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Pareto Improving Financial Innovation in Incomplete Markets

Author

Listed:
  • David Cass

    (Economics Department [European University Institute] - EUI - European University Institute)

  • Alessandro Citanna

    (GSIA, Carnegie Mellon University - CMU - Carnegie Mellon University [Pittsburgh])

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.

Suggested Citation

  • David Cass & Alessandro Citanna, 1998. "Pareto Improving Financial Innovation in Incomplete Markets," Post-Print hal-00479286, HAL.
    • Handle: RePEc:hal:journl:hal-00479286
    DOI: 10.1007/s001990050198
    as

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    Keywords

    financial innovation; incomplete markets; Pareto;
    All these keywords.

    JEL classification:

    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • D60 - Microeconomics - - Welfare Economics - - - General
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets

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