Working Paper: NBER ID: w23723
Authors: Geoffrey Heal
Abstract: I extend the classical general equilibrium treatment of uncertainty about exogenous states of nature to uncertainty about prices. Traders do not know the prices at which markets will clear but have expectations over possible prices. They trade price-contingent securities (derivatives) to insure against the risks arising from this uncertainty. I establish four results. One is set of conditions that are necessary and sufficient for the existence of equilibrium (called an equilibrium with price insurance) in this framework. A second is that equilibria with price insurance are Pareto efficient. I give conditions under which agents are fully insured at an equilibrium. Finally I show that agents' price expectations matter in the sense that they affect the equilibrium allocation of resources, and that the existence of price-contingent securities alters the equilibrium of the underlying real economy.
Keywords: derivatives; price uncertainty; endogenous uncertainty; general equilibrium; price expectations; hilbert space
JEL Codes: D5; D53; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| existence of price-contingent securities (G10) | equilibrium allocation of resources (D51) |
| overlapping price expectations (D84) | equilibria with price insurance (G52) |
| structure of the market (including price-contingent securities) (G10) | overall welfare (I31) |
| agents' price expectations (D84) | resource allocation (H61) |
| introduction of price-contingent securities (G10) | improved resource allocation (D61) |
| equilibria with price insurance (G52) | Pareto efficiency (D61) |
| identical price expectations aligned with Walrasian equilibria (D50) | consumption allocations consistent across different price states (D10) |