Default and Punishment in General Equilibrium

Pradeep Dubey, John Geanakoplos () and Martin Shubik
Additional contact information
Pradeep Dubey: SUNY, Stony Brook
John Geanakoplos: Yale University, Cowles Foundation, http://cowles.econ.yale.edu/faculty/geanakoplos.htm

No 1304, Cowles Foundation Discussion Papers from Cowles Foundation, Yale University

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.

Keywords: Default; incomplete markets; adverse selection; moral hazard; equilibrium refinement; endogenous assets (search for similar items in EconPapers)
JEL-codes: D4 D5 D8 D41 D52 D81 D82 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ent, nep-gth and nep-net
Date: Written
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Related works:
Working Paper: Default and Punishment in General Equilibrium (2001)
Working Paper: Default and Punishment in General Equilibrium (2004)
Journal Article: Default and Punishment in General Equilibrium (2005)
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