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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 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.

Suggested Citation

  • Pradeep Dubey & John Geanakoplos & Martin Shubik, 2001. "Default and Punishment in General Equilibrium," Cowles Foundation Discussion Papers 1304R5, Cowles Foundation for Research in Economics, Yale University, revised Mar 2004.
  • Handle: RePEc:cwl:cwldpp:1304r5
    Note: CFP 1108.
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    1. Hart, O. & Moore, J., 1989. "Default And Renegotiation: A Dynamic Model Of Debt," Working papers 520, Massachusetts Institute of Technology (MIT), Department of Economics.
    2. Allen, Franklin & Gale, Douglas, 1991. "Arbitrage, Short Sales, and Financial Innovation," Econometrica, Econometric Society, vol. 59(4), pages 1041-1068, July.
    3. Franklin Allen, Douglas Gale, 1988. "Optimal Security Design," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 229-263.
    4. Jack High (ed.), 2001. "Competition," Books, Edward Elgar Publishing, number 1751.
    5. 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.
    6. 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.
    7. 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.
    8. Pesendorfer Wolfgang, 1995. "Financial Innovation in a General Equilibrium Model," Journal of Economic Theory, Elsevier, vol. 65(1), pages 79-116, February.
    9. 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.
    10. Pradeep Dubey & John Geanakoplos, 2001. "Signalling and Default: Rothschild-Stiglitz Reconsidered," Cowles Foundation Discussion Papers 1305, Cowles Foundation for Research in Economics, Yale University.
    11. Douglas Gale, 1992. "A Walrasian Theory of Markets with Adverse Selection," Review of Economic Studies, Oxford University Press, vol. 59(2), pages 229-255.
    12. 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.
    13. Bisin, Alberto & Gottardi, Piero, 1999. "Competitive Equilibria with Asymmetric Information," Journal of Economic Theory, Elsevier, vol. 87(1), pages 1-48, July.
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    More about this item

    Keywords

    Default; incomplete markets; adverse selection; moral hazard; equilibrium refinement; endogenous assets;

    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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