Entry-Proofness and Market Breakdown under Adverse Selection

Abstract

We show that a necessary and sufficient condition for entry to be unprofitable under adverse selection is that no buyer type be willing to trade at a price above the expected unit cost of serving the types who are as least as eager to trade than her. We provide two applications of this result. First, we clarify the conditions under which adverse selection causes market breakdown. Second, we consider active markets in which buyers cannot be prevented from conducting additional trades with an entrant, and we fully characterize the unique entry-proof market tariff. Our general approach emphasizes the formal analogy between these two situations, thereby providing a unified perspective on entry-proofness in adversely selected markets. We argue that estimates of upper-tail conditional expectations of unit costs are a key variable for tests of adverse selection, and we outline such a test in nonexclusive insurance markets.