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Default and Punishment in General Equilibrium

Abstract

We extend the standard model of general equilibrium with incomplete markets to allow for default and punishment. 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 moral hazard, adverse selection, and signalling phenomena (including the Akerlof lemons model and Rothschild-Stiglitz insurance model) in a general equilibrium framework. We impose a condition on the expected delivery rates for untraded assets that is similar to the trembling hand refinements used in game theory. Despite earlier claims about the nonexistence of equilibrium with adverse selection, we show that equilibrium always exists, even with exclusivity constraints on asset sales, and transactions-liquidity costs or information-evaluation costs for asset trade. We show that more lenient punishment which encourages default may be Pareto improving because it allows for better risk spreading. We also show that default opens the door to a theory of endogenous assets.

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File URL: http://cowles.yale.edu/sites/default/files/files/pub/d13/d1304.pdf
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Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1304.

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Length: 48 pages
Date of creation: May 2001
Handle: RePEc:cwl:cwldpp:1304
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Keywords: Default; incomplete markets; adverse selection; moral hazard; equilibrium refinement; endogenous assets;

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Find related papers by JEL classification:
  • D4 - Microeconomics - - Market Structure, Pricing, and Design
  • D5 - Microeconomics - - General Equilibrium and Disequilibrium
  • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
  • D41 - Microeconomics - - Market Structure, Pricing, and Design - - - 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; Mechanism Design

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  1. Douglas Gale, 1992. "A Walrasian Theory of Markets with Adverse Selection," Review of Economic Studies, Oxford University Press, vol. 59(2), pages 229-255.
  2. Pesendorfer Wolfgang, 1995. "Financial Innovation in a General Equilibrium Model," Journal of Economic Theory, Elsevier, vol. 65(1), pages 79-116, February.
  3. Hart, O. & Moore, J., 1989. "Default And Renegotiation: A Dynamic Model Of Debt," Working papers 520, Massachusetts Institute of Technology (MIT), Department of Economics.
  4. Hellwig, Martin, 1987. "Some recent developments in the theory of competition in markets with adverse selection ," European Economic Review, Elsevier, vol. 31(1-2), pages 319-325.
  5. Zame, William R, 1993. "Efficiency and the Role of Default When Security Markets Are Incomplete," American Economic Review, American Economic Association, vol. 83(5), pages 1142-1164, December.
  6. Allen, Franklin & Gale, Douglas, 1991. "Arbitrage, Short Sales, and Financial Innovation," Econometrica, Econometric Society, vol. 59(4), pages 1041-1068, July.
  7. Franklin Allen, Douglas Gale, 1988. "Optimal Security Design," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 229-263.
  8. Bisin, Alberto & Gottardi, Piero, 1999. "Competitive Equilibria with Asymmetric Information," Journal of Economic Theory, Elsevier, vol. 87(1), pages 1-48, July.
  9. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  10. Jack High (ed.), 2001. "Competition," Books, Edward Elgar Publishing, number 1751, July.
  11. Pradeep Dubey & John Geanakoplos & Martin Shubik, 1988. "Default and Efficiency in a General Equilibrium Model with Incomplete Markets," Cowles Foundation Discussion Papers 879R, Cowles Foundation for Research in Economics, Yale University, revised Feb 1989.
  12. Radner, Roy, 1972. "Existence of Equilibrium of Plans, Prices, and Price Expectations in a Sequence of Markets," Econometrica, Econometric Society, vol. 40(2), pages 289-303, March.
  13. John Geanakoplos, 1996. "Promises Promises," Cowles Foundation Discussion Papers 1143, Cowles Foundation for Research in Economics, Yale University.
  14. Prescott, Edward C & Townsend, Robert M, 1984. "Pareto Optima and Competitive Equilibria with Adverse Selection and Moral Hazard," Econometrica, Econometric Society, vol. 52(1), pages 21-45, January.
  15. George A. Akerlof, 1970. "The Market for "Lemons": Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, Oxford University Press, vol. 84(3), pages 488-500.
  16. Helpman, Elhanan & Laffont, Jean-Jacques, 1975. "On moral hazard in general equilibrium theory," Journal of Economic Theory, Elsevier, vol. 10(1), pages 8-23, February.
  17. Pradeep Dubey & John Geanakoplos, 2001. "Signalling and Default: Rothschild-Stiglitz Reconsidered," Cowles Foundation Discussion Papers 1305, Cowles Foundation for Research in Economics, Yale University.
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