General Equilibrium Theory Lecture Notes

General equilibrium theory
Lecture notes
Alberto Bisin
Dept. of Economics
NYU
November 5, 2011
ii
Contents
1 Introduction 1
2 Demand theory: A quick review 3
2.1 Consumer theory . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.1.1 Duality . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.1.2 Aggregate demand . . . . . . . . . . . . . . . . . . . . 11
2.2 Producer theory . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3 Arrow-Debreu exchange economies 17
3.1 The economy . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.2 Pareto eciency . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.3 Competitive equilibrium . . . . . . . . . . . . . . . . . . . . . 19
3.3.1 Uniqueness . . . . . . . . . . . . . . . . . . . . . . . . 23
3.3.2 Local uniqueness . . . . . . . . . . . . . . . . . . . . . 23
3.3.3 Dierentiable approach: A rough primer . . . . . . . . 25
3.3.4 Competitive equilibrium in production economies . . . 31
3.4 Mathematical appendix . . . . . . . . . . . . . . . . . . . . . . 31
3.4.1 References . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.5 Strategic foundations . . . . . . . . . . . . . . . . . . . . . . . 34
4 Two-period economies 35
4.1 Arrow-Debreu economies . . . . . . . . . . . . . . . . . . . . . 35
4.2 Financial market economies . . . . . . . . . . . . . . . . . . . 38
4.2.1 The stochastic discount factor . . . . . . . . . . . . . . 42
4.2.2 Arrow theorem . . . . . . . . . . . . . . . . . . . . . . 44
4.2.3 Existence . . . . . . . . . . . . . . . . . . . . . . . . . 46
4.2.4 Constrained Pareto optimality . . . . . . . . . . . . . . 47
4.2.5 Aggregation . . . . . . . . . . . . . . . . . . . . . . . . 54
iii
iv CONTENTS
4.2.6 Asset pricing . . . . . . . . . . . . . . . . . . . . . . . 63
4.2.7 Some classic representation of asset pricing . . . . . . . 63
4.2.8 Production . . . . . . . . . . . . . . . . . . . . . . . . 68
5 Asymmetric information 79
5.1 A simple insurance economy . . . . . . . . . . . . . . . . . . . 80
5.1.1 The Symmetric information benchmark . . . . . . . . . 81
5.2 The moral hazard economy . . . . . . . . . . . . . . . . . . . . 82
5.3 The adverse selection economy . . . . . . . . . . . . . . . . . . 85
5.4 Information revealed by prices . . . . . . . . . . . . . . . . . . 86
5.4.1 References . . . . . . . . . . . . . . . . . . . . . . . . . 90
6 Innite-horizon economies 93
6.1 Asset pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
6.1.1 Arrow-Debreu economy . . . . . . . . . . . . . . . . . . 94
6.1.2 Financial markets economy . . . . . . . . . . . . . . . 94
6.1.3 Conditional asset pricing . . . . . . . . . . . . . . . . . 95
6.1.4 Predictability or returns . . . . . . . . . . . . . . . . . 97
6.1.5 Fundamentals-driven asset prices . . . . . . . . . . . . 98
6.2 Bubbles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
6.2.1 (Famous) Theoretical Examples of Bubbles . . . . . . . 106
6.3 Double Innity . . . . . . . . . . . . . . . . . . . . . . . . . . 108
6.3.1 Overlapping generations economies . . . . . . . . . . . 111
6.4 Default . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
7 To add 123
Chapter 1
Introduction
These notes constitute the material for the second half of the Micro I (rst
year) graduate course at NYU. They owe much to the brilliant TAs I had,
Sevgi Yuksel and (somewhat in expectations) Bernard Herskovic. The topic
of this section of the course is general equilibrium theory (the other section,
decision theory, is taught by Ariel Rubinstein).
The standard approach to graduate teaching of general equilibrium the-
ory involves introducing a series of theorems on existence, characterization,
and welfare properties of competitive equilibria under weaker and weaker
assumptions in larger and larger commodity spaces. Such an approach intro-
duces the students to precise rigorous mathematical analysis and invariably
impresses them with the elegance of the theory. Various textbooks take this
approach, in some form or another:
A. Mas-Colell, M. Whinston, and J. Green (1995): Microeconomic Theory,
Oxford University Press, Part 4, is the main reference; it also contains
a short introduction to two-period economies.
L. McKenzie (2002), Classical General Equilibrium Theory, MIT Press, is a
beautiful modern treatment of the classical theory.
K. Arrow and F. Hahn (1971): General Competitive Analysis, North Hol-
land, is the classical treatment of the classical theory.
1
1
And so is G. Debreu (1972), Theory of Value: An Axiomatic Analysis of Economic
Equilibrium, Cowles Foundation Monographs Series, Yale University Press, an invaluable
little book for several generations of theorists.
1
2 CHAPTER 1. INTRODUCTION
B. Ellickson (1994): Competitive Equilibrium: Theory and Applications,
Cambridge University Press. It contains a useful chapter on non-convex
economies.
M. Magill and M. Quinzii (1996): Theory of Incomplete Markets, MITPress,
takes a classical theory approach on nancial market equilibrium in
two-period economies.
The approach adopted in these notes aims instead at introducing gen-
eral equilibrium theory per se but also as the canonical microfoundation for
macroeconomics and nance. To this end, the standard theory of general
equilibrium is introduced in its rigour and elegance, but only under restric-
tive assumptions, allowing some shortcuts in analysis and proofs. On the
other hand, we shall be able to introduce nancial market equilibria in two-
period economies after only a few classes, exposing students to fundamen-
tal conceptual notions like complete and incomplete markets, no-arbitrage
pricing, constained eciency, equilibria in moral hazard and adverse selec-
tion economies, and more. The course ends with a treatment of dynamic
economies and recursive competitive equilibria. Pedagogically, from two-
period to fully dynamic economies the step is rather short, so that we can
concentrate on purely dynamic concepts, like bubbles.
Chapter 2
Demand theory: A quick
review
The consumption set A is the set of admissible levels of consumption of 1
existing commodities. In this section we shall assume
A = R
1
+
. with generic element r.
A is then a convex set, bounded below. For any r. A. we say r if
r
|
_
|
. for any | = 1. 2. .... 1. and r
|

|
for at least one | = 1. 2. .... 1.
Assumption 1 The consumer has a utility function
1
l : R
1
+
R
which satises the following properties,
Strong Monotonicity: r = l() l(r). for any r. R
1
+
;
1
In these notes we shall adopt the utility function as a primitive. That is, we shall
assume that any agents underlying preference ordering % on X (is complete, transitive,
and continuous; so that it) can be represented by a utility function; see Rubinstein (2009).
A preference ordering % on X which (is not continuous and hence it) cannot be represented
by a utility function is the Lexicographic ordering:
x % y if x
1
_ y
1
or x
1
= y
1
and x
l
_ y
l
; for l = 2; :::; L:
3
4 CHAPTER 2. DEMAND THEORY: A QUICK REVIEW
Strict Convexity: l : R
1
+
R is strictly quasi-concave, that is,
l (cr + (1 c) ) _ cl(r) + (1 c) l(). for any r. R
1
+
and c [0. 1]. and
l (cr + (1 c) ) cl(r) + (1 c) l(). if r ,= and c (0. 1)
Dierentiability: l : R
1
+
R is C
2
on the interior of its domain.
Let \l denote the gradient of the map l : R
1
+
R. Exploiting dier-
entiability strong monotonicity can be equivalently written as
\l(r) R
1
++
. for any r R
1
++
;
while strict quasi-concavity as
\
2
l(r) < 0 for any ,= 0 R
1
such that \l(r) = 0. for any r R
1
++
.
Common properties of utility functions at times studied in applications
include:
Quasi-linearity: l(r) = r
1
+ (r
2
. .... r
1
). for some : R
11
+
R
satisfying strong monotonicity, strict convexity, and dierentiability.
Homotheticity: l(cr) = cl(r). for any c R
++
.
Examples of homothetic utility functions include:
Cobb Douglas: l(r) = r
c
1
r
1c
2
;CES: l(r) = r
o
1
+ r
o
2
.
Dierentiability is violated, for instance, by Leontief preferences:
l(r) = min .... `
|
r
|,...
. for some ` R
1
++
.
2.1 Consumer theory
Markets are competitive, that is, the consumer takes market prices as given,
independent of his decisions (each agent is a price taker). In addition we
consider the case where:
prices are linear: unit price j
|
of each commodity | is xed, independent of
level of individual trades (and the same for all agents);
2.1. CONSUMER THEORY 5
prices are non-negative: this is justied under free disposal, that is, when
agents can freely dispose of any amount of any commodity;
markets are complete: for each commodity | in A there is a market where
the commodity can be traded.
Given wealth level :, the budget set is:
1(j. :) =
_
r A : j r =
1
|=1
j
|
r
|
_ :
_
The budget set is convex, compact, and non-empty for j R
1
++
. : _
0.Furthermore, the budget set is homogeneous of degree 0:
1(j. :) = 1(cj. c:). for all c 0.
Consider the consumers utility maximization problem,
max
a1(j,n)
l(r).
For any j R
1
++
. : _ 0. under our assumptions on l(r), by the Max-
imum theorem, a solution of the consumers problem exists. Furthermore,
the solution of the consumers problem for every j. : induces the consumers
demand correspondence r : R
1
++
R
+
R
1
+
. r(j. :). Strict quasi-concavity
of l(r). again by the Maximum theorem, implies that r(j. :) is a in fact a
continuous function.
Proposition 1 The individual consumers demand r(j. :) satises the fol-
lowing properties:
Homogeneity of degree zero in j. ::
r(j. :) = r(cj. c:) for all j R
1
++
. c 0;
Continuity: r(j. :) is a continuous function in j. :;
Walras Law: jr(j. :) = :;
WARP: for any (j. :). (j
t
. :
t
) R
1
++
R
+
such that r = r(j. :) ,= r
t
=
r(j
t
. :
t
):
if jr
t
_ :. then j
t
r :
t
.
Proof. These properties are straightforward consequences of the assump-
tions. Homogeneity of degree zero is a consequence of homogeneity of degree
zero of the budget set. Continuity follows from the Maximum theorem under
strict quasi-concavity of l(r) (weak quasi-concavity would induce an upper-
hemi-continuous, convex valued correspondence r : R
1
++
R
+
R
1
+
. WARP
and Walras law follow easily from strict monotonicity.
It is important to notice that WARP does not imply the (uncompensated)
Law of demand, that is,
(j j
t
) (r(j. :) r(j
t
. :
t
)) _ 0. for : = :
t
.
Note also that the (uncompensated) Law of demand is equivalently written,
exploiting dierentiability, as
dj1
j
r(j. :)dj _ 0.
Therefore, WARP does not imply that 1
j
r(j. :) is negative semi-denite.
In general in fact, 1
j
r(j. :) is NOT negative semi-denite. If preferences
are homothetic, however, the individual consumers demand r(j. :) does
satisfy the (uncompensated) Law of demand. Furthermore, in this case, the
individual consumers demand r(j. :) is homogeneous of degree 1 in ::
r(j. c:) = cr(j. :) for all j R
1
++
. :. c 0.
2
WARP on the other hand does imply the (compensated) Law of demand
(j j
t
) (r(j. :) r(j
t
. :
t
)) _ 0. for ::
t
= (j j
t
)r(j
t
. :
t
).
Once again, exploiting dierentiability we can express the (compensated) Law
of demand through the properties of the Slutsky matrix of compensated price
eects. Consider the following compensated price change:
dj. d:: d: = r dj
The induced demand change is
dr = 1
j
r(j. :)dj + 1
n
r(j. :)d: =
= 1
j
r(j. :) dj + 1
n
r(j. :)(rdj).
2
This is a consequence of the fact that homotheticity implies that marginal rates of
substitution,
@U(x)
@x
l
@U(x)
@x
l
0
; for any l; l
0
; are invariant with respect to expansions along rays from
the origin.
Dene then the Slutsky matrix of compensated price eects as
o(j. :) = 1
j
r(j. :) + 1
n
rr.
WARP then implies the following.
Proposition 2 o(j. :) is negative semi denite; that is,
djo(j. :)dj _ 0. for any dj R
1
.
Finally, any solution of the consumers problem satises the following
system of Kuhn Tucker necessary and sucient conditions. In the case of
interior solutions, these are:
\l `j = 0
:j r = 0.
for some ` 0, the Lagrange multiplier associated to the budget constraint.
Local properties of r(j. :) can then be obtained using the Implicit Function
theorem on the previous rst order conditions (focs):
_
\
2
l `j
`j
T
0
_ _
dr
d`
_
=
_
`
r
T
_
dj +
_
0
1
_
d:
Note that the second order conditions (socs) guarantee that
_
\
2
l `j
`j
T
0
_
is invertible
when evaluated at an (r. `. j) satisfying focs. A simple proof of this state-
ment follows for completeness.
Proof. We show that @(. .) R
1+1
, (. .) ,= 0 such that
_
\
2
l `j
`j
T
0
_ _

.
_
=
_
\
2
l `j.
`j
_
= 0.
3
3
For any strict quasi concave and C
2
function f : R
L
+
R; the matrix
_
\
2
f \f
\f
T
0
_
is called bordered Hessian and has a non-zero determinant. Note that
_
\
2
U p
p
T
0
_
is
the bordered Hessian of the Lagrangian.
By contradiction, suppose such a (. .) exists. Then pre-multiplying \
2
l
`j. by , yields:
\
2
l = `j..
But `j. = 0. and hence \
2
l = 0. But the second order conditions (socs;
in turn guaranteed by strict quasi-concavity of the Lagrangian, l(r)`(jr
:)), require that \
2
l < 0 on all ,= 0 such that (\l `j) = 0; a
contradiction.
2.1.1 Duality
Let \ : R
1
++
R
+
. \ (j. :), be dened by
\ (j. :) = l(r(j. :)).
\ (j. :) is the indirect utility function.
Proposition 3 The indirect utility function \ (j. :) satises the following
properties:
J\ (j. :),J: = ` 0: the consumers marginal utility of wealth equals the
shadow value of relaxing the budget constraint;
\ (j. :) is homogenous of degree zero in j. :;
J\ (j. :),Jj
|
_ 0 for all |. j 0;
\ (j. :) is quasi-convex in j: the lower contour set
_
j : \ (j. :) _

\
_
is
convex.
Proof. The properties are straighforward consequences of the assumptions
on l(r) and the properties of r(j. :). We leave them to the reader, except
quasi-convex in j. which is proved as follows. Take any pair j
t
. j
tt
such that
\ (j
t
. :). \ (j
tt
. :) _

\ and consider ^ j = cj
t
+(1 c)j
tt
for c [0. 1]. Note
that for all r such that ^ j r _ : we must have either j
t
r _ : and/or
j
tt
r _ :; thus l(r) _ .
Consider the consumers cost minimization problem,
min
aA
j r
s.t.l(r) _ n
A solution exists for all n _ l(0) and j R
1
++
. The solution /(j. n). with
/ : R
1
++
R R
1
+
. is typically referred to as compensated - or Hicksian -
demand. By the socs,
1
j
/(j. n) is symmetric, negative semi-denite.
We say that Hicksian demands /(j. n) satisfy the law of demand.
Let c : R
1
++
R R
+
. c(j. n) = j/(j. n) dene the expenditure function.
Proposition 4 The expenditure function c(j. n) has the following properties:
Jc(j. n),Jn 0;
Jc(j. n),Jj
|
_ 0 for all | = 1. ... 1;
c(j. n) is homogeneous of degree one in j;
c(j. n) is concave in j.
Proof. The properties are straighforward consequences of the Maximum
theorem and the assumptions on l(r). We leave them to the reader, except
quasi-concavity in j. which is proved as follows. For any pair j
t
. j
tt
, consider
^ j = cj
t
+ (1 c)j
tt
for c [0. 1]. Then, for any n, c(^ j. n) = ^ j /(^ j. n) =
cj
t
/(^ j. n) +(1c)j
tt
/(^ j. n). which is in turn _ cc(j
t
. n) +(1c)c(j
tt
. n).
For all j R
1
++
, : 0. n l(0), the following identities hold:
r(j. :) = /(j. n)
for n = \ (j. :) and c(j. n) = :.
(2.1)
By the envelope theorem, the compensated demand can be obtained from
the expenditure function:
/(j. n) = 1
j
c(j. n).
Hence the properties of /(j. n) can also be obtained from those of c(j. n).
Similarly, dierentiating the equation dening the indirect utility,
\ (j. :) = l(r(j. :) `(jr :)
with respect to j, we obtain Roys identity:
\
j
\ (j. :) = `r(j. :) = \
n
\ (j. :) r(j. :).
A brief summary of the duality relationships can be helpful:
Figure 2.1: Brief summary of duality relations
r(j. :) /(j. n) Slutsky:
1
j
r(j. n) 1
n
r r
T
= 1
j
/(j. n).
\ (j. :) r(j. :) Roys identity:
r(j. :) =
1
\
n
\ (j. :)
\
j
\ (j. :).
c(j. n) /(j. n) Expenditure function properties:
/(j. n) = \
j
c(j. n).
\ (j. :) c(j. n) Utility-expenditure duality, for given j R
1
++
:
\ (.. :) = c
1
(.. :).
c(.. n) = \
1
(.. n)
r(j. :) /(j. n) Marshallian-Hicks demand duality:
r(j. :) = /(j. \ (j. :))
/(j. n) = r(j. c(j. n))
2.1.2 Aggregate demand
It is useful to study in detail the properties of aggregate demand, as a func-
tion of wealth. With some abuse of notation, let introduce the notation to
index agents, i = 1. .... 1. Let the wealth of agent i be denoted :
i
. Fix the
distribution of wealth as follows,
:
i
= c
i
: for some given c
i
_ 0, for all i,

i
c
i
= 1.
The Marshallian demand of any agent i is then denoted r
i
(j. :
i
) and
r(j. :) =

i1
r
i
(j. :
i
)
is the aggregate demand.
Aggregate demand trivially inherits several properties from individual
demand, i.e., dierentiability, homeogeneity of degree 0, Walras Law. But
does r(j. :) satisfy WARP? Not, typically. Take (j. :) and (j
t
. :
t
) such
that r (j
t
. :
t
) ,= r (j. :) and
j r (j
t
. :
t
) _ :.
It is immediate to see that the following inequality can still hold:
j
t
r (j. :) _ :
t
(because jr (j
t
. :
t
) _ : does not imply jr
i
(j
t
. :
it
) _ :
i
for all i; similarly
for j
t
r (j. :) _ :
t
.)
A sucient condition for aggregate demand r (j. :) to satisfy WARP
is that individual Marshallian demands satisfy the (uncompensated) law of
demand, that is, substitution eects prevail over income eects.
Proposition 5 Suppose r
i
(j. :
i
) satises the (uncompensated) law of de-
mand, that is,
1
j
r
i
(j. :
i
) is negative semi-denite
for all i. Then r (j. :) also satises the (uncompensated) law of demand
and hence WARP.
2.2 Producer theory
We shall study the production activity of rms operating in competitive
markets. A production plan is a R
1
, interpreted as the net output of the
1 goods:
i
< 0 : input
i
0 : output
The production set is the set of (technologically feasible) production plans:
1 R
1
.
Whenever the commodities which are outputs in the production set are xed,
C 1. ... 1 (and hence also the complementary set of those which are in-
puts), the outer boundary of 1 can typically be represented by a (continuous)
2.2. PRODUCER THEORY 13
production function, describing the maximal output level attainable for any
level of inputs. In the case where C = 1 . e.g.,
1
= ,(.) i
(
1
. .) 1
@
t
1

1
: (
t
1
. .) 1
We assume that 1 and and , : R
11
+
R
+
satisfy the following assump-
tions:
Regularity 1 is nonempty, closed, 1 R
1
+
= 0 (no free lunch and
possibility of inaction), and it satises free disposal :
1 and
t
_ =
t
1
Correspondingly, , : R
11
+
R
+
is monotonically increasing.
Convexity 1 is strictly convex:
.
t
1 =c + (1 c)
t
i:t1
Correspondingly, , : R
11
+
R
+
is strictly concave (has decreasing
returns to scale). (1 is convex,
1 =c 1 for all c [0. 1]
corresponds to , : R
11
+
R
+
is concave - has non-increasing returns
to scale.)
Any rm chooses a production plan so as to maximize prots:
max j
s.t. 1
Existence of a solution requires conditions ensuring that 1 is bounded
above. For every j _ 0, a solution induces a net supply correspondence
(j).
Proposition 6 The net supply correspondence (j) satises the following
properties:
(j) is homogeneous of degree 0 in j;
(j) is a convex-valued correspondence (a single valued function if , :
R
11
+
R
+
is strictly concave).
The value of the solution is a prot function :(j) = j (j).
Proposition 7 The prot function :(j) satises the following properties:
:(j) is homogeneous of degree 1 in j;
:(j) is a convex function.
Proof. The properties are straighforward consequences of the properties
of (j). We leave them to the reader, except convexity. which is proved as
follows. Take any pair j
t
. j
tt
and consider ^ j = cj
t
+ (1 c)j
tt
for c (0. 1).
Note that :(^ j) = (^ j) (cj
t
+ (1 c)j
tt
) _ c(j
t
) j
t
+ (1 c)(j
tt
) j
tt
= c:(j
t
) + (1 c):(j
tt
).
Suppose 1 is a convex cone,
1 =c 1 for all c 0.
that is, the technology has constant returns to scale. Correspondingly, the
production function , : R
11
+
R
+
is homogeneous of degree 1 in its argu-
ments and,
- (j) =c (j) for all c 0;
- :(j) = 0 for all j.
Whenever , is dierentiable, any solution of the rms problem satisfy
the following system of focs (stated here for the case of interior solutions):
j
1
1, = n.
Focs are also sucient if , is concave.
Assume , is continuously dierentiable and strictly concave. Applying
the Implicit Function theorem to focs, we obtain:
1
&
. =
1
j
1
_
1
2
,
_
1
is symmetric, negative denite
Furthermore, by the envelope theorem, (j) = 1
j
:, so that 1
j
= 1
2
:
is:
2.2. PRODUCER THEORY 15
- symmetric,
- positive - recall . = (
2
. ...
1
) ! - semidenite (by the convexity of :) and
- such that 1
j
j = 0 (by the homogeneity of (j)).
Let j =
_
j
1
n
_
and =
_

1
.
_
. The input level . which solves the rms
choice problem also solves the following problem:
min
:R
L1
+
C = n.
:.t. ,(.) _
1
.
This is perfectly analogous to expenditure minimization problem of con-
sumer. Hence we know that:
- C(n.
1
) is concave in n and such that JC,J
1
0 and JC,Jn
|
_ 0.
| = 1. ... 1 1;
- .(n.
1
) = 1
&
C exhibits the properties of a compensated demand function.
Chapter 3
Arrow-Debreu exchange
economies
3.1 The economy
The economy is polupated by 1 consumers with preferences described by
l
i
: R
1
+
R and resources .
i
R
1
+
, i 1 = 1. ... 1 .
1
An allocation is an
array (r
1
. ... r
1
) R
11
+
, and it is feasible if it satises
1
i=1
r
i
_
1
i=1
.
i
In the special case in which 1 = 2, 1 = 2, feasible allocations can be graphi-
cally represented using the Edgeworth Box.
Unless otherwise noted, we shall impose the following strong (but not
outrageous) assumptions.
Assumption 2 l
i
: R
1
+
R is C
2
in any open subset of R
1
+
.strictly monotonic
in its arguments and strictly quasi-concave. Furthermore, . R
11
++
.
3.2 Pareto eciency
An allocation x R
11
+
is Pareto ecient if it is feasible and there is no other
feasible allocation ^ x R
11
+
which Pareto dominates it:
l
i
(^ r
i
) _ l
i
(r
i
) for all i, for at least one i.
1
We are conscious of the notational abuse.
17
18 CHAPTER 3. ARROW-DEBREU EXCHANGE ECONOMIES
Pareto dominance denes a (social) preference relation over the set of allo-
cations R
11
+
, which is however incomplete.
PE allocations are solutions of the problem:
max
x
l
i
(r
i
)
s.t.

i
r
i
_
i
.
i
l
i
0
(r
i
0
) _

l
i
0
for all i
t
,= i
for some given
_
l
i
0
_
i
0
,=i
.
The focs (for an interior solution) of this problem are:
\l
i
= j
j
i
0
\l
i
0
= j for all i
t
,= i
i
r
i
=

i
.
i
where
_
j
i
0
_
i
0
,=i
and j are the Lagrange multipliers of the two sets of con-
straints above. Thus
\l
i
= j
i
0
\l
i
0
for all i
t
,= i
and utility gradients are co-linear for all agents (Marginal rates of substitu-
tion are equalized across agents).
Varying the values of

l
i
0
for i
t
,= i we obtain the set Pareto ecient
allocations, the Pareto frontier.
Let the Utility possibility set be the image of the feasible allocations in
the space of utility levels
U =
_
l R
1
l _
_
l
i
(r
i
)
_
1
i=1
, for some r R
11
+
such that

i
r
i
_
i
.
i
_
U is closed, convex, bounded above. Furthermore, the set of Pareto optimal
utilities is dened as
UP = l U[@l
t
U such that l
t
l .
2
2
In our notation, U
0
> U requires U
0i
_ U
i
, for any i I; with at least one strict
inequality.
3.3. COMPETITIVE EQUILIBRIUM 19
Theorem 8 (Negishi) Let r R
11
+
be a Pareto ecient allocation. Then
there exist a c R
1
+
, c ,= 0, such that
r = arg max
i1
c
i
l
i
(r
i
)
s.t.

i
r
i
_

i
.
i
.
Furthermore,
c
i
c
i
0
= j
i
0
. for any i
t
,= i 1.
Proof. Consider a Pareto optimal allocation r. so that l(r) = l
i
(r
i
)
i1

UP. Furthermore, l(r) /d:(U), and U is closed, convex, bounded above.
An appropriate separating hyperplane theorem then implies that there exists
a c R
1
, c ,= 0, such that
cl(r) _ cl. for any l U;
that is,
l(r) = arg max
i1
c
i
l
i
s.t. l U.
Trivially, then
r = arg max
i1
c
i
l
i
(r
i
)
s.t.

i
r
i
_

i
.
i
.
Finally, U is unbounded below, which implies that c R
1
+
.
PE allocations support points on the outer boundary of l1.
3.3 Competitive equilibrium
Agents trade in perfectly competitive markets.
A competitive equilibrium is an allocation r = (.... r
i
. ..) R
11
+
and a
price j R
1
++
such that
r
i
arg max l
i
(r
i
)
s.t. jr
i
_ j.
i
.
for any i 1. and

i
r
i
_
i
.
i
.
Trade is voluntary, hence equilibrium allocations will satisfy individual ra-
tionality:
l
i
(r
i
) _ l
i
(.
i
) for all i = 1. .... 1.
Letting :
i
= j.
i
we can derive agent 1s Marshallian demand from his
consumer problem, as in the previous chapter. It is convenient, however,
represent demand functions in terms of endowments rather than wealth:
r
i
: R
1
++
R
1
++
R
1
+
.
Let .
i
(j. .
i
) denote agent i 1s excess demand: .
i
(j. .
i
) = r
i
(j. .
i
) .
i
.
Finally, the aggregate excess demand . : R
1
++
R
11
++
R
1
+
is dened as
. (j. .) =

i1
.
i
_
j. .
i
_
.
Proposition 9 For any economy . R
11
++
the aggregate excess demand
. (j. .) satises the following properties:
smoothness: . (j. .) is C
1
;
homogeneity of degree 0: . (`j. .) = . (j. .) .for any ` 0;
Walras Law: j. (j. .) = 0. \j 0;
lower boundedness: : such that .
|
(j. .) :, \| 1;
boundary property:
j
a
j ,= 0. with j
|
= 0 for some |. =max .
1
(j
a
. .). .... .
1
(j
a
. .) .
Lets rst study the welfare properties of competitive equilibrium alloca-
tions.
Theorem 10 (First welfare) All competitive equilibrium allocations are
Pareto ecient.
Proof. Suppose r = (... r
i
. ..) is a competitive equilibrium allocation for
some price j and it is not Pareto ecient. Then there must be another
allocation ^ r = (... ^ r
i
. ..) which is feasible and Pareto dominates r. But since
r
i
is the optimal choice of consumer i at prices j and preferences are strongly
monotone, l
i
(^ r
i
) _ l
i
(r
i
) implies j ^ r
i
_ jr
i
for all i and also, j ^ r
i
_ j.
i
,
with all the previous inequalities being strict for at least some i. Summing
the latter inequality over i yields j
i
^ r
i
j
i
.
i
which contradicts the
feasibility of ^ r.
Theorem 11 (Second welfare) For any Pareto ecient allocation r
R
11
+
, there exist transfers t 1
11
, such that

i
t
i
= 0 and r 1
11
+
is a
competitive equilibrium allocation (for some prices j 1
1
++
) of the economy
with initial endowment . + t 1
11
+
.
Proof. Let t
i
= r
i
.
i
for all i. The theorem is an implication of the
separating hyperplane theorem.
Let . = (.
i
)
i1
denote the vector of aggregate endowments.Competitive
equilibrium prices are solutions of:
.(j; .) =
i
r
i
(j. j .
i
)
i
.
i
= 0.
a system of 1 equations in 1 unknowns, the prices j. By Walras law
j
_
i
r
i
(j. j .
i
)
i
.
i
_
= 0. for all j
and hence at most 1 1 equations are independent (the market clearing
equation for one market can be o,itted without loss of generality). By ho-
mogeneity of degree 0 in j of r
i
(j. j .
i
). for any i 1. prices can always be
normalized, e.g., restricted without loss of generality to
j
11
=
_
j R
1
+
:

|
j
|
= 1
_
.
the 1-simplex, a compact ad convex set.
The equilibrium equations can thus be always reduced to 11 equations
in 1 1 unknowns. Since equations are typically nonlinear, having number
of unknowns less or equal than number of independent equations does not
ensure a solution exists.
Theorem 12 (Existence) Let . :
11
1
1
be a continuous function,
such that j .(j) = 0 for all j. Then there exists j
+
such that .(j
+
) _ 0.
Sketch of the proof.
Let ,
|
(j) =
j
|
+ max 0. .
|
(j)
1
)=1
[j
)
+ max 0. .
)
(j)]
, | = 1. ..1
Note that
11
is convex and compact, and , :
11

11
. Hence by
the Brouwer Fixed Point theorem there is a xed point j
+
:
j
+
|
=
j
+
|
+ max 0. .
|
(j
+
)
1
)=1
[j
)
+ max 0. .
)
(j)]
, | = 1. ..1.
Then
.
|
(j
+
)j
+
|
1
)=1
_
j
+
)
+ max 0. .
)
(j
+
)
= .
|
(j
+
)j
+
|
+ .
|
(j
+
) max 0. .
|
(j
+
)
and summing over | yields:
0 =

|
.
|
(j
+
) max 0. .
|
(j
+
) =.
|
(j
+
) _ 0 for all | = 1. .... 1.
Since j
+
satises .(j
+
) _ 0 and Walras law, j
+
.(j
+
) = 0,
.
|
(j
+
) < 0 i j
+
|
= 0.
But this is impossible under strong monotonicity and hence:
.(j
+
) = 0.
To properly claim existence of a competitive equilibrium need to face one last
problem: the consumers demand is not dened for prices on the boundary of
11
(when the price of some good is zero). We need to use a limit argument,
considering . :
11
.
R
1
, for
11
.
=
_
j R
1
+
:

|
j
|
= 1, j
|
_ for all |
_
,
and taking limits as 0.
3.3.1 Uniqueness
Existence of a competitive equilibrium can be proved under quite general con-
ditions.
3
Equilibria are however unique only under very strong restrictions.
Several examples of such restrictions are listed in the following.
The endowment distribution is Pareto ecient, and hence the only equilib-
rium is autarchic: r
i
= .
i
for all i 1.
Preferences satisfy an aggregation condition (so that a representative con-
sumer exists) for all j and for given (:
I
)
1
I=1
.
Aggregate demand satises WARP and equilibria are locally isolated.
Aggregate demand satises the gross substitution property:
j
t
|
j
|
and j
t
)
= j
)
. for all , ,= |.
==
.
)
(j
t
) .
)
(j).
Note that gross substitution implies that the law of demand holds at
any equilibrium price. Gross substitution holds for instance for Cobb
Douglas and CES utility functions (provided o < 1).
3.3.2 Local uniqueness
Let an economy be parametrized by the endowment vector . R
11
++
keeping
preferences (n
i
)
i1
xed. Furthermore, normalize j
1
= 1 and eliminate the
1-th component of the excess demand. Then
. : R
11
++
R
11
++
R
11
represents an aggregate excess demand for an exchange economy . = (.
i
)
i1

R
11
++
.
Denition 13 A j R
1
++
such that . (j. .) = 0 is regular if 1
j
. (j. .)
has rank 1 1.
3
We shall leave this statement essentially unsubstantiated. General equilibrium theory,
for more than half a century, has considered this as one of its main objectives.
Denition 14 An economy . R
11
++
is regular if 1
j
. (j. .) has rank 11
for any j R
11
++
such that . (j. .) = 0.
Denition 15 An equilibrium price j R
11
++
is locally unique if an
open set 1 such that j 1 and for any j
t
,= j 1, . (j
t
. .) ,= 0.
Proposition 16 A regular equilibrium price j R
11
++
is locally unique.
Proof. Fix an arbitrary . R
11
++
. Since 1
j
. (j. .) has rank 1 1. by
regularity of j, the Inverse function theorem - Local (see Math Appendix)
applied to the map . : R
11
++
R
11
, directly implies local uniqueness of j
R
11
++
.
Proposition 17 Any economy . in a full measure Lebesgue subset of R
11
++
is regular.
We say then that regularity is a generic property in R
11
++
, as it holds in a
full measure Lebesgue subset of R
11
++
.
Proof. The statement follows by the Transversality theorem (see Math
Appendix), if . t 0. We now show that . t 0. Pick an arbitrary agent
i 1. It will be sucient to show that, for any (j. .) R
11
++
R
11
++
such
that .(j. .) = 0. we can nd a perturbation d.
i
R
1
such that d. =
1
.
i .(j. .)d.
i
, for any d. R
11
. Consider any perturbation d.
i
such that
d.
i
1
+ jd.
i
1
= 0. for d.
i
1
= (.
i
|
)
1
|=2
. Any such perturbation, leaves each
agent i 1 demand unchanged and hence it implies 1
.
i .(j. .)d.
i
= d.
i
1
,
for any arbitrary d.
i
1
R
1
.
Proposition 18 The set of equilibrium prices of an economy . R
11
++
is a
smooth manifold (see Math Appendix) of dimension 11.
Proof. 1
j
. (j. .) has rank 1 1, as shown in the proof of the previous
proposition. The Inverse function theorem - Global (see Math Appendix)
applied to . : R
11
++
R
11
++
R
11
. directly implies that the set j .
1
(0).
as a function of . R
11
++
, is a smooth manifold of dimension 11.
3.3.3 Dierentiable approach: A rough primer
The dierential techniques exploited to study generic local uniqueness can
be expanded to provide a general characterization of competitive equilibria
as a manifold parametrized by endowments. This characterization implies an
existence result. We sketch some of the analysis, just to provide the reader
with the avor of the arguments.
Denition 19 The index i(j. .) of a price j R
11
++
such that . (j. .) = 0
is dened as
i(j. .) = (1)
11
:iq:[1
j
. (j. .)[ .
The index i(.) of an economy (.
i
)
i1
is dened as
i(.) =

j::(j,.)=0
i(j. .).
Theorem 20 (Index) For any regular economy . R
11
++
, i(.) = 1.
Proof. The theorem is a deep mathematical result whose proof is clearly
beyond the scope of this class. Let it suce to say that the proof relies
crucially on the boundary property of excess demand. Adventurous reader
might want to look at Mas Colell (1985), section 5,6, p. 201-15.
Corollary 21 Any regular economy . has an odd number of equilibria. In
particular, any regular economy . R
11
++
has at least one equilibrium.
Corollary 22 Any economy . R
11
++
has at least one equilibrium price j
R
11
++
.
Proof. By contradiction. Suppose there exist an economy . R
11
++
with
no equilibrium. Then, . R
11
++
is regular, by denition of regularity - a
contradiction with previous corollary.
The existence result is then a corollary of the Index theorem. It is useful
to study the simple case in which 1 = 2. In this case, then, . : R
++
R.
The boundary properties of the excess demand .(j. .) imply that, for any
. R
21
++
.
.(j. .) + as j 0
.(j. .) 1 as j .
As a consequence, an equilibrium exists by continuity of .(j. .). Further-
more, suppose . is regular, and let the prices j
)
such that .(j. .) = 0 be
ordered, so that j
)
< j
)+1
. , = 1. 2. .... Then
0:(j,.)
0j
[
j=j
1
< 0. Actually,
0:(j,.)
0j
p=p
j
_
< 0 for , odd
0for , even
. As a consequence, i(.) = 1.
We can also try and give more sense of the arguments, o of the proof
of the Index theorem, required for this approach to the existence question.
Let . R
11
++
be an arbitrary regular economy. Pick an economy .
t
R
11
++
such that there exist a unique price j R
11
++
such that .(j) = 0. and
1
j
.(j) has rank 1 1. One such economy can always be constructed by
choosing .
t
R
11
++
to be a Pareto optimal allocation. In fact, [we can show
that] generic regularity holds in the subset of economies with Pareto optimal
endowments. Let t. + (1 t).
t
. for 0 _ t _ 1. represent a 1-dimensional
subset of economies. Let 2(j. t) be the map 2 : R
11
++
[0. 1] R
11
induced
by 2(j. t) = .(j. t. + (1 t).
t
) for given (.. .
t
). We say that 2(j. t) is an
homotopy, or that .(j. .) and .(j. .
t
) are homotopic to each other. [We
can show that] 12(j. t) has rank 1 1 in its domain. It follows from the
Corollary of the Inverse function theorem - Global (see Math Appendix) that
the set (j. t) 2
1
(0). is a smooth manifold of dimension 1. [We can show
that] prices j can, without loss of generality, be restricted to a compact set
1 such that 2
1
(0) 1 [0. 1] = ?.
4
As a consequence 2
1
(0) is a compact
smooth manifold of dimension 1. By the Classication theorem (see Math
Appendix), 2
1
(0) is then homeomorphic to a countable set of segments
in R and of circles o.
5
Regularity of 2
1
(0) at the boundary, t = 0 and
t = 1 and the property that 2
1
(0) 1 [0. 1] = ? imply that at least one
component of 2
1
(0) is homeomorphic to a line with boundary at t = 0 and
t = 1. It looks confusing, but its easier with a few gures.
The only possible representation of 2
1
(0) is then as in the following
gure. Therefore: an equilibrium price j 1 exists, for any t [0. 1].
and furthermore, for a full-measure Lebesgue subset of [0. 1] the number of
equilibria is odd.
4
This is a consequence of the boundary conditions of excess demand systems. In other
words, we could adopt the alternative normalization, restricting prices in the simplex ;
a compact set, and show that equilibrium prices are never on @:
5
Along a component of Z
1
(0) (a line or a circle), a change in index occurs when the
manifold folds.
Figure 3.1: Characterization of 2
1
(0) - impossible
1
(0) - impossible
1
(0) - impossible
1
(0)
3.4. MATHEMATICAL APPENDIX 31
Figure 3.5: Parametrization of a 1-manifold A
3.3.4 Competitive equilibriumin production economies
[...]
3.4 Mathematical appendix
Theorem 23 (Inverse function theorem - Local). Let , : R
a
R
a
be C
o
.
If 1, has rank :. at some r R
a
, there exist an open set \ _ R
a
and
a function ,
1
: \ R
a
such that ,(r) \ and ,
1
(,(.)) = . in a
neighborhood of r.
Denition 24 A subset A R
n
is a smooth manifold of dimension : if for
any r A there exist a neighborhood l A and a C
o
function , : l R
n
such that 1, has rank : in the whole domain.
Let ,(l) = \. A smooth manifold of dimension : is then locally parame-
trized by a restriction of the function ,
1
on the open set \ R
a
0
na
,
in the sense that ,
1
maps \ R
a
0
na
onto l. a neighborhood of r
on A.
Example 25 An example of a 1-manifold of R
2
is o =
_
r R
2
(r
1
)
2
+ (r
2
)
2
= 1
_
,
the circle. An explicit parametrization for o can be constructed as follows.
Seeing a restriction of ,
1
on the open set \ R
a
0
na
as a map
c
i
: R
a
R
n
. the following four maps are sucient to parametrize o:
c
1
(r
1
) =
_
r
1
.
_
1 (r
1
)
2
_
if r
2
0
c
2
(r
1
) =
_
r
1
.
_
1 (r
1
)
2
_
if r
2
< 0
c
3
(r
2
) =
_
_
1 (r
2
)
2
. r
2
_
if r
1
0
c
4
(r
2
) =
_
_
1 (r
2
)
2
. r
2
_
if r
1
< 0
Denition 26 Let , : R
n
R
a
. : _ :. be C
o
. , is transversal to 0,
denoted , t 0. if 1, has rank : for any r R
n
such that ,(r) = 0.
Theorem 27 (Transversality). Let , : R
n
++
R
a
++
. : _ :. be C
o
and
transversal to 0, , t 0. Decompose any vector r R
n
++
as r =
_
a
1
a
2
. with
r
1
R
na
++
. r
2
R
a
++
. Then 1
a
2
,(r) has rank : for all r in a Lebesgue
measure-1 subset of R
n
++
.
Denition 28 A subset A R
n
is a smooth manifold with boundary of
dimension : if for any r A there exist a neighborhood l A and a C
o
function , : l R
n1
R
+
such that 1, has rank : in the whole domain.
The boundary JA of A is dened by JA = ,
1
(0
n1
R
+
)A. It can
be shown that, if A R
n
is a smooth manifold with boundary of dimension
:. then JA is a smooth manifold (without boundary) of dimension : 1.
Example 29 An example of a smooth manifold with boundary of dimension
2 in R
2
is S =
_
r R
2
(r
1
)
2
+ (r
2
)
2
_ 1
_
, the sphere. A parametrization
for can be constructed S, by means of a series of maps c
i
: R
2
R
2
+
. along
the lines of the parametrization of the circle, o. Furthermore, JS =o.
3.4. MATHEMATICAL APPENDIX 33
Figure 3.6: Parametrization of a 2-manifold with boundary
Theorem 30 (Inverse function theorem - Global) Let , : R
n
R
a
.
: _ :. be C
o
. Suppose that 1
a
, has rank : for any r R
n
. Then ,
1
(0) =
r R
n
[,(r) = 0 is a smooth manifold of dimension ::.
Corollary 31 Let , : R
a
[0. 1] R
a
be C
o
. Suppose that 1
a
, has rank :
for any (r. t) R
a
[0. 1]. Then ,
1
(0) = (r. t) R
a
[0. 1] [,(r. t) = 0
is a smooth 1manifold with boundary.
Theorem 32 (Classication) Every compact smooth 1manifold is home-
omorphic to a disjoint union of countably many copies of segments in R and
of o.
Furthermore, J ,
1
(0) = r R
a
[,(r. 0) = 0 ' r R
a
[,(r. 1) = 0 .
3.4.1 References
The main reference is:
A. Mas-Colell (1985): The Theory of General Economic Equilibrium: A
Dierentiable Approach, Econometric Society Monograph, Cambridge
University Press.
But, as Andreu told me once, "I do not hate students so much that I
would give them this book to read." Similar comments hold, in my opinion,
for
Y. Balasko (1988): Foundations of the Theory of General Equilibrium, Aca-
demic Press.
You are then left with:
A. Mas-Colell, M. Whinston, and J. Green (1995): Microeconomic Theory,
Oxford University Press, ch. 17.D.
A. Mas-Colell, Four Lectures on the Dierentiable Approach to General
Equilibrium Theory, in A. A. Ambrosetti, F. Gori, and R. Lucchetti
(eds.), Lecture Notes in Mathematics, No. 1330, Springer-Verlag, Berlin,
1986.
3.5 Strategic foundations
[...]
Chapter 4
Two-period economies
In a two-period pure exchange economy we study nancial market equilib-
ria. In particular, we study the welfare properties of equilibria and their
implications in terms of asset pricing.
In this context, as a foundation for macroeconomics and nancial eco-
nomics, we study sucient conditions for aggregation, so that the standard
analysis of one-good economies is without loss of generality, sucient condi-
tions for the representative agent theorem, so that the standard analysis of
single agent economies is without loss of generality.
The No-arbitrage theorem and the Arrow theorem on the decentraliza-
tion of equilibria of state and time contingent good economies via nancial
markets are introduced as useful means to characterize nancial market equi-
libria.
4.1 Arrow-Debreu economies
Consider an economy extending for 2 periods, t = 0. 1. Let i 1. .... 1
denote agents and | 1. .... 1 physical goods of the economy. In addition,
the state of the world at time t = 1 is uncertain. Let 1. .... o denote the
state space of the economy at t = 1. For notational convenience we typically
identify t = 0 with : = 0, so that the index : runs from 0 to o.
Dene : = 1(o+1). The consumption space is denoted then by A _ 1
a
+
.
Each agent is endowed with a vector .
i
= (.
i
0
. .
i
1
. .... .
i
S
), where .
i
c
1
1
+
.
for any : = 0. ...o. Let n
i
: A 1 denote agent is utility function. We
will assume:
35
36 CHAPTER 4. TWO-PERIOD ECONOMIES
Assumption 1 .
i
1
a
++
for all i
Assumption 2 n
i
is continuous, strongly monotonic, strictly quasiconcave
and smooth, for all i (see Magill-Quinzii, p.50 for denitions and details).
Furthermore, n
i
has a Von Neumann-Morgernstern representation:
n
i
(r
i
) = n
i
(r
i
0
) +
S
c=1
j:o/
c
n
i
(r
i
c
)
Suppose now that at time 0, agents can buy contingent commodities.
That is, contracts for the delivery of goods at time 1 contingently to the
realization of uncertainty. Denote by r
i
= (r
i
0
. r
i
1
. .... r
i
S
) the vector of all
such contingent commodities purchased by agent i at time 0, where r
i
c
1
1
+
.
for any : = 0. .... o. Also, let r = (r
1
. .... r
1
).
Let c = (c
0
. c
1
. .... c
S
). where c
c
1
1
+
for each :. denote the price of
state contingent commodities; that is, for a price c
|c
agents trade at time 0
the delivery in state : of one unit of good |.
Under the assumption that the markets for all contingent commodities
are open at time 0, agent is budget constraint can be written as
1
c
0
(r
i
0
.
i
0
) +
S
c=0
c
c
(r
i
c
.
i
c
) = 0 (4.1)
Denition 33 An Arrow-Debreu equilibrium is a (r
+
. c
+
) such that
1. r
+i
arg max n
i
(r
i
) s.t. c
0
(r
i
0
.
i
0
) +
S
c=0
c
c
(r
i
c
.
i
c
) = 0. and
2.
1
i=1
r
+i
.
i
c
= 0, for any : = 0. 1. .... o
Observe that the dynamic and uncertain nature of the economy (con-
sumption occurs at dierent times t = 0. 1 and states : o) does not
manifests itself in the analysis: a consumption good | at a time t and state :
is treated simply as a dierent commodity than the same consumption good
| at a dierent time t
t
or at the same time t but dierent state :
t
. This is
1
We write the budget constraint with equality. This is without loss of generality under
monotonicity of preferences, an assumption we shall maintain.
4.1. ARROW-DEBREU ECONOMIES 37
the simple trick introduced in Debreus last chapter of the Theory of Value.
It has the fundamental implication that the standard theory and results of
static equilibrium economies can be applied without change to our dynamic)
environment. In particular, then, under the standard set of assumptions on
preferences and endowments, an equilibrium exists and the First and Second
Welfare Theorems hold.
2
Denition 34 Let (r
+
. c
+
) be an Arrow-Debreu equilibrium. We say that r
+
is a Pareto optimal allocation if there does not exist an allocation A
1
such that
1. n(
i
) _ n(r
+i
) for any i = 1. .... 1 (strictly for at least one i), and
2.
1
i=1
i
.
i
c
= 0, for any : = 0. 1. .... o
Theorem 35 Any Arrow-Debreu equilibrium allocation r
+
is Pareto Opti-
mal.
Proof. By contradiction. Suppose there exist a A such that 1) and 2)
in the denition of Pareto optimal allocation are satised. Then, by 1) in
the denition of Arrow-Debreu equilibrium, it must be that
c
+
0
(
i
0
.
i
0
) +
S
c=0
c
+
c
(
i
c
.
i
c
) _ 0.
for all i; and
c
+
0
(
i
0
.
i
0
) +
S
c=0
c
+
c
(
i
c
.
i
c
) 0.
for at least one i.
Summing over i, then
c
+
0
1
i=1
(
i
0
.
i
0
) +
S
c=0
c
+
c
1
i=1
(
i
c
.
i
c
) 0
which contradicts requirement 2) in the denition of Pareto optimal alloca-
tion.
The proof exploits strict monotonicity of preferences. Where?
2
Having set denitions for 2-periods Arrow-Debreu economies, it should be apparent
how a generalization to any nite T-periods economies is in fact eectively straightforward.
Innite horizon will be dealt with in successive notes.
4.2 Financial market economies
Consider the 2-period economy just introduced. Suppose now contingent
commodities are not traded. Instead, agents can trade in spot markets and
in , 1. .... J assets. An asset , is a promise to pay c
)
c
_ 0 units of good
| = 1 in state : = 1. .... o.
3
Let c
)
= (c
)
1
. .... c
)
S
). To summarize the payos
of all the available assets, dene the o J asset payo matrix
=
_
_
c
1
1
... c
J
1
... ...
c
1
S
... c
J
S
_
_
.
It will be convenient to dene c
c
to be the :-th row of the matrix. Note that
it contains the payo of each of the assets in state :.
Let j = (j
0
. j
1
. .... j
S
), where j
c
1
1
+
for each :, denote the spot price
vector for goods. That is, for a price j
|c
agents trade one unit of good |
in state :. Recall the denition of prices for state contingent commodities in
Arrow-Debreu economies, denoted c. Note the dierence. Let good | = 1
at each date and state represent the numeraire; that is, j
1c
= 1, for all
: = 0. .... o.
Let r
i
c|
denote the amount of good | that agent i consumes in good :. Let
= (
1
. ....
J
) 1
J
+
, denote the prices for the assets.
4
Note that the prices
of assets are non-negative, as we normalized asset payo to be non-negative.
Given prices (j. ) and the asset structure , any agent i picks a con-
sumption vector r
i
A and a portfolio .
i
1
J
to
max n
i
(r
i
)
s.t.
j
0
(r
i
0
.
i
0
) = .
i
j
c
(r
i
c
.
i
c
) =
c
.
i
. for : = 1. ...o.
3
The non-negativity restriction on asset payos is just for notational simplicity.
4
Quantities will be row vectors and prices will be column vectors, to avoid the annoying
use of transposes.
4.2. FINANCIAL MARKET ECONOMIES 39
Denition 36 A Financial markets equilibrium is a (r
+
. .
+
. j
+
.
+
) such that
1. r
+i
arg max n
i
(r
i
) s.t.
j
0
(r
i
0
.
i
0
) = .
i
. and
j
c
(r
i
c
.
i
c
) = c
c
.
i
. for : = 1. ...o; and furthermore
2.
1
i=1
r
+i
.
i
c
= 0, for any : = 0. 1. .... o. and
1
i=1
.
+i
Financial markets equilibrium is the equilibrium concept we shall care
about. This is because i) Arrow-Debreu markets are perhaps too demanding a
requirement, and especially because ii) we are interested in nancial markets
and asset prices in particular. Arrow-Debreu equilibrium will be a useful
concept insofar as it represents a benchmark (about which we have a wealth
of available results) against which to measure Financial markets equilibrium.
Remark 37 The economy just introduced is characterized by asset markets
in zero net supply, that is, no endowments of assets are allowed for. It is
straightforward to extend the analysis to assets in positive net supply, e.g.,
stocks. In fact, part of each agent is endowment (to be specic: the projection
of his/her endowment on the asset span, < = t 1
S
: t = .. .
1
J
) can be represented as the outcome of an asset endowment, .
i
&
; that is,
letting .
i
1
= (.
i
11
. .... .
i
1S
), we can write
.
i
1
= n
i
1
+ .
i
&
and proceed straightforwardly by constructing the budget constraints and the
equilibrium notion.
No Arbitrage
Before deriving the properties of asset prices in equilibrium, we shall invest
some time in understanding the implications that can be derived from the
milder condition of no-arbitrage. This is because the characterization of no-
arbitrage prices will also be useful to characterize nancial markets equilbria.
For notational convenience, dene the (o + 1) J matrix
\ =
_

_
.
Denition 38 \ satises the No-arbitrage condition if there does not exist
a
there does not exist a . 1
J
such that \. 0.
5
The No-Arbitrage condition can be equivalently formulated in the follow-
ing way. Dene the span of \ to be
< \ = t 1
S+1
: t = \.. . 1
J
.
This set contains all the feasible wealth transfers, given asset structure .
Now, we can say that \ satises the No-arbitrage condition if
< \

1
S+1
+
= 0.
Clearly, requiring that \ = (. ) satises the No-arbitrage condition is
weaker than requiring that is an equilibrium price of the economy (with
asset structure ). By strong monotonicity of preferences, No-arbitrage is
equivalent to requiring the agents problem to be well dened. The next
result is remarkable since it provides a foundation for asset pricing based
only on No-arbitrage.
Theorem 39 (No-Arbitrage theorem)
< \

1
S+1
+
= 0 ==^ : 1
S+1
++
such that ^ :\ = 0.
First, observe that there is no uniqueness claim on the ^ :, just existence.
Next, notice how ^ :\ = 0 implies ^ :t = 0 for all t < \ . It then provides
a pricing formula for assets:
^ :\ =
_
_
...
^ :
0
)
+ ^ :
1
c
)
1
+ ... + ^ :
S
c
)
S
...
_
_
=
_
_
...
0
...
_
_
Ja1
and, rearranging, we obtain for each asset ,,
)
= :
1
c
)
1
+ ... + :
S
c
)
S
. for :
c
=
^ :
c
^ :
0
(4.2)
5
Wz > 0 requires that all components of Wz are _ 0 and at least one of them > 0:
Note how the positivity of all components of ^ : was necessary to obtain
(4.2).
Proof. == Dene the simplex in 1
S+1
+
as = t 1
S+1
+
:

S
c=0
t
c
= 1.
Note that by the No-arbitrage condition, < \

is empty. The proof
hinges crucially on the following separating result, a version of Farkas Lemma,
which we shall take without proof.
Lemma 40 Let A be a nite dimensional vector space. Let 1 be a non-
empty, compact and convex subset of A. Let ` be a non-empty, closed and
convex subset of A. Furthermore, let 1 and ` be disjoint. Then, there
exists ^ : A0 such that
sup
tA
^ :t < inf
t1
^ :t.
Let A = 1
S+1
+
, 1 = and ` =< \ . Observe that all the required
properties hold and so the Lemma applies. As a result, there exists ^ :
A0 such that
sup
t<W
^ :t < inf
t
^ :t. (4.3)
It remains to show that ^ : 1
S+1
++
. Suppose, on the contrary, that there
is some : for which ^ :
c
_ 0. Then note that in (4.3 ), the RHS_ 0. By (4.3),
then, LHS < 0. But this contradicts the fact that 0 < \ .
We still have to show that ^ :\ = 0, or in other words, that ^ :t = 0 for
all t < \ . Suppose, on the contrary that there exists t < \ such
that ^ :t ,= 0. Since < \ is a subspace, there exists c 1 such that
ct < \ and ^ :ct is as large as we want. However, RHS is bounded
above, which implies a contradiction.
== The existence of ^ : 1
S+1
++
such that ^ :\ = 0 implies that ^ :t = 0
for all t < \ . By contradiction, suppose t
+
< \ and such that
t
+
1
S+1
+
0. Since ^ : is strictly positive, ^ :t
+
0. the desired contradiction.
A few nal remarks to this section.
Remark 41 An asset which pays one unit of numeraire in state : and noth-
ing in all other states (Arrow security), has price :
c
according to (4.2). Such
asset is called Arrow security.
Remark 42 Is the vector ^ : obtained by the No-arbitrage theorem unique?
Notice how (??) denes a system of J equations and o unknowns, represented
by :. Dene the set of solutions to that system as
1() = : 1
S
++
: = :.
Suppose, the matrix has rank J
t
_ J (that it, has J
t
linearly independent
column vectors and J
t
is the eective dimension of the asset space). In
general, then 1() will have dimension o J
t
. It follows then that, in this
case, the No-arbitrage theorem restricts ^ : to lie in a o J
t
+ 1 dimensional
set. If we had o linearly independent assets, the solution set has dimension
zero, and there is a unique : vector that solves (??). The case of o linearly
independent assets is referred to as Complete markets.
Remark 43 Let preferences be Von Neumann-Morgernstern:
n
i
(r
i
) = n
i
(r
i
0
) +

c=1,...,S
j:o/
c
n
i
(r
i
c
)
where

c=1,...,S
j:o/
c
= 1. Let then :
c
=
s
jvcbs
. Then
)
= 1 (:
)
)
In this representation of asset prices the vector : 1
S
++
is called Stochastic
discount factor.
4.2.1 The stochastic discount factor
In the previous section we showed the existence of a vector that provides the
basis for pricing assets in a way that is compatible with equilibrium, albeit
milder than that. In this section, we will strengthen our assumptions and
study asset prices in a full-edged economy. Among other things, this will
allow us to provide some economic content to the vector :
Recall the denition of Financial market equilibrium. Let `1o
i
c
(r
i
)
denote agent is marginal rate of substitution between consumption of the
numeraire good 1 in state : and consumption of the numeraire good 1 at
date 0:
`1o
i
c
(r
i
) =
0&
i
(a
i
s
)
0a
i
1s
0&
i
(a
i
0
)
0a
i
10
Let `1o
i
(r
i
) = (. . . `1o
i
c
(r
i
) . . .) denote the vector of marginal rates
of substitution for agent i, an o dimentional vector. Note that, under the
assumption of strong monotonicity of preferences, `1o
i
(r
i
) 1
S
++
.
By taking the First Order Conditions (necessary and sucient for a max-
imum under the assumption of strict quasi-concavity of preferences) with
respect to .
i
)
of the individual problem for an arbitrary price vector , we
obtain that
)
=
S
c=1
j:o/
c
`1o
i
c
(r
i
)c
)
c
= 1
_
`1o
i
(r
i
) c
)
_
. (4.4)
for all , = 1. .... J and all i = 1. .... 1. where of course the allocation r
i
is the
equilibrium allocation. At equilibrium, therefore, the marginal cost of one
more unit of asset ,,
)
, is equalized to the marginal valuation of that agent
for the assets payo,

S
c=1
j:o/
c
`1o
i
c
(r
i
)c
)
c
.
Compare equation (4.4) to the previous equation (4.2). Clearly, at any
equilibrium, condition (4.4) has to hold for each agent i. Therefore, in equi-
librium, the vector of marginal rates of substitution of any arbitrary agent i
can be used to price assets; that is any of the agents vector of marginal rates
of substitution (normalized by probabilities) is a viable stochastic discount
factor :.
In other words, any vector (. . . j:o/
c
`1o
i
c
(r
i
) . . .) belongs to 1() and is
hence a viable : for the asset pricing equation (4.2). But recall that 1() is of
dimension o J
t
. where J
t
is the eective dimension of the asset space. The
higher the the eective dimension of the asset space (sloppily said, the larger
nancial markets) the more aligned are agents marginal rates of substitution
at equilibrium (sloppily said, the smaller are unexploited gains from trade
at equilibrium). In the extreme case, when markets are complete (that is,
when the rank of is o), the set 1() is in fact a singleton and hence the
`1o
i
(r
i
) are equalized across agents i at equilibrium: `1o
i
(r
i
) = `1o.
for any i = 1. .... 1.
Problem 44 Write the Pareto problem for the economy and show that, at
any Pareto optimal allocation, r. it is the case that `1o
i
(r
i
) = `1o. for
any i = 1. .... 1. Furthermore, show that an allocation r which satises the
feasibility conditions (market clearing) for goods and is such that `1o
i
(r
i
) =
`1o. for any i = 1. .... 1. is Pareto optimal.
We conclude that, when markets are Complete, equilibrium allocations
are Pareto optimal. That is, the First Welfare theorem holds for Financial
market equilibria when markets are Complete.
Problem 45 (Economies with bid-ask spreads)Extend our basic two-period
incomplete market economy by assuming that, given an exogenous vector
1
J
++
:
the buying price of asset , is
)
+
)
while
the selling price of asset , is
)
for any , = 1. .... J.and exogenous. Write the budget constraint and the
First Order Conditions for an agent is problem. Derive an asset pricing
equationfor
)
in terms of intertemporal marginal rates of substitution at
equilibrium.
4.2.2 Arrow theorem
The Arrow theorem is the fondamental decentralization result in nancial
economics. It states sucient conditions for a form of equivalence between
the Arrow-Debreu and the Financial market equilibrium concepts. It was
essentially introduced by Arrow (1952). The proof of the theorem introduces
a reformulation of the budget constraints of the Financial market economy
which focuses on feasible wealth transfers across states directly, on the span
of ,
< =
_
t 1
S
: t = .. . 1
J
_
in particular. Such a reformulation is important not only in itself but as a
lemma for welfare analysis in Financial market economies.
Proposition 46 Let (r
+
. c
+
) represent an Arrow-Debreu equilibrium. Sup-
pose :c:/() = o (nancial markets are Complete). Then (r
+
. .
+
. j
+
.
+
) is
a Financial market equilibrium, where
c
+
c
= :
c
j
+
c
. for any : = 1. .... o. and
+
=
S
c=1
j:o/
c
`1o
i
c
(r
i+
)
c
Futhermore, the converse also holds: if (r
+
. .
+
. j
+
.
+
) is a Financial market
equilibrium of an economy with :c:/() = o, (r
+
. c
+
) represents an Arrow-
Debreu equilibrium, where c
+
c
= :
c
j
+
c
. for any : = 1. .... o.
Proof. Financial market equilibrium prices of assets
+
satisfy No-arbitrage.
There exists then a vector ^ : 1
S+1
++
such that ^ :\ = 0. or
+
= :. The
budget constraints in the nancial market economy are
j
+
0
_
r
i+
0
.
i
0
_
+
+
.
i+
= 0
j
+
c
_
r
i+
c
.
i
c
_
=
c
.
i+
. for : = 1. ...o.
Substituting = :. expanding the rst equation, and writing the con-
straints at time 1 in vector form, we obtain:
j
+
0
_
r
i+
0
.
i
0
_
+
S
c=1
:
c
j
+
c
_
r
i+
c
.
i
c
_
= 0 (4.5)
_
_
.
.
j
+
c
(r
i+
c
.
i
c
)
.
.
_
_
< (4.6)
But if :c:/() = o. it follows that < = 1
S
. and the constraint
_
_
.
.
j
+
c
(r
i+
c
.
i
c
)
.
.
_
_
<
is never binding. Each agent is problem is then subject only to
j
+
0
_
r
i+
0
.
i
0
_
+
S
c=1
:
c
j
+
c
_
r
i+
c
.
i
c
_
= 0.
the budget constraint in the Arrow-Debreu economy with
c
+
c
= :
c
j
+
c
. for any : = 1. .... o.
Furthermore, by No-arbitrage
+
=
S
c=1
j:o/
c
`1o
i
c
(r
i+
)
c
.
Finally, using :
c
= j:o/
c
`1o
i
c
(r
i+
), for any : = 1. .... o. proves the re-
sult. (Recall that, with Complete markets `1o
i
(r
i+
) = `1o. for any
i = 1. .... 1.)
The converse is straightforward.
4.2.3 Existence
We do not discuss here in detail the issue of existence of a nancial market
equilibrium when markets are incomplete (when they are complete, existence
follows from the equivalence with Arrow-Debreu equilibrium provided by
Arrow theorem). A sketch of the proof however follows.
The proof is a modication of the existence proof for Arrow-Debreu equi-
librium. By Arrow theorem, fact, we can reduce the equilibrium system to an
excess demand systemfor consumption goods; that is, we can solve out for the
asset portfolios .
i
s. The only conceptual problem with the proof is that the
boundary condition on the excess demand system might not be guaranteed as
each agents excess demand is restricted by
_
_
.
.
j
c
(r
i
c
.
i
c
)
.
.
_
_
< . This
is where the Cass trick comes in handy. It is in fact an important Lemma.
Cass trick. For any Financial market economy, consider a modied econ-
omy where the constraint
_
_
.
.
j
c
(r
i
c
.
i
c
)
.
.
_
_
< is imposed on all
agents i = 2. .... 1 but not on agent i = 1. Any equilibrium of the
Financial Market economy is an equilibrium of the modied economy,
and any equilibrium of the modied economy is a Financial market
equilibrium.
Proof. Consider an equilibrium of the modied economy in the state-
ment. At equilibrium,

1
i=1
j
c
(r
i
c
.
i
c
) = 0. Therefore,
1
i=2
j
c
(r
i
c
.
i
c
) =
j
c
(r
1
c
.
1
c
) . But
_
_
.
.
j
c
(r
i
c
.
i
c
)
.
.
_
_
< . for any i = 2. .... 1. and
hence

1
i=2
j
c
(r
i
c
.
i
c
) < . Since

1
i=2
j
c
(r
i
c
.
i
c
) = j
c
(r
1
c
.
1
c
) .
it follows that j
c
(r
1
c
.
1
c
) < . and hence that j
c
(r
1
c
.
1
c
) <
. Therefore, the constraint j
c
(r
1
c
.
1
c
) < must necessarily hold
at an equilibrium of the modied economy. In other words, the constraint
j
c
(r
1
c
.
1
c
) < is not binding at a Financial market equilibrium. The
equivalence between the modied economy and the Financial Market econ-
omy is now straightforward.
4.2.4 Constrained Pareto optimality
Under Complete markets, the First Welfare Theorem holds for Financial
market equilibrium. This is a direct implication of Arrow theorem.
+
. .
+
. j
+
.
+
) be a Financial market equilibrium of an
economy with Complete markets (with :c:/() = o). Then r
+
is a Pareto
optimal allocation.
However, under Incomplete markets Financial market equilibria are gener-
ically inecient in a Pareto sense. That is, a planner could nd an allocation
that improves some agents without making any other agent worse o.
Theorem 48 At a Financial Market Equilibrium (r
+
. .
+
. j
+
.
+
) of an incom-
plete nancial market economy, that is, of an economy with :c:/() < o,
the allocation r
+
is generically
6
not Pareto Optimal.
6
We say that a statement holds generically when it holds for a full Lebesgue-measure
subset of the parameter set which characterizes the economy. In these notes we shall
assume that the an economy is parametrized by the endowments for each agent, the asset
payo matrix, and a two-parameter parametrization of utility functions for each agent;
see Magill-Shafer, ch. 30 in W. Hildenbrand and H. Sonnenschein (eds.), Handbook of
Mathematical Economics, Vol. IV, Elsevier, 1991.
Proof. From the proof of Arrow theorem, we can write the budget con-
straints of the Financial market equilibrium as:
j
+
0
_
r
i+
0
.
i
0
_
+
S
c=1
:
c
j
+
c
_
r
i+
c
.
i
c
_
= 0 (4.7)
_
_
.
.
j
+
c
(r
i+
c
.
i
c
)
.
.
_
_
< (4.8)
for some : 1
S
++
. Pareto optimality of r
+
requires that there does not exist
an allocation such that
1. n(
i
) _ n(r
+i
) for any i = 1. .... 1 (strictly for at least one i), and
2.
1
i=1
i
.
i
c
= 0, for any : = 0. 1. .... o
Reproducing the proof of the First Welfare theorem, it is clear that, if such
a exists, it must be that
_
_
.
.
j
+
c
(
i+
c
.
i
c
)
.
.
_
_
, < . for some i = 1. .... 1;
otherwise the allocation would be budget feasible for all agent i at the
equilibrium prices. Generic Pareto sub-optimality of r
+
follows then directly
from the following Lemma, which we leave without proof.
7
Lemma 49 Let (r
+
. .
+
. j
+
.
+
) represent a Financial Market Equilibrium of
an economy with :c:/() < o. For a generic set of economies, the con-
straints
_
_
.
.
j
+
c
(r
i+
c
.
i
c
)
.
.
_
_
< are binding for some i = 1. .... 1.
7
The proof can be found in Magill-Shafer, ch. 30 in W. Hildenbrand and H. Sonnen-
schein (eds.), Handbook of Mathematical Economics, Vol. IV, Elsevier, 1991. It requires
mathematical tecniques from dierential topology which are not appropriate to be intro-
duced in this course.
Remark 50 The Lemma implies a slightly stronger result than generic Pareto
sub-optimality of Financial market equilibrium for economies with incomplete
markets. It implies in fact that a Pareto improving allocation can be found
locally around the equilibrium, as a perturbation of the equilibrium.
Pareto optimality might however represent too strict a denition of social
welfare of an economy with frictions which restrict the consumption set, as in
the case of incomplete markets. In this case, markets are assumed incomplete
exogenously. There is no reason in the fundamentals of the model why they
should be, but they are. Under Pareto optimality, however, the social welfare
notion does not face the same contraints. For this reason, we typically dene a
weaker notion of social welfare, Constrained Pareto optimality, by restricting
the set of feasible allocations to satisfy the same set of constraints on the
consumption set imposed on agents at equilibrium. In the case of incomplete
markets, for instance, the feasible wealth vectors across states are restricted
to lie in the span of the payo matrix. That can be interpreted as the
economys nancial technology and it seems reasonable to impose the same
technological restrictions on the planners reallocations. The formalization
of an eciency notion capturing this idea follows. Let r
i
t=1
= (r
i
c
)
S
c=1
1
S1
+
;
and similarly j
t=1
= (j
c
)
S
c=1
1
S1
+
Denition 51 (Diamond, 1968; Geanakoplos-Polemarchakis, 1986) Let (r
+
. .
+
. j
+
.
+
)
represent a Financial market equilibrium of an economy whose consumption
set at time t = 1 is restricted by
r
i
t=1
. 1(j
t=1
). for any i = 1. .... 1
In this economy, the allocation r
+
is Constrained Pareto optimal if there does
not exist a (. o) such that
1. n(
i
) _ n(r
+i
) for any i = 1. .... 1, strictly for at least one i
2.
1
i=1
i
c
.
i
c
= 0, for any : = 0. 1. .... o
and
3.
i
t=1
1(q
+
t=1
(.. o)). for any i = 1. .... 1
where q
+
t=1
(.. o) is a vector of equilibrium prices for spot markets at t = 1
opened after each agent i = 1. .... 1 has received income transfer o
i
.
The constraint on the consumption set restricts only time 1 consump-
tion allocations. More general constraints are possible but these formulation
is consistent with the typical frictions we encounter in economics, e.g., on
nancial markets. It is important that the constraint on the consumption
set depends in general on q
+
t=1
(.. o), that is on equilibrium prices for spot
markets opened at t = 1 after income transfers to agents. It implicit identi-
es income transfers (besides consumption allocations at time t = 0) as the
instrument available for Constrained Pareto optimality; that is, it implicitly
constrains the planner implementing Constraint Pareto optimal allocations
to interact with markets, specically to open spot markets after transfers.
On the other hand, the planner is able to anticipate the spot price equilib-
rium map, q
+
t=1
(.. o); that is, to internalize the eects of dierent transfers
on spot prices at equilibrium.
+
. .
+
. j
+
.
+
) represent a Financial market equilibrium
of an economy with complete markets (:c:/() = o) and whose consumption
set at time t = 1 is restricted by
r
i
t=1
1 _ 1
S1
+
. for any i = 1. .... 1
In this economy, the allocation r
+
is Constrained Pareto optimal.
Crucially, markets are complete and 1 is independent of prices. The
proof is then a straightforward extension of the First Welfare theorem com-
bined with Arrow theorem.
8
Constraint Pareto optimality of Financial mar-
ket equilibrium allocations is guaranteed as long as the constraint set 1 is
exogenous.
+
. .
+
. j
+
.
+
) represent a Financial market equilibrium
of an economy with Incomplete markets (:c:/() < o). In this economy,
the allocation r
+
is not Constrained Pareto optimal.
Proof. By the decomposition of the budget constraints in the proof of Arrow
theorem, this economy is equivalent to one with Complete markets whose
consumption set at time t = 1 is restricted by
r
i
t=1
1(q
+
t=1
(.. .)). for any i = 1. .... 1. for any i = 1. .... 1
8
To be careful, we need to guarantee that monotonicity of preferences on R
SL
++
results
in monotonicity on B _ R
SL
++
: This is the case for B open. Thanks to the students for
noticing this.
with the set 1(q
+
t=1
(.. .)) dened implicitly by
_
_
.
.
q
+
c
(.
c
. .) (r
i
c
.
i
c
)
.
.
_
_
< . for any i = 1. .... 1
Note rst of all that, by construction, j
+
c
q
+
c
(.
c
. .
+
). Following the proof of
Pareto sub-otimality of Financial market equilibrium allocations, it then fol-
lows that if a Pareto-improving exists, it must be that
_
_
.
.
j
+
c
(
i+
c
.
i
c
)
.
.
_
_
, <
. for some i = 1. .... 1; while
_
_
.
.
q
+
c
(.
c
. o) (
i
c
.
i
c
)
.
.
_
_
= o
i
, for all
i = 1. .... 1. Generic Constrained Pareto sub-optimality of r
+
follows then
directly from the following Lemma, which we leave without proof.
9
Lemma 54 Let (r
+
. .
+
. j
+
.
+
) represent a Financial Market Equilibrium of
an economy with :c:/() < o. For a generic set of economies, the con-
straints
_
_
.
.
q
+
c
(.
c
. .
+
+ d.) (
i
c
.
i
c
)
.
.
_
_
= (.
i+
+ d.
i
), for some d. 1
J1
0
such that

i=1
I
d.
i
= 0. are weakly relaxed for all i = 1. .... 1, strictly for at
least one.
10
9
The proof is due to Geanakoplos-Polemarchakis (1986). It also requires dierential
topology techniques.
10
Once again, note that the Lemma implies that a Pareto improving allocation can be
found locally around the equilibrium, as a perturbation of the equilibrium.
There is a fundamental dierence between incomplete market economies,
which have typically not Constrained Optimal equilibrium allocations, and
economies with constraints on the consumption set, which have, on the con-
trary, Constrained Optimal equilibrium allocations. It stands out by com-
paring the respective trading constraints
q
+
c
(.
c
. o)(r
i
c
.
i
c
) =
c
o
i
. for all i and :, vs. r
i
t=1
1, for all i.
The trading constraint of the incomplete market economy is determined at
equilibrium, while the constraint on the consumption set is exogenous. An-
other way to re-phrase the same point is the following. A planner choosing
(. o) will take into account that at each (. o) is typically associated a dif-
ferent trading constraint q
+
c
(.
c
. o)(r
i
c
.
i
c
) =
c
o
i
. for all i and :; while any
agent i will choose (r
i
. .
i
) to satisfy j
+
c
(r
i
c
.
i
c
) =
c
.
i
. for all :, taking as
given the equilibrium prices j
+
c
.
The constrained ineciency due the dependence of constraints on equilib-
rium prices is sometimes called a pecuniary externality.
11
Several examples of
such form of externality/ineciency have been developed recently in macro-
economics. Some examples are:
- Thomas, Charles (1995): "The role of scal policy in an incomplete markets
framework," Review of Economic Studies, 62, 449468.
- Krishnamurthy, Arvind (2003): "Collateral Constraints and the Ampli-
cation Mechanism,"
Journal of Economic Theory, 111(2), 277-292.
- Caballero, Ricardo J. and Arvind Krishnamurthy (2003): "Excessive Dol-
lar Debt: Financial Development and Underinsurance," Journal of Fi-
nance, 58(2), 867-94.
- Lorenzoni, Guido (2008): "Inecient Credit Booms," Review of Economic
Studies, 75 (3), 809-833.
- Kocherlakota, Narayana (2009): "Bursting Bubbles: Consequences and
Causes,"
http://www.econ.umn.edu/~nkocher/km_bubble.pdf.
11
The name is due to Joe Stiglitz (or is it Greenwald-Stiglitz?).
- Davila, Julio, Jay Hong, Per Krusell, and Victor Rios Rull (2005): "Con-
strained Eciency in the Neoclassical Growth Model with Uninsurable
Idiosyncractic Shocks," mimeo, University of Pennsylvania.
Remark 55 Consider an economy whose constraints on the consumption set
depend on the equilibrium allocation:
r
i
t=1
1(r
+
t=1
. .
+
). for any i = 1. .... 1
This is essentially an externality in the consumption set. It is not hard to
extend the analysis of this section to show that this formulation introduces
ineciencies and equilibrium allocations are Constraint Pareto sub-optimal.
Corollary 56 Let (r
+
. .
+
. j
+
.
+
) represent a Financial market equilibrium of
a 1-good economy (1 = 1) with Incomplete markets (:c:/() < o). In this
economy, the allocation r
+
is Constrained Pareto optimal.
Proof. The constraint on the consumption set implied by incomplete mar-
kets, if 1 = 1, can be written
(r
i
c
.
i
c
) =
c
.
i
.
It is independent of prices, of the form r
i
t=1
1.
Remark 57 Consider an alternative denition of Constrained Pareto opti-
mality, due to Grossman (1970), in which constraints 3 are substituted by
3
t
.
_
_
.
.
j
+
c
(r
i+
c
.
i
c
)
.
.
_
_
= .
i
. for any i = 1. .... 1
where j
+
is the spot market Financial market equilibrium vector of prices.
That is, the planner takes the equilibrium prices as given. It is immediate to
prove that, with this denition of Constrained Pareto optimality, any Finan-
cial market equilibrium allocation r
+
of an economy with Incomplete markets
is in fact Constrained Pareto optimal, independently of the nancial markets
available (:c:/() _ o).
Problem 58 Consider a Complete market economy (:c:/() = o) whose
feasible set of asset portfolios is restricted by:
.
i
2 ( 1
J
. for any i = 1. .... 1
A typical example is borrowing limits:
.
i
_ /. for any i = 1. .... 1
Are equilibrium allocations of such an economy Constrained Pareto optimal
(also if 1 1)?
Problem 59 Consider a 1-good (1 = 1) Incomplete market economy (:c:/() <
o) which lasts 3 periods. Dene an Financial market equilibrium for this
economy as well as Constrained Pareto optimality. Are Financial market
equilibrium allocations of such an economy Constrained Pareto optimal?
Problem 60 Extend our basic two-period incomplete market economy by as-
suming that, given an exogenous vector 1
J
++
:
the buying price of asset , is
)
+
)
while
the selling price of asset , is
)
for any , = 1. .... J.and exogenous. 1) Suppose the asset payo matrix is
full rank. Do you expect nancial market equilibria to be Pareto ecient?
Carefully justify your answer. (I am not asking for a formal proof, though
you could actually prove this.) 2) Continue to suppose the asset payo matrix
is full rank. How would you dene Constrained Pareto eciency in this
economy? Do you expect nancial market equilibria to be Constrained Pareto
ecient? Carefully justify your answer. (I am really not asking for a formal
proof.)
4.2.5 Aggregation
Agent is optimization problem in the denition of Financial market equi-
librium requires two types of simultaneous decisions. On the one hand, the
agent has to deal with the usual consumption decisions i.e., she has to decide
how many units of each good to consume in each state. But she also has
to make nancial decisions aimed at transferring wealth from one state to
the other. In general, both individual decisions are interrelated: the con-
sumption and portfolio allocations of all agents i and the equilibrium prices
for goods and assets are all determined simultaneously from the system of
equations formed by (??) and (??). The nancial and the real sectors of
the economy cannot be isolated. Under some special conditions, however,
the consumption and portfolio decisions of agents can be separated. This
is typically very useful when the analysis is centered on nancial issue. In
order to concentrate on asset pricing issues, most nance models deal in fact
with 1-good economies, implicitly assuming that the individual nancial de-
cisions and the market clearing conditions in the assets markets determine
the nancial equilibrium, independently of the individual consumption deci-
sions and market clearing in the goods markets; that is independently of the
real equilibrium prices and allocations. In this section we shall identify the
conditions under which this can be done without loss of generality. This is
sometimes called "the problem of aggregation."
The idea is the following. If we want equilibrium prices on the spot
markets to be independent of equilibrium on the nancial markets, then
the aggregate spot market demand for the 1 goods in each state : should
must depend only on the incomes of the agents in this state (and not in
other states) and should be independent of the distribution of income among
agents in this state.
Theorem 61 Budget Separation. Suppose that each agent is prefer-
ences are separable across states, identical, homothetic within states, and
von Neumann-Morgenstern; i.e. suppose that there exists an homothetic
n : 1
1
1 such that
n
i
(r
i
) = n(r
i
0
) +
S
c=1
j:o/
c
n(r
i
c
). for all i = 1. ... 1.
Then equilibrium spot prices j
+
are independent of asset prices and of the
income distribution; that is, constant in
_
.
i
1
1(S+1)
++
1
i=1
.
i
given
_
.
Proof. Normalize all spot prices of good 1: j
10
= j
1c
= 1. for any : o.
The consumers maximization problem in the denition of Financial market
equilibrium can be decomposed into a sequence of spot commodity alloca-
tion problems and an income allocation problem as follows. The spot com-
modity allocation problems. Given the current and anticipated spot prices
j = (j
0
. j
1
. .... j
S
) and an exogenously given stream of nancial income
i
= (
i
0
.
i
1
. ....
i
S
) 1
S+1
++
in units of numeraire, agent i has to pick a
consumption vector r
i
1
1(S+1)
+
to
max n
i
(r
i
)
s.t.
j
0
r
i
0
=
i
0
j
c
r
i
c
=
i
c
. ,o: : = 1. ...o.
Let the 1(o + 1) demand functions be given by r
i
|c
(j.
i
), for | = 1. .... 1.
: = 0. 1. ...o. Dene now the indirect utility function for income by
i
(
i
; j) = n
i
(r
i
(j.
i
)).
The Income allocation problem. Given prices (j. ). endowments .
i
, and the
asset structure , agent i has to pick a portfolio .
i
1
J
and an income
stream
i
1
S+1
++
to
max
i
(
i
; j)
:.t.
j
0
.
i
0
.
i
=
i
0
j
c
.
i
c
+ c
c
.
i
=
i
c
. ,o: : = 1. ...o.
By additive separability across states of the utility, we can break the con-
sumption allocation problem into o+1 spot market problems, each of which
yields the demands r
i
c
(j
c
.
i
c
) for each state. By homotheticity, for each
: = 0. 1. ...o. and by identical preferences across all agents,
r
i
c
(j
c
.
i
c
) =
i
c
r
i
c
(j
c
. 1);
and since preferences are identical across agents,
i
c
r
i
c
(j
c
. 1) =
i
c
r
c
(j
c
. 1)
Adding over all agents and using the market clearing condition in spot mar-
kets :, we obtain, at spot markets equilibrium,
r
c
(j
+
c
. 1)
1
i=1
i
c
i=1
.
i
c
= 0.
Again by homothetic utility,
r
c
(j
+
c
.
1
i=1
i
c
)
1
i=1
.
i
c
= 0. (4.9)
Recall from the consumption allocation problem that j
c
r
i
c
=
i
c
. for : =
0. 1. ...o. By adding over all agents, and using market clearing in the spot
markets in state :,
1
i=1
i
c
= j
+
c
1
i=1
r
i
c
. for : = 0. 1. ...o (4.10)
= j
+
c
1
i=1
.
i
c
. for : = 0. 1. ...o.
By combining (4.9) and (4.10), we obtain
r
c
(j
+
c
. j
+
c
1
i=1
.
i
c
) =
1
i=1
.
i
c
. (4.11)
Note how we have passed from the aggregate demand of all agents in the
economy to the demand of an agent owning the aggregate endowments. Ob-
serve also how equation (4.11) is a system of 1 equations with 1 unknowns
that determines spot prices j
+
c
for each state : independently of asset prices
. Note also that equilibrium spot prices j
+
c
dened by (4.11) only depend .
i
through

1
i=1
.
i
c
.
The Budget separation theorem can be interpreted as identifying condi-
tions under which studying a single good economy is without loss of gener-
ality. To this end, consider the income allocation problem of agent i, given
equilibrium spot prices j
+
:
max
j
i
R
S+1
++
,:
i
R
J

i
(
i
; j
+
)
s.t.
i
0
= j
+
0
.
i
0
.
i
i
c
= j
+
c
.
i
c
+ c
c
.
i
. for : = 1. ...o
If preferences n
i
(r
i
) are identical, homothetic within states, and von Neumann-
Morgenstern, that is, if they satisfy
n
i
(r
i
) = n(r
i
0
) +
S
c=1
j:o/
c
n(r
i
c
). with n(r) homothetic, for all i = 1. ... 1
it is straightforward to show that indirect preferences
i
(
i
; j
+
) are also
identical, homothetic within states, and von Neumann-Morgenstern:
i
(
i
; j
+
) = (
i
0
; j
+
)+
S
c=1
j:o/
c
(
i
c
; j
+
). with (; j
+
) homothetic, for all i = 1. ... 1.
Let n
i
0
= j
+
0
.
i
0
. n
i
c
= j
+
c
.
i
c
. for any : = 1. .... o; and disregard for notational
simplicity the dependence of (; j
+
) on j
+
. The income allocation problem
can be written as:
max
j
i
R
S+1
++
,:
i
R
J
(
i
0
) +
S
c=1
j:o/
c
(
i
c
)
s.t.
i
0
n
i
0
= .
i
i
c
n
i
c
=
c
.
i
. for : = 1. ...o
which is homeomorphic to any agent is optimization problem in the de-
nition of Financial market equilibrium with | = 1. Note that
i
c
gains the
interpretation of agent is consumption expenditure in state :, while n
i
c
is
interpreted as agent is income endowment in state :.
The representative agent theorem
A representative agent is the following theoretical construct.
Denition 62 Consider a Financial market equilibrium (r
+
. .
+
. j
+
.
+
) of an
economy populated by i = 1. .... 1 agents with preferences n
i
: A 1 and
endowments .
i
. A Representative agent for this economy is an agent with
preferences l
1
: A 1 and endowment .
1
such that the Financial market
equilibrium of an associated economy with the Representative agent as the
only agent has prices (j
+
.
+
).
In this section we shall identify assumptions which guarantee that the
Representative agent construct can be invoked without loss of generality.
This assumptions are behind much of the empirical macro/nance literature.
Theorem 63 Representative agent. Suppose preferences satisfy:
n
i
(r
i
) = n(r
i
0
) +
S
c=1
j:o/
c
n(r
i
c
). with homothetic n(r). for all i = 1. ... 1.
Let j
+
denote equilibrium spot prices. If
_
_
.
.
j
+
c
.
i
c
.
.
_
_
< . then there exist
a map n
1
: 1
S+1
+
1 such that:
.
1
=
1
i=1
.
i
c
.
l
1
(r) = n
1
(
0
) +
S
c=1
j:o/
c
n
1
(
c
). where
c
= j
+
1
i=1
r
i
c
. : = 0. 1. .... o
constitutes a Representative agent.
Since the Representative agent is the only agent in the economy, her
consumption allocation and portfolio at equilibrium,
_
r
+1
. .
+1
_
. are:
r
+1
= .
1
=
1
i=1
.
i
.
+1
= 0
If the Representative agents preferences can be constructed indepen-
dently of the equilibrium of the original economy with 1 agents, then equilib-
rium prices can be read out of the Representative agents marginal rates of
substitution evaluated at

1
i=1
.
i
. Since

1
i=1
.
i
is exogenously given, equi-
librium prices are obtained without computing the consumption allocation
and portfolio for all agents at equilibrium, (r
+
. .
+
).
Proof. The proof is constructive. Under the assumptions on preferences in
the statement, we need to show that, for all agents i = 1. .... 1, equilibrium as-
set prices
+
are constant in
_
.
i
1
1(S+1)
++
1
i=1
.
i
given
_
.If preferences sat-
isfy n
i
(r
i
) = n(r
i
0
) +
S
c=1
j:o/
c
n(r
i
c
). for all i = 1. ... 1, with an homothetic
n(r). then by the Budget separation theorem, equilibrium spot prices j
+
are
independent of
+
and constant in
_
.
i
1
1(S+1)
++
1
i=1
.
i
given
_
. There-
fore,
_
_
.
.
j
+
c
.
i
c
.
.
_
_
< can be written as an assumption on fundamentals.
in particular on .
i
. Furthermore, we can restrict our analysis to the single
good economy, whose agent is optimization problem is:
max
j
i
R
S+1
++
,:
i
R
J
(
i
0
) +
S
c=1
j:o/
c
(
i
c
)
s.t.
i
0
n
0
= .
i
i
c
n
c
=
c
.
i
. for : = 1. ...o
where () is homothetic.
We show next that n
1
() = () and .
1
=

1
i=1
.
i
c
constitute a Repre-
sentative agent. By Arrow theorem we can write budget constraints as
i
0
n
i
0
+
S
c=1
:
c
_
i
c
n
i
c
_
= 0
_
_
.
.
i
c
n
i
c
.
.
_
_
<
But,
_
_
.
.
n
i
c
.
.
_
_
< implies that there exist a .
i
&
such that
_
_
.
.
n
i
c
.
.
_
_
= .
i
&
.
Therefore,
_
_
.
.
n
i
c
.
.
_
_
< implies that
i
c
=
c
(.
i
+ .
i
&
), for any : o. We
can then write each agent is optimization problem in terms of (
i
0
. .
i
). and
the value of agent i
t
: endowment is n
i
0
+
S
c=1
:
c
n
i
c
= n
i
0
+
S
c=1
:
c
c
c
.
i
&
=
n
i
0
+ .
i
&
.
In summary, we write the budget constraint as:
i
0
+
S
c=1
:
c
i
c
= n
i
0
+ :
c
c
.
i
&
= n
i
0
+ .
i
&
.
By the fact that preferences are identical across agents and by homo-
theticity of (). then we can write
i
0
_
. n
i
0
_
=
_
n
i
0
+ .
i
&
_
0
(. 1)
i
c
_
. n
i
0
_
=
_
n
i
0
+ .
i
&
_
c
(. 1) . for any : o
At equilibrium then
0
(. 1)
i1
_
n
i
0
+ .
i
&
_
=
0
_
.
i1
_
n
i
0
+ .
i
&
_
_
=

i1
n
i
0
c
(. 1)
i1
_
n
i
0
+ .
i
&
_
=
c
_
.
i1
_
n
i
0
+ .
i
&
_
_
=
c
i1
.
i
&
. for any : o
and prices
+
only depend on

1
i=1
n
i
0
and

1
i=1
.
i
&
.
Make sure you understand where we used the assumption
_
_
.
.
j
+
.
i
c
.
.
_
_
=
_
_
.
.
n
i
c
.
.
_
_
< . Convince yourself that the assumption is necessary in the
proof.
The Representative agent theorem, as noted, allows us to obtain equilib-
rium prices without computing the consumption allocation and portfolio for
all agents at equilibrium, (r
+
. .
+
).Let n =

1
i=1
n
i
. Under the assumptions
of the Representative agent theorem, let n
0
=

i1
n
i
0
. and n
c
=

i1
n
i
c
.
for any : o. Then
=
S
c=1
j:o/
c
`1o
c
(n)
c
. for `1o
c
(n) =
0(&s)
0&s
0(&
0
)
0&
0
That is, asset prices can be computed from agents preferences n
1
= :
1 1 and from the aggregate endowment (n
0
. .... n
c
. ...) . This is called the
Lucas trick for pricing assets.
Problem 64 Note that, under the Complete markets assumption, the span
restriction on endowments,
_
_
.
.
j
+
.
i
c
.
.
_
_
< . for all agents i. is trivially
satised. Does this assumption imply Pareto optimal allocations in equilib-
rium?
Problem 65 Assume all agents have identical quadratic preferences. Derive
individual demands for assets (without assuming
_
_
.
.
j
+
.
i
c
.
.
_
_
< ) and
show that the Representative agent theorem is obtained.
Another interesting but misleading result is the "weak" representative
agent theorem, due to Constantinides (1982).
Theorem 66 Suppose markets are complete (:c:/() = o) and preferences
n
i
(r
i
) are von Neumann-Morgernstern (but not necessarily identical nor ho-
mothetic). Let (r
+
. .
+
. j
+
.
+
) be a Financial markets equilibrium. Then,
.
1
=
1
i=1
.
i
.
l
1
(r) = max
(a
i
)
I
i=1
1
i=1
o
i
n
i
(r
i
) s.t.
1
i=1
r
i
= r.
where o
i
= (`
i
)
1
and `
i
=
Jn
i
(r
i+
)
Jr
i+
10
constitutes a Representative agent.
Clearly, then,
=
S
c=1
j:o/
c
`1o
c
(n)
c
. for `1o
c
(n) =
0l
R
(&s)
0&s
0l
R
(&
0
)
0&
0
.
Proof. Consider a Financial market equilibrium (r
+
. .
+
. j
+
.
+
). By complete
markets, the First welfare theorem holds and r
+
is a Pareto optimal alloca-
tion. Therefore, there exist some weights that make r
+
the solution to the
planners problem. It turns out that the required weights are given by
o
i
=
_
Jn
i
(r
i+
)
Jr
i+
10
_
1
.
This is left to the reader to check; its part of the celebrated Negishi theorem.
This result is certainly very general, as it does not impose identical ho-
mothetic preferences, however, it is not as useful as the real Representative
agent theorem to nd equilibrium asset prices. The reason is that to dene
the specic weights for the planners objective function, (o
i
)
1
i=1
. we need to
know what the equilibrium allocation, r
+
. which in turn depends on the whole
distribution of endowments over the agents in the economy.
4.2.6 Asset pricing
Relying on the aggregation theorem in the previous section, in this section
we will abstract from the consumption allocation problems and concentrate
on one-good economies. This allows us to simplify the equilibrium denition
as follows.
4.2.7 Some classic representation of asset pricing
Often in nance, especially in empirical nance, we study asset pricing rep-
resentation which express asset returns in terms of risk factors. Factors are
to be interpreted as those component of the risks that agents do require a
higher return to hold.
How do we go from our basic asset pricing equation
= 1(:)
to factors?
Single factor beta representation
Consider the basic asset pricing equation for asset ,.
)
= 1(:c
)
)
Let the return on asset ,, 1
)
, be dened as 1
)
=

j
q
j
. Then the asset pricing
equation becomes
1 = 1(:1
)
)
This equation applied to the risk free rate, 1
)
, becomes 1
)
=
1
1n
. Using the
fact that for two random variables r and , 1(r) = 1r1 + co(r. ), we
can rewrite the asset pricing equation as:
11
)
=
1
1:

co(:. 1
)
)
1:
= 1
)
co(:. 1
)
)
1:
or, expressed in terms of excess return:
11
)
1
)
=
co(:. 1
)
)
1:
Finally, letting
,
)
=
co(:. 1
)
)
c:(:)
and
`
=
c:(:)
1:
we have the beta representation of asset prices:
11
)
= 1
)
+ ,
)
`
n
(4.12)
We interpret ,
)
as the "quantity" of risk in asset , and `
n
(which is the
same for all assets ,) as the "price" of risk. Then the expected return of
an asset , is equal to the risk free rate plus the correction for risk, ,
)
`
n
.
Furthermore, we can read (4.12) as a single factor representation for asset
prices, where the factor is :, that is, if the representative agent theorem
holds, her intertemporal marginal rate of substitution.
Multi-factor beta representations
A multi-factor beta representation for asset returns has the following form:
11
)
= 1
)
+
1
)=1
,
))
`
n
f
(4.13)
where (:
)
)
1
)=1
are orthogonal random variables which take the interpretation
of risk factors and
,
))
=
co(:
)
. 1
)
)
c:(:
)
)
is the beta of factor ,, the loading of the return on the factor ,.
Proposition 67 A single factor beta representation
11
)
= 1
)
+ ,
)
`
n
is equivalent to a multi-factor beta representation
11
)
= 1
)
+
1
)=1
,
))
`
n
f
with : =
1
)=1
/
)
:
)
In other words, a multi-factor beta representation for asset returns is
consistent with our basic asset pricing equation when associated to a linear
statistical model for the stochastic discount factor :, in the form of : =
1
)=1
/
)
:
)
.
Proof. Write 1 = 1(:1
)
) as 1
)
= 1
)
cc(n,1
j
)
1n
and then to substitute
: =

1
)=1
/
)
:
)
and the denitions of ,
))
, to have
`
n
f
=
c:(:
)
)/
)
1:
)
The CAPM
The CAPM is nothing else than a single factor beta representation of the
following form:
11
)
= 1
)
+ ,
))
`
n
f
where
:
)
= c + /1
&
the return on the market portfolio, the aggregate portfolio held by the in-
vestors in the economy.
It can be easily derived from an equilibrium model under special assump-
tions.
For example, assume preferences are quadratic:
n(r
i
c
. r
i
1
) =
1
2
(r
i
r
#
)
2
1
2
,
S
c=1
j:o/
c
(r
i
c
r
#
)
2
Moreover, assume agents have no endowments at time t = 1. Let

1
i=1
r
i
c
=
r
c
. : = 0. 1. .... o; and

1
i=1
n
i
0
= n
0
. Then budget constraints include
r
c
= 1
&
c
(n
0
r
0
)
Then,
:
c
= ,
r
c
r
#
r
0
r
#
=
,(n
0
r
0
)
(r
0
r
#
)
1
&
c

,r
#
r
0
r
#
which is the CAPM for c =
oa
#
a
0
a
#
and / =
o(&
0
a
0
)
(a
0
a
#
)
.
Note however that c =
oa
#
a
0
a
#
and / =
o(&
0
a
0
)
(a
0
a
#
)
are not constant, as they
do depend on equilibrium allocations. This will be important when we study
conditional asset market representations, as it implies that the CAPM is
intrinsically a conditional model of asset prices.
Bounds on stochastic discount factors
Write the beta representation of asset returns as:
11j 1
)
=
co(:. 1j )
1:
=
j(:. 1j )o(:)o(1j )
1:
where 0 _ j(:. 1j ) _ 1 denotes the correlation coecient and o(.), the
standard deviation. Then
[
11j 1
)
o(1j )
[_
o(:)
1:
The left-hand-side is the Sharpe-ratio of asset ,.
The relationship implies a lower bound on the standard deviation of any
stochastic discount factor : which prices asset ,. Hansen-Jagannathan are
responsible for having derived bounds like these and shown that, when the
stochastic discount factor is assumed to be the intertemporal marginal rate
of substitution of the representative agent (with CES preferences), the data
does not display enough variation in : to satisfy the relationship.
A related bound is derived by noticing that no-arbitrage implies the ex-
istence of a unique stochastic discount factor in the space of asset payos,
denoted :
j
, with the property that any other stochastic discount factor :
satises:
: = :
j
+ c
where c is orthogonal to :
j
.
The following corollary of the No-arbitrage theorem leads us to this result.
Corollary 68 Let (. ) satisfy No-arbitrage. Then, there exists a unique
t
+
< such that = t
+
.
Proof. By the No-arbitrage theorem, there exists : 1
S
++
such that = :.
We need to distinguish notationally a matrix ` from its transpose, `
T
. We
write then the asset prices equation as
T
=
T
:
T
. Consider :
j
:
:
T
j
= (
T
)
1
.
Clearly,
T
=
T
:
T
j
. that is, :
T
j
satises the asset pricing equation. Further-
more, such :
T
j
belongs to < , since :
T
j
= .
j
for .
j
= (
T
)
1
. Prove
uniqueness.
We can now exploit this uniqueness result to yield a characterization of
the multiplicity of stochastic discount factors when markets are incomplete,
and consequently a bound on o(:). In particular, we show that, for a given
(. ) pair a vector : is a stochastic discount factor if and only if it can
be decomposed as a projection on < and a vector-specic component
orthogonal to < . Moreover, the previous corollary states that such a
projection is unique.
Let : 1
S
++
be any stochastic discount factor, that is, for any : =
1. . . . . o, :
c
=
s
jvcbs
and
)
= 1(:
)
). for , = 1. .... J. Consider the orthogo-
nal projection of : onto < , and denote it by :
j
. We can then write any
stochastic discount factors : as : = :
j
+ , where is orthogonal to any
vector in < . in particular to any
)
. Observe in fact that :
j
+ is also
a stochastic discount factors since
)
= 1((:
j
+)c
)
) = 1(:
j
c
)
) +1(c
)
) =
1(:
j
c
)
), by denition of . Now, observe that
)
= 1(:
j
c
)
) and that we
just proved the uniqueness of the stochastic discount factors lying in < .
In words, even though there is a multiplicity of stochastic discount factors,
they all share the same projection on < . Moreover, if we make the eco-
nomic interpretation that the components of the stochastic discount factors
vector are marginal rates of substitution of agents in the economy, we can
interpret :
j
to be the economys aggregate risk and each agents to be the
individuals unhedgeable risk.
It is clear then that
o(:) _ o(:
j
)
the bound on o(:) we set out to nd.
4.2.8 Production
Assume for simplicity that 1 = 1, and that there is a single type of rm in the
economy which produces the good at date 1 using as only input the amount
/ of the commodity invested in capital at time 0.
12
The output depends on
/ according to the function ,(/; :), dened for / 1, where : is the state
realized at t = 1. We assume that
- ,(/; :) is continuously dierentiable, increasing and concave in /.
- . 1 are closed, compact subsets of R
+
and 0 1.
In addition to rms, there are 1 types of consumers. The demand side of
the economy is as in the previous section, except that each agent i 1 is also
endowed with o
i
0
units of stock of the representative rm. Consumer i has
von Neumann-Morgernstern preferences over consumption in the two dates,
represented by n
i
(r
i
0
) + En
i
(r
i
), where n
i
() is continuously dierentiable,
strictly increasing and strictly concave.
Competitive equilibrium
Let the outstanding amount of equity be normalized to 1: the initial distri-
bution of equity among consumers satises

i
o
i
0
= 1. The problem of the
rm consists in the choice of its production plan /..
12
It should be clear from the analysis which follows that our results hold unaltered
if the rms technology were described, more generally, by a production possibility set
Y R
S+1
.
Firms are perfectly competitive and hence take prices as given. The
rms cash ow, ,(/; :). varies with /. Thus equity is a dierent product
for dierent choices of the rm. What should be its price when all this
continuum of dierent products are not actually traded in the market? In
this case the price is only a conjecture. It can be described by a map Q(/)
specifying the market valuation of the rms cash ow for any possible value
of its choice /.
13
The rm chooses its production plan / so as to maximize
its value. The rms problem is then:
max
I
/ + Q(/) (4.14)
When nancial markets are complete, the present discounted valuation of
any future payo is uniquely determined by the price of the existing assets.
This is no longer true when markets are incomplete, in which case the prices
of the existing assets do not allow to determine unambiguously the value of
any future cash ow. The specication of the price conjecture is thus more
problematic in such case. Let /
+
denote the solution to this problem.
At t = 0, each consumer i chooses his portfolio of nancial assets and of
equity, .
i
and o
i
respectively, so as to maximize his utility, taking as given
the price of assets, and the price of equity Q. In the present environment a
consumers long position in equity identies a rms equity holder, who may
have a voice in the rms decisions. It should then be treated as conceptually
dierent from a short position in equity, which is not simply a negative
holding of equity. To begin with, we rule out altogether the possibility of
short sales and assume that agents can not short-sell the rm equity:
o
i
_ 0. \i (4.15)
The problem of agent i is then:
max
a
i
0
,a
i
,:
i
,0
i
n
i
_
r
i
0
_
+En
i
_
r
i
_
(4.16)
subject to (4.15) and
r
i
0
= .
i
0
+ [/ + Q] o
i
0
Qo
i
.
i
(4.17)
r
i
(:) = .
i
(:) + ,(/; :)o
i
+ (:).
i
. \: o (4.18)
13
These price maps are also called price perceptions.
Let
_
r
i+
0
. r
i+
. .
i+
. o
i+
_
denote the solution to this problem.
In equilibrium, the following market clearing conditions must hold, for
the consumption good:
14
i
r
i
0
+ / _

i
.
i
0
i
r
i
(:) _

i
.
i
(:) + ,(/; :). \: o
or, equivalently, for the assets:
i
.
i
= 0 (4.19)
i
o
i
= 1 (4.20)
In addition, the equity price map faced by rms must satisfy the following
consistency condition:
i) Q(/
+
) = Q;
This condition requires that, at equilibrium, the price of equity conjec-
tured by rms coincides with the price of equity, faced by consumers in the
market: rms conjectures are correct in equilibrium.
We also restrict out of equilibrium conjectures by rms, requiring that
they satisfy:
ii) Q(/) = max
i
E[`1o
i+
,(/)], \/, where `1o
i+
denotes the marginal rate
of substitution between consumption at date 0 and at date 1 in state
: for consumer i. evaluated at his equilibrium consumption allocation
(r
i+
0
. r
i+
).
Condition ii) says that for any / (not just at equilibrium!) the value of
the equity price map Q(/) equals the highest marginal valuation - across all
consumers in the economy - of the cash ow associated to /. The consumers
14
We state here the conditions for the case of symmetric equilibria, where all rms take
the same production and nancing decision, so that only one type of equity is available
for trade to consumers. They can however be easily extended to the case of asymmetric
equilibria as, for instance, in the example of Section ??.
marginal rates of substitutions `1o
i
(:) used to determine the market val-
uation of the future cash ow of a rm are taken as given, unaected by
the rms choice of /. This is the sense in which, in our economy, rms are
competitive: each rm is small relative to the mass of consumers and each
consumers holds a negligible amount of shares of the rm.
To better understand the meaning of condition ii), note that the con-
sumers with the highest marginal valuation for the rms cash ow when
the rm chooses / are those willing to pay the most for the rms equity in
that case and the only ones willing to buy equity - at the margin - when
its price satises ii). Given i) such property is clearly satised for the rms
equilibrium choice /
+
. Condition ii) requires that the same is true for any
other possible choice /: the value attributed to equity equals the maximum
any consumer is willing to pay for it. Note that this would be the equilibrium
price of equity of a rm who were to deviate from the equilibrium choice
and choose / instead: the supply of equity with cash ow corresponding to
/ is negligible and, at such price, so is its demand.
In this sense, we can say that condition ii) imposes a consistency con-
dition on the out of equilibrium values of the equity price map; that is, it
corresponds to a "renement" of the equilibrium map, somewhat analogous
to bacward induction. Equivalently, when price conjectures satisfy this con-
dition, the model is equivalent to one where markets for all the possible types
of equity (that is, equity of rms with all possible values of /) are open, avail-
able for trade to consumers and, in equilibrium all such markets - except the
one corresponding to /
+
- clear at zero trade.
15
It readily follows from the consumers rst order conditions that in equi-
librium the price of equity and of the nancial assets satisfy:
Q = max
i
E
_
`1o
i+
,(/
+
)
(4.21)
= E
_
`1o
i+

The denition of competitive equilibrium is stated for simplicity for the

case of symmetric equilibria, where all rms choose the same production plan.
When the equity price map satises the consistency conditions i) and ii) the
rms choice problem is not convex. Asymmetric equilibria might therefore
15
An analogous specication of the price conjecture has been earlier considered by
Makowski (1980) and Makowski-Ostroy (1987) in a competitive equilibrium model with
dierentiated products, and by Allen-Gale (1991) and Pesendorfer (1995) in models of
nancial innovation.
exist, in which dierent rms choose dierent production plans. The proof
of existence of equilibria indeed requires that we allow for such asymmetric
equilibria, so as to exploit the presence of a continuum of rms of the same
type to convexify rms choice problem. A standard argument allows then
to show that rms aggregate supply is convex valued and hence that the
existence of (possibly asymmetric) competitive equilibria holds.
Proposition 69 A competitive equilibrium always exist.
Objective function of the rm
Starting with the initial contributions of Diamond (1967), Dreze (1974),
Grossman-Hart (1979), and Due-Shafer (1986), a large literature has dealt
with the question of what is the appropriate objective function of the rm
when markets are incomplete.The issue arises because, as mentioned above,
rms production decisions may aect the set of insurance possibilities avail-
able to consumers by trading in the asset markets.
If agents are allowed innite short sales of the equity of rms, as in the
standard incomplete market model, a small rm will possibly have a large
eect on the economy by choosing a production plan with cash ows which,
when traded as equity, change the asset span. It is clear that the price
taking assumption appears hard to justify in this context, since changes in
the rms production plan have non-negligible eects on allocations and hence
equilibrium prices. The incomplete market literature has struggled with this
issue, trying to maintain a competitive equilibrium notion in an economic
environment in which rms are potentially large.
In the environment considered in these notes, this problem is avoided
by assuming that consumers face a constraint preventing short sales, (4.15),
which guarantees that each rms production plan has instead a negligible
(innitesimal) eect on the set of admissible trades and allocations available
to consumers. Evidently, for price taking behavior to be justied a no short
sale constraint is more restrictive than necessary and a bound on short sales
of equity would suce; see Bisin-Gottardi-Ruta (2009).
When short sales are not allowed, the decisions of a rm have a negligible
eect on equilibrium allocations and market prices. However, each rms de-
cision has a non-negligible impact on its present and future cash ows. Price
taking can not therefore mean that the price of its equity is taken as given
by a rm, independently of its decisions. However, as argued in the previous
section, the level of the equity price associated to out-of-equilibrium values
of / is not observed in the market. It is rather conjectured by the rm. In a
competitive environment we require such conjecture to be consistent, as re-
quired by condition ii) in the previous section. This notion of consistency of
conjectures implicitly requires that they be competitive, that is, determined
by a given pricing kernel, independent of the rms decisions.
16
But which
pricing kernel? Here lies the core of the problem with the denition of the ob-
jective function of the rm when markets are incomplete. When markets are
incomplete, in fact, the marginal valuation of out-of-equilibrium production
plans diers across dierent agents at equilibrium. In other words, equity
holders are not unanimous with respect to their preferred production plan
for the rm. The problem with the denition of the objective function of the
rm when markets are incomplete is therefore the problem of aggregating
equity holders marginal valuations for out-of-equilibrium production plans.
The dierent equilibrium notions we nd in the literature dier primarily in
the specication of a consistency condition on Q(/), the price map which
the rms adopts to aggregate across agents marginal valuations.
17
Consider for example the consistency condition proposed by Dreze (1974):
Q
1
(/) = E
_
i
o
i+
`1o
i+
,(/)
_
. \/ (4.22)
Such condition requires the price conjecture for any plan / to equal the
pro rata marginal valuation of the agents who at equilibrium are the rms
equity holders (that is, the agents who value the most the plan chosen by
rms in equilibrium). It does not however require that the rms equity
holders are those who value the most any possible plan of the rm, without
contemplating the possibility of selling the rm in the market, to allow the
new equity buyers to operate the production plan they prefer. Equivalently,
the value of equity for out of equilibriumproduction plans is determined using
the - possibly incorrect - conjecture that the rms equilibrium shareholders
will still own the rm out of equilibrium.
16
Independence of the kernel is guarantee by the fact that MRS
i
(s); for any i, is
evaluated at equilibrium.
17
A minimal consistency condition on Q(k) is clearly given by i) in the previous section,
which only requires the conjecture to be correct in correspondence to the rms equilibrium
choice. Due-Shafer (1986) indeed only impose such condition and nd a rather large
indeterminacy of the set of competitive equilibria.
Grossman-Hart (1979) propose another consistency condition and hence
a dierent equilibrium notion. In their case
Q
G1
(/) = E
_
i
o
i
0
`1o
i+
,(/)
_
. \/
We can interpret such notion as describing a situation where the rms plan
is chosen by the initial equity holders (i.e., those with some predetermined
stock holdings at time 0) so as to maximize their welfare, again without
contemplating the possibility of selling the equity to other consumers who
value it more. Equivalently, the value of equity for out of equilibrium pro-
duction plans is again derived using the conjecture belief that rms initial
shareholders stay in control of the rm out of equilibrium.
Unanimity
Under the denition of equilibrium proposed in these notes, equity holders
unanimously support the rms choice of the production and nancial deci-
sions which maximize its value (or prots), as in (4.14). This follows from
the fact that, when the equity price map satises the consistency conditions
i) and ii), the model is equivalent to one where a continuum of types of equity
is available for trade to consumers, corresponding to any possible choice of
/ the representative rm can make, at the price Q(/). Thus, for any pos-
sible value of / a market is open where equity with a payo ,(/; :) can be
traded, and in equilibrium such market clears with a zero level of trades for
the values of / not chosen by the rms.
For any possible choice / of a rm, the (marginal) valuation of the rm
by an agent i is
E
_
`1o
i+
,(/
+
)
.
and it is always weakly to the market value of the rm, given by
max
i
E
_
`1o
i+
,(/
+
)
.
Proposition 70 At a competitive equilibrium, equity holders unanimously
support the production /
+
; that is, every agent i holding a positive initial
amount o
i
0
of equity of the representative rm will be made - weakly - worse
o by any other choice /
t
of the rm.
Eciency
A consumption allocation (r
i
0
. r
i
)
1
i=1
is admissible if:
18
1. it is feasible: there exists a production plan / such that
i
r
i
0
+ / _
i
.
i
0
(4.23)
i
r
i
(:) _
i
.
i
(:) + ,(/; :). \: o (4.24)
2. it is attainable with the existing asset structure: for each consumer i,
there exists a pair
_
.
i
. o
i
_
such that:
r
i
(:) = .
i
(:) + ,(/; :) o
i
+ (:).
i
. \: o (4.25)
Next we present the notion of eciency restricted by the admissibility
constraints:
Constrained eciency. A competitive equilibrium allocation is constrained
Pareto ecient if we can not nd another admissible allocation which
is Pareto improving.
The validity of the First Welfare Theorem with respect to such notion
can then be established by an argument essentially analogous to the one used
to establish the Pareto eciency of competitive equilibria in Arrow-Debreu
economies.
First welfare theorem. Competitive equilibria are constrained Pareto ef-
cient.
18
To keep the notation simple, we state both the denition of competitive equilibria and
admissible allocations for the case of symmetric allocations. The analysis, including the
eciency result ,extends however to the case where asymmetric allocations are allowed are
admissible; see also the next section.
Modigliani-Miller
We examine now the case where rms take both production and nancial
decisions, and equity and debt are the only assets they can nance their
production with. The choice of a rms capital structure is given by the
decision concerning the amount 1 of bonds issued. The problem of the rm
consists in the choice of its production plan / and its nancial structure 1.
To begin with, we assume without loss of generality that all rms debt is risk
free. The rms cash ow in this context is then [,(/; :) 1] and varies with
the rms production and nancing choices, /. 1. Equity price conjectures
have the form Q(/. 1), while the price of the (risk free) bond is independent
of (/. 1); we denote it j. The rms problem is then:
max
I,1
/ + Q(/. 1) + j 1 (4.26)
The consumption side of the economy is the same as in the previous
section, except that now agents can also trade the bond. Let /
i
denote the
bond portfolio of agent i. and let continue to impose no-short sales contraints:
o
i
_ 0
/
i
_ 0. \i.
Proceeding as in the previous section, at equilibrium we shall require that
Q(/) = max
i
E
_
`1o
i+
[,(/) 1]
. \/.
j = max
i
E
_
`1o
i+
where `1o
i+
denotes the marginal rate of substitution between consumption
at date 0 and at date 1 in state : for consumer i. evaluated at his equilibrium
consumption allocation (r
i+
0
. r
i+
). Suppose now that nancial markets are
complete, that is :c:/() = o. At equilibrium then `1o
i+
= `1o
+
, \i.
Therefore, in this case
Q(/. 1) + j 1 = E[`1o
+
,(/)] . \/.
and the value of the rm, Q(/. 1) + j 1. is independent of 1. This proves
the celebrated
Modigliani-Miller theorem. If nancial markets are complete the nanc-
ing decision of the rm, 1. is indeterminate.
It should be clear that when nancial markets are not complete and agents
are restricted by no-short sales constraints, the Modigliani-Miller theorem
does not quite necessarily hold.
Chapter 5
Asymmetric information
Do competitive insurance markets function orderly in the presence of moral
hazard and adverse selection? What are the properties of allocations at-
tainable as competitive equilibria of such economies? And in particular, are
competitive equilibria incentive ecient?
For such economies the interaction between the private information di-
mension (e.g., the unobservable action in the moral hazard case, the unob-
servable type in the adverse selection case) and the observability of agents
trades plays a crucial role, since trades have typically informational con-
tent over the agents private information. In particular, to decentralize in-
centive ecient Pareto optimal allocations the availability of fully exclusive
contracts, i.e., of contracts whose terms (price and payo) depend on the
transactions in all other markets of the agent trading the contract, is gener-
ally required. The implementation of these contracts imposes typically the
very strong informational requirement that all trades of an agent need to be
observed.
The fundamental contribution on competitive markets for insurance con-
tracts is Prescott and Townsend (1984). They analyze Walrasian equilibria
of economies with moral hazard and with adverse selection when exclusive
contracts are enforceable, that is, when trades are fully observable.
1
In these
1
The standard strategic analysis of competition in insurance economies, due to
Rothschild-Stiglitz (1976), considers the Nash equilibria of a game in which insurance
companies simultaneously choose the contracts they issue, and the competitive aspect of
the market is captured by allowing the free entry of insurance companies. Such equi-
librium concept does not perform too well: equilibria in pure strategies do not exist for
robust examples (Rothschild-Stiglitz (1976)), while equilibria in mixed strategies exist
79
80 CHAPTER 5. ASYMMETRIC INFORMATION
notes we concentrate on the simpler case of moral hazard. We refer to Bisin-
Gottardi (2006) for the case of adverse selection.
5.1 A simple insurance economy
Agents live two periods, t = 0. 1. and consume a single consumption good
only in period 1. Uncertainty is purely idiosyncratic and all agents are ex-
ante identical. In particular, each agent faces a (date 1) endowment which
is an identically and independently distributed random variable . on a nite
support o.
2
Moral hazard (hidden action) is captured by the assumption that the
probability distribution of the period 1 endowment that each agent faces
depends from the value taken by a variable c 1, an unobservable level of
eort which is chosen by the agent.
Let j:o/
c
(c) be the probability of the realization .
c
given c. Obviously
cS
j:o/
c
(c) = 1. for any c 1. a compact, convex set. By the Law of
Large Numbers, j:o/
c
(c) is also the fraction of agents who have chosen eort
c for which state : is realized. Agents preferences are represented by a von
Neumann-Morgenstern utility function of the following form:
cS
j:o/
c
(c)n(r
c
) (c)
where (c) denotes the disutility of eort c. We assume the following
regularity conditions:
The utility function n(r) is strictly increasing, strictly concave, twice
continuously dierentiable, and lim
a0
n
t
(r) = . The cost function (c)
is strictly increasing, strictly convex, twice continuously dierentiable, and
sup
c1

t
(c) = .
(Dasgupta-Maskin (1986)) but, in this set-up, are of dicult interpretation. Even when
equilibria in pure strategies do exist, it is not clear that the way the game is modelled is
appropriate for such markets, since it does not allow for dynamic reactions to new contract
oers (Wilson (1977) and Riley (1979); see also Maskin-Tirole (1992)). Moreover, once
sequences of moves are allowed, equilibria are not robust to minor perturbations of the
extensive form of the game (Hellwig (1987)).
2
Measurability issues arise in probability spaces with a continuum of indipendent ran-
dom variables. We adopt the usual abuse of the Law of Large Numbers.
5.1. A SIMPLE INSURANCE ECONOMY 81
Essentially without loss of generality, let the state space o be ordered so
that .
c
.
c1
. for all : = 2. .... o. We then impose the following standard
restriction.
Single-crossing property. The odds ratio
jvcbcs(c)
jvcbc
s1
(c)
is strictly increasing
in c, for any : = 2. .... o.
5.1.1 The Symmetric information benchmark
Consider now the benchmark case of symmetric information, in which c is
commonly observed. An allocation (r. c) R
S
+
1 of consumption and eort
is optimal under symmetric information if it solves:
max
a,c
cS
j:o/
c
(c)n(r
c
) (c). (5.1)
s.t.

cS
j:o/
c
(c)(r
c
.
c
) = 0
Let
c
(c) denote the (linear) price of consumption in state : for agents
who chose eort c. By allowing the prices of the securities whose payo is
contingent on the idiosyncratic uncertainty to depend on c, we eectively
are introducing price conjectures: we read
c
(c) as the price of consumption
contingent to state : if the agent chooses eort c, for any c 1. not just
at the equilibrium c. This is the same problem we found in production
economies with incomplete markets, where the price faced by the rm was a
whole map Q(/). interpreted as a price conjecture.
At a competitive equilibrium each agent solves
max
a,c
cS
j:o/
c
(c)n(r
c
) (c). (5.2)
s.t.

cS
c
(c)(r
c
.
c
) = 0
and markets clear

cS
j:o/
c
(c)(r
c
.
c
) = 0 (5.3)
We impose the following consistency condition on the price conjecture:
c
(c) = j:o/
c
(c).
Under the consistency condition it is now straightforward to prove the
First and Second Welfare theorems for this economy under symmetric infor-
mation.
5.2 The moral hazard economy
Consider now the case of asymmetric information, in which his choice of
eort c is private information of each agent. In this context, an allocation
(r. c) R
S
+
1 of consumption and eort is incentive constrained optimal if
it solves:
max
a,c
cS
j:o/
c
(c)n(r
c
) (c). (5.4)
s.t.

cS
j:o/
c
(c)(r
c
.
c
) = 0
and
c c(r) = arg max
cS
j:o/
c
(c)n(r
c
) (c). given r
The last constraint, called incentive constraint, requires that the allocation
(r. c) must be such that the agent prefers (r. c) to any other allocation (r. c
t
),
for any c. c
t
1.
At a Prescott-Townsend competitive equilibrium prices cannot have the
form
c
(c), as the agents choice for c is not observed. What is observed,
however is the consumption allocation r demanded by the agent in the mar-
ket. (Note that the exclusivity assumption guarantees that this is the case,
that r is observable). Price conjectures can then be dened as a function of
r as
c
(r) =
c
(c(r)).
At a competitive equilibrium then each agent solves
max
a,c
cS
j:o/
c
(c)n(r
c
) (c). (5.5)
5.2. THE MORAL HAZARD ECONOMY 83
s.t.
cS
c
(r)(r
c
.
c
) = 0
where
c
(r) =
c
(c (r)) and c(r) = arg max
cS
j:o/
c
(c)n(r
c
) (c)
and markets clear

cS
j:o/
c
(c)(r
c
.
c
) = 0 (5.6)
At an equilibrium we also impose the following consistency condition on
the price conjecture:
c
(c(r)) = j:o/
c
(c(r))
The First and Second Welfare theorems, in its incentive constrained versions,
hold straightforwardly for the moral hazard economy.
An equivalent notion of equilibrium is possible, which is equivalent to
the one just proposed. It is a (sort of) mechanism design formulation of the
competitive equilibrium. Since prices cannot depend on eort c, which is un-
observable, they depend on agents message/declaration about eort, which
we denote : 1 and which his optimally chosen by the agents themselves.
An agent declaring : will face prices
c
(:) but also a restriction on the
space of allocations 1(:) _ R
S
++
designed to guarantee that his declaration
coincides with his eort choice, that is, designed to guarantee truth-telling:
: = c.
Specically, we write the agents problem as follows:
max
aR
S
++
,(c,n)1
2
cS
j:o/
c
(c)n(r
c
) (c). (5.7)
s.t.
cS
c
(:)(r
c
.
c
) = 0 and r 1(:).
where 1(:) =
_
r R
S
++
: : arg max
.1
cS
j:o/
c
()n(r
c
) ()
_
At equilibrium then markets clear
cS
j:o/
c
(c)(r
c
.
c
) = 0. (5.8)
In other words, the truth-telling constraint, r 1(:), requires that in the
market with prices (:) only incentive compatible allocations are oered,
that is, only allocations which induce the agent to choose eort :. for any
: 1.
3
It is straightforward to see that this equilibrium notion is equivalent
to the one with rational price conjectures we have proposed. The interpre-
tation is dierent however: with rational conjectures it is the conjectures
on prices of non incentive compatible allocations which are restricted, while
with the equilibrium notion in this remark it is tradable allocations which
are restricted to exclude non incentive compatible ones.
It is important to note that the allocation (r
c
)
cS
is assumed observable.
This corresponds to the exclusivity case, as it is called in the literature. The
next problem deals with the non-exclusivity case in a simple but instructive
example.
Problem 71 In the context of these moral hazard economies M. Harris and
R. Townsend (1981) prove a version of the Revelation principle. Formulate
the statement and sketch the proof.
Problem 72 Characterize Incentive constrained optima and competitive equi-
libria (with the consistency condition on price maps) of the moral hazard
economy specialized so that
o = 1. 2; c = /. |; (/) (|); :
1
(/) :
1
(|); .
1
.
2
.
Set-up and characterize equilibria of this economy under the constraint that
prices are linear (independent of r):
c
(c(r)) =
c
.
Are equilibrium allocations in this case Incentive constraint ecient?
3
Typically, the declaration of eort on the part of the agent is implicit and the problem
of the agent is written
max
x2R
S
++
;e2E
s2S
prob
s
(e)u(x
s
) v(e); (5.9)
s.t.
s2S
q
s
(e)(x
s
!
s
) = 0;
x B(e) =
_
x R
S
++
: e arg max
"2E
s2S
prob
s
(")u(x
s
) v(")
_
5.3. THE ADVERSE SELECTION ECONOMY 85
5.3 The adverse selection economy
Consider now an asymmetric information economy in which c is private in-
formation of each agent, but it is not chosen by the agent: it is rather an
exogenous type. Assume that a fraction `
c
of agents has type c 1 (1 is
nite). In this context, an allocation is r = (r
c
)
c1
R
S1
++
.
An allocation r R
S1
++
incentive constrained optimal if, for some (
c
)
c1

1
. it solves:
max
aR
SE
++
c1
cS
j:o/
c
(c)n(r
c
c
). (5.10)
s.t.

c1
`
c
cS
j:o/
c
(c)(r
c
c
.
c
) = 0
and
c arg max
.1
cS
j:o/
c
(c)n(r
.
c
). for any c 1
The last constraint, called incentive constraint or truth-telling, requires that,
for any type c 1. the allocation r
c
R
S
++
must be such that the agent
prefers r
c
to any other allocation r
.
, for any 1.
Consider now a Prescott-Townsend competitive equilibrium. Prices can-
not have the form
c
(c), as the agents type c is not observed. But once again
price conjectures can be dened as a function of the observables. Dene the
map t : R
S1
++
1 1 by
t(r. c) = arg max
.1
cS
j:o/
c
(c)n(r
.
c
). for any c 1.
Let t(r) = '
c1
t(r. c) _ 1
We can dene price perceptions by
c
(r) =
c
(t(r)).
and at a competitive equilibrium then each agent of type c 1 solves
max
aR
S
++
cS
j:o/
c
(c)n(r
c
c
)
s.t.

cS
c
(t(r))(r
c
c
.
c
) = 0.
At a competitive equilibrium, also, markets clear
c1
`
c
cS
j:o/
c
(c)(r
c
c
.
c
) = 0
and prices perceptions satisfy the consistency condition
c
(t(r)) =

ct(a)
{
c
j:o/
c
(c). with {
c
=
`
c
ct(a)
`
c
.
Note that, as we have just written it, the problem of each agent of type c
1 depends on the whole allocation r R
S1
++
. that is on the agents allocation
r
c
as well on all the other types allocations r
.
. 1. In other words, each
types consumption problem contains an externality. As a consequence, the
First and Second Welfare theorems, in its incentive constrained versions, do
not hold for the adverse selection economy; see Bisin-Gottardi (2006) for
details (many more than you might ever want to).
In the adverse selection case, as well in the moral hazard case, it is im-
portant to note that the allocation (r
c
)
cS
is assumed observable. The next
problem deals with the non-exclusivity case in a simple but instructive ex-
ample.
Problem 73 Characterize Incentive constrained optima and competitive equi-
libria (with the consistency condition on price maps) of the adverse selection
economy specialized so that
o = 1. 2; c = /. |; :
1
(/) :
1
(|); .
1
.
2
.
Set-up and characterize equilibria of this economy under the constraint that
prices are linear (independent of r):
c
(t(r)) =
c
.
Are equilibrium allocations in this case Incentive constraint ecient?
5.4 Information revealed by prices
In the previous sections, moral hazand and adverse selection regarded asym-
metric information about idiosyncratic shocks which they acquired insur-
ance against. In this section we study instead economies in which agents
5.4. INFORMATION REVEALED BY PRICES 87
are endowed with asymmetric information regarding aggregate shocks, e.g.,
because dierent agent types observe dierent signals about the aggregate
endowment process. In this case, under rational expectations agents choices
contain implicitly information about the signal they have received, which in
turn implies that prices might contain some of this information, and hence
that agents at equilibrium condition on the information contained in prices.
If equilibrium prices aggregate in a signicant manner the information
which is asymmetrically distributed across agents in the economy, then com-
petitive equilibrium allocations might in fact Pareto dominate the alloca-
tions which a benevolent planner could choose without observing equilibrium
prices. This is the fundamental insight due to Friederick August Hayek in
The Road to Serfdom, University of Chicago, 1944.
On the other hand, economies in which prices do not reveal completely
the information asymmetrically distributed across agents in the economy, are
economies in agents have dierent probability distributions across aggregate
endowments, and hence trade in nancial markets on account of risk sharing
as well as information, a positive property which seem to characterize real
nancial markets.
Consider a nancial market economy with one good, 1 = 1. and 2 periods,
t = 0. 1. Let i 1. .... 1 denote agents. Let : 1. .... o denote the
realization of the state of the world of the economy at t = 1. The consumption
space is denoted then by A _ R
S+1
+
. Each agent is endowed with a vector
.
i
R
S+1
++
. Let n
i
: A R denote agent is utility function. Financial
markets are characterized by J assets with payo matrix R
SJ
+
. J _ o.
with rank J.
Each agent of type i 1. .... 1 observes, before markets are open at
t = 0. the realization of a signal o
i
= 1. .... . which is possibly
correlated with the state of the world : o. All agents have identical
prior over the distribution of states of the world and signals in o
1
.
denoted j:o/
c,o
. Let j:o/
o
i
c,o
denote the posterior after conditioning on o
i
. Furthermore, let o = (o
i
)
i1

1
; and let j:o/
o
c
denote the posterior
distribution over : 1. .... o after conditioning on o
1
. Finally, given
a price map c :
1
R
J
+
. such that
o
= c(o). let j:o/
o
i
,
1
(q)
c
denote the
posterior distribution over : 1. .... o after conditioning on o
i
and
o c
1
(
o
).
Each agent type i 1s choice problem is the following:
max
(a
i
,:
i
)R
S+1
+
R
J
+
n
i
(r
i
0
) +
cS
j:o/
o
i
,
1
(q)
c
n
i
(r
i
c
)
s.t.
r
i
0
+
o
.
i
_ .
i
0
r
i
c
_
c
.
i
+ .
i
c
Note that agent is expected utility is calculated after conditioning on the
private signal o
i
and the information on o contained in prices
o
. Let .
i
(
o
. c)
denote the solution to this problem in terms of portfolios .
i
. Let then
2(
o
. c) =

i1
.
i
(
o
. c)
denote the excess demand system for this economy, J equations, one for each
asset. Note that the condition 2(
o
. c) = 0 is sucient for all markets to
clear, as in this case r
i
c
=
c
.
i
+.
i
c
implies

i1
r
i
c
.
i
c
= 0, for any : o.
and

i1
r
i
0
.
i
0
= 0 by Walras Law.
We are now ready for the denition of equilibrium, Rational Expectation
Equilibrium (REE).
Denition 74 A REE price is a map c
+
:
1
R
J
+
such that
2(c
+
(o) . c
+
) = 0. for any o
1
.
This notion of equilibrium is due to Robert E. Lucas (1972) and has been
taken up by a series of important papers by S. Grossman and by S. Grossman
and J. Stiglitz in the late 70s. Several examples in the literature show that
REE prices might not exist for some economies (the rst example is due to
D. Kreps). Furthermore, even when they exist, characterizing REE prices
is typically a daunting task. On the other hand, it is not (that) hard to
characterize the information contained in the prices, for generic economies.
This result is due to Radner (1979).
Theorem 75 For a generic subset of economies parametrized by endow-
ments . R
S+1
+
, a REE price c
+
:
1
R
J
+
is fully revealing, that is,
c
+
(o) ,= c
+
(o
t
) . for any o. o
t

1
.
Proof. Let each agent type i 1s choice problem be the following:
max
(a
i
,:
i
)R
S+1
+
R
J
+
n
i
(r
i
0
) +
cS
j:o/
o
c
n
i
(r
i
c
)
s.t.
r
i
0
+
o
.
i
_ .
i
0
r
i
c
_
c
.
i
+ .
i
c
Let .
i
(
o
. j:o/
o
) denote the solution to this problem in terms of portfolios .
i
when the signals prole is o
1
. Let then
2(
o
. j:o/
o
) =

i1
.
i
(
o
. j:o/
o
)
denote the excess demand system for this economy, J equations, one for each
asset. The statement of the theorem is a consequence of the application of
the Transversality theorem to the following system,
2(
o
. j:o/
o
) = 0
2(
o
0 . j:o/
o
0
) = 0
o
=
t
o
for o. o
t

1
. While we avoid the perturbation argument, we note that the
system has 3J equations in 2J unknowns, prices
o
.
o
0 .
Notice that a fully revealing price map c
+
is invertible, by denition, and
hence
j:o/
o
i
,
1
(q)
c
= j:o/
o
c
.
At a fully revealing REE, therefore, agents posterior probability distributions
over : o are identical. As a consequence, it follows that existence is generic
and that at these equilibria agents do not trade on account of information.
Consider however the following information structure. Each agent of type
i 1. .... 1 observes, before markets are open at t = 0. the realization of
a signal o
i
R
. = 1. .... . which is possibly correlated with the state

of the world : o. All agents have identical prior over the distribution of
states of the world and signals in o R
1
. denoted j:o/
c,o
.Let j:o/
o
c
denote
the posterior distribution over : 1. .... o after conditioning on o R
1
.
In this economy, a REE price is a map c
+
: R
I
R
J
+
such that
2(c
+
(o) . c
+
) = 0. for any o R
1
.
Theorem 76 Suppose 1 J. For a generic subset of economies parame-
trized by endowments . R
S+1
+
, a REE price exists and it is not is fully
revealing, that is,
c
+
(o) is not invertible.
While we shall not prove the theorem (see Allen, 1981, for a proof), we
notice that c
+
maps a 1 dimensional set into a J dimensional one; if 1 J.
then, the result is at least not surprising.
5.4.1 References
Bennardo, A. and P.A. Chiappori (2003): Bertrand and Walras Equilibria
under Moral Hazard, Journal of Political Economy, 111(4), 785-817.
Bisin, A. and P. Gottardi (1999): Competitive Equilibria with Asymmetric
Information, Journal of Economic Theory, 87, 1-48.
Bisin, A. and P. Gottardi (2006): Ecient Competitive Equilibria with
Adverse Selection, Journal of Political Economy, 114(3), 485-516.
Dubey, P., J. Geanakoplos (2004): Competitive Pooling: Rothschild-Stiglitz
Re-considered, Quarterly Journal of Economics.
Gale, D. (1992): A Walrasian Theory of Markets with Adverse Selection,
Review of Economic Studies, 59, 229-55.
Gale, D. (1996): Equilibria and Pareto Optima of Markets with Adverse
Selection, Economic Theory, 7, 207-36.
Grossman, S. and O. Hart (1983): An Analysis of the Principal-Agent
Problem, Econometrica, Vol. 51, No. 1.
Hellwig, M. (1987): Some Recent Developments in the Theory of Compe-
tition in Markets with Adverse Selection, European Economic Review,
31, 319-325.
Prescott, E.C. and R. Townsend (1984): Pareto Optima and Competitive
Equilibria with Adverse Selection and Moral Hazard, Econometrica,
52, 21-45; and extended working paper version dated 1982.
Prescott, E.C. and R. Townsend (1984b): General Competitive Analysis
in an Economy with Private Information, International Economic Re-
view, 25, 1-20.
Rothschild, M. and J. Stiglitz (1976): Equilibrium in Competitive Insur-
ance Markets: An Essay in the Economics of Imperfect Information,
Quarterly Journal of Economics, 80, 629-49.
Wilson, C. (1977): A Model of Insurance Markets with Incomplete Infor-
mation, Journal of Economic Theory, 16, 167-207.
Chapter 6
Innite-horizon economies
Note that the commodity space is innite dimensional. Good discussion
of the spaces we typically study is in Lucas-Stokey with Prescott (1989),
Recursive economic dynamics, Harvard Univ. Press. Existence and rst
welfare theorems are straightforwardly extended as long as the number of
agents is nite. See Zame, "Competitive equilibria in production economies
with an innite dimensional commodity space," Econometrica, 55(5), 1075-
1108.
6.1 Asset pricing
Assume a representative-agent economy with one good. Let time be indexed
by t = 0. 1. 2. .... Uncertainty is captured by a probability space represented
by a tree. Suppose that there is no uncertainty at time 0 and call :
0
the
root of the tree. Without much loos of generality, we assume that each node
has a constant number of successors, o. At generic node at time t is called
:
t
o
t
. Note that the dimensionality of o
t
increases exponentially with time
t (abusing notation it is in fact o
t
).
When a careful specication of the underlying state space process is not
needed, we will revert to the usual notation in terms of stochastic processes.
Let r := r
t
o
t=0
denote a stochastic process for an agents consumption,
where r
t
: o
t
1
+
is a random variable on the underlying probability
space, for each t. Similarly, let . := .
t
o
t=0
be a stochastic processes de-
scribing an agents endowments. Let 0 < , < 1 denote the discount factor.
93
94 CHAPTER 6. INFINITE-HORIZON ECONOMIES
6.1.1 Arrow-Debreu economy
Suppose that at time zero, the agent can trade in contingent commodities.
Let j := j
t
o
t=0
denote the stochastic process for prices, where j
t
: o
t
1
+
, for each t.
Then ((r
+i
)
i
. j
+
) is an Arrow-Debreu Equilibrium if
i. given j
+
.
r
+i
arg maxn(r
0
) + 1
0
[
o
t=1
,
t
n(r
t
)]
:.t.
o
t=0
j
+
t
(r
t
.
t
) = 0
ii. and

i
r
+i
.
i
= 0.
The notation does not make explicit that the agent chooses at time 0 a
whole sequence of time and state contingent consumption allocations, that
is, the whole sequence of r(:
t
) for any :
t
o
t
and any t _ 0.
6.1.2 Financial markets economy
Suppose that throughout the uncertainty tree, there are J assets. We shall
allow assets to be long-lived. In fact we shall assume they are and let the
reader take care of the straightforward extension in which some of the assets
pay o only in a nite set of future times. Let . := .
t
o
t=1
denote the se-
quence of portfolios of the representative agent, where .
t
: o
t
1
J
. Assets
payos are captured at each time t by the o J matrix
t
. Furthermore,
capital gains are
t
t1
, and returns are 1
t
=
t+qt
q
t1
.
In a nancial market economy agents do not trade at time 0 only. They
in fact, at each node :
t
receive endowments and payos from the portfolios
they carry from the previous node, they re-balance their portfolios and choose
state contingent consumption allocations for any of the successor nodes of :
t
,
which we denote :
t+1
[ :
t
.
Denition 77 (r
+i
. .
+i
)
i
.
+
is a Financial Markets Equilibrium if
i. given
+
. at each time t _ 0
(r
+i
. .
+i
) arg maxn(r
t
) + 1
t
[
o
t=1
,
)
n(r
t+t[c
t )]
:.t.
r
t+t
+
+
t+t
.
t+t
= .
t+t
+
t+t
.
t+t1
.
for t = 0. 1. 2. .... with .
1
= 0
some no-Ponzi scheme condition
6.1. ASSET PRICING 95
Denition 78 ii.

i
r
+i
.
i
= 0 and

i
.
+i
= 0.
6.1.3 Conditional asset pricing
From the FOC of the agents problem, we obtain
t
= 1
t
_
,n
t
(r
t+1
)
n
t
(r
t
)

t+1
_
= 1
t
(:
t+1
t+1
) (6.1)
or,
1 = 1
t
_
,n
t
(r
t+1
)
n
t
(r
t
)
1
t+1
_
. (6.2)
Example 1. Consider a stock. Its payo at any node can be seen as the
dividend plus the capital gain, that is,
1
t+1
=

t+1
+ d
t+1
t
.
for some exogenously given dividend stream d. By plugging this payo into
equation (6.1), we obtain the price of the stock at t.
Example 2. For a call option on the stock, with strike price / at some
future period 1 t, we can dene
t
= 0. t < 1. and
T
= max
T
/. 0
Dene now
:
t,T
=
,
Tt
n
t
(r
T
)
n
t
(r
t
)
and observe that the price of the option is given by
t
= 1
t
(:
t,T
max
T
/. 0) .
Note how the conditioning information drives the price of the option: the
price changes with time, as information is revealed by approaching the exe-
cution period 1.
Example 3. The risk-free rate is know at time t and therefore, equation
(6.2) applied to a 1-period bond yields
1
1
)
t+1
= 1
t
_
,n
t
(r
t+1
)
n
t
(r
t
)
_
.
Once again, note that the formula involves the conditional expectation at
time t. Therefore, while the return of a risk free 1-period bond paying at
t+1 is known at time t, the return of a risk free 1-period bond paying at t+2
is not known at time t. [.... relationship between 1 and t period bonds....
from the red Sargent book]
Conditional versions of the beta representation hold in this economy:
1
t
(1
t+1
) 1
)
t+1
=
Co
t
(:
t+1
. 1
t+1
)
1
t
(:
t+1
)
= (6.3)
=
Co
t
(:
t+1
. 1
t+1
)
\ c:
t
(:
t+1
)
_
\ c:
t
(:
t+1
)
1
t
(:
t+1
)
_
=: ,
t
`
t
.
Unconditional moment restrictions
Recall that our basic pricing equation is a conditional expectation:
t
= 1
t
(:
t+1
t+1
). (6.4)
In empirical work, it is convenient to test for unconditional moment restric-
tions.
1
However, taking unconditional expectations of the previous equation
implies in principle a much weaker statement about asset prices than equa-
tion (6.4):
1(
t
) = 1(:
t+1
t+1
). (6.5)
where we have invoked the law of iterated expectations. It should be clear
that equation (6.4) implies but it is not implied by (6.5).
The theorem in this section will tell us that actually there is a theoretical
way to test for our conditional moment condition by making a series of tests
of unconditional moment conditions.
Dene a stochastic process i
t
o
t=0
to be conformable if for each t, i
t
belongs to the time-t information set of the agent. It then follows that for
any such process, we can write
i
t
t
= 1
t
(:
t+1
i
t
t+1
)
1
Otherwise, specic parametric assumptions need be imposed on the stochastic
process of the economy underlying the asset pricing equation. For instance this is
the route taken by the literature on autoregressive conditionally heteroschedastic (that
is, ARCH - and then ARCH-M, GARCH,...) models. See for instance the work by
??rengle/http://pages.stern.nyu.edu/ rengle/ = 13 .
6.1. ASSET PRICING 97
and, by taking unconditional expectations,
1(i
t
t
) = 1(:
t+1
i
t
t+1
).
This fact is important because for each conformable process, we obtain an
additional testable implication that only involves unconditional moments.
Obviously, all these implications are necessary conditions for our basic pricing
equation to hold. The following result states that if we could test these
unconditional restrictions for all possible conformable processes then it would
also be sucient. We state it without proof.
Theorem 79 If 1(r
t+1
i
t
) = 0 for all i
t
conformable then 1
t
(r
t+1
) = 0.
By dening r
t+1
= :
t+1
t+1
t
. the theorem yields the desired result.
6.1.4 Predictability or returns
Recall the asset-pricing equation for stocks:
t
= 1
t
(:
t+1
(
t+1
+ d
t+1
)) .
It is sometimes argued that returns are predictable unless stock prices to
follow a random walk. (Where in turn predictability is interpreted as a
property of ecient market hypothesis, a fancy name for the asset pricing
theory exposed in these notes). Is it so? No, unless strong extra assumptions
are imposed Assume that no dividends are paid and agents are risk neutral;
then, for values of , close to 1 (realistic for short time periods), we have
t
= 1
t
(
t+1
).
That is, the stochastic process for stock prices is in fact a martingale. Next,
for any
t
such that 1
t
(
t+1
) = 0 at all t, we can rewrite the previous
equation as
t+1
=
t+1
+
t+1
.
This process is a random walk when c:
t
(
t+1
) = o is constant over time.
A more important observation is the fact that marginal utilities times
asset prices (a risk adjusted measure of asset prices) follow approximately
a martingale (a weaker notion of lack of predictability). Again under no
dividends,
n
t
(c
t
)
t
= ,1
t
(n
t
(c
t+1
)(
t+1
+ d
t+1
)).
which is a supermartingale and approximately a martingale for , close to 1.
6.1.5 Fundamentals-driven asset prices
For assets whose payo is made of a dividend and a capital gain, FOC dictate
t
= 1
t
(:
t+1
(
t+1
+ d
t+1
)) .
where
:
t+1
=
,n
t
(c
t+1
)
n
t
(c
t
)
.
By iterating forward and making use of the Law of Iterated Expectations,
t
= lim
To
1
t
_
T
)=1
:
t,t+)
d
t+)
_
+ lim
To
1
t
_
T
)=1
:
t,t+)
t+)
_
.
As we shall see, innite horizon models (with innitely lived agents) usu-
ally satisfy the no-bubbles condition, or
lim
To
1
t
_
T
)=1
:
t,t+)
t+)
_
= 0.
In that case, we say that asset prices are fully pinned down by fundamentals
since
t
= 1
t
_
o
)=1
:
t,t+)
d
t+)
_
.
Conditional factor models and the conditional CAPM
[...from Cochrane...]
Frictions
He-Modest
Luttmer
6.2 Bubbles
Let
2
` = A
o
t=0
o
t
be the set of nodes of the tree. Recall we denoted with :
0
denote the root of the tree and with :
t
an arbitrary node of the tree at time
t. Use :
t+t
[:
t
to indicate that :
t+t
is some successor of :
t
, for t 0.
2
In this section we follow closely Santos-Woodford (1997), Econometrica.
6.2. BUBBLES 99
At each node, there are J securities traded. Also, it is important that
the notation include Overlapping Generation economies. We need therefore
to account for nitely lived agents. Let 1(:
t
) be the set of agents which are
active at node :
t
. Let `
i
be the subset of nodes of the tree at which agent i
is allowed to trade. Also, denote by `
i
the terminal nodes for agent i.
The following assumptions will not be relaxed.
1. If an agent i is alive at some non-terminal node :
t
, she is also alive at
all the immediate successor nodes. That is, :
t
c`
i
`
i
== :
t+1
c` :
:
t+1
[:
t
`
i
.
2. The economy is connected across time and states: at any state there is
some agent alive and non-terminal. Formally,
\:
t
. i : :
t
`
i
`
i
.
Assets are long lived. Let : ` 1
J
be the mapping dening the
vector of security prices at each node :
t
. Similarly, let d : ` 1
J
denote
the vector-valued mapping that denes the dividends (in units of numeraire)
that are paid by the assets at node :
t
. We assume that d(:
t
) _ 0 for any :
t
.
Each of the households alive at :
0
enters the markets with an initial
endowment of securities .
i
.
_ 0. Therefore, the initial net supply of assets is
given by
.
.
=

i1(c
0
)
.
i
.
.
As assets are long lived, a supply .
.
of assets is available at any :
t
.
At each node :
t
, each households in 1(:
t
) has an endowment of numeraire
good of .
i
(:
t
) _ 0. We shall assume that the economy has a well-dened
aggregate endowment
.(:
t
) =

i1(c
t
)
.
i
(:
t
) _ 0
at each node :
t
. This is the case, e.g., if 1(:
t
) is nite, for any :
t
. Taking into
account the dividends paid by securities in units of good, the aggregate good
supply in the economy is given by
.(:
t
) = .(:
t
) + d(:
t
).
.
_ 0.
The utility function of any agent i is written
l(r) = n
i
(r(:
0
) +
o
t=1
,
t

c
t
[c
0
j:o/(:
t
) n
i
(r(:
t
)).
Dene the 1-period payo vector (in units of numeraire) at node :
t
by
(:
t
) = d(:
t
) + (:
t
).
Any agent i faces a sequence of budget constraints, one for every node :
t
`
i
. Let r
i
(:
t
) denote the consumption of agent i at node :
t
`
i
and .
i
(:
t
)
his a J-dimensional portfolio vector at :
t
`
i
. The agent budget constraint
at any :
t
[:
0
`
i
is:
r
i
(:
t
) + (:
t
).
i
(:
t
) _ .
i
(:
t
) + (:
t
).
i
(:
t
1).
with
r
i
(:
t
) _ 0
(:
t
).
i
(:
t
) _ 1
i
(:
t
).
where 1
i
: ` 1
+
indicates an exogenous and non-negative household
specic borrowing limit at each node. We assume households take the bor-
rowing limits as given, just as they take security prices as given. At :
0
. if
:
0
`
i
, the budget constraint is:
r
i
(:
0
) + (:
0
).
i
(:
0
) _ .
i
(:
0
) + (:
0
).
i
.
.
At equilibrium, markets clear: that is, at each :
t
`.
i1(c
t
)
r
i
(:
t
) = .(:
t
)
i1(c
t
)
.
i
(:
t
) = .
.
Given the price process , we say that no arbitrage opportunities exist at
:
t
if there is no . 1
J
such that
(:
t+1
). _ 0. for all :
t+1
[:
t
.
(:
t
). _ 0.
with at least one strict inequality.
6.2. BUBBLES 101
Lemma 80 When satises the no-arbitrage condition at :
t
`. there
exists a set of state prices :(:
t+1
[:
t
) with :(:
t+1
[:
t
) 0 for all :
t+1
[:
t
,
such that the vector of asset prices at :
t
` can be written as
(:
t
) =

c
t+1
[c
t
:(:
t+1
[:
t
)(:
t+1
[:
t
). (6.6)
Proof. As usual, proof follows from applying an appropriate separation
theorem.
Applying the Lemma at any :
t
` we can construct a stochastic process
: : ` 1
S
++
recursively as follows:
:(:
t+2
[:
t
) = :(:
t+2
[:
t+1
):(:
t+1
[:
t
). for t = 0. 1. ...
Let (:
t
) denote the set of such processes for the subtree with root :
t
.
Only under complete markets is the set (:
t
) a singleton.
As a remark, note that nancial market completeness is an endogenous
property in this economy since one-period payos contain asset prices.
Therefore, the rank property which denes completeness can only be assessed
at each given equilibrium.
For any state-price process : (:
t
). dene the J vector of fundamental
values for the securities traded at node :
t
by
,(:
t
. :) =
o
T=t+1
c
T
[c
t
:(:
T
[:
t
)d(:
T
[:
t
). (6.7)
Observe that the fundamental value of a security is dened with reference
to a particular state-price process, however the following properties it displays
are true regardless of the state prices chosen.
Proposition 81 At each :
t
`, ,(:
t
. :) is well-dened for any : (:
t
)
and satises
0 _ ,(:
t
. :) _ (:
t
).
Proof. First of all, 0 _ ,(:
t
. :) follows directly from non-negativity of
:, the dividend process d, and the price process . We therefore turn to
,(:
t
. :) _ (:
t
). From equation (6.6), we have
(:
t
) =

c
t+1
[c
t
:(:
t+1
[:
t
)d(:
t+1
[:
t
) +

c
t+1
[c
t
:(:
t+1
[:
t
)(:
t+1
)
and, iterating on this equation we obtain
(:
t
) =
b
T
T=t+1
c
T
[c
t
:(:
T
[:
t
)d(:
T
[:
t
) +

c
b
T
[c
t
:(:
b
T
[:
t
)(:
b
T
)
for any

1 t. Since by construction, (:
b
T
) is non-negative and : (:
t
)
is a positive state-price vector, the second term on the right-hand-side is
non-negative. So,
(:
t
) _
b
T
T=t+1
c
T
[c
t
:(:
T
)d(:
T
[:
t
). for any

1 t.
and
(:
t
) _
o
T=t+1
c
T
[c
t
:(:
T
[:
t
)d(:
T
[:
t
)
We can correspondingly dene the vector of asset pricing bubbles as
o(:
t
. :) = (:
t
) ,(:
t
. :). (6.8)
for any : (:
t
) for the J securities. It follows from the proposition that
0 _ o(:
t
. :) _ (:
t
).
for any : (:
t
). This corollary is known as the impossibility of negative
bubbles result. Substituting (6.8) and (6.7) into (6.6) yields
o(:
t
. :) =

c
t+1
[c
t
:(:
t+1
[:
t
)o(:
t+1
).
This is known as the martingale property of bubbles: if there exists a (nonzero)
price bubble on any security at date t, there must exist a bubble as well on
the security at date 1, with positive probability, at every date 1 t. Fur-
thermore, if there exists a bubble on any security at node :
t
, then there must
have existed a bubble as well on some security at every predecessor of the
node :
t
.
6.2. BUBBLES 103
Remark 82 Suppose our economy is deterministic. Some of the earliest
analyses on bubbles dealt with this case, e.g., Samuelsons and Bewleys mod-
els of money. In this case, let o
t
denote the bubble at time t. The martingale
property of bubbles implies that
o
t
= :
t
o
t+1
:
t
= ,`1o
i
t+1,t
(r
i+
t
)
We shall get back to this example when well study the Overlapping Genera-
tion economy at the end of this section.
What does this imply for securities with nite maturity? Your answer
must depend on how you dene securities with nite maturity in this context.
In an economy with incomplete markets, the fundamental value need not
be the same for all state-price processes consistent with no arbitrage. But
even in this case, we can dene the range of variation in the fundamental
value, given the restrictions imposed by no-arbitrage.
Let r : ` 1
+
denote a non-negative stream of consumption goods.
For any :
t
, pick any : (:
t
) and dene the present value at :
t
of r with
respect to : by
\
a
(:
t
. :) =
o
T=t+1
c
T
[c
t
:(:
T
[:
t
)r(:
T
).
Since this present value depends on the stochastic discount factor :, let
us now dene the bounds for the present value at :
t
of dividends r.
For any :
t
, dene
:
a
(:
t
) = inf
(c
t
)
\
a
(:
t
. :)
:
a
(:
t
) = sup
(c
t
)
\
a
(:
t
. :).
A few remarks follow from these denitions. First note that these deni-
tions are conditional on a given price process since the set of no-arbitrage
stochastic discount factors are dened with respect to . Next observe that,
for any security with dividend process d
)
,
:
o
j (:
t
) _ ,
)
(:
t
. :) _ :
o
j (:
t
) _
)
(:
t
). for all : (:
t
);
furthermore, :
o
j (:
t
) <
)
implies that there is a pricing bubble for the secu-
rity with payo process r
)
.
For any a non-negative stream of consumption goods r : ` 1
+
it
can be shown that :
a
j (:
t
) = sup (:
t
) . (:
t
) where the sup is taken over all
plans . (:
v
[:
t
) . : _ t such that
r
_
:
v
[:
v1
_
+ d
_
:
v
[:
v1
_
.
_
:
v1
_
_ (:
v
) . (:
v
) . for any :
v
[:
t
and any : _ t
and
1 such that (:
v
) . (:
v
) _ 0. for any :
v
[:
t
with : _ 1.
In words, :
a
j (:
t
) is the least upper bound for the amount that an agent
can borrow at node :
t
if the endowment of the agent is r (:
v
[:
v1
) for any
:
v
[:
t
and any : _ t. under the constraint that the agent has to maintain a
non-negative wealth after some time 1.
Recall that to rule out Ponzi schemes when agents are innitely lived, a
lower bound on individual wealth is needed. Let us dene a particular type
of borrowing limit.
An agents borrowing ability is only limited by her ability to repay out of
her own future endowment if
1
i
(:
t
) = :
~ .
i (:
t
). (6.9)
for each :
t
c`
i
`
i
.
It can be shown that these borrowing limits never bind at any nite
date (see Magill-Quinzii, Econometrica, 94), but rather only constrain the
asymptotic behavior of a households debt.
3
This constraint is to the eect that each agent can eectively trade his
own future endowment stream any node :
t
. An important consequence of
this specication is the following.
Proposition 83 Suppose that agent i has borrowing limits of the form (6.9).
Then the existence of a solution to the agents problem for given prices
implies that :
~ .
i (:
t
) < . at each :
t
`
i
. so that the borrowing limit is
nite at each node.
This is because, if agent i can borrow o of the value of ~ .
i
. this value must
be nite at equilibrium prices for the agents problem to be well-dened. If
3
They are equivalent to requiring that the consumption process lies in the space of
measurable bounded sequences. In the case of nitely lived agents, these borrowing limits
are equivalent to imposing no-borrowing at all nonterminal nodes.
6.2. BUBBLES 105
it is nite at equilibrium prices, it must be nite at all implied no-arbitrage
state prices. If
:
o
j (:
t
) _ ,
)
(:
t
. :) _ :
o
j (:
t
) _
)
(:
t
). for all : (:
t
).
in fact, then :
a
(:
t
) _ :
a
(:
t
) and :
a
(:
t
) is less than or equal to the equilibrium
price of the portfolio strategy supporting r.
We can now prove the following fundamental lemma.
Lemma 84 Consider an equilibrium r
+i
. .
+i
. . Suppose that the (supre-
mum of the) value of aggregate wealth is nite, i.e., :
~ .
(:
t
) < . Suppose
also that there exists a bubble on some security in positive net supply at :
t
so that o(:
t
).(:
t
) 0. Then, \1 0. there exists a time 1 and :
T
[:
t
such
that
o(:
T
).(:
T
) 1 .(:
T
).
Proof. The martingale property of pricing bubbles implies,
o(:
t
).(:
t
) =

c
T
[c
t
:(:
T
[:
t
)o(:
T
).(:
T
)
and hence

c
T
[c
t
:(:
T
[:
t
)o(:
T
).(:
T
) is constant for any 1 t. On the other
hand,

c
T
[c
t
:(:
T
[:
t
) .(:
T
) must converge to 0 in 1 to guarantee that
:
~ .
(:
t
) =

T
c
T
[c
t
:(:
T
[:
t
) .(:
T
) < .
That is, there is a positive probability that the total size of the bubble
on the securities becomes an arbitrarily large multiple of the value of the
aggregate supply of goods in the economy. A contradiction. The proof
exploits crucially the martingale property of bubbles. It follows from this
result that some agent must accumulate, at some node :
T
, a wealth whose
value is larger than the value of the aggregate endowment.
We already learned that no bubbles can arise in securities with nite
maturity. The next theorem shows that no bubbles can arise to securities
in positive net supply as long as we are at equilibria with nite aggregate
wealth. The proof uses the nonoptimality of the behavior implied by the
previous lemma.
Theorem 85 Consider an equilibrium r
+i
. .
+i
. . Suppose that at each
node :
t
`. there exists : (:
t
) such that :
~ .
(:
t
) < . Then
)
(:
T
) = ,
)
(:
T
. :).
for all :
T
[:
t
and : (:
t
), for each security , traded at :
T
that has positive
net supply, .
)
.
0.
This is a crucial: if an agents endowment can be traded, then its value
is on the right hand side of the present value budget constraint of the agent,
and hence it must be nite.
The next two corollaries to the theorem provide conditions on the primi-
tives of the model that guarantee that the value of aggregate wealth is nite
at any equilibrium.
Corollary 86 Suppose that there exists a portfolio .c1
J
+
such that
d(:
t
[:
0
) . _ ~ .(:
t
). \:
t
`.
Then the theorem holds at any equilibrium.
Intuitively, if the existing securities allow such a portfolio . to be formed,
it must have a nite price at any equilibrium. But since the dividends paid
by this portfolio are higher at every state than the aggregate endowment, the
equilibrium value of the aggregate endowment is bounded by a nite number.
Corollary 87 Suppose that there exists an (innitely lived) agent i and an
0 such that i) .
i
(:
t
) _ .(:
t
). \:
t
` and ii) 1
i
(:
t
) = :
.
i (:
t
). \:
t
`
and for all i. Then the theorem holds at any equilibrium.
Again, the result follows because in equilibrium, .(:
t
) must have a nite
value as it appears on the right hand side of agent is budget set. If a positive
fraction of aggregate wealth has a nite value in equilibrium, then aggregate
wealth has nite value.
As a remark, note that these two corollaries share the same spirit and
somewhat imply that bubbles are not a robust equilibrium phenomenon (for
securities in positive net supply).
6.2.1 (Famous) Theoretical Examples of Bubbles
Recall that at money is a security that pays no dividends. Its only return
comes from paying one unit of itself in the next period. Therefore if at
money is in positive net supply and has a positive price in equilibrium, that
is a bubble. The following two models have equilibria with such a property.
6.2. BUBBLES 107
Samuelson (1958)s OLG model
Consider an economy in which
_
c
t
.
1(:
t
) is (countably) innite, even though
1(:
t
) is nite for any :
t
`. In this case even if :
~ .
i (:
t
) < , it is still
possible that :
~ .
(:
t
) = (and hence that :
~ .
(:
t
) = ). The theorem does
not apply and bubbles are possible.
Bewley (1980)s turnpike model
Consider the case in which stringent borrowing limits are imposed on trading,
i.e., 1
i
(:
t
) < :
~ .
i (:
t
). In this case, nothing will exclude the possibility that
:
~ .
i (:
t
) = . The theorem does not apply and bubbles are possible. For a
detailed but simple treatment, see L. Ljungqvist and T. Sargent, Recursive
macroeconomic theory, MIT Press, 2004; Ch. 25.
More recent examples of bubbles
Many papers have studied bubbles recently. This is so even though the
previous analysis leaves relatively little space for bubbles in the classes of
models we are studying. Nonetheless, see, e.g.,
- Boyan Jovanovic (2007), Bubbles in Prices of Exhaustible Resources, NBER
Working Paper No. 13320, http://www.nber.org/papers/w13320.
Others have studied models with either behavioral agents (e.g., overcon-
dent). See, e.g.,
- Harrison Hong, Jose Scheinkman, Wei Xiong (2006), Asset Float and Spec-
ulative Bubbles, Journal of Finance, American Finance Association,
vol. 61(3), pages 1073-1117.
- Dilip Abreu and Markus Brunnermeier (2003), Bubbles and Crashes, Econo-
metrica, 71(1), 173-204.
Yet others have studied economies where the rational expectations as-
sumption is relaxed (more precisely, the common knowledge assumption of
rational expectation models). See, e.g.,
- Franklin Allen, Stephen Morris, and Hyun Song Shin (2003), Beauty Con-
tests, Bubbles and Iterated Expectations in Asset Markets, Cowles
Foundation Discussion Paper 1406, http://cowles.econ.yale.edu/P/cd/d14a/d1406.pdf
6.3 Double Innity
In this section we consider innite horizon economies with an innite num-
ber of agents (hence double innity). The classic example is an overlapping
generation economy, where at each time t = 0. 1. 2. ... a nitely-lived gen-
eration is born.
We consider rst the case of an Arrow-Debreu economy with a complete
set of time and state contingent markets. Assume a representative-agent
economy with one good. Let time be indexed by t = 0. 1. 2. .... Uncertainty is
captured by a probability space represented by a tree with root :
0
and generic
node, at time t, :
t
o
t
. Let /
o
+
denote the space of non-negative bounded
sequences endowed with the :njnorm.
4
Let r
i
:= r
i
t
o
t=0
/
o
+
denote a
stochastic process for an agent is consumption, where r
i
t
: o
t
1
+
is a
random variable on the underlying probability space, for each t. Similarly,
let .
i
= .
i
t
o
t=0
/
o
+
be a stochastic processes describing an agent is
endowments. Each agent i
t
s preferences , l
i
: /
o
+
R. satisfy:
l
i
(r) = n
i
0
(r
0
) + 1
0
[
o
t=1
,
t
n
i
t
(r
t
)]
where n
i
t
: R
+
R satisfy the standard dierentiability, monotonicity, and
concavity properties, for any i 0 and any t 0. Obviously, 0 < , < 1
denotes the discount factor.
We say that an agent i is alive at :
t
` if .
i
(:
t
) 0 and n
i
t
(r
t
) 0
for some r
t
R
+
. We assume that .
i
(:
t
) 0 implies n
i
t
(r
t
) 0 for some
r
t
R
+
and conversely, n
i
t
(r
t
) 0 for some r
t
R
+
implies .
i
(:
t
) 0 for
all :
t
o
t
.We maintain the previous section assumptions that if an agent i
is alive at some non-terminal node :
t
, she is also alive at all the immediate
successor nodes, and that the economy is connected across time and states
(at any state there is some agent alive and non-terminal). We nally assume
that,
4
See Lucas-Stokey with Prescott (1989), Recersive methods in economic dynamics, Har-
vard University Press, for denitions.
6.3. DOUBLE INFINITY 109
i) each agent is nitely-lived: .
i
0 for nitely many times t _ 0;
ii) at each node :
t
o
t
. the set of agents alive (with positive endowments
and preferences for consumption), 1( :
t
) is nite.
Suppose that at time zero, the agent can trade in contingent commodities.
Let j := j
t
o
t=0
/
o
+
denote the stochastic process for prices, where j
t
:
o
t
1
+
, for each t. The denition of Arrow-Debreu equilibrium in this
economy is exactly as for the one with nite agents i 1. Let r = (r
i
)
i0
.
Denition 88 (r
+
. j
+
) is an Arrow-Debreu Equilibrium if
i. given j
+
.
r
+i
arg maxn(r
0
) + 1
0
[
o
t=1
,
t
n(r
t
)]
:.t.
o
t=0
j
+
t
(r
t
.
i
t
) = 0
ii. and

i
r
+i
.
i
= 0.
Note that, under our assumptions,
o
t=0
j
+
t
.
i
t
< . for any i _ 0
i
.
i
_ .
While the denition of Arrow-Debreu equilibrium is unchanged once an
innite number of agents is allowed for, its welfare properties change sub-
stantially.
As always, we say that r
+
is a Pareto optimal allocation if there does not
exist an allocation /
o
+
such that
l
i
(
i
) _ l
i
(r
+i
) for any i _ 0 (strictly for at least one i), and
1
i=1
i
.
i
= 0,
Does the First welfare theorem hold in this economy? Is any Arrow-Debreu
equilibrium allocation r
+
Pareto Optimal? Well, a qualication is needed.
First welfare theorem for double innity economies. Let (r
+
. j
+
) be an
Arrow-Debreu equilibrium. If at equilibrium aggregate wealth is nite,
o
t=0
j
+
t
_
i
.
i
t
_
< .
then the equilibrium allocation r
+
Pareto Optimal.
The important result here is that the converse does not hold. An equi-
librium with innite

o
t=0
j
+
t
(
i
.
i
t
) might not display Pareto optimal allo-
cation. In other words, with double innity of agents the proof of the First
welfare theorem breaks unless

o
t=0
j
+
t
(
i
.
i
t
) < . Lets see this.
Proof. By contradiction. Suppose there exist a /
o
+
which Pareto domi-
nate r
+
.Then it must be that
o
t=0
j
+
t
(
i
t
.
i
t
) _ 0. strictly for one i _ 0.
Summing over i _ 0, even though
i0
i
.
i0
.
i
are nite,
o
t=0
j
+
t
(
i
.
i
t
)
might not be. In this case, we cannot conclude that
o
t=0
j
+
t
_
i
t
_

o
t=0
j
+
t
_
i
.
i
t
_
.
The qualication
o
t=0
j
+
t
(
i
.
i
t
) < is however sucient to obtain
o
t=0
j
+
t
(
i
t
)
o
t=0
j
+
t
(
i
.
i
t
) and hence the contradiction
i
t

i
.
i
t
, for some t _ 0.
Importantly, the proof has no implication for the converse. In other
words, the proof is silent on

o
t=0
j
+
t
(
i
.
i
t
) < being necessary for Pareto
optimality. We shall show by example that:
-

o
t=0
j
+
t
(
i
.
i
t
) < is not necessary for Pareto optimality; that is, there
exist economies which have Arrow-Debreu equilibria whose allocations
are Pareto optimal and nonetheless

o
t=0
j
+
t
(
i
.
i
t
) is innite;
- there exist economies which have Arrow-Debreu equilibria whose alloca-
tions are NOT Pareto optimal.
Remark 89 The double innity is at the root of the possibility of inecient
equilibria in these economies. The First welfare theorem in fact holds with
nite agents i 1 even if the economy has an innite horizon, t _ 0. This we
know already. But it follows trivially (check this!) from the proof above that
the First welfare theorem holds for nite horizon economies, t = 0. 1. .... 1
even if populated by an innite number of agents i _ 0. provided of course
i
.
i
_ .
6.3.1 Overlapping generations economies
We will construct in this section a simple overlapping generations economy
which displays i) Arrow-Debreu equilibria with Pareto inecient allocations
(aggregate wealth is necessarily innite in this case, ii) Arrow-Debreu equi-
libria with innite aggregate wealth whose allocations are Pareto ecient.
The economy is deterministic and is populated by two-period lived agents.
An agents type i _ 0 indicates his birth date (all agent born at a time t ae
identical, for simplicity). Therefore, the stochastic process for the endowment
of an agent i _ 0. .
i
, satises
.
i
t
0 for t = i. i + 1 and = 0 otherwise.
We assume there is also an agent i = 1 with .
1
0
0. The utility functions
are as follows:
l
i
(r
i
) = n(r
i
i
) + (1 )n(r
i
i+1
). for any i _ 0.
5
l
1
(r
1
) = n(r
1
0
).
Arrow-Debreu equilibria are easily characterized for this economy.
Autarchy The economy has a unique Arrow-Debreu equilibrium (r
+
. j
+
)
which satises:
r
t+
t
= .
t
t
. r
t+
t+1
= .
t
t+1
. for any t _ 0.
r
1+
0
= .
1
0
and
j
0
= 1. and
j
t+1
j
t
=
(1 )n
t
(.
t
t+1
)
n
t
(.
t
t
)
. for t _ 0.
The restriction j
0
= 1 is the standard normalization due to the homo-
geneity of the Arrow-Debreu budget constraint.
Proof. First of all,
r
1+
0
= .
1
0
follows directly fromagent i = 1s budget constraint. Then, market clearing
at time t = 0 requires
r
1+
0
+ r
0+
0
= .
1
0
+ .
0
0
.
Substituting r
1+
0
= .
1
0
. we obtain r
0+
0
= .
0
0
. We can now proceed by induc-
tion to show that r
t+
t
= .
t
t
implies r
t+
t+1
= .
t
t+1
(using the budget constraint
of agent t), which in turn implies r
t+1+
t+1
= .
t+1
t+1
(using the market clearing
condition at time t + 1.
The characterization of equilibrium prices then follows trivially from the
rst order conditions of each agents maximization problems.
It is convenient to specialize this economy to a simple stationary example
where
.
1
0
= c. .
t
t
= 1 c. .
t
t+1
= c. for any t _ 0.
n(r) = ln r.
Then, at the Arrow-Debreu equilibrium,
r
1+
0
= c. r
t+
t
= 1 c. r
t+
t+1
= c. for any t _ 0.
j
+
t
=
_

1
1 c
c
_
t1
.
A symmetric Pareto optimal allocation is as follows (it is straightforward
to derive, once symmetry is imposed): at the Arrow-Debreu equilibrium,
r
1
0
= . r
t+
t
= 1 . r
t+
t+1
= . for any t _ 0.
It follows then that,
The Arrow-Debreu equilibrium (autarchy) is Pareto ecient if and only if
_ c.
Proof. The case = c is obvious. If < c all agents i _ 0 prefer
the allocation
_
r
i
i
= 1 . r
i
i+1
=
_
to autarchy, but agent i = 1 prefers
r
1+
0
= c to r
1
0
= . Autarchy is then Pareto ecient. If otherwise c
all agents i _ 0 prefer the allocation
_
r
i
i
= 1 . r
i
i+1
=
_
to autarchy, and
agent i = 1 as well prefers r
1
0
= to r
1+
0
= c. Autarchy is then NOT
Pareto ecient.
Furthermore, note that in this economy, the aggregate endowment
i0
.
i
t
=
1. for any t _ 0. and hence the value of aggregate wealth is:
o
t=0
j
+
t
_
i
.
i
t
_
=
o
t=0
j
+
t
=
o
t=0
_

1
1 c
c
_
t1
.
It follows that
The value of aggregate wealth is nite when
< c
and autarchy is ecient. On the other hand, the value of aggregate
wealth is innite when
_ c.
In this case, autarchy is ecient if = c and inecient when c.
Note that we have in fact shown what we were set to from the beginning
of this section: i) Arrow-Debreu equilibria with Pareto inecient allocations
(aggregate wealth is necessarily innite in this case, ii) Arrow-Debreu equi-
libria with innite aggregate wealth whose allocations are Pareto ecient.
Bubbles
We have seen previously that, when the value of the aggregate endowment is
innite, bubbles in innitely-lived positive net supply assets might arise. We
shall now show that this is the case in the overlapping generation economy we
have just studied. Interestingly, it will turn out that bubbles, in this economy
might restore Pareto eciency. (This is special to overlapping generations
economies, by no means a general result).
Suppose agent i = 1 is endowed with a innitely-lived asset, in amount
:. The asset pays no dividend ever: it is then interpreted to be at money.Any
positive price for money, therefore, must be due to a bubble. Let the price of
money, in units of the consumption good at time t = 0. at time t. be denoted
n
t
. We continue to normalize j
0
= 1. The Arrow-Debreu budget constraints
in this economy for agent i = t _ 0 can be written as follows:
o
t=0
j
t
(r
t
.
i
t
) = j
t
(r
t
t
.
t
t
) + j
t+1
(r
t
t+1
.
t
t+1
) = 0;
or, denoting :
t
the demand for money of agent i = t _ 0:
j
t
r
t
t
+
n
t
:
t
= .
t
t
j
t+1
(r
t
t+1
.
t
t+1
) =
n
t+1
:
t
.
The budget constraint for agent i = 1 is:
r
1
0
= .
0
0
+
n
0
:.
Turning back to the stationary economy example where
.
1
0
= c. .
t
t
= 1 c. .
t
t+1
= c. for any t _ 0.
n(r) = ln r.
we can easily characterize equilibria. Suppose in particular that c
and autarchy is inecient. We restrict the analysis to following stationarity
restriction:
n
t
=
n
for any t _ 0.
The autarchy allocation is obtained as an Arrow-Debreu equilibrium of this
economy, for
n+
= 0 and
j
+
t+1
j
+
t
=

1
1 c
c
.
The Pareto optimal allocation
r
1
0
= . r
t+
t
= 1 . r
t+
t+1
= . for any t _ 0
is also obtained an Arrow-Debreu equilibrium of this economy, for
n+
=
c
:
and
j
+
t+1
j
+
t
= 1.
It is straightforward to check that these are actually Arrow-Debreu equi-
libria of the economy. Note that Pareto optimality is obtained at equilibrium
for
n+
0. that is, when money has positive value and hence a bubble exist.
At this equilibrium, prices j
+
t
are constant over time and hence the value of
the aggregate wealth is innite.
Remark 90 The stationary overlapping generation example introduced in
this section has been studied by Samuelson (1958). The fundamental intuition
for the role of money in this economy is straightforward: money allows any
agent i _ 0 to save by acquiring money (in exchange for goods) at time t = i
from agent i1 and then transfering the same amount of money (in exchange
for the same amount of goods) to agent i + 1 at time t = i + 1. Money, in
other words, serves the purpose of a pay-as-you-go social security system;
and in fact such a system, implemented by an innitely lived agent (like a
benevolent government), could substitute for money in this economy. (Try
and set it up formally!) Furthermore, note that, for money to have value in
this economy, we need c. Consistently with the interpretation of money
as a social security mechanism, the condition c is interpreted to require
that i) the endowment of any agent i _ 0 at time t = i + 1, c. be relatively
small and that ii) any agent i _ 0 discounts relatively little the future, that
is, , =

1
is high.
Remark 91 Large-square economies, with a continuum of agents and com-
modities, are studied by Kehoe-Levine-Mas Colell-Woodford (1991), "Gross-
substitutability in large-square economies," Journal of Economic Theory, 54(1),
1-25.
Problem 92 Consider our basic Overlapping Generation economy with no
money, when specialized to specialize this economy to a simple stationary
example where
.
1
0
= c. and .
t
t
= 1 c. .
t
t+1
= c. for any t _ 0.
l
1
(r
1
) = ln r
1
0
. and l
t
(r
t
) = ln r
t
t
+ ln r
t
t+1
. for any t _ 0.
Assume however that population grows at rate : 0: at time t = 0 the
economy is populated by a mass 1 of agents of generation i = 1 and a mass
1 + : of agents of generation i = 0. and so on. Suppose also that a social
security system can be imposed on the economy. It works as follows: any
generation i _ 0 pays to the social security system 0 _ t _ 1 c units of
the consumption good at time t = i and receive / = t(1 + :) units of the
consumption good at time t = i + 1.
1. For given 0 _ t _ 1c solve for a competitive equilibrium (quantities
and prices).
2. Derive a condition on t which guarantees that the equilibrium allocation
Pareto dominates autarchy (with no social security system).
3. When this conditions is satised, characterize the subset of ts which
induce equilibrium allocations which are Pareto optimal. Does aggregate
wealth have nite value at such Pareto optimal allocations.
6.4 Default
Consider the following economy, populated by a nite set of innitely-lived
agents, i 1. Let ` = A
o
t=0
o
t
be the set of nodes of the tree, :
0
the root of
the tree, :
t
an arbitrary node of the tree at time t. Use :
t+t
[:
t
to indicate
that :
t+t
is some successor of :
t
, for t 0.
At each node, there are o securities in zero-net supply traded with lin-
early independent payos: nancial markets are complete. Without loss of
generality we let the nancial assets be a full set of Arrow securities: = 1
S
(the odimensional identity matrix).
Let : ` 1
S
be the mapping dening the vector of asset prices at
each node :
t
.
At each node :
t
, each households has an endowment of numeraire good
of .
i
(:
t
) 0; aggregate endowment is then
.(:
t
) =

i1
.
i
(:
t
) _ 0
at each node :
t
. At the root of the tree the expected utility of agent i 1 is:
l
i
(r; :
0
) = n
i
(r(:
0
) +
o
t=1
,
t

c
t
[c
0
j:o/(:
t
:
0
) n
i
(r(:
t
:
0
)).
Any agent i 1. at any node :
t
` can default (more precisely: cannot
commit not to default). If he does default at a node :
t
, he is forever kept out
6.4. DEFAULT 117
of nancial markets and is therefore limited to consume his own endowment
.
i
(:
t+t
[:
t
) at any successor node :
t+t
[:
t
`.
An agent i 1. therefore, will default at a node :
t
on allocation r
i
if
l
i
(r
i
; :
t
) < l
i
(.
i
; :
t
).
The notion of equilibrium we adopt for this economy will be the one used
by Prescott and Townsend for economies with asymmetric information where
a no-default constraint
l
i
(r
i
; :
t
) _ l
i
(.
i
; :
t
). for any :
t
`.
takes the place of the incentive compatibility constraint. In particular we
shall choose the notion of equilibrium introduced in the remark, where these
constraints are interpreted as constraints on the set of tradable allocation
(rather than rationality restrictions on price conjectures).
Let ((r
+i
)
i
. j
+
) be an Arrow-Debreu Equilibrium if r
+i
. for any agent
i 1. solves
max
a
i
l
i
(r
i
; :
0
)
s.t.
j
+
(r
i
.
i
) = 0. and
l
i
(r
i
; :
t
) _ l
i
(.
i
; :
t
). for any :
t
`
and markets clear:

i
r
+i
.
i
= 0.
This problem is formulated and studied by T. Kehoe and D. Levine,
Review of Economic Studies, 1993. Note that
i) the value of aggregate wealth for each agent i 1 is necessarily nite at
equilibrium:
j
+
.
i
<
(and 1 is nite by assumption)
ii) the set of constraints which guarantee no-default at equilibrium do not
depend on equilibrium prices
l
i
(r
i+
; :
t
) _ l
i
(.
i
; :
t
). for any :
t
`.
Let now incentive constrained Pareto optimal allocations be those which
solve
max
(a
i
)
i2I
i1
o
i
l
i
(r
i
; :
0
)
s.t.
i1
r
i
.
i
= 0. and
l
i
(r
i+
; :
t
) _ l
i
(.
i
; :
t
). for any :
t
`.
for some o R
1
+
such that

i1
o
i
= 1.
It follows easily then that
Any Arrow-Debreu Equilibrium allocation of this economy is constraint
Pareto optimal.
6
Consider now a nancial market equilibrium for this economy. The ob-
jective is to capture the no-default constraints by means of appropriate bor-
rowing constraints. In other words we want to set borrowing constraints as
loose as possible provided no agent would ever default. To this end we need
to write exploit the recursive structure of the economy. Let c
i
(:
t+1
[:
t
) de-
note the portfolio of Arrow security paying o in node :
t+1
acquired at the
predecessor node :
t
. The borrowing constraints an agent i 1 will face at
node :
t
will then take the form
c
i
(:
t+1
:
t
) _ 1
i
(:
t+1
:
t
). for any :
t+1
:
t
;
and 1
i
(:
t+1
[:
t
) must be chosen to be as loose as possible provided it induces
agent i 1 not to default at any node :
t+1
[:
t
. Formally, the value function
of the problem of agent i 1 at any node :
t
` when i) the agent enters
state :
t
` with c
i
units of the Arrow security which pays at :
t
`. and
the agent faces borrowing limits 1
i
(:
t+1
[:
t
), can be constructed as follows:
\
i
(c
i
; :
t
) = max
a
i
,c
i
(c
t+1
[c
t
)
n
i
(r
i
) + ,
c
t+1
[c
t
j:o/(:
t+1
[:
t
)\
i
(c
i
(:
t+1
[:
t
); :
t
)
:.t.
r
i
+
c
t+1
[c
t
c
i
(:
t+1
[:
t
)(:
t+1
[:
t
) = c
i
+ .
i
(:
t+1
[:
t
). and
c
i
(:
t+1
[:
t
) _ 1
i
(:
t+1
[:
t
).
6
In fact, in the Kehoe and Levine paper, L > 1 commodities are traded at each node
and the conquence of default is that trade is restricted to spot markets at any future node.
In this economy the non-default constraints depend on spot prices and Arrow-Debreu
equilibrium allocations are not incentive constrained optimal.
6.4. DEFAULT 119
The condition that the borrowing limits 1
i
(:
t+1
[:
t
) be as loose as possible
is then endogenously determined as
\
i
(1
i
(:
t+1
:
t
; :
t
) = l
i
(.
i
; :
t+1
).
It can be shown that \
i
(1
i
(:
t+1
[:
t
; :
t
) is monotonic (decreasing) in its rst
argument, for any :
t
`. Borrowing limits 1
i
(:
t+1
[:
t
) are then uniquely
determined at any node. Note that they are determined at equilibrium,
however, as they depend on the value function \
i
(.; :
t
).
Market clearing brings no surprises:
i
r
i
.
i
= 0.
We can now show the following.
The autarchy allocation
r
+i
(:
t
) = .
i
(:
t
). for any :
t
`.
can always be supported as a nancial market equilibrium allocation with
borrowing constraints
1
i
(:
t+1
:
t
) = 0. for any :
t
`.
Note in particular that \
i
(1
i
(:
t+1
[:
t
; :
t
) = l
i
(.
i
; :
t+1
) is satised at this
equilibrium.
Let
(:
t+2
[:
t
) = (:
t+2
[:
t+1
)(:
t+1
[:
t
). for t = 0. 1. ...
We can then show the following.
Any nancial market equilibrium allocation (r
+i
)
i1
whose supporting prices
+
(:
t+1
[:
t
) satisfy
.
i
_
:
0
_
+
t0
c
t+1
[c
0
+
(:
t+1
:
0
).
i
(:
t+1
:
0
) <
is an Arrow-Debreu equilibrium allocation supported by prices
j
+
(:
0
) = 1. j
+
(:
t
) =
+
(:
t
:
0
).
This can be proved by repeatedly solving forward the nancial market
equilibrium budget constraints, using the relation between Arrow-Debreu
and nancail market equilibrium prices in the statement. The solution is
necessarily the Arrow-Debreu budget constraint only if lim
To
+
(:
T
[:
0
) =
0, which is the case if the value of aggregate wealth is nite at the nancial
market equilibrium.
In this case, then the nancial market equilibrium allocation (r
+i
)
i1
is
constrained Pareto optimal. When (r
+i
)
i1
is not autarchic (easy to show by
example that robustly, such nancial market equilibrium allocations exist)
it Pareto dominates autarchy (as autarchy is always budget feasible and
satises the no-default constraint). In this case the autarchy allocation is not
constrained Pareto optimal and the value of some agents wealth is innite
at the autarchy equilibrium.
7
Problem 93 Show that an the autarchy allocation asset prices must satisfy
+
(:
t+1
:
t
) _ max
i1
n
it
(.
i
(:
t+1
))
n
it
(.
i
(:
t
))
.
Problem 94 Write down the nancial market equilibrium notion in which
rational price conjecture substitute borrowing constraints. How do prices look
like?
Problem 95 Agents live two periods, t = 0. 1. and consume a single con-
sumption good only in period 1. Uncertainty is purely idiosyncratic. Each
agent faces a (date 1) endowment which is an identically and independently
distributed random variable . = (.
1
. .
1
) . with .
1
.
1
. Agents come in 2
types, c = /. |. which are dierentiated in terms of the probability distribution
of their endowments: :
c
c
is the probability of state : for agents of type c. Let
:
I
1
:
|
1
. (Notation is set so that H is the "high state" (the state where en-
dowment is high) and / is the "high type" (the type with a higher probability
of the high state). The fraction of / types in the economy is
1
2
.Types are only
privately observable. (Yes, this is an adverse selection economy). Agents
preferences are represented by a von Neumann-Morgenstern utility function
of the following form:

cS
:
c
c
ln r
c
7
A?? by Gaetano Bloise and Pietro Reichlin (2009) proves that in this economy nancial
market equilibria with innite value of aggregate wealth other than autrachy exist. Some
of these equilibria are ecient and some are not. The machinery used to prove these
results is related to the classical analysis of Overlapping Generations and Bewley models.
Not surprisingly, bubbles also arise.
6.4. DEFAULT 121
1. Write the incentive constrained optimal planning problem for the plan-
ner (with equal weight across types).
2. Write the denition of competitive equilibrium with rational conjectures
(where prices are function of the allocations). Anything "strange" in
these prices?
Chapter 7
To add
1. Constantinedes and Due on Asset Pricing with incomplete markets
2. aggregation in Angeletos (two periods and innite horizon)
3. Citanna-Siconol on decentralization of adverse selection
4. papers by Townsend with Weerachart Kilenthong <wkilenthong@gmail.com;
http://cier.uchicago.edu/papers/working/Moral%20Hazard_Submitted.pdf
5. Papers by Meier-Minelli-Polemarchakis, Correia-da-Silva on two-sided
asymmetric information; write them in the context of a nancial market
economy (see also Tirelli et al. on ET); see also Acharya-Bisin
6. Paper by Aguiar and Amador - On small open economy with debt and
taxes: nice example of ineciency in kehoe Levine with 2 goods (labor
and consumption)
7. Boldrin and Levine on activity analysis; and Long and Plosser on multi-
sector models of real business cycles
8. MacKenzies constant return to scales is withput loss of generality -
managerial rents - result. Linked to Makowski-Ostroy eqm concept
9. Section on assignment problem, equilibrium in matching and search
10. Section on monopolistic competition; use also Eaton-Kortum(in Alvarez-
Lucas form) as example
123
124 CHAPTER 7. TO ADD
11. Section on search with complete information (Moen JPE ) and incom-
plete information (Guerrieri and Shimer); is there also a static/dynamic
distinction? look for literature.

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General equilibrium theory

The denition of competitive equilibrium is stated for simplicity for the

. = 1. .... . which is possibly correlated with the state

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