Pareto improving financial innovation in incomplete markets

David Cass and Alessandro Citanna
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Alessandro Citanna: GSIA, Carnegie Mellon University, Pittsburgh, PA 15213, USA

Economic Theory, 1998, vol. 11, issue 3, 467-494

Abstract: In this paper we develop a differential technique for investigating the welfare effects of financial innovation in incomplete markets. Utilizing this technique, and after parametrizing the standard competitive, pure-exchange economy by both endowments and utility functions, we establish the following (weakly) generic property: Let S be the number of states, I be the number of assets and H be the number of households, and consider a particular financial equilibrium. Then, provided that the degree of market incompleteness is sufficiently larger than the extent of household heterogeneity, S-I\geq2H-1 [resp. S-I\geqH+1], there is an open set of single assets [resp. pairs of assets] whose introduction can make every household better off (and, symmetrically, an open set of single assets [resp. pairs of assets] whose introduction can make them all worse off ). We also devise a very simple nonparametric procedure for reducing extensive household heterogeneity to manageable size, a procedure which not only makes our restrictions on market incompleteness more palatable, but could also prove to be quite useful in other applications involving smooth analysis.

JEL-codes: C60 D52 D60 G10 (search for similar items in EconPapers)
Date: 1998-05-05
Note: Received: August 14, 1995; revised version: April 14, 1997
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Working Paper: Pareto Improving Financial Innovation in Incomplete Markets (1998)
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