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For each state, agents have utility functions. An agent is risk-averse if his
utility function is concave, and risk neutral if it is linear. Concave Bernoulli
utility functions imply convex preferences. With one good and two states of the
world, the slope at any point along an indifference curve is given by:
M RS =
1i u0i (x1 )
(1 1i )u0i (x2 )
The set of points on the diagonal, i.e. such that x1 = x2 is the certainty
line. Along those points, the individual faces no risk.
With respect to the production side of the economy, we consider statecontingent production plans yj RLS . Shares ij 0 are not state-contingent.
Arrow-Debreu equilibrium
If at date zero, before the resolution of uncertainty, there is a market for every
contingent commodity ls, then we can introduce the concept of Arrow-Debreu
equilibrium as the relevant equilibrium concept. At date zero, what is being
traded are commitments to receive or deliver amounts of physical good l if state
s occurs. Deliveries are contingent on the state, but payments are not. After
uncertainty is solved, and the agents know the realization of the state, what they
promised to deliver and/or receive at any other state of the world is irrelevant.
The definition of an Arrow-Debreu equilibrium is an allocation (x1 , ..., xI , y1 , ..., yJ )
LS(I+J)
R
and p = (p11 , ..., pLS ) RLS such that:
i) j, yj satisfies pyj pyj yj Yj .
(
)
P
If such date zero (before the resolution of uncertainty) markets exist, the two
welfare theorems apply. Thus, an efficient allocation of risk can be achieved.
1
z1 ,z2 ,t0
s.t. p1 z1 + p2 z2 + pt t
pt ,
= p1
u2
= p2
u 1 f1 + u 2 f2
= pt
Thus, we obtain:
u1
u2
pt
p1
p2
= p1 f1 + p2 f2 ,
which implies that, if we normalize by dividing by the price of fruit in the second
period,
u1
pt
=
f1 + f2 .
p2
u2
2
Example 2 Consider a competitive economy with two periods and two states
of nature. The probability of state 1 is 1/3, and that of state 2 is 2/3. There
are three goods in the economy: a is first period consumption, b1 is second
period state 1 consumption, and b2 is second period state 2 consumption. There
is a continuum of measure 1 of identical consumers, who are expected utility
maximizers, using correct probabilities, and whose utility function is u = 12 ln a+
1
2 ln b. The endowments are the same for every consumer: 12 units of the first
period consumption good and none of the second period consumption good.
There are two types of firms, and a large number of each type (the exact
number is irrelevant, since there are CRS). All firms have CRS. Type 1 firms can
convert 1 unit of first period consumption into 1.25 units of second period state
1 consumption. Type 2 firms can convert 1 unit of first period consumption into
0.5 units of second period state 1 consumption, and 0.5 units of second period
state 2 consumption. Each firm is owned in equal shares by all consumers (since
profits will be zero, the ownership structure is irrelevant).
If there is a complete set of contingent markets, what are the Walrasian
Equilibrium price and quantities?
Radner equilibrium
xi RLS
s.t.
X
qs zsi 0 and ps xsi ps si + p1s zsi s
s
Now, zsi is good one traded contingently at time zero, and the price of this
good is qs . Notice that there are S + 1 constraints in total, one for contingent
trade at t = 0, and one for each of the states of the world at t = 1. Of course,
once uncertainty is resolved, only one of the S constraints that are included in
the second condition will actually be in place, the rest of the constraints will be
irrelevant, because those states of the world will never actually happen.
The equilibrium concept in this setting is Radner equilibrium. We will define
what a Radner equilibrium is and then argue that it is equivalent to the ArrowDebreu equilibrium.
3
It turns out that the set of Arrow Debreu and Radner equilibrium allocations
are identical. Formally, this is presented in Proposition 19.D.1 in MWG, which
S
says that if x RLSI , p RLS
++ are an Arrow-Debreu equilibrium, q R++ ,
SI
LS
z R such that x , z and (p1 , ..., pS ) R++ are a Radner equilibrium.
Conversely, if x RLSI , z RSI , q RS++ and (p1 , ..., pS ) RLS
++ are a
Radner equilibrium, then (1 , ..., S ) RS++ such that x , (1 p1 , ..., S pS )
RLS
++ are an Arrow-Debreu equilibrium. The multiplier s is the value, at t = 0,
of a dollar at t = 1 and state s, or the relative value of wealth at t = 1.
Those multipliers will be chosen so that s p1s = qs . It is important that agents
correctly anticipate spot prices at t = 0.
Assets
Assets play the role of transferring wealth across states of the world (or across
time), in a similar way as contingent trade in good 1. A unit of an asset is an
entitlement to receive an amount rs of good 1 at t = 1 if state s occurs. Thus,
we can characterize an asset by its return vector r = (r1 , ..., rS ) RS . Examples
of assets are Arrow security: (0, 0, 0, 1, 0) or a riskless asset: (1, 1, 1, 1).
We assume there is an exogenously given set of K assets, which will constitute the asset structure. These assets have prices (q1 , ..., qK ). We thus generalize
the definition of a Radner equilibrium given the asset structure.
)
q RK , asset prices at t = 0, ps = (p1s , ..., pLs ) RL s, zi = (z1i
, ..., zKi
LS
at t = 0 and xi R at t = 1 are a Radner equilibrium if
a) i, zi , xi solve:
max
Ui (x1i , ..., xSi )
xi RLS
zi RK
P
s.t. i) qk zki 0
k
P
ii) ps xsi ps si + p1s zki rsk s
k
P
P
P
b) zki
0 k, xsi si s.
i
Thus, given the asset structure of the economy, we can define the return
matrix R whose kth column is the return vector of the kth asset. If rank(R) = S,
then the asset structure is said to be complete. If rank(R) < S, the asset
structure is incomplete.
Using this notation, the budget constraint becomes:
Bi (p, q, R) =
p1 (x1i 1i )
Rzi
...
s.t. for some portfolio zi RK , qzi 0 and
pS (xSi Si )
x RLS
KI
prices q RK
and
z
=
(z
,
such that x , z q, (p1 , ..., pS ) RLS
++
++
1 ..., zI ) R
are a Radner equilibrium.
LS
ii) if x RLSI , z = (z1 , ..., zI ) RKI , q RK
++ , (p1 , ..., pS ) R++ are a
S
100, 95
95, 85
1 100, 90
80, 70
1
100, 90
100, 85
85, 75
there are arbitrage opportunities. I can purchase one unit of asset 2 and sell
85
units of asset 1. At t=2, if s=1, then I get 95, pay 95
100 89.5. If s=2, I
85
get 90, while only paying 95 100 89.5. There is no value of > 0 such that
there are no arbitrage opportunities, i.e., such that
90
85
95
+
(1 ) .
1,
= 1,
95
100
100
85
95