Matching markets with adverse selection

This paper considers a market with adverse selection in the spirit of Rothschild and Stiglitz (Quart. J. Econ. 90 (1976) 629). The major departure from existing approaches is that we model a decentralized market that is open-ended and constantly refilled by new participants, e.g., by new workers and firms in the case of a labor market. The major novelty of this approach is that the distribution of types in the market becomes an endogenous variable, which is jointly determined with equilibrium contracts. As frictions become small, we show that the least-cost separating contracts are always supported as an equilibrium outcome, regardless of the distribution of types among entrants. Moreover, we derive conditions under which this outcome is also unique. r 2004 Elsevier Inc. All rights reserved. JEL classification: D82; D83