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Pareto improving financial innovation in incomplete markets

Author

Listed:
  • David Cass

    (Economics Department, European University Institute, Badia Fiesolana, San Domenico di Fiesole, I-50016 Firenze, ITALY)

  • Alessandro Citanna

    (GSIA, Carnegie Mellon University, Pittsburgh, PA 15213, USA)

Abstract

In this paper we develop a differential technique for investigating the welfare effects of financial innovation in incomplete markets. Utilizing this technique, and after parametrizing the standard competitive, pure-exchange economy by both endowments and utility functions, we establish the following (weakly) generic property: Let S be the number of states, I be the number of assets and H be the number of households, and consider a particular financial equilibrium. Then, provided that the degree of market incompleteness is sufficiently larger than the extent of household heterogeneity, S-I\geq2H-1 [resp. S-I\geqH+1], there is an open set of single assets [resp. pairs of assets] whose introduction can make every household better off (and, symmetrically, an open set of single assets [resp. pairs of assets] whose introduction can make them all worse off ). We also devise a very simple nonparametric procedure for reducing extensive household heterogeneity to manageable size, a procedure which not only makes our restrictions on market incompleteness more palatable, but could also prove to be quite useful in other applications involving smooth analysis.

Suggested Citation

  • David Cass & Alessandro Citanna, 1998. "Pareto improving financial innovation in incomplete markets," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 11(3), pages 467-494.
    • Handle: RePEc:spr:joecth:v:11:y:1998:i:3:p:467-494
    Note: Received: August 14, 1995; revised version: April 14, 1997
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    JEL classification:

    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • D60 - Microeconomics - - Welfare Economics - - - General
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets

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