7.

General Equilibrium under

Uncertainty
Uncertainty is formalized by the existence of some states of the world s =
1, ..., S. Technologies, endowments and preferences depend on the state of the
world. Assume that S is finite and that different states are mutually exclusive.
A state-contingent commodity vector is x = (x11 , ..., xL1 , ..., x1S , ..., xLS )
RLS is an entitlement to receive commodity vector (x1s , ..., xLs ) if state s S
occurs. Endowments are also contingent: i = (11 , ..., L1 , ..., 1S , ..., LS )
RLS .
Preferences are also contingent on the state of the world: <i on Xi RLS .
The most usual example is that
usi (x1s , ..., xLs )
P of Bernoulli utility functions:
P
0
0
0
with xi <i xi if, and only if, si usi (x1s , ..., xLs ) si usi (x1s , ..., xLs ).
s

For each state, agents have utility functions. An agent is risk-averse if his
utility function is concave, and risk neutral if it is linear. Concave Bernoulli
utility functions imply convex preferences. With one good and two states of the
world, the slope at any point along an indifference curve is given by:
M RS =

1i u0i (x1 )
(1 1i )u0i (x2 )

The set of points on the diagonal, i.e. such that x1 = x2 is the certainty
line. Along those points, the individual faces no risk.
With respect to the production side of the economy, we consider statecontingent production plans yj RLS . Shares ij 0 are not state-contingent.

Arrow-Debreu equilibrium

If at date zero, before the resolution of uncertainty, there is a market for every
contingent commodity ls, then we can introduce the concept of Arrow-Debreu
equilibrium as the relevant equilibrium concept. At date zero, what is being
traded are commitments to receive or deliver amounts of physical good l if state
s occurs. Deliveries are contingent on the state, but payments are not. After
uncertainty is solved, and the agents know the realization of the state, what they
promised to deliver and/or receive at any other state of the world is irrelevant.
The definition of an Arrow-Debreu equilibrium is an allocation (x1 , ..., xI , y1 , ..., yJ )
LS(I+J)
R
and p = (p11 , ..., pLS ) RLS such that:
i) j, yj satisfies pyj pyj yj Yj .
(
)
P

ii) i, xi is maximal for <i in xi Xi such that pxi pi + ij pyj .

j
P
P
P
iii) xi = yj + i .
i

If such date zero (before the resolution of uncertainty) markets exist, the two
welfare theorems apply. Thus, an efficient allocation of risk can be achieved.
1

In order to satisfy convexity of preferences, we need to assume that the utility

functions be concave.
For example, in an economy with two agents, one physical good, and two
states of the world and endowments 1 = (1, 0) and 2 = (0, 1), if utility
functions are Ui (x1i , x2i ) = 1i ui (x1i ) + (1 1i )ui (x2i ), for i = 1, 2, ArrowDebreu equilibrium will imply that the final allocation is an efficient distribution
of risk, in other words, that the final allocation will be in the Pareto Set. This is
11
= 12
,
just a direct application of the First Welfare Theorem. Moreover, if 21
22
then the Pareto set will be the diagonal.
In the case of aggregate risk existing, i.e., if total endowment is different
across states of the world, then the price of a unit of the good delivered in the
state where total endowment is lower is higher than in the other state (assuming
both states happen with the same probability and both agents have the same
expectations on the probabilities).
Example 1 Consider an economy with many identical consumers. The economy lasts two periods. The consumers have identical endowments of trees, .
Each tree yields f1 units of fruit in period 1 and f2 units of fruit in period 2.
Each consumer has utility function u(x1 , x2 ), where xi is fruit eaten in period i.
There are competitive markets in trees, fruit in period 1 and fruit in period 2,
and all clear before period 1. Derive the equation for the price of trees relative
to the price of fruit in terms of the preferences and endowment.
Let t be the number of trees purchased, and z1 , z2 the amounts of fruit purchased in excess of what the trees purchased produce. Then, the consumers
problem is
max u(f1 t + z1 , f2 t + z2 )

z1 ,z2 ,t0

s.t. p1 z1 + p2 z2 + pt t

pt ,

and therefore, the first-order conditions, at an interior solution, are:

u1

= p1

u2

= p2

u 1 f1 + u 2 f2

= pt

Thus, we obtain:
u1
u2
pt

p1
p2
= p1 f1 + p2 f2 ,

which implies that, if we normalize by dividing by the price of fruit in the second
period,
u1
pt
=
f1 + f2 .
p2
u2
2

Example 2 Consider a competitive economy with two periods and two states
of nature. The probability of state 1 is 1/3, and that of state 2 is 2/3. There
are three goods in the economy: a is first period consumption, b1 is second
period state 1 consumption, and b2 is second period state 2 consumption. There
is a continuum of measure 1 of identical consumers, who are expected utility
maximizers, using correct probabilities, and whose utility function is u = 12 ln a+
1
2 ln b. The endowments are the same for every consumer: 12 units of the first
period consumption good and none of the second period consumption good.
There are two types of firms, and a large number of each type (the exact
number is irrelevant, since there are CRS). All firms have CRS. Type 1 firms can
convert 1 unit of first period consumption into 1.25 units of second period state
1 consumption. Type 2 firms can convert 1 unit of first period consumption into
0.5 units of second period state 1 consumption, and 0.5 units of second period
state 2 consumption. Each firm is owned in equal shares by all consumers (since
profits will be zero, the ownership structure is irrelevant).
If there is a complete set of contingent markets, what are the Walrasian
Equilibrium price and quantities?

Radner equilibrium

The next step is to consider what happens if we remove the assumption of

forward markets existing at time zero. Assume that t = 0, 1. There is no information at t = 0, and at t = 1, uncertainty is resolved. From the First Welfare
Theorem, it is clear that agents have no incentive to retrade on spot markets
at t = 1, after resolution of uncertainty. However, if not all the LS contingent
markets exist, it could still be the case that Pareto optimality can be reached.
In order for this to happen, we need consumers to be able to somehow transfer
wealth across states. This is the case when at least one physical commodity
can be traded contingently at t = 0, spot markets open at t = 1, and agents
correctly anticipate spot prices at t = 0.
This way, consumers solve
max Ui (x1i , ..., xSi )

xi RLS

s.t.

X
qs zsi 0 and ps xsi ps si + p1s zsi s
s

Now, zsi is good one traded contingently at time zero, and the price of this
good is qs . Notice that there are S + 1 constraints in total, one for contingent
trade at t = 0, and one for each of the states of the world at t = 1. Of course,
once uncertainty is resolved, only one of the S constraints that are included in
the second condition will actually be in place, the rest of the constraints will be
irrelevant, because those states of the world will never actually happen.
The equilibrium concept in this setting is Radner equilibrium. We will define
what a Radner equilibrium is and then argue that it is equivalent to the ArrowDebreu equilibrium.
3

q RS , ps = (p1s , ..., pLs ) RL s, zi RS i, and xi RLS i constitutes

a Radner equilibrium if

above utility maximization problem.

i) i,
P zi , xi solve
P the P
ii) zsi 0, xsi si s.
i

It turns out that the set of Arrow Debreu and Radner equilibrium allocations
are identical. Formally, this is presented in Proposition 19.D.1 in MWG, which
S
says that if x RLSI , p RLS
++ are an Arrow-Debreu equilibrium, q R++ ,

SI

LS
z R such that x , z and (p1 , ..., pS ) R++ are a Radner equilibrium.
Conversely, if x RLSI , z RSI , q RS++ and (p1 , ..., pS ) RLS
++ are a
Radner equilibrium, then (1 , ..., S ) RS++ such that x , (1 p1 , ..., S pS )
RLS
++ are an Arrow-Debreu equilibrium. The multiplier s is the value, at t = 0,
of a dollar at t = 1 and state s, or the relative value of wealth at t = 1.
Those multipliers will be chosen so that s p1s = qs . It is important that agents
correctly anticipate spot prices at t = 0.

Assets

Assets play the role of transferring wealth across states of the world (or across
time), in a similar way as contingent trade in good 1. A unit of an asset is an
entitlement to receive an amount rs of good 1 at t = 1 if state s occurs. Thus,
we can characterize an asset by its return vector r = (r1 , ..., rS ) RS . Examples
of assets are Arrow security: (0, 0, 0, 1, 0) or a riskless asset: (1, 1, 1, 1).
We assume there is an exogenously given set of K assets, which will constitute the asset structure. These assets have prices (q1 , ..., qK ). We thus generalize
the definition of a Radner equilibrium given the asset structure.

)
q RK , asset prices at t = 0, ps = (p1s , ..., pLs ) RL s, zi = (z1i
, ..., zKi

LS
at t = 0 and xi R at t = 1 are a Radner equilibrium if
a) i, zi , xi solve:
max
Ui (x1i , ..., xSi )
xi RLS
zi RK
P
s.t. i) qk zki 0
k
P
ii) ps xsi ps si + p1s zki rsk s
k
P
P
P
b) zki
0 k, xsi si s.
i

Thus, given the asset structure of the economy, we can define the return
matrix R whose kth column is the return vector of the kth asset. If rank(R) = S,
then the asset structure is said to be complete. If rank(R) < S, the asset
structure is incomplete.
Using this notation, the budget constraint becomes:

Bi (p, q, R) =

p1 (x1i 1i )

Rzi
...
s.t. for some portfolio zi RK , qzi 0 and

pS (xSi Si )

x RLS

If the asset structure is complete, then

i) if x RLSI and p RLS
++ are an Arrow-Debreu equilibrium, then asset

KI
prices q RK
and
z
=
(z
,
such that x , z q, (p1 , ..., pS ) RLS
++
++
1 ..., zI ) R
are a Radner equilibrium.
LS
ii) if x RLSI , z = (z1 , ..., zI ) RKI , q RK
++ , (p1 , ..., pS ) R++ are a
S

Radner equilibrium, then (1 , ..., S ) R++ such that x , (1 p1 , ..., S pS )

RLS
++ are an Arrow-Debreu equilibrium.
Now, if the asset structure is not complete, or K < S, a Radner equilibrium
need not be Pareto optimal.
A way to price assets is by considering that q T = R (there are multipliers
for wealth that make this hold). In other words, the price must satisfy the
arbitrage-free condition.
q RK
++ is arbitrage-free if @ z = (z1 , ..., zK ) such that q z 0, Rz 0 and
Rz 6= 0.
Example 3 The arbitrage-free condition is a way to price an asset. For instance, in the following asset prices:

100, 95

95, 85
1 100, 90

80, 70
1

100, 90

100, 85

85, 75

there are arbitrage opportunities. I can purchase one unit of asset 2 and sell
85
units of asset 1. At t=2, if s=1, then I get 95, pay 95
100 89.5. If s=2, I
85
get 90, while only paying 95 100 89.5. There is no value of > 0 such that
there are no arbitrage opportunities, i.e., such that


 
90
85
95
+
(1 ) .
1,
= 1,
95
100
100
85
95