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Default and Punishment in General Equilibrium

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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.

Suggested Citation

  • Pradeep Dubey & John Geanakoplos & Martin Shubik, 2001. "Default and Punishment in General Equilibrium," Cowles Foundation Discussion Papers 1304, Cowles Foundation for Research in Economics, Yale University.
    • Handle: RePEc:cwl:cwldpp:1304
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    More about this item

    Keywords

    Default; incomplete markets; adverse selection; moral hazard; equilibrium refinement; endogenous assets;
    All these keywords.

    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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