Screening and Adverse Selection in Frictional Markets

Ariel Zetlin-Jones, Benjamin Lester, Ali Shourideh, Venky Venkateswaran - Jul 06, 2018

Working Paper No.  00038-00

We incorporate a search-theoretic model of imperfect competition into an otherwise standard model
of asymmetric information with unrestricted contracts. We develop a methodology that allows for
a sharp analytical characterization of the unique equilibrium, and then use this characterization to
explore the interaction between adverse selection, screening, and imperfect competition. We show
how the structure of equilibrium contracts—and hence the relationship between an agent’s type, the
quantity he trades, and the corresponding price—is jointly determined by the severity of adverse
selection and the concentration of market power. This suggests that quantifying the effects of adverse
selection requires controlling for the market structure. We also show that increasing competition
and reducing informational asymmetries can be detrimental to welfare. This suggests that recent
attempts to increase competition and reduce opacity in markets that suffer from adverse selection
could potentially have negative, unforeseen consequences.

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