On the Ratchet Effect in Competitive Markets

We study a two-period economy with a continuum of perfectly competitive firms, each composed by a principal and an exclusive agent privately informed about his (persistent) production cost. Principals lack commitment power and can only use spot contracts. If players do not discount future profits, so that principals cannot fully screen types in the first period, and the adverse selection problem is sufficiently severe, there exists an equilibrium in which: (i) principals and agents randomize in the first period; (ii) principals' expected profit is an increasing function of the severity of the adverse selection problem; (iii) aggregate output may decrease over time (declining industry). If, instead, full separation is attainable in the first period, then, for intermediate values of the adverse selection problem, the game features a novel type of semi-separating equilibrium in which principals, rather than agents, randomize. In this equilibrium, aggregate production is constant over time, and principals are better off when the adverse selection problem worsens. These qualitative results also hold when considering long-term renegotiation-proof contracts.