Restaurants, touring musicians, and sports franchises are not out to gouge every last penny out of their patrons.  They want patrons to enjoy their craft but also to come away feeling like they didn’t pay an arm and a leg.  Yesterday I tried to formalize this motivation as maximizing consumer surplus but that didn’t give a useful answer. Maximizing consumer surplus means either complete rationing (and zero profit) or going all the way to an auction (a more general argument why appears below.)  So today I will try something different.

Presumably the restaurant cares about profits too.  So it makes sense to study the mechanism that maximizes a weighted sum of profits and consumer’s surplus. We can do that.  Standard optimal mechanism design proceeds by a sequence of mathematical tricks to derive a measure of a consumer’s value called virtual surplus.  Virtual surplus allows you to treat any selling mechanism you can imagine as if it worked like this

1. Consumers submit “bids”
2. Based on the bids received the seller computes the virtual surplus of each consumer.
3. The consumer with the highest virtual surplus is served.

If you write down the optimal mechanism design problem where the seller puts weight $\alpha$ on profits and weight $1 - \alpha$ on consumer surplus, and you do all the integration by parts, you get this formula for virtual surplus.

$\alpha v + (1 - 2\alpha) \frac{1 - F(v)}{f(v)}$

where $v$ is the consumer’s willingness to pay, $F(v)$ is the proportion of consumers with willingness to pay less than $v$ and $f(v)$ is the corresponding probability density function.   That last ratio is called the (inverse) hazard rate.

As usual, just staring down this formula tells you just about everything you want to know about how to design the pricing system.  One very important thing to know is what to do when virtual surplus is a decreasing function of $v$. If we have a decreasing virtual surplus then we learn that it’s at least as important to serve the low valuation buyers as those with high valuations (see point 3 above.)

But here’s a key observation: its impossible to sell to low valuation buyers and not also to high valuation buyers because whatever price the former will agree to pay the latter will pay too.  So a decreasing virtual surplus means that you do the next best thing: you treat high and low value types the same. This is how rationing becomes part of an optimal mechanism.

For example, suppose the weight on profit $\alpha$ is equal to $0$. That brings us back to yesterday’s problem of just maximizing consumer surplus. And our formula now tells us why complete rationing is optimal because it tells us that virtual surplus is just equal to the hazard rate which is typically monotonically decreasing. Intuitively here’s what the virtual surplus is telling us when we are trying to maximize consumer surplus. If we are faced with two bidders and one has a higher valuation than the other, then to try to discriminate would require that we set a price in between the two. That’s too costly for us because it would cut into the consumer surplus of the eventual winner.

So that’s how we get the answer I discussed yesterday.  Before going on I would like to elaborate on yesterday’s post based on correspondence I had with a few commenters, especially David Miller and Kane Sweeney. Their comments highlight two assumptions that are used to get the rationing conclusion:  monotone hazard rate, and no payments to non-buyers.  It gets a little more technical than usual so I am going to put it here in an addendum to yesterday (scroll down for the addendum.)

Now back to the general case we are looking at today, we can consider other values of $\alpha$

An important benchmark case is $\alpha = 1/2$ when virtual surplus reduces to just $v$, now monotonically increasing.  That says that a seller who puts equal weight on profits and consumer surplus will always allocate to the highest bidder because his virtual surplus is higher.  An auction does the job, in fact a second price auction is optimal.  The seller is implementing the efficient outcome.

More interesting is when $\alpha$ is between $0$ and $1/2$. In general then the shape of the virtual surplus will depend on the distribution $F$, but the general tendency will be toward either complete rationing or an efficient auction.  To illustrate, suppose that willingness to pay is distributed uniformly from $0$ to $1$. Then virtual suplus reduces to

$(3 \alpha - 1) v + (1 - 2 \alpha)$

which is either decreasing over the whole range of $v$ (when $\alpha \leq 1/3$), implying complete rationing or increasing over the whole range (when $\alpha > 1/3$), prescribing an auction.

Finally when $\alpha > 1/2$ virtual surplus is the difference between an increasing function and a decreasing function and so it is increasing over the whole range and this means that an auction is optimal (now typically with a reserve price above cost so that in return for higher profits the restaurant lives with empty tables and inefficiency.  This is not something any restaurant would choose if it can at all avoid it.)

What do we conclude from this?  Maximizing a weighted sum of consumer surplus and profit yields again yields one of two possible mechanisms: complete rationing or an auction.  Neither of these mechanisms seem to fit what Nick Kokonas was looking for in his comment to us and so we have to go back to the drawing board again.

Tomorrow I will take a closer look and extract a more refined version of Nick’s objective that will in fact produce a new kind of mechanism that may just fit the bill.

Addendum: Check out these related papers by Bulow and Klemperer (dcd: glen weyl) and by Daniele Condorelli.