Endogenous Market Incompleteness Without Market Frictions: Dynamic Suboptimality of Competitive Equilibrium in Multiperiod Overlapping Generations Economies

Espen Henriksen and Stephen Spear

No 2005-E37, GSIA Working Papers from Carnegie Mellon University, Tepper School of Business

Abstract: In this paper, we show that within the set of stochastic three-period-lived OLG economies with productive assets (such as land), markets are necessarily sequentially incomplete, and agents in the model do not share risk optimally. We start by characterizing perfect risk sharing and find that it requires a state-dependent consumption claims which depend only on the exogenous shock realizations. We show then that the recursive competitive equilibrium of any overlapping generations economy with weakly more than three generations is not strongly stationary. This then allows us to show directly that there are short-run Pareto improvements possible in terms of risk-sharing and hence, that the recursive competitive equilibrium is not Pareto optimal. We then show that a financial reform which eliminates the equity asset and replaces it with zero net supply insurance contracts (Arrow securities) will implement to Pareto optimal stochastic steady-state known to exist in the model. Finally, we also show via numerical simulations that a system of government taxes and transfers can lead to a Pareto improvement over the competitive equilibrium in the model.

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Journal Article: Endogenous market incompleteness without market frictions: Dynamic suboptimality of competitive equilibrium in multiperiod overlapping generations economies (2012)
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