Equilibria and Pareto optima of markets with adverse selection

SummaryThis paper examines the efficiency properties of competitive equilibrium in an economy with adverse selection. The agents (firms and households) in this economy exchange contracts, which specify all the relevant aspects of their interaction. Markets are assumed to be complete, in the sense that all possible contracts can, in principle, be traded. Since prices are specified as part of the contract, they cannot be used as free parameters to equate supply and demand in the market for the contract. Instead, equilibrium is achieved by adjusting the probability of trade. If the contract space is sufficiently rich, it can be shown that rationing will not be observed in equilibrium. A further refinement of equilibrium is proposed, restricting agents' beliefs about contracts that are not traded in equilibrium. Incentive-efficient and constrained incentive-efficient allocations are defined to be solutions to appropriately specified mechanism design problems. Constrained incentive efficiency is an artificial construction, obtained by adding the constraint that all contracts yield the same rate of return to firms. Using this notion, analogues of the fundamental theorems of welfare economics can be proved: all refined equilibria are constrained incentive-efficient and all constrained incentive-efficient allocations satisfying some additional conditions can be decentralized as refined equilibria. A constrained incentive-efficient equilibrium is typically not incentive-efficient, however. The source of the inefficiency is the equilibrium condition that forces all firms to earn the same rate of return on each contract.

[1]  J. Mertens,et al.  ON THE STRATEGIC STABILITY OF EQUILIBRIA , 1986 .

[2]  Andrew M Weiss.  A Sorting-cum-Learning Model of Education , 1983, Journal of Political Economy.

[3]  J. Stiglitz,et al.  Credit Rationing in Markets with Imperfect Information , 1981 .

[4]  Joseph E. Stiglitz,et al.  Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information , 1976 .

[5]  Robert M. Townsend,et al.  Resource Allocation under Asymmetric Information , 1981 .

[6]  Edward C. Prescott,et al.  Pareto Optima and Competitive Equilibria with Adverse Selection and Moral Hazard , 1984 .

[7]  George J. Mailath.  An abstract two-period game with simultaneous signaling—Existence of separating equilibria , 1988 .

[8]  Paul Beaudry,et al.  Signalling and renegotiation in contractual relationships , 1993 .

[9]  Jacques H. Dreze,et al.  Existence of an Exchange Equilibrium under Price Rigidities , 1975 .

[10]  Nicholas C. Yannelis,et al.  Incentive compatibility and information superiority of the core of an economy with differential information , 1993 .

[11]  Thomas Russell,et al.  Imperfect Information, Uncertainty, and Credit Rationing , 1976 .

[12]  Nicholas C. Yannelis,et al.  The value allocation of an economy with differential information , 1994 .

[13]  R. Selten.  Reexamination of the perfectness concept for equilibrium points in extensive games , 1975, Classics in Game Theory.

[14]  J. Sobel,et al.  Strategic stability and uniqueness in signaling games , 1990 .

[15]  G. Mailath.  On the behavior of separating equilibria of signaling games with a finite set of types as the set of types becomes dense in an interval , 1988 .

[16]  J. Sobel,et al.  Equilibrium Selection in Signaling Games , 1987 .

[17]  Edward C. Prescott,et al.  Financial intermediary-coalitions , 1986 .

[18]  Martin Hellwig,et al.  Some recent developments in the theory of competition in markets with adverse selection , 1986 .

[19]  Edward C. Prescott,et al.  General Competitive Analysis in an Economy with Private Information , 1984 .

[20]  J. Bigelow.  Efficiency and adverse selection , 1990 .

[21]  J. Bigelow.  Experts against adverse selection: A note on the existence of equilibrium with costly appropriable information , 1985 .

[22]  M. Spence.  Job Market Signaling , 1973 .

[23]  Robert M. Townsend.  Advances in Economic Theory: Arrow-Debreu programs as microfoundations of macroeconomics , 1987 .

[24]  Frank Hahn,et al.  A THEOREM ON NON-TATONNEMENT STABILITY , 1962 .

[25]  Jean-Francois Richard,et al.  Models With Several Regimes and Changes in Exogeneity , 1980 .

[26]  Charles A. Wilson,et al.  A model of insurance markets with incomplete information , 1977 .

[27]  Helmut Bester,et al.  Screening vs. Rationing in Credit Markets with Imperfect Information , 1985 .

[28]  David M. Kreps,et al.  Signaling Games and Stable Equilibria , 1987 .

[29]  Andrew Postlewaite,et al.  Strategic Information Revelation , 1990 .

[30]  Nicholas C. Yannelis,et al.  Incentive compatibility and information superiority of the core of an economy with differential information , 1991 .

[31]  Douglas Gale,et al.  A Walrasian Theory of Markets with Adverse Selection , 1992 .

[32]  Frank Hahn,et al.  On Non-Walrasian Equilibria , 1978 .

[33]  Roger B. Myerson,et al.  Sustainable Matching Plans with Adverse Selection , 1995 .

[34]  E. Damme,et al.  Signalling in a Dynamic Labour Market , 1990 .