Professional Documents
Culture Documents
Matthew Basilico
April, 2013
Part I
General Equilibrium
Chapter 15 - General Equilibrium Theory: Examples
0
Consumer is endowment vector is ωi = (ω1i , ω2i )
∗ Total endowment of good l is ω̄l = ωl1 + ωl2
• Allocation
1
An allocation x ∈ R4+ is an assignment of a nonnegative consumption vector to each con-
sumer
Wealth: Not given exogenously, only endowments are given. Wealth is determined by by
prices.
∗ p · ωi = p1 ω1i + p2 ω2i
Budget Set: Given endowment, budget set is a function of prices
∗ Bi (p) = xi ∈ R2+ : p · xi ≤ p · ωi
p1
∗ Graphically, draw budget line [slope = − p2 ]. Consumer 1's budget set consists of
all nonnegative vectors below and to the left; consumer 2's is above and to the right
• Graph:
2
As p varies, budget line pivots around ω . Given this line, consumer demands most preferred
point in B (p). This set of demanded consumptions makes up oer curve
∗ Just like demand function: x1 (p, p · ω1 )
∗ Curve passes through the endowment point. Also, since at each point endowment is
aordable, every point on oer curve must be at least as good as ωi .
Denition: Price vector p∗ and an allocation x∗ = (x∗1 , x∗2 ) in the Edgeworth box such that
for i = 1, 2
∗ x∗i %i xi for all x0i ∈ Bi (p∗ )
At equilibrium, the oer curves of the two consumers intersect
p∗
Only relative prices 1
p2∗ are determined in equilibrium, since each consumer's demand is
(a) To determine p∗ , only need to nd that for which one market clears. Other will neces-
sarily clear at these prices.
See PS1 Q6
3
• Multple WE
Can certainly have multiple WE, as you will have a WE any time the Oer Curves intersect
more than once
∗ i.e. quasilinear utility with respect to dierent numeraires (doctored a bit, MWG 521)
• Non-existance of WE
1. Non-monotonic Preferences
2. Nonconvex Preferences
(a) In example, consumer 1's oer curve is disconnected, so it does not intersect consumer
2's
4
• Pareto Optimum
• Pareto Set
• Contract Curve
The part of the Pareto Set where both consumers do at least as well as at their initial
endowments
Verbally: Under convexity assumptions (not required for 1st WT), a planner can achieve
any desired Pareto optimal allocation by appropriately redistributing wealth in a lump-sum
fashion and then letting the market work
∗ Nonconvexities: May fail when preferences aren't convex (given budget line, consumer
with nonconvex preference may prefer dierent point to intended x∗ )
∗ Monotonicity: (Figure 10(a) above). ω is PO, but cannot be supported as an equilib-
rium with transfers
5
15C: The One-Consumer, One-Producer Economy
• Set up
Endowment: L̄ of leisure, 0 of x2 (although consumer owns rm and gets prots, which are
positive)
• Production
max pf (z) − wz
z≥0
Given prices (p, w), [p is price of x2 , w is wage] rm has optimal labor demand z (p, w),
output q (p, w) and π (p, w)
• Consumption
max u (x1 , x2 )
(x1 ,x2 )∈R2+
s.t. px2 ≤ w L̄ − x1 + π (p, w)
• Walrasian Equilibrium
x2 (p∗ , w∗ ) = q ∗ (p∗ , w∗ )
L̄ − x1 (p∗ , w∗ ) = z (p∗ , w∗ )
6
Graphically: 15.C.1(b) is not an equilibrium; 15.C.2 is
A particular consumption-leisure combination is an WE ⇐⇒ it maximizes the consumer's
utility subject to the economy's technological and endowment constraints
• Graph
1. xi ∈ Xi ∀i
7
2. yj ∈ Yj ∀j
P P
3. i xi = ω̄ + j yj
n P P o
The set of feasible allocations is denoted by A = (x, y) ∈ X1 × · · · × XI × Y1 × · · · × YI : i x i = ω̄ + j yj ⊂
RL(I+J)
Pareto Optimum
Walrasian Equilibrium n o
I J I
Given a private ownership economy specied by {(Xi , %i )}i=1 , {Yj }j=1 , (ωi , θi1 , . . . , θiJ )i=1 ,
1. p · yj ≤ p · yj∗ ∀yj ∈ Yj
x∗i = ω̄ + yj∗
P P
3. i j
Note that if p∗ = 0, then all are satised except (2), since can be another bundle with more of a good
that is aordable.
Local Nonsatiation
• Denition: The preference relation %i on the consumption set Xi is LNS if for every xi ∈ xi and
every ε > 0, ∃ x0i ∈ Xi s.t. kx0i − xi k ≤ ε and x0i i xi
Note that this assumes divisibility of goods, so it can't happen in a real economy.
8
1st Theorem of Welfare Economics
Statement:
• Suppose %i is LNS ∀i
• Let (x∗ , y ∗ , p∗ ) be a WE
• Then (x∗ , y ∗ ) is PO
Proof:
• By (2) we must have p · x†i ≥ wi ∀i, and by (1) we must have p · x†i > wi for some i.
px†i > i wi
P P
Hence, i
∗
P P
(and since i wi = p · ω̄ + j p · yj ) we have
px†i >
X X X
wi = p · ω̄ + p · yj∗
i i j
yj∗ pyj∗ ≥
P
• Moreover, because
P is prot maximizing for rm j at price vector p,we have p · ω̄ + j
p · ω̄ + j pyj
p · x†i > p · ω̄ +
X X
Thus p · yj
i j
Contradiction
• Assumption of Local Nonsatiation rules out situation with thick indierence curves, as can be
seen in EWB example.
9
See graph below: consumer 1 is indierent about a move to allocation x, and consumer 2,
having strongly monotone preferences, is strictly better o.
MRS at Prices
[Calculus Proof - downside is corner solutions, 2nd order dierentiability, doesn't make as clear what
you need. But it does have advantages, including helping us think in terms of marginal benets and
costs]
If consumers maximize utility subject to budget constaint, then MRS between any two goods will equal
the price ratio between those goods.
Since we all face same prices, all of our MRS are the same.
Also, if rms are maximizing prot, the MRT (marginal rate of transformation) will equal relative
prices.
So MRS equalized across consumers, MRT equalized across producers, and MRTs = MRSs = price
ratios.
This is FOC for Pareto Optimum.
Best way to do this is to give people utility functions. Maximize one person's utility s.t. all other
utilities being at least at some level. (max u1 s.t. ui ≥ ūi , technological constraints). The FOC will
say MRT = MRS.
Conclusion: WE satises FOCs for a PO.
If then assume everything is convex, then FOCs will also be sucient for a global optimum. We still
need to worry about corner solutions (for MRT=MRS)
• Denition: (x∗ , yP
∗ ∗
, p )is a price P
equilibrium with transfers if ∃ an assignment of wealth levels
(w1 , ..., wI ) with i wi = p∗ ω̄ + j p∗ · yj∗ such that
2. ∀i, x∗i ∈ RL ∗ ∗
+ , p · xi ≤ wi and xi i x∗i =⇒ p∗ xi > wi
(a) MWG style: For every i, x∗i is maximal for %i in the budget set {xi ∈ Xi : p · xi ≤ wi }
(b) Anything strictly better o is unattainable
x∗i − yj∗ − ω̄ = 0
P P
3. i j
10
Price Quasiequilibrium with Transfers:
Only part that changes is from > to ≥ in (2)
• Denition: (x∗ , yP
∗ ∗
, p )is a price P
equilibrium with transfers if ∃ an assignment of wealth levels
(w1 , ..., wI ) with i wi = p∗ ω̄ + j p∗ · yj∗ such that
2. ∀i, x∗i ∈ RL ∗ ∗
+ , p · xi ≤ wi and xi i x∗i =⇒ p∗ xi ≥ wi
P ∗ P ∗
3. i xi − j yj − ω̄ = 0
i) Yj is convex ∀j
• Suppose ii) %i is convex ∀i
iii) %i is LNS ∀i
• Then there exists a price vector p∗ 6= 0 s.t. (x∗ , y ∗ , p∗ ) is a quasiequilibrium with transfers.
[If you have a quasiequilibrium, then competitive market equilibrium if distribution of wealth is
appropriate (15:40)]
[Proof preliminaries:]
The mathematical tool is something called separating hyperplane theorem. Took years to realize this
was the right tool; they used to use calculus (i.e. Samulson). Would say Pareto optimum, use FOC.
From this MRS must be equal between consumers for any good; this must be equal to MRT across
rms. This is assuming no corner solutions.
So if all marginal rates equal, then can set prices equal to all marginal rates. These prices satisfy all
FOCs. If we assume everything so that FOCs are necc and su, then consumers will be maximizing
according to their budget constraint. So we can adjust budgets to get consumers to consume at desired
level.
In both approaches, assume convexity.
The advantage is that this proof shows what is really driving things. Arrow-Debreu realized in early
1950s that you could do it this way.
11
What we will do is see that feasible production set does not intersect what lies above the set that is
preferred to the (consumption set?) ] (26:00)
Proof:
Dene
( )
X
Vi = xi ∈ RL
+ |xi i x∗i
i
X
Let V = Vi
X
Let Y = Yi
• [Notes]
Note that Y + {ω̄}geometrically the aggregate production set with its origin shifted to
ω̄ is the set of aggregate bundles producible with given technology and endowments (and
therefore usable for consumption).
P
Set addition: When you add sets, A+B = x|x = a + b for some a ∈ A, b ∈ B , i.e.
(1, 0, −1/2)+(0, 1, −1/4)=(1, 1, −3/4)]
Step 1:
Vi is convex ∀i
• Proof:
[∴ αxi + (1 − α)x0i ∈ Vi ]
Step 2:
V is convex, Y + {ω} is convex
• Proof:
Step 3:
V ∩ (Y + {ω}) = ∅
12
• Proof:
Step 4: (41:49)
∃ p∗ = (p1 , . . . , pL ) 6= 0 and a number r s.t.
p∗ · z ≥ r ∀z ∈ V
p∗ · z ≤ r ∀z ∈ Y + {ω}
• Proof:
z ∈ RL | p∗ z = r
[Hyperplane is ]
Step 5:
xi %i x∗i ∀i, then p∗ (
P
If i xi ) ≥ r
[This is saying that if I put i then we'd already know if from above, since it would be in V. Only
additional element here is going from to %]
• Proof:
By local nonsatiation, we can nd (x0i )i=1,...,I arbitrarily close to xi s.t. x0i i xi
∗ =⇒ x0i i x∗i
∗ =⇒ x0i ∈ Vi =⇒
P 0
i xi ∈ V
13
∴ p∗ · ( i x0i ) ≥ r
P
Take limits as x0i → xi ∀i
p ∗ · ( i xi ) ≥ r
P
By continuity
Step 6:
P
p∗ · ( i x∗i ) = r = p∗ · ∗
P
j yj + ω̄
• Proof:
p∗ · ( i x∗i ) ≥ r
P
By Step 5,
But we also know: i x∗i =
P P ∗
j yj + ω̄ (feasible allocation)
P
p∗ · ( i x∗i ) = p∗ · ∗
P
y
j j + ω̄ ≤r
P
∴ p∗ · ( x∗i ) = r = p∗ · yj∗ + ω̄
P
i j
Step 7:
∀j, p · yj∗ ≥ p∗ · yj ∀yj ∈ Yj
∗
• Proof:
Hence, p∗ · yj ≤ p∗ · yj∗
[If it's prot maximizing in the aggregate, then it must be maximizing at the individual level. If this
weren't the case, then let some rm maximize prot, keep everyone else the same, then prot increases
in the aggregate]
Step 8:
∗ ∗
P wi = p∗ · xP
Let i
∗ ∗
P ∗
i wi = p · ( i xi ) = r = p · ( i yi + ω̄)
• Proof:
Step 9:
xi i x∗i =⇒ p∗ · xi ≥ wi
• Proof:
Suppose xi i x∗i
Then certainly xi %i x∗i
14
∴ p∗ · xi + k6=i x∗i ≥ p∗ · x∗i + k6=i x∗i
P P
(by step 5)
∗ ∗
=⇒ p · xi ≥ p · x∗i = wi
Conclusion
∗ ∗ ∗
L
• (2) follows from Step 9 ∀i, xi ∈ R+ , xi i xi =⇒ p xi ≥ wi
hP i
∗ ∗ ∗
P ∗
• (3) follows from feasibility of Pareto Optimal allocation (x , y ) x
i i − y
j j − ω̄ = 0
However, it is not consumer 1's preference-maximizing bundle in her budget set. (She would
have innite demand for good 2)
An important reason for failure is that consumer 1's wealth level at the quasiequilibrium is
zero.
15
From Quasiequilibrium to Equilibrium in 2nd Welfare Theorem
1. Assume p∗ · x∗ > 0
Lemma: If not at zero wealth, then a strictly preferred bundle is more expensive (2:00)
Suppose x∗ ∈ Xi = RL
+ and p, wi s.t.
xi i x∗i =⇒ pxi ≥ wi
Then if there exists x0i ∈ Xi s.t. px0i < wi , it follows that
1. Assume %i are strictly monotonic (which means if I give you more than any good, you are strictly
better o )
2. Also assume ω̄ 0
3. And 0 ∈ Yj ∀j (any rm could shut down)
(Quite strong assumptions, but then we are ready to make some progress)
Proof:
We have in price quasiequilirbrium
1. p∗ ≥ 0
(a) Since if have negative prices for any good, just consume more of that good which violates
the above (*)
16
P
p∗ ωi + θij p∗ yj∗
P P P
2. i wi = i j (this is just total wealth in the economy i wi )
= p∗ ω̄ + p∗ yj∗
P
(a) j
(b) ≥ p∗ ω̄ > 0 =⇒ wi > 0 for at least one i, say k
i. For k : xk x∗k
=⇒ p xk > ∗
p∗ x∗k
ii. Consumer k would buy an innite amount of good l if it was free
∗
(c) =⇒ p 0
i. For consumer i 6= k : 2 cases
∗
A. xi 6= 0, then p · x∗i > 0 (cost of your bundle
∗
has to be strictly positive
3. Everyone is maximizing utility subject to their budget constraint, so we have established that
this is a full equilibrium
(a) This is the kind of thing you can do if you don't want to just assume p∗ x∗i > 0, which is
endogenous.
(b) Here we've shown everything works if you have strongly monotone preferences, ω̄ 0.
i. These are pretty strong assumptions. You can weaken them and there was a lot of
work on this in 50s and 60s.
• Take upper contour sets, and take convex hull of those sets
• Show modied economy; want to show that feasible allocation is feasible for the original economy
(only if there are a large number of people)
Take pareto optimum; then go back and say how can you sustain? It's by this trick of
having some above and some below.
• The way this is done is to not have anyone actually consuming that bundle, but to have half
0
below and half above (x1 and x02 ) Figure 16.D.5
17
However can only do this if convexities are bounded. If there are increasing returns to scale
forever, then rms will want to be huge
• For purposes of formal analysis, extremely helpful to be able to express equilibria as a system of
equations.
18
Excess Demand Function
Pure Exchange Economy Set Up
Xi = RL
+ ∀i
%i rational, continuous ∀i
L
ωi ∈ R+ ∀i
P
ω̄ = i ωi 0
Walrasian Equilibrium
• Walrasian Equilibrium
• We also assume
%i is strictly monotonic ∀i
%i is strictly convex ∀i
these imply p∗ 0
L
xi (p, w) ∈ R+ solves : max %i s.t. px ≤ w,
with p 0, w ≥ 0
• Walrasian Equilibrium
19
p∗ s.t. z (p∗ ) = 0
(can also be stated as zl (p∗ ) = 0 for every l = 1, . . . , L)
• If some component is not 0, this means that market is not clearing.
1. z is continuous
(a) Excess demand functions are continuous since it is a sum of demand functions that are
continuous
(a) We're interested in convergence where some (but not all) prices are going to zero. This
tells us that some excess demand will go to inninty.
(b) Suppose the prices good one are going to 0, and other prices are positive, and they like
good one, then consumers would load up on it (buying more and more of it). So then since
demand for one good is going to ∞, the max is going to ∞
(c) More subtle case: suppose 2 goods [p1 , p2 ] are becoming very cheap, and others are not.
p2 might be going to zero much faster than p1 (so z1 (pn ) not necessarily going to ∞) what
you can prove is that you'll load up on something, but may not loading up on everything.
Existance Question:
20
z1 (p∗1 , . . . , p∗L ) = 0
z2 (p∗1 , . . . , p∗L ) = 0
.
.
.
zL (p∗1 , . . . , p∗L ) = 0
Equation Counting:
L equations, L unknowns. But more complicated than this:
Result: If (x∗1 , . . . , x∗I , p∗ ) is a WE, then so is (x∗1 , . . . , x∗I , λp∗ ) ∀λ > 0
This is just saying that if I double prices, the budget constraint gets doubled, so whatever you were
doing before is still optimal. There is no money in this economy.
For the equation counting approach, this poses some diculties. We can just normalize the price of
one good to 1.
So we'll start out saying p∗L = 1. But now have decreased number of unknowns. But now system is
overdetermined (more equations than unknowns).
However, turns out we don't need to worry about this because of Walras' law, which will get rid of 1
equation. This will leave us with (N − 1) equations, (N − 1) unknowns.
Solution: xi (p, wi )
It is telling us in and out of equilibrium: whatever prices are out there, if people report excess demands,
if you add them up, the value of excess demands is 0. Everybody is spending everything they have,
which means that net value of demands is 0. If you're buying something, you must be selling something
to satisfy your budget constraint. Can't have a net decit or a net surplus.
Formally:
Because of Walras' law, to verify that a price vector p0 clears all markets, it suces to check that
it clears all markets but one.
P
• If p0 and z1 (p) = · · · = zL−1 (p) = 0, then because p · z (p) = l pl zl (p) = 0 and pL > 0, we
must also have zL (p) = 0.
This gets rid of an equation, so we we're back to L−1 equations, L−1 unknowns.
[Though remember that equation counting is just a rst step, need to go further]
21
We can do everything in the edgeworth box.
Draw indierence curves from endowment point. Price line will cut in between them towards the
center., with price line
Draw
• Endowment point
∗ The set of Pareto optima in between the two indierence curves are called the con-
tract curve
∗ That is, the set of Pareto allocations that are individually rational
· So each consumer is at least as well o as if they walked away with their initial
endowment
• Move along the contract curve. At each point can draw the common tangent. As long as
everything is continuous, it common tangent must go through contract curve somewhere.
22
Existance of GE
Conditions:
• z (p) is a function dened for all strictly positive price vectors, satisfying conditions 1-5 above
Proposition:
∃p s.t. z(p) = 0
Proof:
Preliminary:
" #
X
Let ∆ = p ∈ RL
+| pi = 1
i
Construct f : ∆→∆
Step 1 :
Construction of the xed-point correspondence for p ∈ interior∆
For p ∈ interior∆
then because of Walras' law [p · z (p) = 0] we have zl (p) < 0 for some l and zl0 (p) > 0 for
some l0 6= l.
Thus, for such a p, any q ∈ f (p) has ql = 0 for some l.
• In contrast
23
z (p) = 0 =⇒ f (p) = ∆
Step 2:
Construction of the xed-point correspondance for p ∈ boundary∆
For p ∈ boundary∆
f (p) = {q ∈ ∆| q · p = 0}
• Because pl = 0 for some l, we have f (p) 6= ∅
• Note that no price on the boundary can be a xed point
That is, p ∈ boundary∆ and p ∈ f (p) cannot occur because p·p > 0 while p·q = 0 for all
q ∈ f (p)
p = 0, 14 , 34 ; q = (1, 0, 0)]
[Ex:
Step 3:
A xed point of f (·) is an equilibrium
∗ We must have p∗ 0
∗ We cannot have z (p∗ ) 6= 0
· Since we saw in step 1 that f (p∗ ) ∈ boundary∆, which is incompatible with
∗
p∗ ∈ f (p) and p∗ 0.
Is f (p) convex?
Yes. (Kakutani's FPT)
Step 4:
The xed-point correspondence is convex-valued and upper hemicontinuous
[See MWG]
Step 5:
A xed point exists.
24
Examples of Non-Existance
• Two classic examples (same as Ch 15)
1. Non-monotonic Preferences
(c) Price of good 2 is zero. Consumer 2 strictly prefers receiving more of good 1 (but
won't). But also prefers to receive more of good 2 at price 0.
2. Nonconvex Preferences
(a) In example, consumer 1's oer curve is disconnected, so it does not intersect consumer
2's
Extra Issues
Uniqueness?
Would be very nice but it's hard to get. (see graph 3 - nothing pathological about this)
25
2. Gross substitutes
(a) If z satises GS if: if p0 and p are s.t. for some l, p0l > pl and p0k = pk ∀k 6= l then
zk (p0 ) > zk (p) ∀k 6= l
(b) This is a strong assumption, but it does get you what you want.
Proof:
By gross substitution, the excess demand of good l cannot decrease in any step, and because
p 6= p0 , it will actually increase in at least one step.
Locally unique if
• Finite number
• Odd number
• z homogeneous of deree 0 in p
L
• pz (p) = 0 ∀p ∈ R++
we can nd an economy that has z as its excess demand function
(Can also go much further and see that this economy is well behaved...)
Set up:
I consumers %i
L goods
26
ωi
Blocking Denition:
L
1. xi ∈ R+ ∀i
P P
2. i xi = i ωi
Must be feasible allocation just to the subset to whom there is one person who can benet (and no
one is worse o )
Core Denition
• Denition
Is core nonempty?
• Indeed, in many games it can be empty.
• But in economic environments we're alright: under a few assumptions it isn't empty.
27
Core when i = 2:
The core for for i = 2 is just the set of Pareto optimal allocations, which can be found by equating the
marginal utilities of the two consumers.
Proposition:
• Any Walrasian Equilibrium is in the core (Assuming all consumers are LNS)
Proof:
• Suppose not in the core. Then we can nd S⊂I and (x0i )i∈S s.t. [from above]
28
• If we just add over people in the coalition
!
X X X X
∗
p x0i − ωi > 0 =⇒ p∗ x0i > p∗ ωi
i∈S i∈S i∈S i∈S
• Intuition: The value of the alternative allocation must be greater than the value of our endow-
ment. Which means it's not feasible for us.
• Converse: Converse (that every core allocation is WE) of course is not true. It will later be
argued that the converse does approximately hold if consumers are numerous.
Core Convergence
In a very large economy, the core and the set of WE are the same. We'll look at economies with N of
each type.
(gure 3)
Start with EW Box economy. Now think of economy with 2 2's and 2 1's.
Look at a coalition with 2 2's and 1 1. A new equilibria will be proposed.
...
So we see that core shrinks as you add consumers.
N-Replica Economy
Debreu-Scarf 1963
• Set up
H types of consumers h = 1, . . . , H
L L
Consumer h has consumption set R+ , %h strictly convex∀h = 1, ..., h, ωh ∈ R+
Replica economy EN :
WE of EN = WE of E1
• Observation 1:
29
WE of EN ≡ WE of E1
Let's start with something that is a WE in E1 . There are prices, people are utility maxi-
mizing, demand = supply.
Now larger economy. Each consumer will do what their type did in smaller economy.
Markets will clear again old WE will still be a WE.
Converse is also true. Because of strictly convex preferences, will be a unique solution is
all maximizing utility subject to budget constraints.
So if demand = supply, it must be that demand=supply for all cross-sections of the economy.
• Proposition:
Any allocation (xhn ) h = 1, . . . , H in the core of EN has the equal treatment property
n = 1, . . . , N
• Proof:
Suppose not.
∗ Choose from every type the person who is treated worst in that type.
PN
Let x0h = 1
N j=1 xhj h = 1, . . . , H
x0h = 1 1
P P P P P
∗ h N h j xhj = N (N h ωh ) = h ωh
• Formally
WLOG suppose that for every type h, consumer h1 is the worse-o individual
1
P
Dene the average consumption for each type: x̂h = N n xhn
Form the coalition S = {11, ..., h1, ...H1} (the worst o members) attaining the average
bundle (x̂1 , ..., x̂h )
∗ See that x̂h %h xh1 for all h and for the group not treated identically (WLOG h = 1)
x̂1 1 x11
30
∗ So will block as long as feasible
Check feasibility:
P P P
∗ Note that since x is feasible, there is y ∈ Y such that h n xhn = y + N ( h ωh )
1 1
P P P P
· Dividing by N: h x̂h = N h n xhn = N y + ( h ωh )
1
∗ By constant returns assumption on Y: Ny ∈Y
Proposition:
Proof:
[Form a blocking coalition by getting rid of one of the most favored and have everybody
else in the coalition]
• Each coalition consumer gets new bundle x0h by dividing most favoreds surplus over the rest of
the coalition
x0h = x∗h + 1
N −1+N (H−1) (x∗1 − ω1 ).
(Dividing what we were handing over to 1, and giving it to everyone else. This will ensure
that demand = supply for people in the coalition)
31
• Argue that for N large enough, this is an unambiguous gain.
1. First we see that p · (x1 − ω1 ) > 0 implies ∇uh (xh ) · (x1 − ω1 ) > 0
2. From Figure 18.B.3 (or Taylor expansion), we see that there is an ᾱ > 0 such that for every
h, uh (xh + α (x1 − ω1 )) > uh (xh ) when 0 < α < ᾱ.
1
3. Hence for any N large enough that
N −1+N (H−1) < ᾱ, the coalition will actually be blocking
• Intuitively, if N is large, each consumer in the coalition is taking only a very small fraction of the
most favored's surplus. Hence the individual gains will be at the margin and thus individually
favorable.
∗ [Look at 2 extremes from no trade, to completely free trade. Could that be bad?]
∗ Because, if that was true, then country could block, and go back to their old way
∗ So Core says somebody must be better o. And actually says there's a net gain.
Then we can have an equilibrium with transfers that makes everyone better o
32
Ch 19: General Equilibrium Under Uncertainty
Easiest examples of states of the world involve things like weather. Because it is a complete
description.
Double tree diagram intermediate time nodes are not states of the world because they
are not complete descriptions
We can extend the previous analysis if we are prepared to (make a big assumption) assume a complete
set of contingent commodity markets. [Arrow (1953), Debreu (1959)]
Example:
• Say price of apple at date 0 is $1, and price of apple at date 1 state 3 is $.50. Why?
Arrow-Debreu
We have contingent commodity markets. Contingent commodities are those whose delivery is
conditional on a certain state of the world being realized. All contingent commodity markets operate
at date 0. People's initial endowments, producers' production plans, and peoples' shares in rms are
also state-contingent. The First and Second Welfare Theorems still hold in terms of ex ante
utility/welfare. Existence is also a-ok as long as we have the convexity assumptions above.
Remember that MRS is the ratio of marginal utilities of goods. This comes in handy in certain
problems. If consumers are risk-neutral, their MRS will equal the probabilities of realizing each state
π1
(i.e. M RS =
π2 ). If there is aggregate risk, the MRS will not be the same as the probability ratio.
[Thanks Heather S]
33
Arrow-Debreu Equilibrium Looking at contingent commodity markets where consumers buy and
sell commitments to receive or deliver certain amounts of contingent commodities if a certain state
occurs. The Walrasian equilibrium in these markets is called an Arrow-Debreu equilibrium.
Formally, an allocation (x∗i , . . . , x∗I , y1∗ , . . . , yJ∗ ) is an Arrow-Debreu eqm if:
Properties of Arrow-Debreu:
• Walrasian Equilibrium
L(S+1)
1. x∗i ∈ R+ , p∗ x∗i ≤ p∗ ωi , xi i x∗i =⇒ p∗ xi > p∗ ωi
P ∗ P
2. i xi = i ωi
ex-ante Pareto optimality implies ex-post Pareto optimality, and hence no ex-post trade
[Risk aversion makes things nice. Recently have been eorts to incorporate. We're not going to
worry about this here]
Example:
L(S+1)
• T = 2, Xi = R+ , xi = x0i , x1si s=1,...,S , ωi = ωi0 , ωsi
1
s=1,...,S
, i has preferences %i
over Xi
πsi usi x0i , x1si
P
Leading expression: s
πsi Vi x0i + δi Vi x1si
P
∗ Consumer has state independent preferences: s
Transition to Arrow: That we have all these contingent commodity markets seems crazy.
34
Sequential Trade - Arrow Simplication
Intuition: Arrow - we can interpret the contingent commodity market equilibrium as:
Instead of contingent commodity markets, assume that at date 0, markets open for L date 0 goods,
and markets for securities.
• Date 1: L markets
Set up
Exchange economy
∗ Xi = RLS
+ ∀i
i0 s
P
∗ Agent preferences: πsi usi (xsi )
∗ Endowments: ωi = (ω1i , . . . , ωSi )
zi = (z1i , . . . , zSi )
$1 in state s
$0 in all other states
Consumer's Problem
X
max πsi Usi (xsi ) s.t.
i
S + 1 budget constraints for each consumer i, (1) for security market, and (2) for each spot
market
35
1. X
qs zsi ≤ 0
s
2.
ps · xsi ≤ ps · ωsi + zsi
(a) consumer believes that at state s this will be the price vector
(b) must obey budget constraint for each state of the world. as long as you're correct
about predicting these prices you'll be able to honor the promises that you've made.
• q ∗ ∈ RS
• p∗ = (p∗1 , . . . , p∗s ) ∈ RLS
• (zi∗ )i=1,...,I , zi∗ ∈ RS ∀i collection of portfolios for consumers
• s.t.
Transition:
1:1 relationship between this equilibrium an the complete market equilibrium (what we got assuming
contingent commodity markets) (30:00)
Arrow → Arrow-Debreu
1. Arrow Optimization Problem
X
max πsi usi (xsi ) s.t.
i
(a)
X
qs zs = 0
s
(b)
ps xsi = ps ωsi + zsi
36
2. Substitute for zsi = ps xsi − ps ωsi , so both budget constraints become:
X
qs (ps xsi − ps ωsi ) = 0
s
3. Re-write as
X
((qs ps ) xsi − (qs ps ) ωsi ) = 0
s
Which is also
Arrow-Debreu → Arrow
1. Arrow-Debreu Optimization Problem
X
max πsi usi (xsi )
xi
s
X X
s.t. p̂s xsi ≤ p̂s ωsi
s s
2. Dene ps , zsi
X
max πsi usi (xsi ) s.t.
i
(a)
X
qs zsi ≤ 0
s
37
(b)
ps xsi ≤ ps ωsi + zsi
X X
= p̂s x∗si − p̂s ωsi = p̂x∗i − p̂ωi = 0
s s
!
X X X
ps x∗i − ωsi =0
i i i
An obvious reaction to what we've done so far is that yes, Arrow has brought us closer to reality
(although RE assumption); but clearly don't have all these futures markets.
So look at incomplete markets.
L
• Security k pays (r1k , . . . , rsk ) where rsk ∈ R+
Best way of thinking of this is buying a share in rm. What are you getting? If the rm is
producing a vector of goods. Can think of it as a shareholder you're getting some portion
of that share of goods.
• RE (rational expectation)
• Radner equilibrium
38
Optimal portfolios zi∗ ∈ RK ∀i
x∗i = (x∗i1 , . . . , x∗iS ) ∈ R+
LS
X
max πsi usi (xsi )
x
s
s.t. qz ≤ 0
Now:
K
X
ps xsi ≤ ps ωsi + zki ps rsk
k=1
2. Markets clear
X
zi∗ = 0
i
X X
x∗si = ωsi ∀i
i i
All we're trying to capture here is that the number of trading opportunities around may be limited
If only one security, no one would trade (there's nothing to trade)
Questions:
• Is it Pareto Optimal?
• First-best - means planner can do better than market, since planner can do things that are not
available in the market
e.g. L = 1, S = 2, K = 0, 1
39
K
!
X X
max πsi usi ωsi + zki rsk
s k=1
s.t. qz ≤ 0
X
2. zi∗ = 0
i
2, 8, 9, 12
i.e. S=4 set (1, 1, 3, 7) and K=2 sec
Planner can't do any better than market does. Planner won't be able to make improve-
ments.
Next time: if have more than 1 good, result goes out the window.
!
X X
Vi (z1i , . . . , zKi ) = πsi usi ωsi + zki rsk
s k
• Prices q1 , . . . , qL
• Consumer i:
max Vi (zi )
s.t. qzi ≤ 0
CE in PO
Meaning?
(zi0 )i=1,...,I 0
Vi (zi0 ) ≥ Vi (zi ) ∀i
P
A planner cannot nd
P s.t. i zi =0 and
Eq q i zi =0
• S = 2, I = 2, L = 2
π1 u1 (x11 ) + π2 u2 (x21 )
40
π1 u2 (x12 ) + π2 u2 (x22 )
• If you could nd 2 market equilibria that are pareto ranked, then you can argue it
• Assume 3 equilibria in each state (see graph), A, B (medium), C in state 1, A', B', C' in state 2
Convey the fact that when you have incomplete markets you're going to have constrained markets,
that this will fall apart when you have more than two goods (and/or more than two dates).
Can have two euqilibrium for whole economy, one at these prices, but if you choose your parameters,
you could have no trading in securities at all, since the prices will be linearly dependent
Start with incomplete markets, add a market, then everyone is worse o
May disagree
To have these Arrow securities, we better be able to verify that the state occurred. It is
plausible that some of these states are not so easy to verify
41
∗ Not a very good story for the following reason:
· S = 3, L = 1, K = 1.
· (1, 2, 3) single rm producing this bundle
∗ Argue: with a security lke this, even if states are not verifyable, ways of creating new
securities
· =⇒ trade derivatives. I.e. I'll pay out 1 in state 1 if my share pays out 1. If
it pays 2 or 3 then I know I don't need to pay.
· can go all the way as long as you can nd one rm in the economy that will
payout dierently in a dierent state of the economy
Part II
• (Assymetric Information)
• Incomplete contracts
• 1st best
• 2nd best
∗ Substute FOC of IC
42
1.1 CARA Utility Model
Lecture, BD 4.2
Not going to try to be very general. Look at a simple situation where you have a principle and an
agent.
• P wants A to do something.
• Assume q =a+ε
Variables
∗ q is revenue
∗ ε is noise
• Won't go much beyond 2 people since we have our hands full
Utility Functions :
• Agent:
2
UA = −e−r(ω− 2 ca )
1
• Principal
UP = q − ω
43
First Best
a is verifyable
• P thinks as follows: suppose I want agent to choose â. What do I have to pay him?
2
−e−r(ω̂− 2 câ ) ≥ −e−rω̄
1
1
ω̂ − câ2 = ω̄ (IR)
2
1
ω̂ = ω̄ + câ2
2
• P will pay using a wage. There is no moral hazard since a is verifyable here. Wage will be best
for both because agent is risk averse, P is risk neutral.
Principal's utility:
1
UP = q − ω̂ = â − câ2 − ω̄
2
Maximization Problem:
1
max UP = max â − câ2
â 2
1
F OC : 1 = câ =⇒ â =
c
Second Best
P doesn't observe a or ε
• Concise Version:
Prinicipal Maximization:
1 1 2 2 s
s.t. a ∈ arg max t + sa − ca − rs σ ⇒ a = (IC)
2 2 c
1 1
t + sa − ca2 − rs2 σ 2 = ω̄ (IR)
2 2
44
Substitute both constraints:
s 1 s2 1
⇒ max − − rs2 σ 2 − ω̄
s c 2 c 2
FOC
1
s=
1 + rcσ 2
• Background:
2
max E −e−r(t+sa+sε− 2 ca )
1
2
UA = −e−r(ω− 2 ca ) ,
1
[Since Agent's utility is: where ω = t + sq = t + sa + sε]
Certainty Equivalance
∗ Agent's problem looks complicated but turns out it isn't, since we can use certainty
equivalent:
where X ∼ (m, v)
1
C.E. of X = m − rV
2
The maximization problem is now
1 1
max t + sa − ca2 − rs2 σ 2
a 2 2
∗ Agent just ends up maximizing (since last term follows out, t follows out):
1
max sa − ca2
a 2
s
a=
c
Agent works harder the steeper the slope of the incentive scheme
45
Intuition:
1 2 2
· The risk premium
2 rs σ , for a given s, is increasing in the coecient or
relative risk aversion (r ) and in the variance of output (σ). It is also increasing
in s, since the higher the s, the more the agent bears the risk associated to q.
• Principal solves
max E (q − t − sq)
s,t
1 1 2 2 s
s.t. a ∈ arg max t + sa − ca − rs σ ⇒ a = (IC)
2 2 c
1 1
t + sa − ca2 − rs2 σ 2 = ω̄ (IR)
2 2
Substitute in from (IR) to remove t:
max E (q − t − sq)
s,t
= max a − E (t + sa)
s,t
1 2 1 2 2
= max a − E −sa + ca + rs σ + ω̄ + sa
s 2 2
1 1
= max a − ca2 − rs2 σ 2 − ω̄
s 2 2
s
s.t. a= (IC)
c
Substite in for (IC) so that a is chosen optimally:
s 1 s2 1
= max − − rs2 σ 2 − ω̄
s c 2 c 2
46
FOCs :
1 s
− − rsσ 2 = 0
c c
1
s=
1 + rcσ 2
• Intuition:
We see s (the eort and variable compensation component) thus go down when c (cost of
eort), r (degree of risk aversion) and σ 2 (randomness of perfomance) go up, a result that
is intuitive.
If s = 1, you are essentially selling the rm to the agent. Will only be s=1 if r=0 or σ 2 = 0)
Firm is worth much more to principal, since agent doesn't like bearing so much risk.
• Probabilities
• Utility functions
Principal
UP = V (q − w)
Agent
UA = u (w) − ψ (a)
47
∗ simplify by assuming ψ (a) = a
First Best
Agent's choice of action is observable (a is observable)
• Strategy
Write as Lagrangian:
• 3 FOCs:
Borch Rule :
V 0 (1 − w1 ) V 0 (−w0 )
= λ =
u0 (w1 ) u0 (w0 )
• We can formulate the same problem through the Agent's maximization problem.
• Strategy:
48
• Agent's maximization problem
First-Best: Examples
1. Risk-Neutral Principal
• Have V (x) = x
Write as Lagrangian:
• 3 FOCs:
Borch Rule :
1 1
=λ= 0
u0 (w1 ) u (w0 )
This implies w1 = w0 = w∗
∗ FOCa : p0 (a) − λ = 0
49
Together, FOCa and the Borch Rule pin down a∗
1
λ = p0 (a∗ ) =
u0 (w∗ )
a∗ = u (w∗ )
• Interpretation
Optimum entails full insurance of agent [u (w ∗ ) in one state = u (w∗ ) in the other]
• Have u (x) = x
• Strategy: Max Principal's utility (choosing a, wi ), s.t. IR
Write as Lagrangian:
• 3 FOCs:
Borch Rule :
V 0 (1 − w1 ) = λ = V 0 (−w0 )
50
This implies: 1 − w1 = −w0 =⇒ w1∗ − w0∗ = 1
∗ FOCa : p0 (a) λ = λ =⇒
p0 (a∗ ) = 1
• Interpretation
Once again, marginal productivity of eort is equated with its marginal cost for the
principal
Second-Best
Agent's choice of action is unobservable (a is unobservable)
• Strategy
∗ Note that a is a choice variable for principal, since IC contraint says that a will be
chosen maximally as the agent would choose
51
max p (a) V (1 − w1 ) + (1 − p (a)) V (0 − w0 )
a,wi
• Write as Lagrangian:
max p (a) V (1 − w1 )+(1 − p (a)) V (0 − w0 )+λ (p (a) u (w1 ) + [1 − p (a)] u (w0 ) − a)+µ (p0 (a) [u (w1 ) − u (w0 )])
a,wi
3 FOCs:
V 0 (1 − w1 ) p0 (a)
= λ + µ
u0 (w1 ) p (a)
V 0 (−w0 ) p0 (a)
= λ − µ
u0 (w0 ) 1 − p (a)
∗ FOCa : p0 (a) (V (1 − w1 ) − V (−w0 ))+p0 (a) λ (u (w1 ) − u (w0 ))−λ+µ (p00 (a) [u (w1 ) − u (w0 )]) =
0
Interpretation
∗ We can see that if µ = 0, then the Borch rule is recovered. However, the optimum is
µ>0 under quite general conditions.
· Agent gets a larger share of the surplus in the case of high performance
· Agent gets a smaller share of the surplus in the case of low performance
52
ω̄, ω, q
Solve for the rst best:
1
aF B =
c
1
If agent works this hard, then
1 q = c +ε
We can choose q s.t. P rob c + ε < q is very small.
What is less obvious if that if we look at agent's marginal incentives.
Suppose he slacks a little bit, then probability of disaster goes up.
d
da P rob[a+c≤q]
What you can show looking at normal density is large.
P rob[a+ε≤q ]
If he deviates a little bit, the risk is still small, but it goes up by quite a bit.
(Intuition 22:30)
Balton-Duetrepon Book Ch 10
Suppose ε ∼ [−K, K]
1
What we can do is to say that we want the guy to choose
c.
1 1
q∈ − K, + K
c c
1
So what we can say is that we'll pay you a at wage unless q falls below
c −K
1
w = w̄ unless −Kε<
c
1
P rob +ε<q
c
So far, trade-o between eort and risk-sharing. People haven't found this to be such an important
trade-o. How do incentive schemes vary with the environment that they are in? Prendergast found
that s↑ in riskier environments. [Perhaps in risky environment it is harder to motivate the agent]
53
Dierent model, where eort isn't the issue, but where choice of task is the right issue.
t + sq ; q − t − sq
s will be the same as the situation in which we had.
B is not veriable.
What is verifyable?
z1 = a1 + ε1
z2 = a2 + ε2
• Assume that V of ε2 = ∞
Hence z2 gives us no information.
So really the only thing we have is
z1 = a1 + ε1
Now assume ε ∼ N 0, σ 2
Incentive Scheme:
Assume B1 > 0, B2 > 0
w = t + sz
E [w] = t + sa
UP = B1 a1 + B2 a2 − t − sa1
What's this worth to agent? Need to do certainty equivalent:
1
UA = t + sa1 − rs2 σ 2 − C (a1 , a2 )
2
This is strictly concave.
I can max some of these, subject to the the incentive constraint:
1
max B1 a1 + B2 a2 − rs2 σ 2 − C (a1 , a2 )
2
s.t. s = C1 ; 0 = C2 (IC)
54
1
max B1 a1 + B2 a2 − rs2 σ 2 − C (a1 (s) , a2 (s))
2
FOC
da1 da2
1 = C11 + C12
ds ds
da1 da2
0 = C12 + C22
ds ds
When you plug in, get a linear equation in s, and so get a formula for s:
C12
B1 − B2 C 22
s=
C2
1 + rσ 2 C11 − C1222
Special cases:
1. C12 = 0
B1
s=
1 + rσ 2 C11
(a) This is telling us that he fact that we have a dierent task doesn't matter.
(b) *benchmark.
2. C12 < 0
(a) I have rasied the numerator, reduced the demoninator relative to benchmark
3. C12 > 0
(a) substitutes
∂s
(b) What you can show is that
∂C12 <0 at C12 = 0
(c) **this is economically interesting, because it gives justication for low-powered incentive
schemes. What one might be concerned about is that we're incentivizing only one thing,
we're going to have the agent move away from things that we might care about.
55
i. If you incentivize doctors according to costs, may compromise on quality.
2 Incomplete Contracting
Theory of the Firm and Incomplete Contracts
Strategies
• First best
All choice variables at disposal of social planner (allows for complete contracting)
• Second Best
Nash Bargaining
• Let
• Nash Bargaining:
P
(S − ūi )
Ui∗ = i
+ ūi
n
56
∗ If they agree that B will purchase S for price p
· No renegotiation =⇒ no spillover
• Setup
Cost
vi2
∗ Each i ∈ {A, B} can acquire skill vi at cost
2θi
Payo
∗ Yes trade
∗ No trade
Ex-Post Bargaining
• First Best
57
Each agent's problem
X vi2
max vi −
vA ,vB
i
2θi
∗ FOC
vi
1= =⇒ vi = θi
θi
X θi2
1 1
θi − = θA + θB
i
2θi 2 2
• Second Best
Set up
· vi and 0, respectively
· vi + vj
1. Gains from Trade: Ex-Post Total Trade Surplus from Nash Bargaining
2. Nash Bargaining Outcome: Ex-Post Individual Trade Surplus from Nash Bargaining (to i
and j)
1
∗ Individual ExPNS =
2 [Total Ex-Post Trade Surplus]
threat point +
(S− i ūi )
P
∗
∗ [See above for Nash Bargaining: Ui =
n + ūi ]
1 vj
(a) i : vi + 2 [(vi + vj ) − (vi + 0)] = vi + 2
1 vj
(b) j : 0+ 2 [(vi + vj ) − (vi + 0)] = 2
58
(a)
h vj i v2
max vi + − i
vi 2 2θi
(b)
hv i
j vj2
max −
vj 2 2θi
i. FOCs
(c)
vi
1= =⇒ vi = θi
θi
(d)
1 vj 1
= =⇒ vj = θj
2 θj 2
i. Add surplus for each agent, plugging in FOC values from (2)
2
θj
2
θj θi θj 2 θi θj θj 1 3
θi + − + − = θi − + − = θi + θj
4 2θi 4 2θj 2 4 8 2 8
5. Interpretation
(b) Would you describe the worker's investment as asset specic? Person specic?
• Setup
∗ B =buyer, S =seller
59
Cost
∗ Cost to seller = 0
i2
∗ Cost to buyer =
2
Payo
∗ Yes trade
∗ No trade
Ex-Post Bargaining
• First Best
∗ In this case, with contracting, the Buyer will be able to take all the surplus
Buyer's
i2
max i −
i 2
∗ FOC
i=1
Set up
· 0 and 0, respectively
60
∗ Total gross surplus:
· i
1. Gains from Trade: Ex-Post Total Trade Surplus from Nash Bargaining
(a) (i + 0) − (0 + 0) = i
2. Nash Bargaining Outcome: Ex-Post Individual Trade Surplus from Nash Bargaining (to i
and j)
1
Individual ExPNS = threat point + 2 [Total Ex-Post Trade Surplus]
1
(a) B : 0+ 2 [i] = 12 i
1
(b) S : 0+ 2 [i] = 12 i
(b)
1 i2
B : max i −
i 2 2
(c)
1
S : max i − 0
i 2
i. FOCs
(d)
1
i=
2
4. Ex-Ante Total Net Surplus
1 1 1 1 1 1 3
· − · + · −0 =
2 2 4 2 2 2 8
Suppose instead B can can λi with λ ∈ (0, 1), by getting the widget from an alternative
seller
Set up
61
· λi for B, 0 for S
· i
1. Gains from Trade: Ex-Post Total Trade Surplus from Nash Bargaining
(a) (i + 0) − (λi + 0) = (1 − λ) i
2. Nash Bargaining Outcome: Ex-Post Individual Trade Surplus from Nash Bargaining (to i
and j)
1
Individual ExPNS = threat point + 2 [Total Ex-Post Trade Surplus]
1 1+λ
(a) B : λi + 2 [(1 − λ) i] = 2 i
1 1−λ
(b) S : 0+ 2 [(1 − λ)] = 2 i
(b)
i2
1+λ
B : max i−
i 2 2
(c)
1−λ
S : max i−0
i 2
i. FOCs
(d)
1+λ
i=
2
4. Ex-Ante Total Net Surplus
" 2 #
2
1 1+λ 1+λ 1 1 1−λ 1 (1 + λ)
· − · + · −0 = −
2 2 2 2 2 2 2 4
• Suppose there is no alternative seller but you can design the bargaining game at date 1. What
game would achieve the rst-best?
62
∗ He will get the widget for free.
i2
[The buyer maximizes i− 2]
1. thinking costs
2. negotiation costs
3. enforcement costs
I can't force you to go from dept X to dept Y, but can exclude you from dept X
∗ Suppose the electricity company can install a boiler which is more or less specic to
the coal or coal mine. Suppose that we can't contract on this in advance. Because we
write an incomplete contract; you can make me pay a lot for this coal because with
this investment, I have very poor outside options, and can therefore jack up price of
coal.
· One I invest in you, my willingness to pay for your coal will be very high
· p = v, v − p − i = i < 0
· But if I buy the coal mine you can't do this
63
Formal Model
|||
1
0 2 invest 1: (S will supply B with one widget)
M1 M2 2 managers
widget
consumers ← a1 ← a2 2 assets
Interpretation
• M1 working with a1
• M2 working with a2
• No long-term contract
• No discounting
• Symmetric info
M1: Invests i →
• R (i) − p (−i) if trade occurs
• R0 (i) > r0 (i, A) ∀A The more A you have, the better o you'll do when contract breaks
p is price of widget (determined at date 1/2, so when get to date 1 it's a sunk cost)
M2: Invests e→
Driving force in this model is ring grocer when don't own the store (they walk away with groceries)
and when you do own the store
3.5 ( )
R (i) − p (−i) if trade with M2
M1: i → payof f =
A − p̄ (−i)
r i; |{z} if trade elsewhere
64
A =assets M 1 owns
p − C (e) (−e) if trade with M1
M2: e → payof f =
p̄ − c(e; B) (−e) if trade elsewhere
B=Assets M2 owns
Leading cases
First-Best
FOCs
R0 (i) = 1
−C 0 (e) = 1
Second-Best
1
1. M1's payo: = r − p̄ + 2 (R − C − r + c) − i
1
2. M2's payo: = p̄ − c + 2 (R − C − r + c) − e
The assumption is at date 1/2, M1 and M2 choose i, e noncooperatively.
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• This suggests we should be looking at nash equilibrium
• But you also have nash bargaining once you reach date = 1
Nash Equilibria:
M1's:
1
max r − p̄ + (R − C − r + c) − i
i 2
1 0 1
F OC : R (i) + r0 (i; A) = 1
2 2
M2:
By parellel argument:
1 1
F OC : − C 0 (e) − c0 (e; A) = 1
2 2
iSB < iF B
eSB < eF B
Assume r0 (i; A) increasing in A.
As we go from NI to VI(1), because A gets bigger, i goes up. iSB ↑. But we will always have
underinvestment.
(We're getting closer to the rst best, but not all the way there)
However, eSB ↓.
What drives this model, is that once I've xed α, outside options play a role.
How do we evaluate?
Surplus
Main result:
Other results
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Bad things about theory
• Hard to test, Ex-post eciency seems to miss a lot of things, Foundational issues
Not the be-all and end-all, but still the one that is used the most
3 Financial Contracting
In Arrow-Debreu, no one ever breaches a contract. But we see in the world obviously that they do.
We'll be talking about branch of literature that instead starts from rst principals.
• Background
A is E 's wealth
∗ I is cost of investment
∗ Payment D if R>D
∗ Audit R−K if R<D
∗ Restrict analysis to when E tells truth. Will report truth when R > D, will be
audited when R<D
• Procedure
(a) PC, L
(b) PC, E
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3.1.2 Maximization Problem
1. E Maximization:
ˆ
max (R − D) p (R) dR
D R≥D
ˆ ˆ
s.t. Dp (R) dR + (R − K) p (R) dR = I − A (PC, L)
R≥D R<D
ˆ
(R − D) p (R) dR ≥ A (PC,E )
R≥D
ˆ ˆ
Rp (R) dR − Kp (R) dR ≥ I
R R<D
ˆ
Rp (R) dR ≥ I
R
(b) We see that I will be lower for K>0 than perfect information case
• Basic idea
Borrower E (entrepreneur)
Cost of audit: K
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• Use Revelation principal
Can restrict attention to situation where people divulging private information tell the truth
∗ payment must be constant over this region, otherwise E will report R that minimizes
payment
• Implication:
No audit ⇐⇒ R > D
ˆ
max (R − D) p (R) dR
D R≥D
ˆ ˆ
s.t. Dp (R) dR + (R − K) p (R) dR = I − A (IR, L)
R≥D R<D
(IR, L): Lender needs amount loaned (RHS) to equal the amount expected in return (LHS).
The LHS is broken into two terms: that expected if R≥D and that expected if R < D.
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(IR, L) not monotonic in D
Maximizes social surplus satisfying (IR, L)
For a project go go ahead, we need to be able to nd a D s.t. (IR, L) is satised and
ˆ
(R − D) p(R)dR ≥ A (IR,E )
R≥D
ˆ ˆ
Rp (R) dR + (R − K) p (R) dR ≥ I
R≥D R<D
We see that this will be less than the risk-averse funding of an investment (First Best):
ˆ
Rp (R) dR ≥ I
R
∗ I make a report, then we have some randomization device to determine whether I get
inspected or not
No outside equity
∗ The insider is the equity holder, and the outsider has debt
· In the world, we see that lender has a mix of debt, equity, other things
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3.2 Moral Hazard Approach (Ā model)
Holmstrom-Tirole
3.2.1 Concise
1. Principal's Problem:
max p2 wH + (1 − p2 ) wL
wH, wL
s.t. p2 wH + (1 − p2 ) wL − e ≥ p1 wH + (1 − p1 ) wL (IC, E)
max p2 wH
s.t. p2 wH − e ≥ p1 wH (IC)
ep2
A ≥ Ā = + [I − p2 RH − (1 − p2 ) RL ]
p2 − p1
4. Interpret:
p2 RH + (1 − p2 ) RL − e − I ≥ 0
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3.2.2 More Detail
In debt contractat least in good states, I get every extra dollar that I make.
E works:
∗ R = RH with prob p2
∗ R = RL with prob 1-p2
E shirks:
∗ R = RH with prob p1
∗ R = RL with prob 1 − p1
• Cost of eort = e
• Only E observes eort decision
(hidden action)
• First-Best
p2 RH + (1 − p2 ) RL − e > I
∗ p1 RH + (1 − p1 ) RL < I
[Principal solves]
max p2 wH + (1 − p2 ) wL
s.t. p2 wH + (1 − p2 ) wL − e ≥ p1 wH + (1 − p1 ) wL (IC)
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(some intuition 32:00)
Simplifying Assumption: wL = 0
WLOG w2 = 0 [This makes life easier, if we can not worry about wL ]
1. Agent Solves:
max p2 wH
s.t. p2 wH − e ≥ p1 wH (IC)
(a) Important to remember (PC) holds with equality, keep inequality on (IC) for below
p2 RH + (1 − p2 ) RL − (I − A) e
wH = ≥
p2 p2 − p1
[Algebra: re-write (IC), (PC) in terms of p2 , substitute:]
e
(p2 − p1 ) wH ≥ e ⇒ wH ≥ p2 −p1 (IC)
p2 RH + (1 − p2 ) (RL ) − (I − A) = p2 wH (PC)
ep2
A ≥ Ā = + [I − p2 RH − (1 − p2 ) RL ]
p2 − p1
• Intuition
p2 RH + (1 − p2 ) RL − e − I ≥ 0
Ā > 0
[Algebra:
FB:−e ≥ −p2 RH − (1 − p2 ) RL + I
SB: A − e p2p−p
2
1
≥ −p2 RH − (1 − p2 ) RL + I
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p2
∗ Can see that
p2 −p1 < 1, so e is being scaled down compared to FB. Hence A needs
to be positive to compensate.
ep1
>0 if marginal project
p2 − p1
If large project, then I>>0, then Ā could be negative. So you're actually raising more than
I.
ep2
p2 RH + (1 − p2 ) RL −
p2 − p1
• First term from rst best, second term from second best. Why?
e
∗ If I get
p2 −p1 if RH .
∗ Otherwise:
ep2 ep1
−e= >0
p2 − p1 p2 − p1
If we could push w2 below 0, would ease borrowing constraint. And OH jokes that public beatings as
way of solving this.
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3.3 Incomplete Contracting-Type Model
3.3.1 Concise
R prob p
R̃1 = { 1
0 prob 1 − p
E pays 0 → continue with prob y0
At date 1, either
E pays D → continue with prob 1
1. Optimal contract solves:
max p (R1 − D + R2 ) + (1 − p) y0 R2
D,y0
s.t. D = (1 − y0 ) R2 (IC,E )
pD + (1 − p) (1 − y0 ) L = I (PC,S )
p (1 − y0 ) R2 + (1 − p) (1 − y0 ) L = I
I
1 − y0 = = Prob of liq if R1 = 0
pR2 + (1 − p) L
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3.3.2 More Detail
Holmstrom-Tirole has become workhorse, but doesn't capture many things. Importance of control and
collateral missing.
Lit: Aghion-Bolton (control) 1992, Bolton-Schertstein (1990,96), Hart-Moore (1994,98)
Investment R1 prob p
R2R̃1 = {
0 prob 1 − p
|||
0 1 2
• Set Up
No discounting
Risk neutrality
At t = 1, liquidate for L?
∗ R2 > L
∗ I>L
Symmetric info
∗ This is what makes problem interesting. Thing that makes him want to hand over to
investor is the threat of liquidation
• Form of Contract
Assume R1 large
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• Incentive Contraint (IC) for E:
R1 − D + R2 ≥ R1 + y0 R2
Can write as D ≤ (1 − y0 ) R2
max p (R1 − D + R2 ) + (1 − p) y0 R2
D,y0
s.t. D ≤ (1 − y0 ) R2 (IC,E )
pD + (1 − p) (1 − y0 ) L ≥ I (PC,I )
· We've made the probability of continuation a little bit higher, increased the
debt a bit.
• Re-write constraints:
D = (1 − y0 ) R2
p (1 − y0 ) R2 + (1 − p) (1 − y0 ) L = I
I
1 − y0 = = Prob of liq if R1 = 0 (PC)
pR2 + (1 − p) L
IR2
(b) We assume: D = (1 − y0 ) R2 = pR2 +(1−p)L < R1
4. Apply that 1 − y0 ≤ 1
I
1 ≥ 1 − y0 =
pR2 + (1 − p) L
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5. Solve for I.
I ≤ pR2 + (1 − p) L
I < pR1 + R2
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