Negative Externalities And Equilibrium Existence In Competitive Markets With Adverse Selection
Source: Institute for the Study of Labor
Rothschild and Stiglitz (1976) show that there need not exist a competitive equilibrium in markets with adverse selection. Building on their framework the authors demonstrate that externalities between agents â?' an agent's utility upon accepting a contract depends on the average type attracted by the respective principal â?' can solve the equilibrium existence problem, even when the size of the externalities is arbitrarily small. Their result highlights the degree of control a principal has over the attractiveness of his contracts as an important feature for equilibrium existence, thereby offering a new perspective on existing theories of competition in markets with adverse selection.