19.

General Equilibrium under Uncertainty

19.A Introduction
There is uncertainty 19B) Uncertainty is represented by means of states of the world (or of the nature) and contingent commodities (i.e. with delivery conditional on the realization of the associated state of the world). 19C) Arrow-Debreu (or intertemporal) equilibrium. This is a Walrasian equilibrium with contingent commodities. 19D) Sequential equilibrium: there is a sequence of temporary equilibria. Radner equilibrium (perfect foresight of prices, or self-fulfilling expectations). Equivalence between the Arrow-Debreu equilibrium and the Radner equilibrium.
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19B A Market Economy with Contingent Commodities: Description

Uncertainty is dependence on the state of the world (or nature), which is a complete description of a possible outcome of uncertainty. S is the set of all possible states of the world. Taking S to be finite, S = {1, 2,..., S } . Def.19B1 A (state-)contingent commodity , s is commodity only if state s occurs. Then, a contingent commodity vector is x = { x11 ,..., xL1 ,..., x s ,..., x1S ,..., xLS } LS

available

And is understood as an entitlement to receive ( x1s ,..., xLs ) if s occurs. Thus, we will examine economies with LS contingent commodities, I consumers and J firms. Endowments of consumer i i = {11i ,..., L1i ,..., si ,..., 1S i ,..., LSi } LS Preferences of consumer i are a preference relation i on a consumption set X i LS . Production set of firm j concerns contingent commodities: Y j LS
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Example 19B2. Two goods (seeds, = 1, and crops, = 2 ) and two states (good weather, s = 1, and bad weather, s = 2 ). Thus 4 contingent commodities (with y11 = y12 0 since seeds are planted before the resolution of uncertainty). A feasible plan may be y = ( y11 , y21 , y12 , y22 ) = (1,1, 1,0) (i.e. with crops = 1 if good weather and crops = 0 if bad weather).

Also ownership shares could be (state-)contingent. However, for simplicity, this possibility is disregarded. Then, ji 0 is the share of firm j owned by consumer i whatever the state with i ji = 1 for every j.

Information and the Resolution of Uncertainty

In Figure 19B1 there is a case with two times (0 and 1), where in time 0 there is no information on the state of the nature (so there is uncertainty), while in time 1 uncertainty is solved, i.e. the true state is revealed. In Figure 19B2 there is a case with three dates (0, 1 and 2), so that a tree emerges with respect to information available in each date. This representation can be generalized in order to deal with T + 1 dates.
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s s 1 2 3 4 5 t=0 t=1 Figure 19B1 t=0 t=1 Figure 19B2 1 2 3 4 5 6 t=2

Subsets of S are called events, i.e. an event E is a point of the power set 2 S of S (i.e. the set of all subsets of S). A partition S = ( Ei )in=1 of S (i.e. with Ei E j = for every pair i j and n=1 Ei = S ) is called an i information structure (note that every s S belongs to only one Ei in S and that s, s ' Ei means that s and s ' cannot be distinguished in S .
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A sequential revelation of information is represented by a family of information structures (S 0 ,..., S t ,..., ST ) , where S t +1 is an information n structure finer than S t , for every t, i.e., since S t = ( Ei (S t ))i=(1St ) , we have n(S t +1 ) n(S t ) and for every i there is a j such that Ei (S t +1 ) E j (S t ).
Example 19B3. Figure 19B2 implies (S 0 , S1 , S 2 ) , where S0 = ({1,2,3,4,5,6}), S1 = ({1,2} ,{3} ,{4,5,6}), S2 = ({1} ,{2} ,{3} ,{4} ,{5} ,{6}) Assumption: The information structure is the same for all agents. A pair (t, E), where t is a date and E S t is called a date-event a corresponds to a node of the information tree. A commodity is specified by its physical characteristics h (with h (1,..., H ) ) and by the date-event (t, E) in which it is available. In the book, the specification if referred to the physical characteristics h (with h (1,..., H ) ), to the date t (with t (0,..., T ) and to the state of the world s (with s (1,..., S ) and the condition of measurability is introduced, which requires that any vector of commodities zhts cannot be different from zhts ' if s and s ' belong to the same event E of the date t . The total number of (contingent) commodities is H (T + 1) S , i.e. LS, where L = H (T + 1) .
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19C. Arrow-Debreu (or intertemporal) Equilibrium

We examine an economy with contingent commodities where markets are open only at date 0 (i.e. before the resolution of uncertainty) and payments occur only at date 0. Commodities are delivered (or received) at the date-event that specifies every commodity. This economy (( Xi ,i ), Xi LS , i LS , ji [0,1] with iI=1 ji = 1, i = 1,..., I ;Yj LS , j = 1,..., J ) is formally equivalent to the economies already studied. Note that payments and profits are not contingent and both are realized at date 0, whilst deliveries are contingent and can occur at every date. The competitive (or Walrasian) equilibrium of this economy is known as intertemporal (or Arrow-Debreu) equilibrium. Definition 19C1: An allocation (( xi *)iI=1 ,( y j *) Jj =1 ) iI=1 X i Jj =1Y j and a system of prices p = ( p s ) L=1, S=1 LS constitute an Arrow-Debreu eq. if: s (i) For every j, y j * arg max py j ,
(ii) For every i, xi *i xi xi Bi ( p) where Bi ( p) ={ xi Xi : pxi pi +j ji pyj *} , (iii) i xi * = j y j * + i i .
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y j Y j

Of course, both theorems of welfare economics apply. With respect to uncertainty, the theory of expected utility is not necessarily implied, as well as the introduction of probabilities of the possible events. If expected utility is introduced (as implicitly in the book), then the convexity of preferences implies risk aversion. Examples 19C1 and 19C2 (which are not required), where there are two consumers, one commodity and two states of the world, assume expected utilities for both consumers.

19.D Sequential Trade

The intertemporal (or Arrow-Debreu) economy assumes that all contracts and payments occur at date 0. After this date, there is only the execution of the contracts with the delivery of commodities, which depends on the events emerging at each date. In this Section we deal with an economy in which trade and payments can occur at every date. For simplicity, let T = 1 (i.e. only two dates, t = 0 and t = 1), as in LS Figure 19B1, no production, X i = + for every i, and no consumption at date 0 (i.e. consumption goods are available only at t = 1, whilst contracts for future delivery, that is forward trade, can be signed at t = 0 ). In the Arrow-Debreu equilibrium no market is open at t = 1. In the sequential trade model there are both forward markets at t = 0 and spot markets at t = 1 (a market is spot if contract, payment and delivery are simultaneous). Before introducing sequential trade, lets take under consideration the Arrow-Debreu equilibrium of this economy in which contracts are signed at t = 0 and commodities are available at t = 1 LS LS ( X i = + ,U i : X i , i = ( si ) L=1, S=1 + , i = 1,...I ) s
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The Arrow-Debreu equilibrium ( p,( xi *)iI=1 ) , S S where p = ( ps ) S=1 = ( p s ) L=1, s=1 and xi = ( xsi ) s =1 = ( x si ) L=1, S=1 , requires s s i xsi * = i si for every s and xi * arg max U i ( xi ) , where Bi ( p) = { xi Xi : s ps (xsi si ) 0}, for every i.
xi Bi ( p )

Note that if spot markets should be opened at t = 1, contrarily to the rule of the Arrow-Debreu equilibrium and to consumers expectations, nobody would make exchanges. In fact, no consumers can improve his utility from trade. He already owns the optimal commodity bundle with respect to the state of the world that has occurred at t = 1. Intuitively, every consumer buys, at t = 0 for every possible state of the world at t = 1, the optimal consumption bundle. Formally, for every i, (x1i *,..., xsi *,..., xSi *) arg max Ui (x1i ,..., xsi ,..., xSi ) implies, for any particular s,

( x1i *,..., xsi *,..., xSi *) arg max Ui ( x1i *,..., xsi ,..., xSi *) , where
xsi Bsi ( ps )
L Bsi ( ps ) = { xsi + : ps (xsi xsi *) 0} .

xiBi ( p)

The result (as represented by the consumption bundles) may differ if consumers expect that spot markets shall be opened at t = 1. However, we find the same result (as shown in the following) if all consumers have at t = 0 perfect foresight of spot prices at t = 1. In this case, moreover, the assumption that at t = 0 all forward markets are open can be weakened. In fact, in order to obtain a certain commodity at a certain state, there is not only the possibility to buy it on its forward market at t = 0 , but it is also possible to buy at t = 0 any commodity available at that state and, then, exchange it with the desired commodity on the spot markets at t = 1. Consequently, only a forward market for each state is needed (i.e., only S forward markets in place of LS, and there are also spot markets for L commodities at t = 1 in that particular state that has been revealed). Formally, at t = 0 consumers have (perfect foresight) expectations p = ( ps ) S=1 LS regarding the spot prices prevailing at t = 1 for each s possible s S . Suppose that at t = 0 there are forward markets only for S commodity 1 (i.e. for = 1). Their prices are denoted by q = (qs ) s =1 S and their (positive or negative) amounts by zi = ( zsi ) S=1 S for every i. s (By assumption, there is no consumption at t = 0 and no endowment available at t = 0 ).
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Problem 19D1 Then, the intertemporal plan of i is expressed by the problem max S U i ( xi ) s.t. (i) qzi 0, (ii) ps xsi ps si + p1s zsi for every s LS

The budget constraint (i) regards (forward) trade at t = 0 , constraints (ii) (spot) trade at t = 1 for each state. Definition 19D1 A Radner (or sequential) equilibrium is formed by a contingent price vector q = (qs ) S=1 S , a spot price vector s L L ps = ( p s ) =1 for every s, and, for every i, by consumption plans S zi * = ( zsi *) s =1 S and xi * = ( x si *) L=1, S=1 LS , such that s (i) for every i , plans zi * and xi * solve problem 19D1; (ii) i zsi * 0 and i ( xsi * si ) 0 for every s. Note that all budget constraints are homogeneous of degree zero with respect to prices, so that we can normalize prices. We can choose the price of a commodity in each state, for instance we can put p1s = 1 (i.e. take the first commodity as numeraire) and, moreover, q1 = 1 or s qs = 1 .
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xi

, zi

Proposition 19D1 LS (i) If allocation x* LSI and contingent prices p ++ constitute an S Arrow-Debreu equilibrium, then there are prices q ++ for contingent first good commodities and an allocation z* SI of them such that z*, x*, q, p constitute a Radner equilibrium (where p are spot prices). S LS (ii) Conversely, if z* SI , x* LSI , q ++ , and p ++ S constitute a Radner equilibrium, then there is a vector ++ such that S x*, p (where p = ( s p s ) L=1, s =1 LS ) constitute an Arrow-Debreu equilibrium. ( = q if we normalize prices taking p1s = 1 for every s). Proof: (i) Let qs = p1s for every s. We claim that A-D budget sets

{x
i

LS BiAD = { xi + : s ( xsi si ) ps 0} are identical to R budget sets BiR = LS +

: there is a zi S such that s zsi qs 0 and(xsi si ) ps p1s zsi for every s} .

To see this, take a xi BiAD . Denote zsi = ( xsi si ) ps / p1s . Then, zsi p1s = (xsi si ) ps for every s and s zsi qs = s zsi p1s = s ( xsi si ) ps 0. Hence, xi BiR . Conversely, take a xi BiR . Then, s zsi qs 0 for some zi and ( xsi si ) ps zs p1s for every s , so that, summing over s, AD s ( xsi si ) ps s zsi p1s = s zsi qs 0. Hence, xi Bi .
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( xsi * si ) ps for every s) p1s constitute a R equilibrium we check that contingent markets clear: in ps fact, i zsi * = i ( xsi * si ) 0 (since i (xsi *si ) 0 in A-D) for every s p1s q LS (ii) Choose s = s . R budget sets are BiR = xi + : there is a zi S p1s such that s zsi qs 0 and ( xsi si ) ps s qs zsi for every s . Reasoning In order to prove that z*, x*, q, p (with zsi * =

LS as in (i), we find BiR = BiAD = xi + : s (xsi si ) pss 0 . Since xi * BiR

and i ( xsi * si ) 0 for every s, then xi * BiAD and i ( xsi * si ) 0 for every s, so that x*, p constitute an A-D equilibrium. Note that the R equilibrium attains optimality cutting down the number of contingent commodities (from LS to S), but introducing spot markets at t = 1 (for L commodities) and requiring their correct anticipation.

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