Risk-sharing, Sorting, and Early Contracting

hao li, university of toronto
wing suen

Abstract

In an assignment market with uncertainty regarding productive ability of participants, early contracting can occur before the uncertainty is resolved as participants balance the trade-off between insurance provided by early bilateral contracts and the gains from more efficient sorting by remaining in the market. We apply competitive equilibrium analysis to determine the patterns of early contracting, the terms of early contracts, and the distribution of benefits of early contracting. Early contracts can be signed between more promising agents (who are more likely to have higher abilities) because the gains from insurance outweigh the loss of inefficient sorting, while less promising agents wait because the loss outweighs the gains. We establish conditions under which other patterns of early contracting are possible. We show that more promising agents on one side of the market (job applicants) can be driven to sign early contracts with the less promising agents of the other side (firms), because applicants are more risk-averse than firms, have greater uncertainty regarding their qualities, or face a tighter market. Early contracting in this case unambiguously hurts the more promising firms which choose to wait.