General Equilibrium with Asymmetric Information: A Dual Approach

We study markets where the characteristics or decisions of certain agents are relevant but not known to their trading partners. Assuming exclusive transactions, the environment is described as a continuum economy with indivisible commodities. We characterize incentive constrained efficient allocations as solutions to linear programming problems and appeal to duality theory to demonstrate the generic existence of external effects in these markets. Because under certain conditions such effects may generate non-convexities, randomization emerges as a theoretic possibility. In characterizing market equilibria we show that, consistently with the personalized nature of transactions, prices are generally non-linear in the underlying consumption. On the other hand, external effects may have critical implications for market efficiency. With adverse selection, in fact, cross-subsidization across agents with different private information may be necessary for optimality, and so, the market need not even achieve an incentive constrained efficient allocation. In contrast, in the case of a single (type of) commodity, we find that when informational asymmetries arise after the trading period (e.g. moral hazard; ex post hidden types) external effects are fully internalized at a market equilibrium.