COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 1210

Pareto Improving Price Regulation When the Asset Market Is Incomplete

P.J.J. Herings and H.M. Polemarchakis

February 1999

When the asset market is incomplete, competitive equilibria are constrained suboptimal, which provides a scope for pareto improving interventions. Price regulation can be such a pareto improving policy, even when the welfare effects of rationing are taken into account. An appealing aspect of price regulation is that it that it operates anonymously on market variables.

Fix-price equilibria exist under weak assumptions. Such equilibria permit a competitive analysis of an economy with an incomplete asset market that is out of equilibrium. Arbitrage opportunities may arise: with three or more assets actively traded, an individual may hold an arbitrage portfolio at equilibrium.

The local existence of fix-price equilibrium for prices that are almost competitive may fail for robust examples. Under necessary and sufficient conditions for the local existence of fix-price equilibria, Pareto improving price regulation is generically possible.

Keywords: Incomplete asset market, fix-price equilibria, Pareto improvement

JEL classification: D45, D52, D60