COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 1304R5

Default and Punishment in General Equilibrium

Pradeep Dubey, John Geanakoplos and Martin Shubik

Revised March 22, 2004

We extend the standard model of general equilibrium with incomplete markets to allow for default and punishment by thinking of assets as pools. The equilibrating variables include expected delivery rates, along with the usual prices of assets and commodities. By reinterpreting the variables, our model encompasses a broad range of adverse selection and signalling phenomena in a perfectly competitive, general equilibrium framework.

Perfect competition eliminates the need for lenders to compute how the size of their loan or the price they quote might affect default rates. It also makes for a simple equilibrium refinement, which we propose in order to rule out irrational pessimism about deliveries of untraded assets.

We show that refined equilibrium always exists in our model, and that default, in conjunction with refinement, opens the door to a theory of endogenous assets. The market chooses the promises, default penalties, and quantity constraints of actively traded assets.

Keywords: default, incomplete markets, adverse selection, moral hazard, equilibrium refinement, endogenous assets

JEL Classification: D4, D5, D8, D41, D52, D81, D82