Credible Forward Commitments and Risk-Sharing Equilibria

Abstract

It is shown that risk-sharing examined in Rothschild and Stiglitz (1976) has a perfect Nash equilibrium, which is unique, incentive-efficient and continuous in all parameters of the economy. Competition in individual markets of a perfectly competitive economy is generally imperfect and allows for cross-market subsidies. Contrary to the commonly accepted view, buyer's valuation of a contract cannot be identified with her valuation of consumption stipulated by that contract. A promise of future performance by a seller lacks credibility whenever its acceptance by buyers leads to a probable violation of seller's resource constraints. This renders vacuous threats to equilibrium that Rothschild and Stiglitz view as leading to extreme market failure.

Keywords: adverse selection, incomplete information, contracts, bankruptcy, insolvency, default, insurance

JEL Classification: C72. D41, D43, D45, D81, D82, D84, G22, G33, L12