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Default and Punishment in General Equilibrium

  • P. Dubey


  • J. Geanakoplos
  • M . Shubik

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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Paper provided by Stony Brook University, Department of Economics in its series Department of Economics Working Papers with number 01-07.

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Length: 48
Date of creation: 2001
Date of revision:
Handle: RePEc:nys:sunysb:01-07
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  1. 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.
  2. Bisin, Alberto & Gottardi, Piero, 1999. "Competitive Equilibria with Asymmetric Information," Journal of Economic Theory, Elsevier, vol. 87(1), pages 1-48, July.
  3. Franklin Allen & Douglas Gale, . "Optimal Security Design," Rodney L. White Center for Financial Research Working Papers 26-87, Wharton School Rodney L. White Center for Financial Research.
  4. William R. Zame, 1990. "Efficiency and the Role of Default When Security Markets are Incomplete," UCLA Economics Working Papers 585, UCLA Department of Economics.
  5. Pradeep Dubey & John Geanakoplos, 2001. "Signalling and Default: Rothschild-Stiglitz Reconsidered," Cowles Foundation Discussion Papers 1305, Cowles Foundation for Research in Economics, Yale University.
  6. Oliver Hart & John Moore, 1997. "Default and Renegotiation: A Dynamic Model of Debt," STICERD - Theoretical Economics Paper Series 321, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  7. Jack High (ed.), 2001. "Competition," Books, Edward Elgar, number 1751, April.
  8. 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.
  9. Hellwig,Martin, 1986. "Some recent developments in the theory of competition in markets with adverse selection," Discussion Paper Serie A 82, University of Bonn, Germany.
  10. Franklin Allen & Douglas Gale, . "Arbitrage, Short Sales and Financial Innovation," Rodney L. White Center for Financial Research Working Papers 10-89, Wharton School Rodney L. White Center for Financial Research.
  11. Pesendorfer Wolfgang, 1995. "Financial Innovation in a General Equilibrium Model," Journal of Economic Theory, Elsevier, vol. 65(1), pages 79-116, February.
  12. repec:tpr:qjecon:v:84:y:1970:i:3:p:488-500 is not listed on IDEAS
  13. repec:tpr:qjecon:v:90:y:1976:i:4:p:630-49 is not listed on IDEAS
  14. 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.
  15. 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.
  16. Gale, Douglas, 1992. "A Walrasian Theory of Markets with Adverse Selection," Review of Economic Studies, Wiley Blackwell, vol. 59(2), pages 229-55, April.
  17. 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.
  18. John Geanakoplos, 1996. "Promises Promises," Cowles Foundation Discussion Papers 1143, Cowles Foundation for Research in Economics, Yale University.
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