Default and Efficiency in a General Equilibrium Model with Incomplete Markets

Pradeep Dubey, John Geanakoplos () and Martin Shubik
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John Geanakoplos: Cowles Foundation, Yale University, https://economics.yale.edu/people/faculty/john-geanakoplos

No 879R, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

Abstract: We extend the standard model of general equilibrium with incomplete markets (GEI) to allow for default. Default can be either strategic, or due to ill-fortune. Agents who default are penalized to a degree proportional to the size of their default and to penalty parameters lambda. We find that under conditions similar to those necessary to guarantee the existence of GEI equilibrium, we get the existence of GEI_{lambda} equilibrium, for any lambda > 0. We argue that default is thus reasonably modeled as an equilibrium phenomenon. Moreover, we show that more lenient lambda which encourage default may be Pareto improving because they allow for better risk spreading. When default occurs, the Modigliani-Miller theorem typically fails to hold in our framework.

Pages: 37 pages
Date: 1988, Revised 1989-02
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Citations: View citations in EconPapers (52)

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