General Equilibrium under Uncertainty

The Arrow-Debreu Model

General Idea:
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this model is formally identical to the GE model

commodities are interpreted as contingent commodities

(commodities are contingent to a state of nature, date,
location)

Definition of the list of commodities

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S states of nature s = 1, ..., S

L physical commodities l = 1, ..., L

LS contingent commodities (index ls)

The Arrow Debreu model = the GE model with LS goods (the

goods are numbered ls)

Interpreting the model: what does trading contingent goods

mean?
2 periods:
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at t = 0, agents ignore s, they trade contingent goods

to exchange xls units of good ls against xl 0 s 0 units of good l 0 s 0

= to sign a contract committing to deliver xls units of physical
good l if state s occurs at t = 1 in exchange of receiving xl 0 s 0
units of physical goods l 0 if state s 0 occurs at t = 1

At t = 1, no contract is signed (markets are closed): the state

of nature s becomes public, contracts contingent to state s
are executed (= physical goods are delivered and consumed),
contracts contingent to other states are destroyed (they have
no value)

endowment (ils )ls of agent i: at the beginning of date 1, in

state s, agent i receives a quantity ils of physical good l

optimal demand (xils )ls of agent i is a decision taken at t = 0:

at t = 0, agent decides that, at t = 1, if state s occurs, he
will consume xils units of physical good l (at t = 0, he signs a
contract committing him to buy zils = xils ils units of
physical good l if state s occurs at t = 1)

Trading contingent goods allows agents to transfer wealth across

states
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The demand of i maximizes his utility function subject to the

budget constraint p.x = p., that is:
X
X
pls xils =
pls ils
l,s

l,s

This rewrites
X

ts = 0

where ts is the wealth that needs to be transferred to state s:

X
X
ts =
pls xils

pls ils
| l {z

value of the consumption in s

(ts 0 or ts 0)

| l {z

value of the endowment in s

one can have a model with more than 2 periods and 1 state of
nature or more as well (all the contingent goods are traded at
t = 0 and not later, these are commitments to deliver physical
goods at a certain date t in a certain state s in exchange of
receiving something at a date t 00 1 in a state s 0 )

Interest of the model: to discuss risk sharing and intertemporal

trades (saving, borrowing) with all the tools (concepts and
theorems) of the GE Theory (for example, equality between
the MRS at equilibrium across all dates and states)

Remark on the utility of i:

This is a function with LS variables xils
One can assume an expected utility form:
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at t = 0, agent i assigns probability is to state s

vi is a function with L variables ( = a bundle of L physical

goods)

the agent chooses his demand by maximizing

X
is vi (xi1s , ..., xiLs )
ui (xi11 , ..., xiLS ) =
s

vi can depend on s as well:

X
is vi (xi1s , ..., xiLs , s)
max
s

About production of contingent goods

Example with L = S = 2 (2 physical goods, 2 states of nature),
y = (y1a , y1b , y2a , y2b )
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the firm transforms l = 1 into l = 2, whatever s = a, b is

(production function f ). The production set is


y IR 4 /y1a = y1b , y2a = y2b , y2a f (y1a )

the firms technology is not the same in the 2 states (2

production functions fa and fb ) and the firm decides the
amount of input before s is revealed. The production set is


y IR 4 /y1a = y1b , y2a fa (y1a ) , y2b fb (y1a )

Arrow Debreu Equilibrium

This is exactly the usual equilibrium:
I
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ILS , (y , ..., y ) IR JLS ,

an allocation (x1 , ..., xI ) IR+
1
J
LS
prices p IR+

such that
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Individual optimality
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i, xi solves max ui (xi ) subject to the budget constraint

X
ij j
p.xi p.i +
j

j, yj solves max p.yj subject to yj Yj (denote j = p.yj )

Market clearing:
l, s,

X
i

xils
=

X
i

ils +

X
j

yjls

The Welfare Theorems apply (1st Theorem means that risk

sharing across states is efficient)

The existence theorem applies as well (convexity of preferences

and production sets implies existence of an equilibrium)

Risk sharing: an example

an exchange economy with 2 consumers i = A, B, L = 1, S = 2 (2
contingent goods: wealth in state s = 1, 2)
utility has an EU form: for i = A, B, denote
1i ui (x1i ) + 2i ui (x2i )
with ui C 2 (u 00 < 0 < u 0 )
3 cases
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no aggregate uncertainty ($1 = $2 ) and objective

probabilities (1A = 1B )

no aggregate uncertainty and subjective probabilities

(1A < 1B )

aggregate uncertainty ($1 < $2 ) and objective probabilities

Consider an interior equilibrium: MRSA = MRSB . This implies:

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Case $1 = $2 and 1A = 1B
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Case $1 = $2 and 1A < 1B

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complete insurance (xi1 = xi2 )

p2
2
p1 = 1
partial insurance xA1 < xA2 and xB1 > xB2
p2
2B
2A
1B < p1 < 1A

Case $1 < $2 and 1A = 1B

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xA1 < xA2 and xB1 < xB2

p2
p1
2 < 1

The example generalizes to an arbitrary number of states and

consumers

Sequential Trade
Preliminary remark: Mas-Colell et alii present an example of
sequential trade (19D) before the introduction of asset markets
(19E). The case carried in 19D (Definition 19D1 and Proposition
19D1) is an example of a model with asset markets (where the
Arrow assets only are available)
This is why I skip most of this section. I give 2 remarks only

Remark 1
Opening of the markets at t = 1 is useless
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the above interpretation of the AD model: contingent goods

markets at t = 0 and no market at t = 1

one could open the markets at t = 1: spot markets for the L

physical goods

1st Welfare Theorem implies that, at equilibrium, no

additional trade occurs at t = 1

An alternative interpretation is: there would be too many

markets
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that is: agents could trade good ls against good l 0 s at t = 1

(if state s occurs) instead of trading at t = 0

when the spot markets exist, not all the markets at t = 0 are
necessary for the equ alloc to be PO. Markets at t = 0 are
required to transfer wealth across states only (not to exchange
goods within the same state).

This is what the example in 19D shows: trading the S

contingent goods 1s at t = 0 is enough (one good/state).
In the context of asset markets, these goods are named
Arrow assets

Remark 2: rational expectations

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when trade is sequential, there are opened markets at

differents dates
Apparently, the decision that is made at t = 0 concerns goods
traded at t = 0 only
But, to make an optimal choice at t = 0, the agent needs to
determine at the same moment what he will do at t = 1 (the
decisions made at t = 0 and t = 1 both concern max ui )
Hence, at t = 0, he needs to know the prices of the goods
traded at t = 1
The AD model assumes that the agents perfectly anticipates
the prices. Perfect expectations are the so-called rational
expectations in this model (in other models, rational
expectations are not perfect: some uncertainty remains)

Rational Expectations are assumed in most definitions of

equilibrium. A general definition is beyond the scope of this course

Asset Markets
Consider an exchange economy with I consumers, L physical
goods, S states of nature, K assets
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at t = 0, s is unknown and assets are exchanged

at t = 1, s becomes public, asset payoffs are paid, goods are

exchanged

What is an asset?
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a title (price qk ) to receive an amount rsk 0 units of good 1

at t = 1 in state s

this is a real asset (payoff in good 1 only is for convenience) 6=

nominal assets

rsk < 0 could be considered as well

Examples of assets
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safe asset r = (c, ..., c)

the S Arrow assets rs = (0, ..., 0, 1, 0, ..., 0) (rss = 1, rsk = 0

otherwise)

option (example of a derivative asset) with strike price c,

primary asset rk
call :

roption = (max (0, rks c))1sS

put :

roption = (max (0, c rks ))1sS

The agent chooses at t = 0

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a portfolio of assets zi = (zi1 , ..., ziK ) IR K

L in each state s
a commodity bundle xis = (xis1 , ..., xisL ) IR+

max

is ui (xis1 , ..., xisL )

s.t.

qk zik

= 0

pls xils

s,

X
l

X
l

pls ils + p1s

rsk zik

Typically, zk 0 for some k and zk 0 for some other k

no endowment of asset (this assumption for convenience only)

usual endowment ils of physical good l in state s (received at

the beginning of t = 1)

Radner Equilibrium
LSI and prices (q, p) IR K +LS such
An allocation (z, x) IR KI IR+
+
that:
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Individual optimality: i, (zi , xi ) solves the max problem on

the previous slide

Market clearing:
k,

zik

= 0

xils

l, s,

X
i

X
i

ils

Comments:
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ps : spot prices in state s

w.l.o.g. s, ps1 = 1

equilibrium of plans, prices and price expectations (portfolio

and consumption plans, the definition includes an assumption
about the price expectations: see the previous slide on
rational expectations)

Fundamental property 1 of the equilibrium asset prices

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At equilibrium, q is arbitrage-free

The converse implication is not true: an arbitrage-free price

vector q is not always an equilibrium price vector

Proof
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An arbitrage portfolio is zi such that q.zi 0,

X
s,
rsk zki 0 with strict inequality for (at least) one s
k

If there is an arbitrage portfolio, then no agent i has an

optimal decision:
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consider a decision (xi , zi )

zi + zi gives a larger wealth in every state s
0
0
there is xi0 such that ui (xis1
, ..., xisL
) > ui (xis1 , ..., xisL ) in every
s (given that ui is increasing)

loosely speaking, i wants to buy the portfolio zi with

= + in order to get an infinite wealth in every state s (so
that no market clearing is possible - assets or goods -)

Fundamental property 2 of the equilibrium asset prices

At equilibrium, there are (1 , ..., S ) 0 such that, for every asset
with returns rk
X
qk =
s rsk
s
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s is the price of the Arrow asset s

Proof: Farkas lemma (derived from a separating hyperplane

theorem, see Mas-Colell et alii)

Proof
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consider the space IR K



z IR K /q.z < 0 is a convex set

the
 intersection
P of the S convex sets (one for each asset)
K
z IR / s rsk zk 0 is a convex set

the 2 sets do not intersect (the asset prices are arbitrage-free)

there is (1 , ..., S ) 0 such that

q1
X
..

s
. =
s
qK

rs1
..
.
rsK

The fundamental characteristic of the market structure

It is either complete or incomplete
Definition: an asset structure (K assets, associated with a S K
return matrix R = (rsk )s,k ) is complete iff the rank of R is S.
Comments:
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S is the maximal possible rank for a S K matrix

this means that there are S linearly independent assets

(example: the S Arrow assets)

S assets are enough to get a complete market structure (but

the markets may be incomplete even if K > S)

With S linearly independent assets, further assets are

redundant: their rk is a linear combination of the rk of the S
first assets

Interpretation: all the transfers of wealth across states are feasible

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Budget constraint over the S states (this is the BC of the

associated Arrow Debreu economy)
X
X
pls xils =
pls ils
l,s

l,s

define a transfer of wealth to state s

X
X
s, ts =
pls xils
pls ils
l

question is: are these transfers feasible through an appropriate

portfolio zi , that is: is there zi such that
X
s, p1s
rsk zik = ts
k

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if the return matrix R has rank S, then the answer is yes

the remaining question is: does zi satisfy q.zi 0? (see next
slides)

A formal statement of the above interpretation

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This statement = 2 converse implications (stating that

Radner equilibrium = Arrow Debreu equilibrium)

an Arrow Debreu economy with no asset and LS contingent

goods can be associated with every economy with complete
asset markets and sequential trades,

conversely, with an Arrow Debreu economy, we can associate

a market structure (typically the S Arrow assets) and consider
the economy with sequential trade where assets are traded at
t = 0 and the L physical goods are traded at t = 1 (once the
state s is revealed)

Implication 1: Consider an economy with complete asset markets.

LSI IR KI IR LS IR K is a Radner equilibrium
If (x , z , p, q) IR+
+
+
(normalization condition: s, p1s = 1), then there is
S such that (x , p , ..., p ) IR LSI IR LS is
(1 , ..., S ) IR+
1 1
S S
+
+
S is the vector of prices of
an Arrow Debreu equilibrium (ps IR+
contingent goods ls, s is the value of state s, that is the price
of the Arrow asset s)
Fundamental consequence of Implication 1: the 2 welfare theorems
apply
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when asset markets are complete, the allocation x of a

Radner equilibrium is PO

a PO allocation x is the allocation of a Radner equilibrium

(with appropriate wealth transfers)

LSI IR LS is an Arrow Debreu

Implication 2: If (x , p) IR+
+
equilibrium, then there is a market structure with K assets (of
returns rk ) and there are portfolios z IR KI and asset prices
K such that (x , z , p, q) is a Radner equilibrium
q IR+

Fundamental consequence of Implication 2: the existence theorem

applies
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when the asset markets are complete, there is a Radner

equilibrium (given concavity of the ui )

Proofs
R = 1)
Consider the 2 budget sets (p1s


LS /z IR K /q.z 0
xiP
IR+
i P
i P
BR =
and s, l plsR xils l plsR ils + k rsk zik

X
X
LS
BAD =
xi IR+
/
plsAD xils
plsAD ils

l,s

l,s

We show that, for properly chosen p AD and p R , these 2 sets

coincide

Inclusion BR BAD
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consider the s such that qk =

for xi BR

s rsk

!
X

plsR xils

s plsR

xils

l,s
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X

plsR ils +

s plsR

ils +

l,s

that is: xi BAD

X X
k

X
l,s

rsk zik
!

hence, with plsAD = s plsR ,

plsAD xils

X
k

l,s

X

plsAD ils

s rsk

zik

Inclusion BAD BR
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consider the S Arrow assets (complete asset markets)

AD and p R = p AD /p AD (notice p R = 1)
define qs = p1s
1s
1s
ls
ls

for xi BAD , define

s, zis =

AD
p1s

check that q.zi 0

and check that

s,

X
l

that is: xi BR

plsR xils =

plsAD xils

plsAD ils

X
l

plsR ils +

X
k

rsk zik

About redundant assets

If x is the allocation of a Radner equilibrium with an asset
structure associated with a return matrix R, then x is the
allocation of a Radner equilibrium with any other asset structure
associated with a return matrix R 0 such that rangeR 0 = rangeR
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range of a (return) S K matrix:

rangeR = v IR S /v = Rz, z IR K

redundant assets can be deleted without changing the

allocation of Radner equilibrium

About incomplete markets

When markets are incomplete
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there can be no equilibrium

equilibrium can be suboptimal

equilibrium is sometimes not even constrained optimal

(constrained optimality: Pareto optimality among the
allocations x that are feasible given the asset structure)

The end of the chapter