Screening and Adverse Selection in Frictional Markets

Abstract

We develop a tractable framework for analyzing adverse selection economies with imperfect competition. In our environment, uninformed buyers offer a general menu of screening contracts to privately informed sellers. Some sellers receive offers from multiple buyers while others receive offers from only one buyer, as in Burdett and Judd (1983). This specification allows us to smoothly vary the degree of competition, nesting monopsony and perfect competition a la Rothschild and Stiglitz (1976) as special cases. We show that the unique symmetric mixed-strategy equilibrium exhibits a strict rank-preserving property, in that different types of sellers have an identical ranking over the various menus offered in equilibrium. These menus can be all separating, all pooling, or a mixture of both, depending on the distribution of types and the degree of competition in the market. This calls into question the practice of using the incidence of separating contracts as evidence of adverse selection without controlling for market structure. We examine the relationship between exante welfare and the degree of competition, and show that in some cases an interior level of frictions maximizes welfare, while in other cases competition is unambiguously bad for welfare. Finally, we study the effects of various policy interventions — such as disclosure and non-discrimination requirements — and show that our model generates new, and perhaps counter-intuitive insights.