We extend the standard model of general equilibrium with incomplete markets to allow for default and punishment by thinking of assets as pools. The equilibrating variables include expected delivery rates, along with the usual prices of assets and commodities. By reinterpreting the variables, our model encompasses a broad range of adverse selection and signalling phenomena in a perfectly competitive, general equilibrium framework. Perfect competition eliminates the need for lenders to compute how the size of their loan or the price they quote might affect default rates. It also makes for a simple equilibrium refinement, which we propose in order to rule out irrational pessimism about deliveries of untraded assets. We show that refined equilibrium always exists in our model, and that default, in conjunction with refinement, opens the door to a theory of endogenous assets. The market chooses the promises, default penalties, and quantity constraints of actively traded assets.
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Length: 38 pages Date of creation: May 2001 Date of revision:
Mar 2004 Publication status: Published in Econometrica (2005), 73(1): 1-37 Handle: RePEc:cwl:cwldpp:1304r5
Find related papers by JEL classification: D4 - Microeconomics - - Market Structure and Pricing D5 - Microeconomics - - General Equilibrium and Disequilibrium D8 - Microeconomics - - Information, Knowledge, and Uncertainty D41 - Microeconomics - - Market Structure and Pricing - - - Perfect Competition D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Franklin Allen, Douglas Gale, 1988.
"Optimal Security Design,"
Review of Financial Studies,
Oxford University Press for Society for Financial Studies, vol. 1(3), pages 229-263.
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