Contract withdrawals and equilibrium in competitive markets with adverse selection

Abstract

Abstract In competitive common value adverse selection markets, existence of a pure strategy equilibrium is often justified by appealing to Wilson’s (J Econ Theory 16(2):167–207, 1977) concept of ‘anticipatory equilibrium.’ The anticipatory equilibrium is based on the notion that all market participants expect unprofitable contracts to be withdrawn. We present a model of individual contract withdrawals that captures the strategic process underlying the anticipatory equilibrium concept: We introduce an additional—endogenously ending—stage into the Rothschild and Stiglitz (Q J Econ 90(4):629–649, 1976) model in which initial contracts can be withdrawn repeatedly after observation of competitors’ contract offers and withdrawals. Individual contract withdrawal allows for a rich strategic interaction. We show that an equilibrium exists where consumers obtain their respective second-best efficient Miyazaki–Wilson–Spence (MWS) contracts. However, this equilibrium requires latent contracts on offer. Furthermore, any individually rational and incentive-compatible allocation that earns nonnegative profits on aggregate can be sustained as equilibrium allocation. We further allow for contract addition as in Riley’s (Econometrica 47(2):331–359, 1979) ‘reactive equilibrium.’ Allowing for contract addition does not change the set of possible outcomes.