CFDP Revision Date
We extend the standard model of general equilibrium with incomplete markets to allow for default and punishment by thinking of assets as pools. 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 Rothschild-Stiglitz insurance model) in a general equilibrium framework. In contrast to game-theoretic models of adverse selection, our perfectly competitive framework eliminates the need for lenders to compute how the size of their loan or the price they quote might aﬀect default rates. The equilibrium reﬁnement we propose, in order to rule out irrational pessimism about deliveries of untraded assets, is also simpler than its game-theoretic counterparts. We show that reﬁned equilibrium always exists in our model, and that default, in conjunction with reﬁnement, opens the door to a theory of endogenous assets. The market chooses the promises, default penalties, and quantity constraints of actively traded assets.
Dubey, Pradeep; Geanakoplos, John; and Shubik, Martin, "Default and Punishment in General Equilibrium" (2001). Cowles Foundation Discussion Papers. 1561.