Decentralizing Efficient Allocations with Adverse Selection: The General Case

We study competitive economies with adverse selection and fully exclusive con-tractual 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 Arrow-Lindahl equilibria in the presence of non-convexities