Efficient Competitive Equilibria with Adverse Selection

Do Walrasian markets function orderly in the presence of adverse selection? In particular, is their outcome efficient when exclusive contracts are enforceable? This paper addresses these questions in the context of a Rothschild-Stiglitz insurance economy. We identify an externality associated with the presence of adverse selection as a special form of consumption externality. Consequently, we show that competitive equilibria always exist but are not typically incentive efficient. However, as markets for pollution rights can internalize environmental externalities, markets for consumption rights can be designed to internalize the consumption externality due to adverse selection. With such markets competitive equilibria exist and incentive-constrained versions of the first and second welfare theorems hold.