Contracting with endogenous entry

We analyze entry in markets where a principal contracts with a privately informed agent. Before learning his production cost, the agent knows his probability of having a low cost – his ex ante “type” – and decides whether to pay an entry fee to contract with the principal. There are two cut-off equilibria that determine the possible types of an agent who actually enters the market, and neither equilibrium can be discarded by standard selection criteria. Contrasting with standard intuition, in the equilibrium with the highest cut-off an increase in the entry fee reduces the marginal type of the agent who enters, thus increasing entry and the expected cost of an entrant. This equilibrium is selected by a criterion based on “robustness to equilibrium risk,” even though the equilibrium with the lowest cut-off is Pareto dominant for the agent. Public policies that increase entry barriers may be welfare improving.