Screening and Adverse Selection in Frictional Markets

Abstract

We incorporate a search-theoretic model of imperfect competition into an otherwise standard model of asymmetric information with unrestricted contracts. We develop a methodology that allows for a sharp analytical characterization of the unique equilibrium, and then use this characterization to explore the interaction between adverse selection, screening, and imperfect competition. On the positive side, we show how the structure of equilibrium contracts---and hence the relationship between an agent's type, the quantity he trades, and the corresponding price---are jointly determined by the severity of adverse selection and the concentration of market power. This suggests that quantifying the effects of adverse selection requires controlling for the market structure. On the normative side, we show that increasing competition and reducing informational asymmetries can be detrimental to welfare. This suggests that recent attempts to increase competition and reduce opacity in markets that suffer from adverse selection could potentially have negative, unforeseen consequences.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.