Default and Punishment in General Equilibrium
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 in a perfectly competitive, general equilibrium framework. Perfect competition eliminates the need for lenders to compute how the size of their loan or the price they quote might aﬀect default rates. It also makes for a simple equilibrium reﬁnement, which we propose in order to rule out irrational pessimism about deliveries of untraded assets. 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. 1562.