On the Ratchet Effect with Payoff Externalities

We study a two-period perfectly competitive industry where firms are run by agents privately informed about their (persistent) costs, and principals can only use spot contracts. The interplay between payoff externalities and spot contracting has novel implications for industry dynamics. With discounting, the game features a novel semi-separating equilibrium where only principals randomize. Aggregate production is constant over time, and principals are better off when the adverse selection problem worsens. Without discounting, there exists an equilibrium where principals and agents randomize in the first period, principals' profit increases with the severity of adverse selection, and aggregate output declines over time