Perfected Option Markets in Economies with Adverse Selection

In economies with adverse selection, Arrow-Debreu contingent commodity contracts must satisfy incentive constraints. Following Prescott and Townsend (in Econometrica, 1984), an Arrow-Debreu economy is considered with a continuum of agents whose feasible sets are artificially restricted by imposing these incentive constraints. Equilibria in such an economy must be incentive-constrained Pareto efficient. It is shown that deterministic equilibria of this kind are achievable through “perfected” option markets with non-linear pricing in a way which makes the incentive constraints self-enforcing. Rothschild, Stiglitz and others have shown, however, that these equilibria must be vulnerable to free entry by profit seeking firms.