IZA DP No. 4125: Negative Externalities and Equilibrium Existence in Competitive Markets with Adverse Selection
revised version published as 'Team production in competitive labor markets with adverse selection' in: European Economic Review, 2014, 68, 181–198
Rothschild and Stiglitz (1976) show that there need not exist a competitive equilibrium in markets with adverse selection. Building on their framework we demonstrate that externalities between agents − an agent's utility upon accepting a contract depends on the average type attracted by the respective principal − can solve the equilibrium existence problem, even when the size of the externalities is arbitrarily small. Our result highlights the degree of control a principal has over the attractiveness of his contracts as an important feature for equilibrium existence, thereby offering a new perspective on existing theories of competition in markets with adverse selection.