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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 the Rothschild-Stiglitz insurance model) 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 increases the dimension of the asset span without increasing the number of assets traded. 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 chooses the promises, default penalties, and quantity constraints of actively traded assets.

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