Incentive Efficient Price Systems in Insurance Economies with Adverse Selection

We decentralize incentive efficient allocations in large adverse selection economies by introducing a Walrasian market for mechanisms, that is, for menus of contracts. Facing a budget constraint, informed individuals choose lotteries over mechanisms, while firms supply (slots at) mechanisms at given prices. An equilibrium requires that firms cannot favorably change, or cut, prices. We show that an equilibrium exists and is incentive efficient. We provide a way to compute an equilibrium as the solution to a recursive programming problem that selects the incentive efficient outcome preferred by the highest type within an appropriately defined set. For Rothschild and Stiglitz economies, this is the only equilibrium outcome.