Default and Punishment in General Equilibrium

39 Pages Posted: 16 Aug 2004

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: July 2004


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.

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 (July 2004). Available at SSRN:

Pradeep K. Dubey

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

Stony Brook, NY 11794
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John D Geanakoplos (Contact Author)

Yale University ( email )

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Santa Fe Institute ( email )

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Martin Shubik

Yale University - School of Management ( email )

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Yale University - Cowles Foundation ( email )

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