A government awards a contract to the firm that reports the lowest cost, then pays that cost. This procurement rule is NOT incentive-compatible because:
AFirms cannot accurately estimate their own costs under uncertainty
BEvery firm has an incentive to report a cost higher than its true cost to extract a larger payment
CThe government cannot verify actual costs even after the contract is completed
DFirms will collude to report identical costs, making the auction unable to select a winner
Under naive cost-plus procurement, a firm with true cost c knows it will be paid whatever it reports. Reporting c + ε earns ε more profit at no cost — there is no incentive to reveal true costs. This is a textbook IC failure: the mechanism makes lying strictly profitable. An IC-compliant mechanism must restructure payments so that for every possible true type, the expected payoff from truthful reporting weakly dominates any lie. Option C (verification) is a related but distinct issue — IC must hold even without ex-post verification.
Question 2 Multiple Choice
Dominant-strategy incentive compatibility (DSIC) is stronger than Bayesian incentive compatibility (BIC) because:
ADSIC requires truth-telling to be optimal regardless of what any other agent reports; BIC only requires it to be optimal in expectation over the distribution of others' types
BDSIC applies to settings with continuous type spaces; BIC only applies to discrete types
CDSIC eliminates information rents entirely; BIC allows them to persist
DDSIC guarantees a unique equilibrium; BIC only guarantees existence of at least one
DSIC means truth-telling is a dominant strategy — it is optimal no matter what other agents report, no matter what type they actually are. BIC is weaker: truth-telling is optimal only in expectation, integrating over the distribution of others' types. DSIC is therefore more robust — it does not rely on correct beliefs about others — but harder to achieve. Vickrey auctions (second-price) satisfy DSIC; some Bayesian auction formats satisfy BIC but not DSIC.
Question 3 True / False
An incentive-compatible mechanism gets agents to report truthfully by appealing to their honesty and moral character, rather than by making honesty the self-interested choice.
TTrue
FFalse
Answer: False
False. Incentive compatibility is a purely strategic concept — it means that truthful reporting is the *self-interested* choice, regardless of moral preferences. The mechanism is designed so that lying is weakly dominated: no agent can do better by misrepresenting their type, given the payments and allocations the mechanism delivers. IC does not assume or require agents to be honest by nature. This is the mechanism design insight: instead of asking people to 'be honest,' design the rules so that honesty serves their own interests.
Question 4 True / False
Achieving incentive compatibility often requires leaving 'information rents' — extra payoff — to agents with favorable private information, rather than extracting the full available surplus.
TTrue
FFalse
Answer: True
True. This is the fundamental IC constraint in adverse selection settings. A low-cost (high-efficiency) firm must be paid enough that it would not benefit from mimicking a high-cost firm — otherwise it would misreport to capture better terms. The extra payoff that makes truthful reporting rational is the 'information rent.' Extracting these rents completely while maintaining IC is impossible: the designer faces a tradeoff between efficiency and rent extraction. This is why optimal auctions, optimal contracts, and optimal regulation all leave some surplus with privately-informed agents.
Question 5 Short Answer
Why can't a mechanism designer simply instruct all agents to 'report their true type' and rely on the instruction to ensure honest disclosure?
Think about your answer, then reveal below.
Model answer: Agents are self-interested: if misreporting yields a better allocation or larger payment, they will lie regardless of instructions. An instruction to 'be honest' provides no strategic reason to comply when honesty is costly. Incentive compatibility solves this by structuring the mechanism — the mapping from reports to outcomes and transfers — so that truthful reporting is the payoff-maximizing choice. Only when honesty is the dominant (or equilibrium) strategy can the mechanism reliably elicit private information.
This is the core insight of mechanism design: the designer controls the rules, not the agents' preferences or information. Since agents' types are unverifiable before the mechanism runs, the only lever the designer has is the incentive structure — the relationship between reported types and outcomes. IC translates 'how do we get honest reports?' from a vague request into a formal constraint that can be solved for, checked, and incorporated into optimal mechanism design.