Abstract

In the absence of completeness of financial markets, equilibrium allocations are typically Pareto inefficient. In fact, the set of equilibrium allocation itself may be Pareto ranked, completely.
In economies with real assets, however, Pareto ranking of equilibria is the exception, and it becomes important to formulate an appropriate efficiency criterion. The canonical definition of constrained Pareto optimality (CPO) rests on the idea that the minimal efficiency requirement an equilibrium allocation should satisfy is that it cannot be improved upon by a reallocation of asset holdings, and by the adjustment of prices required to restore the equilibrium in the commodity markets. Adopting the convenient fiction of a benevolent planner, this notion of CPO endows her with fairly limited instruments and, most important, it allows her to affect directly the intertemporal allocation of individual incomes using only the opportunities offered by the set of available assets. The possibility of improving upon the equilibrium allocation using portfolio reallocations rests on the welfare effects of the induced changes in equilibrium prices. Different notions of constrained efficiency can be developed, in much the same spirit, by choosing other policy instruments. It has been shown that, under suitable regularity conditions, price regulation can attain a Pareto improvement over fix-price equilibria. Moreover, taxation of asset trades may also allow for Pareto improvements.
In this project, we consider an alternative notion, which allows the planner to reallocate incomes just in the initial trading period, letting the agents choose their individually optimal portfolios and consumption bundles at the new equilibrium prices. Our notion shares the same basic idea behind the canonical criterion: the planner chooses the value of a policy instrument, allows people to choose their optimal behavior, and adjusts prices to restore market clearing. Evidently, to use period 0 endowment reallocations as policy tools is fully coherent with the absence of some assets. In General Equilibrium Models with Incomplete Markets (GEI), the market failure is due to the distorted intertemporal allocation of incomes. Hence, it could appear harder to improve upon the equilibrium allocations by just reallocating endowments at time 0. A key role is played by the choice of the specific vector of lump-sum taxes, so that the policy intervention is not anonymous. Then, the project´s core issue is "can we improve upon a GEI equilibrium allocation by reallocating just period 0 endowments?". This important question has been around for a long time.