COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 1305

Signalling and Default: Rothschild-Stiglitz Reconsidered

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

May 2001

In our previous paper we built a general equilibrium model of default and punishment in which equilibrium always exists and endogenously determines asset promises, penalties, and sales constraints. In this paper we interpret the endogenous sales constraints as equilibrium signals. By specializing the default penalties and imposing an exclusivity constraint on asset sales, we obtain a perfectly competitive version of the Rothschild-Stiglitz model of insurance. In our model their separating equilibrium always exists even when they say it doesn't.

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

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