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Discussion Paper

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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 adverse selection, and signalling phenomena (including the Akerlof lemons model and Rothschild-Stiglitz insurance model) and some moral hazard problems in a general equilibrium framework. Despite earlier claims about the nonexistence of equilibrium with adverse selection, we show that equilibrium always exists. We show that more lenient punishment which encourages default may be Pareto improving because it allows for better risk spreading. We define an equilibrium refinement that requires expected delivery rates for untraded assets to be reasonably optimistic. Default, in conjunction with this refinement, opens the door to a theory of endogenous assets. The market can choose default penalties and quantity constraints on sellers.

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