COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 1304

Default and Punishment in General Equilibrium

Pradeep Dubey
SUNY, Stony Brook
John Geanakoplos
Cowles Foundation, Yale University
Martin Shubik
Cowles Foundation, Yale University

May 2001

We extend the standard model of general equilibrium with incomplete markets to allow for default and punishment. The equilibrating variables include expected delivery rates, along with the usual prices of assets and commodities. By reinterpreting the variables, our model encompasses a broad range of moral hazard, adverse selection, and signalling phenomena (including the Akerlof lemons model and Rothschild-Stiglitz insurance model) in a general equilibrium framework.
     We impose a condition on the expected delivery rates for untraded assets that is similar to the trembling hand refinements used in game theory. Despite earlier claims about the nonexistence of equilibrium with adverse selection, we show that equilibrium always exists, even with exclusivity constraints on asset sales, and transactions-liquidity costs or information-evaluation costs for asset trade.
     We show that more lenient punishment which encourages default may be Pareto improving because it allows for better risk spreading.
     We also show that default opens the door to a theory of endogenous assets.

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

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