So, 𝜃𝑖 is agent 𝑖 ′ 𝑠 private information and is the only idiosyncratic
component across which agents differ.
Solution Concept
• Each agent learns his type before playing his action and therefore
maximizes his interim expected utility.
• If the distribution of reference points is 𝐺, and the distribution of
actual consumption outcomes is 𝐻, the agent's interim expected
utility is

𝑈 𝐻|𝐺, 𝜃 = න න 𝑢(𝑐 𝑔 , 𝑐 𝑚 𝑟 𝑔 , 𝑟 𝑚 , 𝜃 𝑑𝐺 𝑟 𝑔 , 𝑟 𝑚 𝜃 𝑑𝐻 𝑐 𝑔 , 𝑐 𝑚 𝜃
𝑐 𝑔 ,𝑐 𝑚 𝑟 𝑔 ,𝑟 𝑚
• Definition 1: (Koszegi and Rabin (2007)) Conditional on the realization
of the type,𝜃, for any choice set, 𝐷, 𝐻 ∈ 𝐷 is an interim CPE if

𝑈(𝐻|𝐻, 𝜃) ≥ 𝑈(𝐻 ′ |𝐻 ′ , 𝜃) for all 𝐻 ′ ∈ 𝐷

• In a game of incomplete information, conditional on all other agents’
behaviour, each agents’ strategy 𝜎𝑖 : Θ → 𝑆𝑖 , implies a distribution,
𝐻𝑖 (𝒜|𝜎𝑖 , 𝜎−𝑖 ), over the set of outcomes, 𝒜 = [0,1]𝑁 × ℝ𝑁

• Definition 2: Conditional on the realization of the type,𝜃𝑖 , 𝜎𝑖 : Θ → 𝑆𝑖

is an interim CPE strategy if for all 𝑖, 𝜃𝑖 , 𝜃−𝑖 , 𝜎 ′ ∈ 𝑆𝑖 ,

𝑈(𝐻𝑖 (𝒜|𝜎𝑖 (𝜃𝑖 ), 𝜎−𝑖 (𝜃−𝑖 ))|(𝐻𝑖 (𝒜|𝜎𝑖 𝜃𝑖 , 𝜎−𝑖 𝜃−𝑖 ), 𝜃𝑖 )

≥ 𝑈(𝐻𝑖 (𝒜|𝜎 ′ , 𝜎−𝑖 𝜃−𝑖 )|𝐻(𝒜|𝜎 ′ , 𝜎−𝑖 𝜃−𝑖 , 𝜃𝑖 )
• Define Λ 𝑙 = 𝜂𝑙 𝜆𝑙 − 1 > 0, 𝑙 ∈ {𝑔, 𝑚}

• Assumption 1: (No dominance of gain loss utility) Λ 𝑔 ≤ 1

CPE Incentive Compatible Mechanism Design
• Definition 3: A mechanism 𝑀, consists of a collection of allowable
strategies, 𝑆𝑖 , for each agent 𝑖 and an outcome function, 𝐺: ×𝑁 𝑖=1 𝑆𝑖 →
𝒜, where 𝒜 is the set of alternatives.
• A mechanism combined with the description of priors, payoffs, and
the type space ×𝑁 𝑖=1 Θ, describes a Bayesian game, in which a strategy
for agent 𝑖 is a mapping, 𝜎𝑖 : Θ → 𝑆𝑖 .
• Definition 4: A social choice function ℱ, is a mapping from the type
space into the set of alternatives, ℱ:×𝑁 𝑖=1 Θ → 𝒜
• Definition 5: A mechanism 𝑀, implements ℱ in CPE if there is a CPE
strategy profile, {𝜎𝑖 }𝑁𝑖=1 , of the game induced by 𝑀, such that
𝐺(𝜎1 𝜃1 , 𝜎2 𝜃2 ,…, 𝜎𝑁 𝜃𝑁 ) = ℱ(𝜃1 , 𝜃2 ,…, 𝜃𝑁 ), for all (𝜃1 , 𝜃2 ,…, 𝜃𝑁 ) ∈×𝑁
𝑖=1 Θ
• Definition 6: A social choice function ℱ, is CPE incentive compatible
(CPEIC) if the strategy 𝜎𝑖 𝜃𝑖 = 𝜃𝑖 is a CPE strategy in the direct
mechanism, 𝑀𝐷 = . , 𝐺 = ℱ , for all 𝑖, 𝜃𝑖

• Proposition 1: (Revelation Principle for CPE) There is a mechanism

implementing social choice function, ℱ, in CPE if and only if it is CPEIC.
Proof:
Two Dimensions: Narrow Bracketing
• Direct mechanism
• 𝑄𝑖 𝜃𝑖 , 𝜃−𝑖 ∈ {0,1} is the ex-post allocation to agent 𝑖, when he is of
type 𝜃𝑖
• The interim expected allocation to agent 𝑖 is
𝑞𝑖 𝜃𝑖 = න 𝑄𝑖 𝜃𝑖 , 𝜃−𝑖 𝑑𝐹 𝜃−𝑖 |𝜃𝑖
{𝜃−𝑖 }
• 𝑇𝑖 𝜃𝑖 , 𝜃−𝑖 is the ex-post payment of agent 𝑖 when his report is 𝜃𝑖 , and
the vector of his opponents’ reports is 𝜃−𝑖 ,
• The ex-post indirect utility of an agent with type 𝜃𝑖 is
𝑉𝑖 𝜃෡𝑖 𝜃𝑖 , 𝜃−𝑖 = ℬ𝑖 𝜃෡𝑖 , 𝜃−𝑖 𝜃𝑖 − 𝑇𝑖 𝜃෡𝑖 , 𝜃−𝑖 − Ω𝑖 𝜃෡𝑖 , 𝜃−𝑖
where
ℬ𝑖 𝜃෡𝑖 , 𝜃−𝑖 = 𝑄𝑖 𝜃෡𝑖 , 𝜃−𝑖 + 𝜂 𝑔 𝑄𝑖 𝜃෡𝑖 , 𝜃−𝑖 1 − 𝑞𝑖 𝜃෡𝑖 − 𝜂 𝑔 𝜆𝑔 (1 − 𝑄𝑖 𝜃෡𝑖 , 𝜃−𝑖 )𝑞𝑖 𝜃෡𝑖
And

Ω𝑖 𝜃෡𝑖 , 𝜃−𝑖
= 𝜂𝑚 𝜆𝑚 න ( 𝑇𝑖 𝜃෡𝑖 , 𝜃−𝑖 − 𝑇𝑖 𝜃෡𝑖 , 𝜃−𝑖 ′ )𝑑𝐹 𝜃−𝑖 ′ |𝜃𝑖
{𝜃−𝑖 ′ :𝑇𝑖 𝜃
෢𝑖 ,𝜃−𝑖 ′ <𝑇𝑖 𝜃
෢𝑖 ,𝜃−𝑖 }

− 𝜂𝑚 න ( 𝑇𝑖 𝜃෡𝑖 , 𝜃−𝑖 ′ − 𝑇𝑖 𝜃෡𝑖 , 𝜃−𝑖 )𝑑𝐹 𝜃−𝑖 ′ |𝜃𝑖

{𝜃−𝑖 ′ :𝑇𝑖 𝜃
෢𝑖 ,𝜃−𝑖 ′ >𝑇𝑖 𝜃
෢𝑖 ,𝜃−𝑖 }

• ℬ𝑖 𝜃෡𝑖 , 𝜃−𝑖 is the perceived ex-post allocation rule

• 𝒯𝑖 𝜃෡𝑖 , 𝜃−𝑖 = 𝑇𝑖 𝜃෡𝑖 , 𝜃−𝑖 + Ω𝑖 𝜃෡𝑖 , 𝜃−𝑖 is the perceived ex-post payment to the
mechanism
• The ex-post indirect utility of agent 𝑖 with type 𝜃𝑖 in a CPE incentive
compatible (CPEIC) mechanism is
𝑉𝑖 𝜃𝑖 𝜃𝑖 , 𝜃−𝑖 = ℬ𝑖 𝜃𝑖 , 𝜃−𝑖 𝜃𝑖 − 𝒯𝑖 𝜃𝑖 , 𝜃−𝑖
• The interim expected utility of an agent of type 𝜃𝑖 reporting to be
type 𝜃෡𝑖 is
𝑉𝑖 𝜃෡𝑖 𝜃𝑖 = 𝛽𝑖 𝜃෡𝑖 𝜃𝑖 − 𝜏𝑖 (𝜃෡𝑖 )
Where 𝜏𝑖 𝜃෡𝑖 = ‫𝜃{׬‬−𝑖 }
𝒯𝑖 𝜃෡𝑖 , 𝜃−𝑖 𝑑𝐹 𝜃−𝑖 |𝜃𝑖

𝛽𝑖 𝜃෡𝑖 = න ℬ𝑖 𝜃෡𝑖 , 𝜃−𝑖 𝑑𝐹 𝜃−𝑖 |𝜃𝑖 = 𝑞𝑖 𝜃෡𝑖 (1 − Λ 𝑔 1 − 𝑞𝑖 𝜃෡𝑖 )

{𝜃−𝑖 }

• By the revelation principle, the social choice function, ℱ(𝜃1 , 𝜃2 ,…,

𝜃𝑁 ) = ({𝑄𝑖 }𝑁
𝑖=1 , {𝑇 𝑁
𝑖 𝑖=1 ) is CPEIC if and only if
}
𝑉𝑖 𝜃𝑖 𝜃𝑖 = 𝛽𝑖 𝜃𝑖 𝜃𝑖 − 𝜏𝑖 𝜃𝑖 ≥ 𝛽𝑖 𝜃෡𝑖 𝜃𝑖 − 𝜏𝑖 𝜃෡𝑖 = 𝑉𝑖 𝜃෡𝑖 𝜃𝑖
• Proposition 2: (Characterisation of CPEIC)
(i) Let 𝛽𝑖 : 𝜃𝑚𝑖𝑛 , 𝜃𝑚𝑎𝑥 → [− Λ 𝑔 − 1 2 /(4 Λ 𝑔 , 1]. Then, there exists
functions, 𝜏𝑖 : 𝜃𝑚𝑖𝑛 , 𝜃𝑚𝑎𝑥 → ℝ, such that ({𝛽𝑖 }𝑁 𝑖=1 , {𝜏 𝑁
𝑖 𝑖=1 ) satisfy
}
(CPEIC) if and only if 𝛽𝑖 is non-decreasing, for all 𝑖, 𝜃𝑖 .
(ii) If ({𝛽𝑖 }𝑁
𝑖=1 , {𝜏 𝑁
𝑖 𝑖=1 ) satisfy (CPEIC), then
}
𝜃𝑖
𝑉𝑖 𝜃𝑖 𝜃𝑖 = 𝑉𝑖 𝜃𝑚𝑖𝑛 𝜃𝑚𝑖𝑛 + න 𝛽𝑖 𝑠 𝑑𝑠
𝜃𝑚𝑖𝑛
And
𝜃𝑖
𝜏𝑖 𝜃𝑖 = 𝛽𝑖 𝜃𝑖 𝜃𝑖 − 𝑉𝑖 𝜃𝑚𝑖𝑛 𝜃𝑚𝑖𝑛 − න 𝛽𝑖 𝑠 𝑑𝑠
𝜃𝑚𝑖𝑛
• Proposition 3: (Perceived Revenue Equivalence) If ({𝛽𝑖 }𝑁 𝑖=1 , {𝜏 𝑁
𝑖 𝑖=1 )
}
and ({𝛽𝑖 }𝑁
𝑖=1 , ෪
{𝜏 𝑁
𝑖 𝑖=1 ) satisfy (CPEIC), then 𝜏𝑖 𝜃𝑖 − 𝜏෥𝑖 𝜃𝑖 = ℎ𝑖 , for
}
some number, ℎ𝑖 for all 𝑖, 𝜃𝑖 .

Proof:
• The expected physical to the mechanism of an agent of type 𝜃𝑖 , is 𝑡𝑖 𝜃𝑖 = 𝜏𝑖 𝜃𝑖 −
𝜔𝑖 𝜃𝑖 , where
𝜔𝑖 𝜃𝑖 = ‫𝜃{׬‬ Ω𝑖 ( 𝜃𝑖 , 𝜃−𝑖 )𝑑𝐹 𝜃−𝑖 |𝜃𝑖
−𝑖 }

• Lemma 1: 𝜔𝑖 𝜃𝑖 ≥ 0, for all 𝑖, 𝜃𝑖 . If payments are non-degenerate, the inequality

holds strict.
Proof: By definition of Ω𝑖 and 𝜔𝑖 ,
𝜔𝑖 𝜃𝑖 = ‫𝜃{׬‬ Ω𝑖 ( 𝜃𝑖 , 𝜃−𝑖 )𝑑𝐹 𝜃−𝑖 |𝜃𝑖
−𝑖 }

= 𝜂 𝑚 𝜆𝑚 න න ( 𝑇𝑖 𝜃෡𝑖 , 𝜃−𝑖 − 𝑇𝑖 𝜃෡𝑖 , 𝜃−𝑖 ′ ) 𝑑𝐹 𝜃−𝑖 ′ |𝜃𝑖 𝑑𝐹 𝜃−𝑖 |𝜃𝑖

{𝜃−𝑖 } {𝜃−𝑖 ′ :𝑇𝑖 𝜃
෢𝑖 ,𝜃−𝑖 ′ <𝑇𝑖 𝜃
෢𝑖 ,𝜃−𝑖 }

− 𝜂𝑚 න න ( 𝑇𝑖 𝜃෡𝑖 , 𝜃−𝑖 ′ − 𝑇𝑖 𝜃෡𝑖 , 𝜃−𝑖 ) 𝑑𝐹 𝜃−𝑖 ′ |𝜃𝑖 𝑑𝐹 𝜃−𝑖 |𝜃𝑖

{𝜃−𝑖 } {𝜃−𝑖 ′ :𝑇𝑖 𝜃
෢𝑖 ,𝜃−𝑖 ′ >𝑇𝑖 𝜃
෢𝑖 ,𝜃−𝑖 }
𝜔𝑖 𝜃𝑖
= Λ𝑚 න න ( 𝑇𝑖 𝜃෡𝑖 , 𝜃−𝑖 − 𝑇𝑖 𝜃෡𝑖 , 𝜃−𝑖 ′ ) 𝑑𝐹 𝜃−𝑖 ′ |𝜃𝑖 𝑑𝐹 𝜃−𝑖 |𝜃𝑖
{𝜃−𝑖 } {𝜃−𝑖 ′ :𝑇𝑖 𝜃
෢𝑖 ,𝜃−𝑖 ′ <𝑇𝑖 𝜃
෢𝑖 ,𝜃−𝑖 }

• If payments are deterministic, then 𝜔𝑖 𝜃𝑖 = 0 for all 𝑖, 𝜃𝑖 .

Optimization Problem
• Individual Rationality constraint (IR)
𝑉𝑖 𝜃𝑖 𝜃𝑖 = 𝛽𝑖 𝜃𝑖 𝜃𝑖 − 𝜏𝑖 𝜃𝑖 ≥ 0 for all 𝑖, 𝜃𝑖
• Designer problem is
𝑁 𝜃𝑚𝑎𝑥
𝑚𝑎𝑥{𝛽 ,𝑞 𝑡 ,𝜔 ,𝑄 ,𝑉 }𝑁 {෍ න 𝑡𝑖 𝜃𝑖 𝑑𝐹(𝜃𝑖 )}
𝑖 𝑖 𝑖 𝑖 𝑖 𝑖 𝑖=1
𝑖=1 𝜃𝑚𝑖𝑛
Subject to
CPEIC
IR
𝜔𝑖 𝜃𝑖 ≥ 0
𝑞𝑖 𝜃𝑖 = න 𝑄𝑖 𝜃𝑖 , 𝜃−𝑖 𝑑𝐹 𝜃−𝑖 |𝜃𝑖
{𝜃−𝑖 }
𝛽𝑖 𝜃𝑖 = 𝑞𝑖 𝜃𝑖 (1 − Λ 𝑔 1 − 𝑞𝑖 𝜃𝑖 )
𝑄𝑖 𝜃𝑖 , 𝜃−𝑖 ∈ {0,1}
σ𝑁𝑖=1 𝑄𝑖 𝜃𝑖 , 𝜃−𝑖 ≤ 1, for all 𝑖, 𝜃𝑖 , 𝜃−𝑖
• Using the characterisation result in proposition 2 and substituting for 𝑡𝑖 𝜃𝑖 ,
designer’s problem𝑁 can be written as
𝜃𝑚𝑎𝑥 𝜃𝑖
𝑚𝑎𝑥{𝛽 ,𝑞 ,𝜔 𝑁 {෍ න (𝛽𝑖 𝜃𝑖 𝜃𝑖 − 𝜔𝑖 𝜃𝑖 − 𝑉𝑖 𝜃𝑚𝑖𝑛 𝜃𝑚𝑖𝑛 − න 𝛽𝑖 𝑠 𝑑𝑠) 𝑑𝐹(𝜃𝑖 )}
𝑖 𝑖 𝑖, 𝑄𝑖 ,𝑉𝑖 }𝑖=1
𝑖=1 𝜃𝑚𝑖𝑛 𝜃𝑚𝑖𝑛

Subject to
Monotonicity of 𝛽𝑖
IR
𝜔𝑖 𝜃𝑖 ≥ 0
𝑞𝑖 𝜃𝑖 = න 𝑄𝑖 𝜃𝑖 , 𝜃−𝑖 𝑑𝐹 𝜃−𝑖 |𝜃𝑖
{𝜃−𝑖 }
𝛽𝑖 𝜃𝑖 = 𝑞𝑖 𝜃𝑖 (1 − Λ 𝑔 1 − 𝑞𝑖 𝜃𝑖 )
𝑄𝑖 𝜃𝑖 , 𝜃−𝑖 ∈ {0,1}
σ𝑁𝑖=1 𝑄𝑖 𝜃𝑖 , 𝜃−𝑖 ≤ 1, for all 𝑖, 𝜃𝑖 , 𝜃−𝑖
• By lemma 1, 𝜔𝑖 𝜃𝑖 ≥ 0 for all 𝑖, 𝜃𝑖 , which enters with a negative sign in
designer’s objective.
• Designer chooses 𝜔𝑖 𝜃𝑖 = 0 for all 𝑖, 𝜃𝑖 .
• Using integration by parts, designer’s problem can be written as
𝑁 𝜃𝑚𝑎𝑥 𝑁
1 − 𝐹(𝜃𝑖 )
𝑚𝑎𝑥{𝛽 ,𝑞 ,𝑄 ,𝑉 }𝑁 {෍ න 𝛽𝑖 𝜃𝑖 (𝜃𝑖 − )𝑑𝐹 𝜃𝑖 − ෍ 𝑉𝑖 𝜃𝑚𝑖𝑛 𝜃𝑚𝑖𝑛 }
𝑖 𝑖 𝑖 𝑖 𝑖=1
𝜃𝑚𝑖𝑛 𝑓(𝜃𝑖 )
𝑖=1 𝑖=1
Subject to
Monotonicity of 𝛽𝑖
IR
𝑞𝑖 𝜃𝑖 = න 𝑄𝑖 𝜃𝑖 , 𝜃−𝑖 𝑑𝐹 𝜃−𝑖 |𝜃𝑖
{𝜃−𝑖 }
𝛽𝑖 𝜃𝑖 = 𝑞𝑖 𝜃𝑖 (1 − Λ 𝑔 1 − 𝑞𝑖 𝜃𝑖 )
𝑄𝑖 𝜃𝑖 , 𝜃−𝑖 ∈ {0,1}
σ𝑁𝑖=1 𝑄𝑖 𝜃𝑖 , 𝜃−𝑖 ≤ 1, for all 𝑖, 𝜃𝑖 , 𝜃−𝑖

1−𝐹(𝜃𝑖 )
• Define 𝜈 𝜃𝑖 = 𝜃𝑖 −
𝑓(𝜃𝑖 )
• Assumption 2: (Regularity) 𝜈 is strictly increasing in 𝜃𝑖 , for all 𝜃𝑖 .