Decentralizing Efficient Allocations with Adverse Selection: The General Case

We study competitive economies with adverse selection and fully exclusive contractual relationships. We show that Walrasian equilibria always exist and are efficient for the general class of adverse selection insurance economies considered by Prescott and Townsend (1984). The result requires an appropriate expansion of the set of markets, in the spirit of Arrow (1969) and Lindahl (1919), to include markets for consumption rights so as to internalize the externality induced by the incentive constraints with adverse selection. Given the non-convexities generated by these constraints, the commodity space is enlarged to allow for lotteries. Our analysis has then also some useful implications for the study of general ArrowLindahl equilibria in the presence of non-convexities. ∗We are grateful to Fernando Alvarez, Douglas Gale, Roger Guesnerie, Danilo Guaitoli, Ramon Marimon, Ed Prescott, Rob Townsend, Rajiv Vohra for helpful comments, as well as to Aldo Rustichini and Paolo Siconolfi for useful discussions which lead to the correction of a mistake. Part of the work for this paper was carried out when the first author was visiting the University of Minnesota, the Minnenapolis Fed, and then IGIER at Bocconi University, and when the second author was visiting NYU; we wish to thank these institutions for their very kind hospitality. We benefited from the technical and financial support of the C.V. Starr Center for Applied Economics, the financial support from a NSF Grant to the first author and from a MIUR grant to the second author.