Default and Punishment in General Equilibrium

35 Pages Posted: 15 Apr 2003

See all articles by Pradeep K. Dubey

Pradeep K. Dubey

SUNY Stony Brook - Center for Game Theory in Economics

John Geanakoplos

Yale University; Santa Fe Institute

Martin Shubik

Yale University - School of Management; Yale University - Cowles Foundation

Multiple version iconThere are 3 versions of this paper

Date Written: April 2003


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.

Keywords: Default, Incomplete Markets, Adverse Selection, Moral Hazard, Equilibrium Refinement, Endogenous Assets

JEL Classification: D4, D5, D8, D41, D52, D81, D82

Suggested Citation

Dubey, Pradeep K. and Geanakoplos, John D and Shubik, Martin, Default and Punishment in General Equilibrium (April 2003). Available at SSRN:

Pradeep K. Dubey

SUNY Stony Brook - Center for Game Theory in Economics ( email )

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John D Geanakoplos (Contact Author)

Yale University ( email )

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Martin Shubik

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