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Pareto Improving Financial Innovation in Incomplete Markets

Abstract : In this paper we develop a differential technique for investigating the welfare effects of financial innovation in incomplete markets. Utilizing this technique, and after parametrizing the standard competitive, pure-exchange economy by both endowments and utility functions, we establish the following (weakly) generic property: Let S be the number of states, I be the number of assets and H be the number of households, and consider a particular financial equilibrium. Then, provided that the degree of market incompleteness is sufficiently larger than the extent of household heterogeneity, S−I≥2H−1 [resp. S−I≥H+1], there is an open set of single assets [resp. pairs of assets] whose introduction can make every household better off (and, symmetrically, an open set of single assets [resp. pairs of assets] whose introduction can make them all worse off ). We also devise a very simple nonparametric procedure for reducing extensive household heterogeneity to manageable size, a procedure which not only makes our restrictions on market incompleteness more palatable, but could also prove to be quite useful in other applications involving smooth analysis.
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Submitted on : Friday, April 30, 2010 - 4:28:02 PM
Last modification on : Friday, April 30, 2010 - 4:28:02 PM

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David Cass, Alessandro Citanna. Pareto Improving Financial Innovation in Incomplete Markets. Economic Theory, Springer Verlag, 1998, Vol.11,n°3, pp.467-494. ⟨10.1007/s001990050198⟩. ⟨hal-00479286⟩

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