Arrow Debreu Hahn

INTRODUCTION
TO THE
SERIES
The aim of the Handbooks in Economics series is to produce Handbooks for

various branches of economics, each of which is a definitive source, reference,
and teaching supplement for use by professional researchers and advanced
graduate students. Each Handbook pro.vides self-contained surveys of the
current state of a branch of economics in the form of chapters prepared by
leading specialists on various aspects of this branch of economics. These
surveys summarize not only received results but also newer developments,
from recent journal articles and discussion papers. Some original material is
also included, but the main goal is to provide comprehensive and accessible
surveys. The Handbooks are intended to provide not only useful reference
volumes for professional collections but also possible supplementary readings
for advanced courses for graduate students in economics.
K E N N E T H J. A R R O W and M I C H A E L D. I N T R I L I G A T O R
CONTENTS
OF THE HANDBOOK*
VOLUME I
Historical Introduction
PART 1 - MATHEMATICAL METHODS IN ECONOMICS
Chapter 1
Mathematical Analysis and Convexity with Applications to Economics
J E R R Y G R E E N and W A L T E R P. H E L L E R
Chapter 2
Mathematical Programming with Applications to Economics
M I C H A E L D. I N T R I L I G A T O R
Chapter 3
Dynamical Systems with Applications to Economics
H A L R. V A R I A N
Chapter 4
Control Theory with Applications to Economics
DAVID KENDRICK
Chapter 5
Measure Theory with Applications to Economics
A L A N P. K I R M A N
Chapter 6
The Economics of Uncertainty: Selected Topics and Probabilistic
Methods
STEVEN A. L I P P M A N and J O H N H. M c C A L L
Chapter 7
Game Theory Models and Methods in Political Economy
MARTIN SHUBIK
*Detailed contents of this volume (Volume IV of the Handbook) may be found on p. xxi.
vii
viii
Contents of the Handbook
Chapter 8
Global Analysis and Economics

STEVE S M A L E
VOLUME II
Part 2 - MATHEMATICAL APPROACHES TO
MICROECONOMIC THEORY
Chapter 9
Consumer Theory
A N T O N P. B A R T E N and V O L K E R BOHM
Chapter I0
Producers Theory
M. ISHAQ NADIRI
Chapter 11
Oligopoly Theory
JAMES W. F R I E D M A N
Chapter 12
Duality Approaches to Microeconomic Theory

W.E. D I E W E R T
Chapter 13
On the Microeconomic Theory of Investment under Uncertainty

R O B E R T C. M E R T O N
Chapter 14
Market Demand and Excess Demand Functions

WAYNE S H A F E R and H U G O SONNENSCHEIN
Part 3 - MATHEMATICAL APPROACHES TO COMPETITIVE

EQUILIBRIUM
Chapter 15
Existence of Competitive Equilibrium

GERARD DEBREU
Chapter 16
Stability
FRANK HAHN
Chapter 17
Regular Economies
EGBERT DIERKER
Chapter 18
Core of an Economy
WERNER HILDENBRAND
Chapter 19
Temporary General Equilibrium Theory

JEAN-MICHEL GRANDMONT
Chapter 20
Equilibrium under Uncertainty

ROY RADNER
Chapter 21
The Computation of Equilibrium Prices: An Exposition

H E R B E R T E. S C A R F
VOLUME
III
Part 4 - M A T H E M A T I C A L APPROACHES TO
W E L F A R E ECONOMICS
Chapter 22
Social Choice Theory

A M A R T Y A SEN
Chapter 23
Information and the Market

K E N N E T H J. A R R O W
Chapter 24
The Theory of Optimal Taxation

J.A. M I R R L E E S
ix

Chapter 25
Positive Second-Best Theory

EYTAN SHESHINSKI
Chapter 26
Optimal Economic Growth, Turnpike Theorems and Comparative

Dynamics
LIONEL W. McKENZIE
Part 5 - MATHEMATICAL APPROACHES TO ECONOMIC

ORGANIZATION AND PLANNING
Chapter 27
Organization Design
THOMAS A. MARSCHAK
Chapter 28
Incentive Aspects of Decentralization

LEONID HURWlCZ
Chapter 29
Planning
GEOFFREY HEAL
V O L U M E IV
Part 6 - UNCERTAINTY
Chapter 30
Incomplete Markets
MICHAEL MAGILL and WAYNE SHAFER
Chapter 31
The Theory of Value in Security Markets

DARRELL DUFFIE
Chapter 32
Sunspot Equilibria in Sequential Markets Models

PIERRE ANDRI~ CHIAPPORI and ROGER GUESNERIE
Con~n~of~e Handbook
Chapter 33
Utility Theory with Uncertainty

EDI KARNI and DAVID SCHMEIDLER
Part 7 - INFINITE ECONOMIES

Chapter 34
Equilibrium Theory in Infinite Dimensional Spaces

A N D R E U MAS-COLELL and WILLIAM R. ZAME
Chapter 35
Overlapping Generations
JOHN D. GEANAKOPLOS and HERAKLIS M. POLEMARCHAKIS
Part 8 - NON-CONVEXITY AND IMPERFECT COMPETITION

Chapter 36
Equilibrium Analysis with Non-Convex Technologies

DONALD J. BROWN
Chapter 37
Monopolistic Competition
JEAN-PASCAL BIS.NASSY
Part 9 - COMPUTATION AND MATHEMATICAL METHODS

Chapter 38
Computation and Multiplicity of Equilibria

TIMOTHY J. K E H O E
Chapter 39
Non-Standard Analysis with Applications to Economics

ROBERT M. ANDERSON
Chapter 40
Non-Linear Dynamical Systems: Instability and Chaos in Economics

WILLIAM A. BROCK and W. DAVIS DECHERT
xi
PREFACE
TO THE
HANDBOOK
The field of mathematical economics

Mathematical economics includes various applications of mathematical concepts and techniques to economics, particularly economic theory. This branch
of economics traces its origins back to the early nineteenth century, as noted in
the historical introduction, but it has developed extremely rapidly in recent
decades and is continuing to do so. Many economists have discovered that the
language and tools of mathematics are extremely productive in the further
development of economic theory. Simultaneously, many mathematicians have
discovered that mathematical economic theory provides an important and
interesting area of application of their mathematical skills and that economics
has given rise to some important new mathematical problems, such as game
theory.
Purpose
The Handbook of Mathematical Economics aims to provide a definitive source,
reference, and teaching supplement for the field of mathematical economics. It
surveys, as of the late 1970s, the state of the art of mathematical economics.
Bearing in mind that this field is constantly developing, the Editors believe that
now is an opportune time to take stock, summarizing both received results and
newer developments. Thus all authors were invited to review and to appraise
the current status and recent developments in their presentations. In addition
to its use as a reference, the Editors hope that this Handbook will assist
researchers and students working in one branch of mathematical economics to
become acquainted with other branches of this field. Each of the chapters can
be read independently.
Organization
The Handbook includes 40 chapters (published in 4 volumes) on various topics
in mathematical economics, arranged into five parts: Part 1 treats Mathematical
Methods in Economics, including reviews of the concepts and techniques that
xiii
xiv
Preface to the Handbook
have been most useful for the mathematical development of economic theory.
Part 2 elaborates on Mathematical Approaches to Microeconomic Theory,
including consumer, producer, oligopoly, and duality theory. Part 3 treats
Mathematical Approaches to Competitive Equilibrium, including such aspects of
competitive equilibrium as existence, stability, uncertainty, the computation of
equilibrium prices, and the core of an economy, Part 4 covers Mathematical
Approaches to Welfare Economics, including social choice theory, optimal
taxation, and optimal economic growth. Part 5 treats Mathematical Approaches
to Economic Organization and Planning, including organization design and
decentralization. Parts 6 - 9 appear in this volume (Volume IV) of the
Handbook.
Level
All of the topics presented are treated at an advanced level, suitable for use by
economists and mathematicians working in the field or by advanced graduate
students in both economics and mathematics.
Acknowledgements
Our principal acknowledgements are to the authors of chapters in the Handbook of Mathematical Economics, who not only prepared their own chapters
but also provided advice on the organization and content of the Handbook and
reviewed other chapters.
K E N N E T H J. A R R O W
Stanford University
M I C H A E L D. I N T R I L I G A T O R
University of California, Los Angeles
INTRODUCTION
TO VOLUME
IV
1. The Organization of topics

There are many ways to organize the literature of mathematical economics.
Arrow and Intriligator, in their introduction to the first three volumes of the
Handbook of Mathematical Economics, distinguish among the calculus-based
marginalist period (1838-1947), and the set theoretic/linear models period
(1948-1960). They speak further of the period since 1960 as "one of integration in which modern mathematical economics combined elements of calculus,
set theory, and linear m o d e l s . . . [and] mathematical ideas have been extended
to virtually all areas of economics." They identify for the period of 1961 to the
late 1970s eleven important topics that were the subject of significant study by
mathematical economists:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Uncertainty and Information

Global Analysis
Duality Theory
Aggregate Demand Functions
Core of an Economy and Markets with a Continuum of Traders
Temporary Equilibrium
Computation of Equilibrium Prices
Social Choice Theory
Optimal Taxation
Optimal Growth Theory
Organization Theory
The task of explaining the development of mathematical economics since the

appearance of the first three volumes of the Handbook, although significantly
less daunting than summarizing the development of mathematical economics
previous to the late 1970s, presents a substantial challenge. Our challenge
follows from the observation that a very large share of the research recently
undertaken by the mathematical economists can be distributed among three
categories:
Decision Theory and Game Theory
Extensions of the Classical Model of General Equilibrium
Mathematical Methods
XV
xvi
Introduction to Volume IV
Game theory has developed in significant ways since the appearance of the
first three volumes of the Handbook. The conceptual foundations have been
broadened and strengthened, a variety of solution concepts have been developed, and there has been an explosion in the application of game theory to
economic models. The forthcoming Handbook of Game Theory, edited by
Aumann and Hart, will cover developments on that front, and so we have
concentrated on the second and the third of the categories listed above. This
accounts for the fact that no chapter on game theory and only one chapter on
individual decision theory are included in this volume. The emphasis in this
volume on choice under uncertainty, general equilibrium analysis under conditions of uncertainty, economies with an infinite number of consumers or
commodities, and dynamical systems reflects some of the ideas that have been
most influential in mathematical economics since the appearance of the first
three volumes of the Handbook.
2. The chapters
General equilibrium theory has been and continues to be an extraordinarily
fruitful area for mathematical economics. Much of the challenge in recent years
has been to expand the Arrow-Debreu-McKenzie model to include features
that show promise of significantly enhancing our understanding of actual
markets. The classical questions of the existence of equilibrium (Chapter 15,
Volume II of the Handbook by G6rard Debreu) and efficiency of equilibrium
[Debreu (1959)], as well as more recent concern with the determinacy of
equilibrium [Debreu (1974)] provide much of the framework for the analysis
(see also Chapter 8, Volume I of the Handbook by Steve Smale).
The papers of Parts 6, 7 and 8 accord particular attention to three adjustments to the Arrow-Debreu-McKenzie model. First, in economies with
uncertainty one does not see markets that permit agents to hedge against all
conceivable future events. How does this affect the classical welfare theorems?
Under what conditions can the existence of equilibrium be established?
Second, certain economic ideas, for example the institution of a social security
system, depend on there being no final cohort of consumers and no final date.
There are thus an infinite number of consumers and an infinite number of
commodities. How does the presence of an infinite number of commodities
and/or consumers affect the existence, determinacy and efficiency of equilibrium? Third, the standard model of general equilibrium does not apply when
there are monopolistic elements or increasing returns in production. Can these
elements be incorporated in a mathematically precise model of general equilibrium? To what extent can one incorporate the classical remedies for market
failure into such an analysis?
xvii
Part 6 - Uncertainty
In Chapter 30, "Incomplete Markets," Michael Magill and Wayne Shafer

consider a generalization of the Arrow (1953) model of equilibrium with
uncertainty in which trading in assets is used to transfer income across time and
states of the world. The primary interest is in the case in which the asset
market is incomplete. Using new techniques, the authors establish the existence of equilibrium, show that equilibria may fail to be efficient, and analyse
the determinacy of equilibrium. This chapter is related to Chapter 20, Volume
II of the Handbook, by Roy Radner.
Chapter 31 "The Theory of Value in Security Markets," by Darrell Duffle
bridges the areas of general equilibrium theory and finance. Building upon
Arrow's theory of value for security markets [Arrow (1953)], the present
literature explicitly treats multi-period trading opportunities under uncertainty
and incomplete markets. This chapter emphasizes the valuation of financial
assets that arise from the requirement that prices be arbitrage free and that
preferences be of special forms. It is most related to Chapter 13, Volume II of
the Handbook, by Robert C. Merton.
In rational expectations models, the possible existence of "sunspot" equilibria leads to indeterminacy of equilibrium and failure of efficiency. Pierre Andr6
Chiappori and Roger Guesnerie, in Chapter 32, "Sunspot Equilibria in Sequential Markets Models," carefully survey this literature, primarily in the
framework of the overlapping generations model. They provide an extensive
analysis of the conditions under which determinacy and efficiency will be
satisfied.
Chapter 33 is titled, "Utility Theory with Uncertainty" and is authored by
Edi Karni and David Schmeidler. In the past few decades the modelling of
individual behaviour in the presence of uncertainty has been the source of
several important contributions to mathematical economics. Further, a large
portion of the current work on mathematical economics incorporates models of
utility maximization with uncertainty. In Chapter 33 Karni and Schmeidler
provide us with a careful exposition of the von Neumann and Savage theories,
and trace the subsequent developments of the theory, with an emphasis on the
relaxation of the independence axiom and the sure-thing principle. This
chapter has as a counterpart the analysis of consumer theory under conditions
of uncertainty that appears in Chapter 9, Volume II, of the Handbook, by
Anton P. Barten and Volker B6hm.
Part 7 - Infinite e c o n o m i e s
Infinite dimensional commodity spaces occur naturally in models with an

infinite time horizon, in models of commodity differentiation, and in models of
xviii
Introduction to Volume I V
decision making with uncertainty. In Chapter 34, "Equilibrium Theory in

Infinite Dimensional Spaces," Andreu Mas-Colell and William R. Zame survey
the results obtained in the last decade in extending the A r r o w - D e b r e u McKenzie model to allow for infinite dimensional commodity spaces. Existence
and efficiency are established under general conditions, but determinacy of
equilibrium remains an open problem.
In Chapter 35, "Overlapping Generations," John Geanakoplos and Heraklis
Polemarchakis examine the Allais (1947) and Samuelson (1958) overlapping
generations model and give a comprehensive survey of recent results. Existence of equilibrium is obtained under general conditions; however, equilibria
are not in general efficient and determinacy may fail to be satisfied.
Part 8 -Non-convexity and imperfect competition
Chapter 36, "Equilibrium Analysis with Non-Convex Technologies," by

Donald Brown, is related to the classical analysis of the optimal regulation of
publicly owned firms when technology exhibits increasing returns to scale.
Solutions such as marginal cost pricing, average cost pricing, and two-part
tariffs are placed into a rigorous general equilibrium framework and the
existence, determinacy, efficiency, and the computability of equilibrium are
considered. Although somewhat different in spirit, this chapter is most related
to Chapter 25 in Volume III of the Handbook, by Eytan Sheshinski.
The term "monopolistic competition" applies when firms set the prices for
differentiated products, firms disregard the effects of price decisions on actions
of competitors, and there is free entry. In Chapter 37, "Monopolistic Competition," Jean-Pascal B6nassy summarizes the conceptual problems associated
with the modelling of monopolistic competition and provides a synthetic
analysis of the literature on the subject. Applications to macroeconomics are
provided.
Part 9 - Computation and mathematical methods
Many useful applications of general equilibrium analysis require numerical

computation of equilibria. In Chapter 38, "Computation and Multiplicity of
Equilibria," Timothy Kehoe extends the analysis of computation in Chapter
21, Volume II, by considering a variety of standard models, including Walrasian models with production and overlapping generations models. Particular
attention is devoted to problems that arise when there are several equilibria
and to techniques that employ special structure of models.
Non-standard analysis is a powerful mathematical technique, which has been
xix
particularly important in the work on large economies. In Chapter 39, "NonStandard Analysis with Applications to Economics," Robert Anderson presents an introduction to non-standard analysis and provides a survey of its
applications to mathematical economics and other areas. This subject did not
receive attention in the first three volumes of the Handbook.
The use of non-linear dynamical models in economics has undergone substantial development since the appearance of the first three volumes of the
Handbook (see Chapter 3, Volume I by Hal R. Varian). In Chapter 40,
"Non-Linear Dynamical Systems: Instability and Chaos in Economics," William A. Brock and W. Davies Dechert survey the literature on measures of
complexity for dynamical systems and test for the presence of complex
dynamics in the time series data. They illustrate how these ideas are being used
in economics.
References
Allais, M. (1947) Economie et int~r~t (two volumes). Paris: Imprimerie Nationale.
Arrow, K.J. (1953) 'Le r61e des valeurs boursi6res pour la r6partition la meiUeure des risques',
Economdtrie, 41-47, (1953) Discussion, in: Colloques lnternationaux du Centre National de la
Recherche Scientifique No. 40 (Paris 1952). Paris: CNRS, English translation as 'The role of
securities in the optimal allocation of risk bearing' (1964) Review of Economic Studies 31: 91-96.
Debreu, G. (1959) Theory of value. New York, London, Sidney: Wiley.
Debreu, G. (1974) "Economies with a finite set of equilibria', Econometrica 38: 387-392.
Samuelson, P.A. (1958) 'An exact consumption-loan model of interest with or without the social
contrivance of money', Journal of Political Economy 66: 467-482.
Acknowledgements
The authors of chapters served also as reviewers of other chapters. It is a
pleasure to thank them all, and in particular to thank Wayne Shafer for his
advice on the introduction. Most of the chapters have been presented and
discussed during BoWo'89 (Bonn Workshop in Mathematical Economics 1989).
These extensive discussions greatly improved and unified the presentation. The
Workshop was financed by the Deutsche Forschungsgemeinschaft, GottfriedWilhelm-Leibniz-F6rderpreis. The financial support is gratefully acknowledged.
W E R N E R HILDENBRAND
University of Bonn
H U G O SONNENSCHEIN
Princeton University
Chapter 30
INCOMPLETE
MARKETS
MICHAEL MAGILL and WAYNE SHAFER*
University of Southern California
Contents
1.
2.
3.
Introduction
Real assets
1524
1527
2.1.
2.2.
2.3.
2.4.
1527
1539
1547
1557
Nominal assets
3.1.
3.2.
4.
5.
Indeterminacy of GEl equilibrium with nominal assets

Monetary equilibrium and real effects of money
Production and the stock market

Efficiency properties of markets
5.1.
5.2.
6.
Two period exchange economy

Generically complete markets
Incomplete markets
Stochastic exchange economy
Inefficiency in exchange
Inefficiency in production
Concluding remarks
6.1.
6.2.
6.3.
6.4.
6.5.
Interface with finance

Secondary assets
Endogenous asset formation
Bankruptcy
Alternative approaches to firm behavior
References
1565
1567
1573
1576
1590
1590
1601
1607
1607
1607
1608
1609
1609
1610
*We are grateful to the National Science Foundation (NSF Grant SES-870990) and Deutsche
Forschungsgemeinschaft, Gottfried-Wilhelm-Leibniz-F6rderpreis, for research support. We
thank participants in BoWo'89 for stimulating feedback. Our greatest debt is to Werner Hildenbrand for conceiving BoWo'88 and BoWo'89 and for his constant encouragement in our joint
research project with Martine Quinzii on Incomplete Markets. Only Martine Quinzii knows how
much we owe to her.
Handbook of Mathematical Economics, Volume IV, Edited by W. Hildenbrand and H. Sonnenschein

Elsevier Science Publishers B.V., 1991
1524
M. Magill and W. Shafer
I. Introduction
The principal objective of general equilibrium theory is to study the allocation
of resources achievable via a system of markets. If all activity in an economy
could be viewed as taking place in a single period then it would perhaps be
reasonable to assume that markets are complete; that is, there is a market and
an associated price for each good. This is the environment of the classical
theory of resource allocation which finds its most elegant synthesis in the
A r r o w - D e b r e u theory [Debreu (1959)]. As soon as we are concerned with a
world in which time and uncertainty enter in an essential way it is no longer
reasonable to assume the existence of such a complete set of markets: we must
enter the world of incomplete markets. The object of this chapter is to lay out
briefly the principal contributions that have been made to this branch of
general equilibrium theory since the survey article of Radner (1982).
The basic objective of the theory of incomplete markets is to extend the
general equilibrium analysis of markets from the classical A r r o w - D e b r e u
f r a m e w o r k ( G E ) to a more general model with real and financial markets in
which the structure of the markets is incomplete ( G E l ) . The idea is to retain
the simplicity, coherence and generality which are the hallmarks of the
A r r o w - D e b r e u construction while moving the nature of actual markets,
contracts and constraints on agent participation into closer conformity with the
actual structure of markets observed in the real world. Thus in addition to the
traditional real spot markets for goods, there is a rich array of financial markets
such as bond and equity markets, not to speak of options, futures and
insurance contracts, as well as contracts between firms, between employees and
firms and so on. T o model all these markets and contracts in a way that
enhances our understanding of the roles they play in the overall problem of
arriving at an actual allocation of resources over time is a challenging task on
which significant progress has recently been made. Far more of course remains
to be understood. But we are not alone in the profession in our conviction that
a microeconomic foundation for macroeconomics may ultimately come from a
m o r e concrete version of general equilibrium theory in which there is trading
on real and financial markets, where nominal contracts and money enter in an
essential way, but where the ability to trade into the future is limited by the
incompleteness of markets and by the unwillingness or inability of agents to
make more than limited commitments into the future [see Keynes (1936),
A r r o w (1974), Tobin (1980)].
Much of economic theory can be viewed as a study of the causes and
consequences of market failure, with special emphasis on the consequences of
market failure for subgroups of agents or for society as a whole. In such an
Ch. 30: Incomplete Markets
1525
investigation the Arrow-Debreu theory provides the idealised framework in

which markets function at their best. The phenomenon of incomplete markets
taken in its broadest sense includes the classical concept of missing markets
arising from externalities and public goods. However for the purposes of this
survey we interpret the theory of incomplete markets in the narrower sense of
being that branch of economic theory which studies the causes and consequences of incomplete financial markets in a general equilibrium framework
of risk and uncertainty over time. The general equilibrium model that forms
the basis for the analysis satisfies all the idealised assumptions of the standard
Arrow-Debreu model except that it has incomplete markets. While the model
is thus unrealistic in that it retains the remaining idealised assumptions, it
provides a setting in which the effects of this particular market failure can be
isolated and studied.
Classical general equilibrium theory (GE) as synthesised by Arrow-Debreu
has the property of being theoretically the most elegant and yet empirically one
of the least satisfactory parts of the economic theory. It is elegant, because
within the context of a precisely formulated set of hypotheses it leads to a clear
and simple explanation of how an idealised system of markets allocates
resources and achieves what amounts to a best possible solution to the problem
of resource allocation. GE crystallises a classical tradition in economic theory
that has its origin in Adam Smith's theory of the invisible hand, by which a
competitive system with market prices coordinates the otherwise independent
activities of consumers and producers acting purely in their self-interest. A
central conclusion is the idea of laisser-faire: the government should not
interfere with the system of markets that allocates resources in the private
sector of the economy.
GE however stands on shaky empirical foundations: one of its key hypotheses is far from being satisfied. We live in a world in which time and uncertainty
enter in an essential way and in which the system of markets is incomplete.
What is needed is an extension of classical GE which explicitly allows for the
fact that markets are incomplete and it is to this issue that the analysis that
follows addresses itself. We begin by recalling the market structure of GE, the
system of contingent markets. We then introduce the more general market
structure of GEI consisting of a system of spot markets for real goods coupled
with a system of financial markets.
Most of the theory is very recent, having its origins in the classical papers of
Arrow (1953), Diamond (1967), Radner (1972), Drbze (1974) and Hart
(1975). An extensive array of new results has been obtained in the last five
years which seems to call for a re-examination of the status of the theory. What
are the central issues which emerge? In this survey we focus principally on the
consequences as opposed to the causes of incomplete markets: from this
perspective, three basic messages stand out.
1526
M. Magilland W. Shafer
(1) The non-neutrality of financial instruments and the role of money

(2) The conflicting objectives of firms
(3) The potential inadequacy of a decentralised system of markets
These three topics motivate the basic layout of the paper. Thus in Sections 2
and 3 which analyse the G E I model of an exchange economy we find that when
markets are incomplete, changing the financial instruments, or when nominal
assets are present, changing the money supply leads to a change in the
equilibrium allocation; in short financial instruments and money are nonneutral. Section 2 also contains a systematic analysis of the concepts and
mathematical techniques needed for a p r o p e r understanding of the behavior of
G E l equilibria. While real assets are inflation proof, nominal assets are not.
The economic consequence is the striking property exhibited by the G E l model
with nominal assets: indeterminacy if the model is left unchanged (Section 3.1)
and non-neutrality of money if a role is introduced for money as a medium of
exchange (Section 3.2).
Section 4 presents an analysis of the G E l model of a production economy: it
is here that the theory still encounters great difficulties. When markets are
incomplete each firm faces a public goods problem with respect to its constituency of shareholders (and employees) for which there is no evident
solution. We try to bring together the different theories under a common
framework, but cannot claim to have advanced the theory much beyond the
contribution of Grossman and Hart (1979).
When markets are incomplete it should hardly be surprising that equilibrium
allocations are inefficient. What is interesting is to understand the cause of the
inefficiency: this is the subject of Section 5. From a policy point of view (i.e.
should the government intervene or not) what is significant is the magnitude of
the distortions which the inefficiency theorems assert are generically present at
an equilibrium. While the analysis of Section 5 indicates in principle how
estimates of these magnitudes could be made, to our knowledge no such
estimates have yet been made.
We have attempted to present a reasonably coherent view of the current
status of the theory of incomplete markets. In emphasising conceptual continuity we have had to sacrifice a number of important ideas which are dealt
with in only a cursory way in Section 6.
A clarifying comment is perhaps in order regarding the relation between the
concept of equilibrium which forms the basis for the analysis which follows and
that which is used in the related area of temporary equilibrium theory. In a
model in which time and uncertainty enter in an essential way, a concept of
market equilibrium involves two subordinate concepts: one regarding expectation formation and one regarding market clearing. Agents must form expectations about future prices in order to determine their market demand decisions:
Ch. 30: lncomp~ Marke~
1527
These demand decisions are then used via market clearing to determine prices.
In a temporary equilibrium agents form expectations (ex ante) about future
spot prices which are not necessarily fulfilled (ex post): in addition, at a given
date, only the current spot markets are required to clear, no condition being
imposed on future spot markets. This framework provides a natural and
powerful tool for analysing the consequences of incorrect and hence changing
price expectations: it has been the subject of an extensive literature which is
surveyed in G r a n d m o n t (1982, 1988). However when financial markets enter in
an essential way (that is when arbitrage and information are important), a
richer theory can be developed if the much stronger assumption regarding
expectation formation is made that agents correctly anticipate future prices and
all future markets are also cleared. This leads to the concept which Radner
(1972, 1982) has called an equilibrium of plans, prices and price expectations
which forms the basis for the analysis that follows. It should be noted that this
concept permits agents to hold different probability assessments regarding
future events. In the special case where all agents hold common probability
assessments this concept reduces to what is referred to in macroeconomics as a
rational expectations equilibrium.
2. Real assets
2.1. Two period exchange economy

In this section we introduce the basic exchange economy and the concepts of a
G E and a G E l equilibrium. The model which underlies the first part of our
analysis is the simplest two period exchange economy under uncertainty. The
economy consists of a finite n u m b e r of agents (i = 1 , . . . , I) and a finite
n u m b e r of goods (l = 1 , . . . , L). T o capture both time and uncertainty in the
simplest way we consider a model with two time periods (t = 0, 1) in which one
of S states of nature (s = 1 , . . . , S) occurs at date 1. For convenience we call
date t = 0, state s = 0 so that in total there are S + 1 states. The main results
that follow can be extended to a stochastic process over many time periods
(Section 2.4).
Since there are L commodities available in each state (s = 0 , . . . , S) the
commodity space is ~" with n = L(S + 1). Each consumer i (i = 1 , . . . , I) has
an initial endowment of the L goods in each state, to i = (wi0, ofl~. . . . , ~Os).
Since consumer i does not know which state of nature will occur at date 1, the
e n d o w m e n t at date 1, o fI = ( w i l , . . . , ~Os), is a random variable. For concreteness we can think of agent i's endowment w ~C ~n as giving the output at dates
0 and 1 of a farm owned by agent i. The preference ordering of agent i is
represented by a utility function,
M. Magilland W. Sharer
1528
ui:~+--*~,
i=l,...,l,
defined over consumption bundles x i= (Xo, xil . . . . , Xs) lying in the two-period
consumption set X i = E+. A useful example of a utility function is given by the
von N e u m a n n - M o r g e n s t e r n expected utility function
S
i
U(Xo, X1 . . . . .
XS) = E Ps U i(xo,
i Xs)
i
s--I
S
where Ps > 0 denotes the probability of state s and Es= 1 Ps = 1. But the results
that follow in no way depend on such a special form.
Since most of the mathematical proofs that follow are based on the use of
differential topology [see Guillemin and Pollack (1974)] we invoke the classical
smooth preferences introduced by D e b r e u (1972). The characteristics of agent i
are thus summarised by a utility function and endowment vector (u i, w i)
satisfying:
Assumption 1 (agent characteristics). (1) u i : E+ --~ R is continuous on E+ and
on E++ ; (2) if Ui(~:) = {x E E+ I ui(x) >~ui(~)} then U ' ( ~ ) C ~_
V~: E
E++; (3) for each xEE++, Du~(x)EE++ and hVDZug(x)h<O for all h e 0
such that Du~(x)h = 0; (4) w i ~ R++.
Let (u, w) = (u ~, . . . , u t, o91, . . . , wz). The collection of I agents with their
characteristics (u, w) constitutes the smooth exchange economy ~(u, w) which
forms the basis for our initial analysis.
A n allocation of resources for the economy ~(u, w) is a vector of consumption bundles x = (x ~, . . . , x ~) E R+I. Equilibrium theory can be viewed as the
qualitative study of the allocations that arise when we adjoin different market
structures to the basic exchange economy ~(u, w). We will study two such
market structures: first a system of contingent markets and second a system of
spot and financial markets. The former leads to the standard general equilibrium model (GE) of A r r o w - D e b r e u , the latter to the general equilibrium
model with incomplete markets (GEl). For the exchange economy ~(u, o9) the
difference between these two models reflects itself in the different budget sets
that agents face in these two market environments.
Contingent markets ( GE )
A contingent commodity for good l (l = 1 . . . . , L ) in state s (s = 0 . . . . , S) is a
contract which promises to deliver one unit of good l in state s and nothing
otherwise. The price of this contract /'st (measured in the unit of account) is
payable at date 0. If there is available at date 0 a complete set of such
contingent contracts (one for each good in each state) then each agent i can sell
1529
his e n d o w m e n t to i = (to o, ojil . . . . . OJs) at the prices P = (Po, P, . . . . . Ps)

where Ps = ( P s i . . . . . P~L), to obtain the income Pw i= Es=0 Psw~ and can
purchase any consumption vector xi=(Xo, Xil,... ,Xs) satisfying Px i=
S
Es=0
P~Xsi ~~ PoJ.i (Note that we will always write prices as row vectors and
quantities as column vectors so that Px i is the standard scalar product of P and
xi.) Agent i's contingent market ( G E ) budget set is thus defined by
B(P,
= (x'
R% I P(x'- o/) = 0}.
Definition I. A contingent market (CM) equilibrium for the economy $ ( u , to)

is a pair of actions and prices ( 2 , / 5 ) = 071. . . . . 2 I,/5) such that
(i) 2i, i = 1 . . . .
2i=
arg
, I satisfy
max{ui(x i) Ix i E B(P, o9i)}
(ii) E~=, (.f' - to ~) = O.

We also refer to such an equilibrium as a GE equilibrium.
Spot-financial markets (GEl)

A system of contingent markets is a market structure that is principally of
theoretical interest: it can be viewed as an ideal system of markets. It is far
removed however from the sequential structure of markets that is typical of
actual decentralised market economies. To model such a sequential structure
we introduce a collection of real spot markets for each of the L goods at date 0
and in each state s at date 1, together with a system of financial markets. The
spot markets lead to a system of S + 1 budget constraints; the financial markets
provide instruments that enable each agent, at least to some extent, to
redistribute income across the states, thereby reducing the constraints imposed by the basic spot market equations. More precisely, let p =
(P0, P l , - - . , Ps) E~++ denote the vector of spot prices, where ps =
( P s i , - . - , PsL) and Psi denotes the price (measured in units of account)
payable in state s for one unit of good I. The essential distinction between a
spot market in state s and a contingent market for state s is that in the former
the payment is made at date 1 in state s (ifs ~> 1), while in the latter it is always
made at date O. It is this property that leads to the system of S + 1 budget
constraints under a system of spot markets and to a single budget constraint
with a system of contingent markets.
The financial assets we consider will be one of three basic types or a
combination of these three: real assets (such as the equity of firms or futures
M. Magill and W. Sharer
1530
contracts on real goods), nominal assets (such as bonds or financial futures),

and secondary or derivative assets (such as call and put options). In each case
we assume that there is given a system of J financial assets where asset j can be
purchased for the price qj (units of account) at date 0 and delivers a r a n d o m
return V ~ = (V~ . . . . , V~) r across the states at date 1 where the transpose T
indicates that V j is written as a column vector and where V~ is measured in the
unit of account. The J column vectors V j can be combined to form the date 1
matrix of returns
V ~- [ V 1
"-"
vl ..-v.1] .
V J] =
"
(1)
v I
V generates the subspace of income transfers ( V ) , namely the subspace of Ns

spanned by the J columns of V
(2)
Definition 2. If the subspace of income transfers satisfies ( V ) = Ns then the
asset structure is called complete. If ( V ) # Ns then it is incomplete.
Let z i = (zi~. . . . , z ) ) C NJ denote the n u m b e r of units of each of the J assets
purchased by agent i (where zZj < 0 means short-selling asset j ) , then the S + 1
budget constraints can be written as
po(Xio - wo) = - q z i
(3)
p,(x~-w!,)=V,z i ,
s=l .....
where q = ( q l , , qJ) and V, = ( V ~ , . . . , V{) is row s of the matrix V. If we

define the full matrix of returns (i.e. date 0 and date 1)
-ql
....
V~
""
W(q,V)=[vq]=
L
and for p E EL(s+1), x s E
VJ
(4)
~L(S+I)
p D x ' = (PoXio, p , x i l , . . . ,
ql]
define the box product
psXs)
then agent i's G E l budget set is given by
1531
N ( p , q; o f ) = ( x ' C N+ I P [] (x' -- ca') = W ( q , V ) z i, z i e R J}.
(5)
Definition 3. A spot-financial market ( F M ) equilibrium for the e c o n o m y

~ ( u , to) is a pair of actions and prices ( ( , f ) , ( f i , c ~ ) ) = ( ( f l , . . .
,1,
-i
f l ) , (fi, ~ ) ) such that
(i) (2', ~ ' ) , i = 1 . . . . .
I satisfy
lx i E N ( f i , q ; t o g ) }
i=argmax{u'(xi)
p-[]( i - w i ) = w i i,
and
(ii) Xf__ 1 (.~i -- o)i) = O,

(iii) 2 ~= l i i = O.
We also refer to such an equilibrium as a G E l equilibrium.
Real assets
T h e first class of financial assets that we want to analyse is the class of real
assets. A real asset j is a contract which p r o m i s e s to deliver a vector of the L
goods (written as a c o l u m n vector)
Aj = (A~I . . . .
A{L) ~ C ~c ,
s = 1, . . . , S
in each state s = 1 , . . . , S at date 1. A real asset is thus characterised by a date

1 c o m m o d i t y v e c t o r A j = (A{ . . . . . A~) r E NLS (written as a column vector).
T h e r e v e n u e it yields in state s is p r o p o r t i o n a l to the spot price p,
V~:p~'A~,
s:l
....
,S
If there are J real assets then the date 1 matrix of returns (1) is given by
"
PlAl
V= V(p,) =
: 1
.psAs
"-
ps;4~J
w h e r e p , = ( P l , - , Ps) E ~ L S is the date 1 vector of spot prices. If we let Ps

d e n o t e the row v e c t o r ( P s i , . . . , PsL) then we can also write V as
V(p,) =
...
...
o IFA',
o[14,
'
p,
.-
A~]
..
A~J
1532
M . Magill a n d W. S h a f e r
Real assets are inflation-proof in the sense that doubling the spot prices in
state s doubles their income. Thus with real assets if (rio, fi~ . . . . . fis, q) is an
equilibrium price vector then (%fi0, alfil . . . . . asfi s, ao~ ) with a s > 0, s =
0 . . . . , S is also an equilibrium price vector. In short, in an economy with only
real assets, price levels are unimportant.

If we let the J column vectors A j E RLs, j = 1 , . . . ,
L S x J matrix
AI, '
J, be the columns of an
A,]
A=[A''''AJI=I~t~sL
.j
. .
ASL]
then the real asset structure is summarised by the matrix A E (RLS)J. We let
~(u, to; A) denote the exchange economy with real asset structure A.
Example 1 (contingent commodities). Introduce J = S L assets, one for each
good in each state Asset j = (s, 1), s = 1 , . . . , S, l = 1 . . . . . L promises to
deliver one unit of good l in state s and nothing otherwise. Thus A~II = 1 and
A~;,~ = 0 if (o-, h) ~ (s, l). H e r e A = IsL (the S L x SL identity matrix) and
V=
Pl
0
0
P2
"'"
"'"
0
0
-..
ps
Thus ( V ) = R s. Since z i g ~sc, commodities are purchased forward directly

and there is no need to exchange on spot markets at date 1. It is clear that it
suffices to consider the subset of assets which delivers only the first good in each
state: this leads to the next example.
Example 2 (numeraire assets). Suppose each asset j delivers contingent
amounts of only one of the goods, say the first. In this case A { =
(A~I, 0 . . . . . 0) r and V can be written as
v(p,)--
[ ,lO i l{Zl
A~,]
0 p21 iii
...
ps,JEfG '
.." , G /
Note that in general, that is for most S J matrices (A{), changing the prices
Psi (s = 1 , . . . , S) changes the subspace ( V ) spanned by the columns of V but
leaves the dimension of the subspace ( V ) unchanged (i.e. d i m ( V ) = J for all
p , l > 0 , s = l . . . . . S). However since with real assets price levels do not
1533
matter it is often convenient to normalise the spot prices so that Psi = 1

(s = 0 , . . . , S). In this case the matrix V becomes
Iz
V~_
A']
1
JAil
...
so that the subspace ( V ) is independent of p~. For most real asset structures
not only does the subspace ( V ( p l ) ) vary as pl changes, but also the dimension
of ( V ( p l ) ) can change as p~ changes and this creates some quite new
phenomena. In this sense the next two examples are more representative of the
general class of real asset structures.
Example 3 (futures contracts). Suppose there are J ~< L futures contracts on
the goods. If the jth asset is a futures contract for good j then Ajj = 1, A{t = 0,
l#j,s=l,...,S,j=l,...,J.
In this case
LPsl
"'"
PsJJ
L
Note that if the spot prices Ps are all collinear (Ps = asP for a s > 0 , p E R++,
s = 1 . . . . . S) then ( V ) is a one-dimensional subspace; with no price variability
across the states no spanning is achieved with futures contracts.
Example 4 (equity contracts).
Consider the simplest production economy in

which agents hold initial ownership shares of firms. Let there be J firms and
suppose the production decision yJ @ YJ (firm j's production set) has a!ready
been made where y i C ~n; then the equity o f f i r m j is a real asset with A~ = y~,
s = 1 , . . . , S. Let 0 i = ( 0 i l , . . . , 0~) denote the portfolio of shares purchased by
agent i and let ~.i= ( ~ ' ~ l , . . . , ~'~) denote his initial ownership shares, with
~ >/0 and E[_ 1 ~'~ = 1, j -- 1 . . . . , J. We assume that if agent i buys the share
0~. of firm j then he also finances the share O~(-poYo) of the input cost at date 0.
A stock market equilibrium is then defined in the obvious way. In a stock
market equilibrium the assets (equities) are in positive net supply: the change of
variable z t = 0 ~- ~.i, _we= wi + y~.i where y = [yl y J] converts the stockmarket equilibrium into an FM equilibrium in which assets are in zero net
supply. In this case the returns matrix W in (4) is given by
- q l +
W=
PoYlo . . . .
PtYl
"l
PsYs
qJ + PoYgo"
"'"
PlY~
"""
PsYs
"*J
1534
Clearly Examples 3 and 4 can be combined to create an asset structure

consisting of a system of futures contracts and equity.
No-arbitrage equilibrium
T h e idea of arbitrage and the absence of arbitrage opportunities is a basic
concept of finance Applied in an abstract way in the present model, it leads to
an alternative (and equivalent) concept of equilibrium that & analytically simpler

to work with than an FM equilibrium. Let us show how this new concept of
equilibrium is derived We say that q E ~J is a no-arbitrage asset price if there
J
does not exist a portfoho z E ~ such that W(q, V ) z >-0 (where for y ~ ~s+~,
y/> 0 means Ys =>0, s = 0 . . . . , S and ys > 0 for at least one s). Agent i's utility
maximising problem in Definition 3(i) has a solution if and only if q is a
no-arbitrage asset price. Recall the following version of the Minkowski-Farkas
lemma [see Gale (1960, p. 49)].
If W is an (S + 1) x J matrix then either there exists z E ~ such that
~s+l such that/3W=O.
Wz >10 or there exists [3 @o~++
L e m m a 1.
Thus the absence of arbitrage opportunities in the trading of the financial

assets implies the existence of a present value vector (positive state prices)
/ 3 = ( / 3 o , / 3 1 , - - - , / 3 s ) such that / 3 W = 0 which is equivalent to /30qj=
E s_-t /3sVs,
J J = 1 , . . . , J so that the price of each asset equals the present value of
its future income stream. From the budget equations (3), the date 0 equation
becomes
S
/3oPo(Xo-wi~) =-/3oqZ ' = - E

s=l
/3,Vsz'=-E
~ , p s ( x ~ - w~).
(6)
s=l
If we define the new vector of date 0 present value prices

P =/3 [] p .
(7)
Then the date 0 budget equation (6) reduces to the G E budget constraint
P(x g - o') = O .
In the case of real assets, since the date 1 equations are homogeneous functions
of the spot prices, the date 1 equations can be written as
e, [] (x',-
(v(e,))
Ch. 3& Incomplete Markets
1535
where P~ = (P~ . . . . . Ps) is the vector of present value prices for date 1. Thus
under the new vector of prices (7) each agent can be viewed as maximising
utility over the budget set
"
a ( P ; to') = x' ~ ~+
P ( x i - . toi)=O
I
P, [](xi _ to',) E (V(P,)) J
(8)
It is clear that the budget set (8) is the same for all those/3 a n d / 3 ' such that
\/3o /
It thus suffices to choose one no-arbitrage/3. In particular since the first order
conditions for maximising utility subject to the constraints (3) lead to a vector
of marginal utilities of income (Lagrange multipliers) Ai=(A0, Ail)=
(A 0, Ail . . . . . As) for agent i which satisfies
\All/V= q,
we may choose fl = a 1. It is easy to check that with this choice of/3 agent l's
budget set reduces to a GE budget set (i.e. the date 1 constraints are
automatically satisfied).
For reasons that will become clear shortly we need to consider equilibria in
which the subspace of income transfers (V) is of fixed dimension p, where
0 ~< p ~< S. Let G p(~s) denote the set consisting of all linear subspaces of R s of
dimension p. Let ~ E GP(R s) denote a p-dimensional subspace of R s. Replacing the actual subspace of income transfers (V(P l) ) by a surrogate subspace 5,
the budget set (8) becomes
~(P,~;to')=
xi E~+
pl[](xi,_tOil)C~.5~ j .
(9)
We are thus led to the following alternative concept of equilibrium.

Definition 4. A normalised no-arbitrage (NA) equilibrium of rank p with
O<~p<~S for the economy g(u, to;A) is a pair 0?,P, S F ) E R J R + + x
GP(R s) such that
(i) o7' = argmax{ul(x') l x I E B(P, tol)}
~ = arg max{u~(x i) I x~ ~ B(P, Af; to/)} ,
i = 2.... , I
1536

1
(ii)
~] (2' - ~ ' ) = 0
i=l
(iii) {V(/5,)) = c~
Remark. Normalising the no-arbitrage equilibrium by choosing the no-arbitrage present value vector [3 = h~ has two important consequences. First it
gives a GE demand function for agent 1 satisfying the standard boundary
condition. Second it eliminates a condition of dependence for the aggregate
demands at date 1 (S date 1 Walras Law equations) that would otherwise arise
from the fact that each agent satisfies P~ D ( x ~ - C-O/I)~~o This allows transversality arguments to be applied directly. The following lemma shows that the
concepts of an FM equilibrium of rank p that is, with rank V(/3~) = p, and an
NA equilibrium of rank p are equivalent. NA equilibria are analytically easier
to handle.
Lemma 2. (i) If ((2, 2), (fi, ~)) is an FM equilibrium of rank p then there
exists a p-dimensional subspace ~ E G p(Rs) and a no-arbitrage fi C Rs++' such
that (2, [3 [] fi, 5g) is an N A equilibrium of rank p.
(ii) I f (, P, 5~) is an N A equilibrium of rank p then there exist portfolios
2 = ( 2 ' , . . . , 2') and an asset price 4 such that ((2, 2), (P, ~)) is an FM
equilibrium of rank p.
Dual subspaces
Define the subspace of income transfers in ~s+ generated by the columns of
the matrix W
(w)
nS+'l
wz, z
W}
and the orthogonal (dual) subspace of present value vectors (state prices)
{ W } 1 ~-{[3 ~ S + l
[ [3W=O} .
Each agent i's income transfer vector r i= Wz ~arising from asset trading lies in
i i
( W ) and his (normalised)present value vector ~ri = (1/h0))t,
arising from the
portfolio first-order conditions, lies in { W)1. A key idea that underlies the
analysis of incomplete markets can now be given a precise geometric statement. Since ~ s + l = {W} O ( W ) 1, the greater (smaller) the dimension of the
space of income transfers, the smaller (greater) the space of present value
vectors. In short the greater the opportunities for income transfer, the smaller
the differences of opinion among agents about the present value of a stream of
1537
date 1 income. We say that W is a no-arbitrage matrix if ( W ) N ( R S++ l \ 0 ) = Q.

L e m m a 1 can then be stated as
either ( w ) n ( R ~ + ' \ O ) ~ Q
or
(W)" n~S~l~Q.
Thus if W is a no-arbitrage matrix then d i m ( W ) t> 1. In the case of complete

markets d i m ( W ) = S and d i m ( W ) " = 1 so that there is a unique normalised
vector ~-@--++~s+~ (with ~0 = 1) satisfying ~rW= O. With complete markets, all
agents' present value vectors coincide ~r I . . . . .
~ 1 = ~ ; there is complete
agreement about the present value of a stream of date 1 income. This p r o p e r t y
leads to the Pareto optimality of a G E l equilibrium when asset markets are
complete. When the markets are incomplete, if d i m ( W ) = J < S then
dim ( W ) = S - J + 1 > 1. We will show that generically in an associated GEl
equilibrium, agents' normalised present value vectors are distinct. With incomplete asset markets there is disagreement about the present value of a stream
of date 1 income. It is this difference in the zr i vectors which leads to the
Pareto-inefficiency of a G E I equilibrium when asset m a r k e t s are incomplete.
More generally it is the differences in the zri vectors that drive the key results in
the theory of incomplete markets.
Existence of GEl equilibrium
From the classical G E existence t h e o r e m we know that for all characteristics
(u, w) satisfying A s s u m p t i o n 1 the exchange e c o n o m y ~(u, w) has a contingent
m a r k e t ( C M ) equilibrium [Debreu (1959)]. D o e s a G E I equilibrium exist for
all such economies? N o t necessarily, as H a r t (1975) first showed. The key
intuition behind H a r t ' s non-existence example can be illustrated as follows.
Example 5 (non-existence of a GEl equilibrium).
Suppose the only activity at

date 0 is the trading of financial assets. We consider an e c o n o m y with two
agents, two commodities and two states of nature ( I = L = S = 2). T h e utility
functions, endowments and asset structure of the e c o n o m y ~(u, w; A) are as
follows:
(a) Utility functions:
2
i
p U'(xb,
"
u (x0, x , , x ; ) =
Ps > 0 , Pl + P2 = 1 ,
s=l
Ui(~)=aillog~l
i
OL :
i
i
(OL1, 1[~2) ,
+ai21g~2,
i
at>O ,
i=1,2,
i
0~ 1
i
a 2
=1
1538
(b) Endowments: for 0 < e < 1, 1 - e + h > 0,

091 =
6001
1
"O2 ~-
6011
l
60 1
6002
6012
6022J
6001
0) 11
60 1
2
6002
2
6012
6022_]
1 - e + h
1-E
1 --
~"
(c) Real assets: futures contracts for goods 1 and 2:

A~. =
[1
0
'
s = 1,2
so that
V= [Pll
[P21
Pl2]
P22J"
Remark. For the economy with characteristics (u, 60; A) defined by (a)-(c), a
G E I equilibrium exists if and only if either h # 0 or E = or a I = a ~. Thus if
h = 0, e # , a l # a21 then no G E I equilibrium exists.
In this economy there is aggregate risk if and only if h # 0 and individual risk
1
if and only if e # ~.
The condition a l 1 # a l2 states that the two agents have
distinct preferences for the two goods. The assertion is thus that if there is no
aggregate risk (h = 0), if both agents face individual risk (e # ) and if the
agents have distinct preferences for the two goods (O/11 # a l2) , then a risksharing ( G E l ) equilibrium cannot be obtained through a system of futures
markets. Let us indicate briefly two ways of showing that no G E l equilibrium
exists. First three observations:
(1) If a 11~ 0/~ then in a pure spot market equilibrium the spot prices are
linearly independent.
(2) If a G E I equilibrium satisfies rank V = 2, then a CM equilibrium can be
constructed with the same allocation and prices.
(3) If h = 0 then in a CM equilibrium the prices in the two states are
collinear.
If a G E I equilibrium price (fi, q) exists then either rank V = 1 or rank V = 2. If
rank V = 1, then the equilibrium must be a pure spot market equilibrium, since
nothing can be gained from asset trading. By (1) spot prices are linearly
independent, implying rank V = 2, a contradiction. If rank V = 2 then by (2) a
CM equilibrium can be constructed with identical prices, but by (3) the prices
are collinear, implying rank V = 1, a contradiction. Thus neither case can arise
and no G E I equilibrium exists when h = 0, E , a~ # a 2.
A second argument can be obtained by examining the properties of a G E I
equilibrium when h 0. When h # 0 then in a CM equilibrium the prices in the
two states are linearly independent: these equilibrium prices can be calculated.
When h---~ 0 (i.e. as the aggregate risk goes to zero) the prices become more
1539
and more collinear, so that the agents have to trade progressively more to
achieve a given transfer of income. In fact as h ~ 0, IIz i(h)ll--"
so that in the
limit no equilibrium exists.
There is a simple economic message that underlies this example. Futures
markets are not the appropriate markets for sharing individual risk when there
is no underlying aggregate risk. For in the absence of aggregate risk, spot
prices are not sufficiently variable across the states to permit the proper
functioning of a system of futures markets.
References
The basic two period exchange economy of this section together with the
concepts of a CM and an FM equilibrium (in the case where the assets are the
nominal assets called Arrow securities) was first introduced in the classic paper
of A r r o w (1953). While Diamond (1967) was the first to explicitly model
incomplete markets, the first fully articulated general equilibrium model with
incomplete markets is that of R a d n e r (1972); he established existence of an
equilibrium by placing a priori bounds on the agents' trades in asset markets.
Hart (1975) subsequently developed a more convenient model by introducing
the class of real assets: this led to his famous examples of nonexistence and
ranking of equilibria. The concept of no-arbitrage and the associated existence
of prices is as old as economics and finance. Perhaps the earliest mathematical
formalisation appears in the activity analysis literature of the 1950s [see
Koopmans (1951)]. If the columns of W denote activities then the choice of a
portfolio is equivalent to the choice of an activity vector. The absence of
arbitrage is equivalent to the requirement that it is not possible to produce any
good in positive amount without using some other good as an i n p u t - a
condition that Koopmans (1951) called the impossibility of the land of Cockaigne- this is shown to imply the existence of positive prices for the
commodities. The idea of a no-arbitrage equilibrium appears in Fischer (1972)
and is made into a basic tool of analysis in Cass (1985) and Magill and Shafer
(1985).
2.2. Generically complete markets

In this section we shall develop some basic techniques for handling the G E l
model and show how these techniques can be used to establish the conditions
under which the G E l and G E equilibrium allocations coincide. These techniques will play a basic role in all the analysis that follows.
Consider the exchange economy ~(u, oJ; A) with financial structure A. Let
us fix the profile of utility functions u = (u 1. . . . . u 1) with each u i satisfying
1540
A s s u m p t i o n 1 and the asset structure A E ~LSJ If we let the vector of

e n d o w m e n t s to = (to1 . . . . . tot) lie in the o p e n set
~-~
nl
(called the endowment space) then we obtain a parametrised family of

e c o n o m i e s {~Z(to), to E / 2 } . We say that a property holds generically if it is
true on an open set of full measure in the p a r a m e t e r space 12.
Definition 5. Let EA(to ) denote the set of financial market (FM) equilibrium
allocations (i.e. the vector of consumption bundles x = (x 1, . . . , x l) for each
FM equilibrium) for the e c o n o m y ~Z(to)" Similarily let Ec(to ) denote the set of
contingent market (CM) equilibrium allocations for the p a r a m e t e r value to.
T h e most natural way to begin an analysis of the properties of the set
(correspondence) EA(to ) is to try to relate t h e m to the properties of the set
(correspondence) Ec(to), which are well known. F r o m the classical G E theory
we have the following three properties
(P1) Existence: Ec(to ) # ( ~ for all to ~ S2.
(P2) Pareto optimality: x E E c ( t o ) ~ x is Pareto optimal, for all to E O.
(P3) Comparative statics: generically Ec(to ) is a finite set and each equilibrium is locally a smooth function of the p a r a m e t e r to.
T h e p r o b l e m of studying the relation between sets
posed as the solution of the following:
EA(to )
and Ec(to ) can be
Characterisation problem. (a) What condition on the real asset structure

A E ~LSJ ensures that there exist generic sets 2', ~" such that
(1) Ec(to ) C EA(to ) for all to E 0',
(2) E a ( t o ) C Ec(to ) for all to E JT'.
(b) I f there exists a generic set 12" such that Ec(to ) = EA(to ) for all to @ 12",
what restriction does this imply on the real asset structure A?
T h e t h e o r e m s of this section give the solution to the characterisation
p r o b l e m obtained by Magill and Shafer (1985). We begin with the key
condition on the asset structure A.
Definition 6. The real asset structure A ~ ~LSJ is regular if for each state of
nature s = 1 . . . . . S, a row t7s can be selected from the L x J matrix A s =
1541

N
[A~ "'" A~] such that the collection (a,)s=l is linearly independent. Note
that this requires J 1> S.
Example 6.
As =
The asset structure with J = L = S futures contracts
[i 6
=I c ,
s=l .... ,S
is regular.
Theorem 1. If the real asset structure A E ~LSJ is regular then there exists a
generic set 12' C 12 such that
Ec(to ) C E A (to),
Vto ~ 12'.
Proof. The basic idea is simple.

(1) We first establish the following property: if the asset structure A is regular
then the set of critical date 1 prices

K, = {p, E NLS [ r a n k ( V ( p , ) ) < S}
is a closed set of measure zero in R Ls. Define K = NL X K~.
(2) It follows from L e m m a 2(ii) that if (2,/5) is a CM equilibrium for which
r a n k ( V ( / s l ) ) = S, where /5= (P0, P~) then there exist portfolios and prices
fi =/5, ~ = zs=~ V,(fi,) such that ((2, i ) , (fi, ~)) is an FM equilibrium.
(3) If we can show that there is a generic set 12' such that for all economies
to E 12', the CM equilibrium prices do not end up in the critical set K, then the
proof will be complete. To show this we use the following property: Let
U C ~ m and let 4~:U-->~", m ~ n be a submersion (i.e. D x q b : U - - - ~ " is
surjective for all x E U). If K C ~n is a closed set of measure zero then 4) -l(g)
is a closed set of measure zero in ~m.
The natural tool for completing step (3) is the theory of regular economies
introduced by D e b r e u (1970); the basic ideas are explained in the article of
Dierker (1982). Let the function F : ~ +
x ~ l + ~ R" defined by
1
F ( P , tol, . . . , 0.)1) = Z
( f i ( p , p . o)i) _ o)i)
i=1
denote the G E aggregate excess demand function and let F = ( F 1 , . . . , F,_ 1)

denote the truncation of F defined on the normalised price domain ~ = {P
~++ ] P, = 1}. An economy to E 12 is regular if rank(DpF(P, to)) = n - 1 for all
equilibrium prices, i.e. P satisfying F(P, t o ) = 0. It is shown that the set of
regular economies O R is an open set of full measure in 12. Pick o3 E O R then by
1542
the Implicit Function T h e o r e m there exists a neighborhood U~ of o3 and

smooth functions qJ~ : U~ ~ ~ , j = 1 , . . . , r defining the equilibrium prices, so
that
/~(~0J(o~),~o) = 0
for all oJC U~, j = 1 , . . . , r. Thus
O,o~ ~=
- ( D p P ) - I D ~ p , where (DeF) 1 is well defined and of rank n - 1 since oJ is a
regular economy.
Since rank(D~,F) = n - 1 it follows that rank(Do,~0 y) = n - 1 for all w ~ U~,
so that 0 r is a submersion. Applying the property given above ( q / ) - l ( K ) ,
j = 1 , . . . , r are closed sets of measure zero, so that U~ =
=l(~bJ)-~(K)
is an open set of full measure in U~. Repeating the argument over a countable
sequence of regular values leads to a sequence of open sets U~, U ~ , . . . and
O ' = U~=I U~ is then the desired generic set for step (3).
Remark. The key intuition behind step (3) lies in the fact that the price
functions 0 j are locally onto: this implies that ~0j can be moved in any direction
in ~ by a small perturbation in o~, thereby ensuring that all the critical prices K
can be avoided.
Generic existence
Using property P1 of G E theory and T h e o r e m 1 gives the following existence

t h e o r e m for G E l equilibria.
Theorem 2 (existence). I f the real asset structure A E ~LSJ is regular then there
exists a generic set g2' C 12 such that
EA(m) ~=~ ,
Vm E ff2' .
R e m a r k . Property (P2) of G E theory and T h e o r e m 1 imply that whenever

co E 12' there is at least one allocation x E Ez(oO) which is Pareto optimal. Can
there be inefficient equilibria under the regularity condition? Hart (1975)
showed that this can occur. Let us modify the asset structure in Example 5 and
show how this can happen.
Example 5 (continued).
assets
Replace the futures contracts by the following real
It is easy to check that inserting the G E equilibrium prices leads to a V matrix

of rank 2. Thus the G E equilibrium allocation can be achieved as an FM
2 e) such that there is
equilibrium. But it can be shown that there exist (a 1l, ~1,
in addition a pure spot market equilibrium ( i = 0) and this equilibrium is
inefficient (in fact Pareto inferior to the full rank equilibrium). Examples of
this kind are exceptional as the next theorem shows.
1543
Theorem 3. If the real asset structure A E R LsJ is regular then there exists a
generic set 0 " C 0 such that
EA(.,O ) C EC((.O),
VO) e a 't .
Remark. The proofs of Theorems 1 and 2 use known results of G E theory to

obtain a result for a G E l equilibrium. To prove Theorem 3 we need a new tool
for handling the G E l model - a method for systematically handling equilibria of

all possible ranks p (0 <-p <~S) while avoiding the discontinuities created by
changes in the rank of V. This can be done by using the concept of an N A
equilibrium of rank p (Definition 4). With this new concept " m a r k e t clearing"
involves not just the prices P, but also the new variable 3~, which consists of a
p-dimensional subspace of ~s.
We can write an N A equilibrium as the solution of a collection of conditions
on the new price variables (P, 5 g ) E E++ Gp(Rs). Let f l ( p , oj1) denote the
standard G E demand function of agent 1 and define the N A demand functions
of the remaining agents i = 2 . . . . . I
fi(p,
~ ; oji) = arg max{ ui(x i) [ x i e g(P,~;wi)}
(10)
and the aggregate excess N A demand function

1
F(P,
o,' . . . . .
o/) = f'(e,
(fi(e,
o , ' ) - o,' +
,,i) _ ,oh.
(11)
i-2
Then (/3, 5{) E ~++ GP(~ s) is an N A equilibrium of rank p if and only if
F(P, ~a?; w) = 0 ,
(V(/3; A)) =
(12)
where we have included the fact that V depends on the returns matrices A, just
as F depends on the parameters w, an observation that we shall not use
immediately, but which is i m p o r t a n t in Section 2.3. Equation (12) gives the
fundamental conditions characterising equilibria with incomplete markets.

Representation of subspaces
Up till now the set GP(R s) has been viewed purely formally as the collection of
all p-dimensional linear subspaces of the Euclidean space ~s. T o prove
T h e o r e m 3 and to establish the existence of equilibrium with incomplete
markets (Section 2.3) we need an explicit way of representing all p-dimensional
subspaces in the neighborhood of a given subspace ~ E Gp(~s).
1544
Associated with any p-dimensional subspace Lg ~ GP(E s) there is a unique

(S - p)-dimensional subspace ~ , its orthogonal complement, consisting of all
vectors at right angles to
= {o e a s I
i.e. their inner product with any vector from 5 is zero. Pick any collection of
linearly
independent
vectors
Bj E R s, j = 1 . . . . . S - p
such
that
{B 1. . . . , Bs_p) is a basis" for the orthogonal space ~ . Let B be the
(S - p) S matrix whose (S - p) rows are the vectors Bj; then ~ = ( B Y ) ,
where BT denotes the transpose of B and
=
I Bo
0).
(13)
Thus ~ is represented as the solution of a system of equations using the

coefficients of the matrix B ~ ~(s p)s. But there are many ways of choosing the
basis B. In fact if B is a basis for ~ l then so is CB for any non-singular
( S - p ) ( S - p) matrix C. We need to factor out this redundancy in the
representation of ~ l . Note that since rank B = S - p we can always perform a
permutation of the columns of B (this amounts to permuting the states
s = 1 . . . . , S) in such a way that the permuted matrix B' = [B 1 ] B2] where B 1
is an ( S - p) ( S - p) matrix of rank S - p and B 2 is an ( S - p) p matrix.
Let C = B11 then CB = [B[1B~ ] B 1 1 B 2 ] = [ l l E] where I is the (S - p) x
(S-p)
identity matrix and E is an ( S - p ) X p matrix. We now have a
normalised way of representing St? (see Figure 30.1):
sl[II
Ely=O}
(14)
which involves (S - p). p parameters (the matrix E ) rather than the (S - p). S
Figure 30.1. Representation of subspace.
1545
parameters (the matrix B) in the representation (13). It is now true that there
exists a neighborhood of ~ in G(A s) such that for any ~ close to ~LPthere exists
a unique matrix E in R (s-p) such that ~ is represented via (14) with E.
Conversely with any E in N(s-o)o we can associate a unique ~ E G(Ns).
Proof of Theorem 3. The idea of the proof is simple. We show that there is a
generic set 12" such that for all to E 12", every G E I equilibrium satisfies
d i m ( V ( p ~ ) ) = S . This is equivalent to proving that equilibria with
d i m ( V ( p l ) ) = p for O ~ p < S cannot arise. By L e m m a 2 we know that
analysing GEI equilibria of rank p is equivalent to analysing NA equilibria of
rank p. We show that NA equilibria of rank p can be defined (locally) as
solutions of a system of equations in which the number of equations exceeds the
number of variables and in which the number of linearly independent equations
exceed the number of variables. Once this is established, the existence of the
desired generic set 12" follows from a standard transversality argument.
(1) It can be shown that there exists a finite collection of manifolds Mk,
k=l,...,r
with d i m M k f f S L - 1
such that the K ~ = { P ~ c ~ S L I r a n k
V(P1) ( S} satisfies K 1 C Uk= 1 M k. Let V be partitioned as V = [W~] where V
is p x J and let M ; = {P1C M k I rank V~(P1) = p}.
(2) Using (14) we can write aggregate demand as a function of E so that the
local equations for an NA equilibrium of rank p become
F(P, E, to) = 0 ,
G(P, E) = 0
where F = (F 1. . . . . Fn_l) and G(P, E) = [ I I EIV(P,). Thus (F, G) : ~0 x

M'~x N (s-) x ~+I..._~L-1X ~SL X ~J(S-p) where ~0 = {P0 E NL+ I Pol = 1}.
Since rank(D,,F) = L - 1 + SL and rank(DeG ) = p(S - p), the number of
independent equations exceeds the number of variables by 1.
Using property (P2) of G E equilibria or directly using the fact that rank V = S
implies 7r ~ . . . . .
zr t, gives the following.
T h e o r e m 4 (Pareto optimality).
If the real asset structure A E R Ls] & regular

then there exists a generic set 12"C 12 such that x @ EA(to ) implies x is Pareto
optimal, for all to E 12".
Combining Theorems 1-4 and defining 12" = 12' fq 12" shows that the regularity condition ensures that generically GE and G E I market equilibrium
allocations coincide.
T h e o r e m 5 (equivalence under regularity).
If the asset structure A @ NLS] is

regular then there exists a generic set 12" C 12 such that
1546
EA(to) = Ec(O)),
Vto E g-~*
Let M R C ~css denote the set o f regular asset structures. It is clear that M R is
open: but beyond this it seems to be a complicated set. It is natural to ask what
happens to equilibrium allocations as we let A vary in the set MR.
Theorem 6 (invariance of financial structure).
generic set On C J2 such that for to E ~2A
EA,(to ) = EA(to )
Let A ~ M R then there exists a
for almost all A' ~ M R .
Furthermore EA(tO ) = EA+dA(to ) for all local changes d A @ ~csg.
Remark. Theorem 6 reveals a remarkable invariance property: under the

regularity condition equilibrium allocations o f the G E l model are invariant with
respect to changes in the return structure o f the financial assets. We shall see that
when markets are incomplete Theorem 6 fails dramatically, for then the basic
dichotomy that it reflects between the real and financial sectors of the economy
is no longer valid.
Theorem 5 combined with property (P3) for GE equilibria ]namely Debreu's
(1970) theorem] leads to the following result.
Theorem 7 (comparative statics). I f the asset structure A E E Lsg is regular then
generically EA(to)#Q~ is a finite set and each equilibrium is locally a ~ l
function o f the parameter to.
We have shown that regularity is a sufficient condition for ensuring that
generically GE and GEl equilibrium allocations coincide: the next result shows
that regularity is also a necessary condition for this property to hold. We have
thereby obtained a complete solution to the characterisation problem posed at
the beginning of this section.
Theorem 8 (necessity of regularity). I f there ex&ts a generic set O* such that
Ec(to ) = Ea(to ) for all w E J2* then the asset structure A is regular.
References
The techniques and results of this section were obtained by Magill and Shafer
(1985). A special case of Theorems 1 and 2 where A represents futures
contracts was obtained by Magill and Shafer (1984) and independently by
McManus (1984) and Repullo (1986). Magill and Shafer (1985) also extended
these results to the case of a stochastic exchange economy (Section 2.4).
1547
2.3. Incomplete markets

In this section we will study the properties of the GEl model when the markets
are incomplete. The key technique for establishing the generic existence of a
GEl equilibrium is the global analysis of a slight weakening of the concept of a
no-arbitrage (NA) equilibrium which we call a pseudo-equilibrium. The
theorems of this section reveal the very different qualitative properties of the
set EA(O9) when asset markets are incomplete (J < S).
In the previous section genericity was with respect to the space of endowments O = i +n~
+ . In this section the parameter space is augmented by adding
the space of (real) asset structures ~1 = ~LSJ. Thus genericity is with respect to
the parameters
(w,A) E I ] x g .
To emphasise this choice of parameters we let E(w, A) = E a(w ) denote the set
of GEI equilibrium allocations for the economy ~(w, A) = ~A (W). In view of
this extended concept of genericity the theorems that follow are weaker than
those presented in the previous section in the case where the markets are
complete. The first result asserts the generic existence of a GEI equilibrium
and will be proved later in this section.
Theorem 9 (existence). Let ~(u, oo; A) be a GEl exchange economy satisfying
Assumption 1. l f J < S then there exists a generic set A' C g2 x M such that
E(to, A ) ~ ,
V (o~, A) e A'.
The next theorem asserts that when markets are incomplete GEl equilibrium
allocations are generically Pareto inefficient. A more thorough analysis of the
precise sense in which GEl equilibria are inefficient is postponed to Section 5.
The second property asserted by the theorem is that all agents have distinct
(normalised) present value vectors. As we shall see in Section 4 this has
particularly important consequences when we introduce firms that need to
make decisions (at date 0) on production plans at date 1. Agents will hold quite
different opinions on the present value of any such productions plans.
Theorem 10 (Pareto inefficiency). If J < S then there exists a generic set
A" C ~2 x s~l such that x E E(w, A) implies x is Pareto inefficient, for all
(w, A) ~ A". Furthermore the present value coefficients of the agents
,./Ti ~ ~S+I ,
i = 1. . . . , I
are distinct for each x E E(w, A), V (w, A) E A".
M. Magilland W. Shafer
1548
Proof (idea). It is the fact that d i m ( V ) = J C : > d i m ( V ) = S - J > 0

that
allows agents (normalised) 7ri vectors to be distinct in equilibrium. This is
proved by adjoining the equations 7r1~- 7ril = 0 to the equations of equilibrium
and showing that the resulting system of equations involves more independent
equations than unknowns.
Let zl* = A' N zl", then we have the following analogue of Theorem 5 which
compares the GE and G E l equilibrium allocations.
Theorem 11.
If J < S then there is a generic set A* C 12 x ~l such that
E(~o,A) NEc(oJ ) = 0 ,
V ( w , A ) E fl*.
The invariance theorem of the previous section asserted that when markets
are complete, changing the asset structure does not alter the equilibrium
allocations: in short, with complete markets financial changes have no real
effects. This property of invariance with respect to financial structure is no
longer true when markets are incomplete. In this case, changing the structure
of financial assets in general alters the equilibrium allocations: in short, when
markets are incomplete financial changes have real effects. Unlike Theorem 6,
the following result is confined to a statement about the effects of local changes
in the asset structure.
Theorem 12 (real effects of financial assets). If J < S then there exists a generic
set A* C 12 s~l such that for all (w, A) ~ A*
E(w, A) fq E(o~, A + dA) =- ;~
for almost all local changes dA E ~JLS.
Proof of Theorem 12 (idea). Consider an NA equilibrium of rank J with price
vector /5. For generic dA, (V(_/5, A)) ~ (V(/5, A + d A ) ) _ s i n c e J < S . Since
generically /51D(xil- o)~)~(V(P, A + d A ) ) for some i, P cannot remain an
equilibrium price vector. But any new equilibrium price P ' ~ / 5 must change
the demand of agent 1 and hence the equilibrium allocation.
Example 7. Consider the following simple example: I = 2, L --- 1, J = 1, agents
have identical log-linear utility functions log x 0 + log x I + log x2, and endowments ~o~= (1,2, e), 092=- (I, E, 2). The single asset delivers one unit of the
good in state 1 and 1 + 8 units in state 2. If 0 < E < 2, it is not difficult to verify
that if 8 = 0, the unique equilibrium is the no trade equilibrium, and that if
~ 0 is small, trade takes place in equilibrium. The 6 # 0 equilibrium is Pareto
superior to the ~ = 0 equilibrium.
1549
Theorem 12 and the above example make it clear that the nature of assets
has both private and social consequences, and that a general theory of trade
with financial assets needs to include a specification of the process by which
assets are designed and introduced into the economy. It is a restrictive
assumption to suppose that the financial structure of an economy is given
independent of the characteristics of the agents that constitute the economy.
An interesting question is whether private incentives to offer assets are
compatible with social welfare criteria, when it is not possible to complete the
markets.
Proof of Theorem 9.
Recall the strategy of the proof with potentially complete markets. (1) Show that a GE equilibrium exists. (2) Show that generically in a GE equilibrium dim(V(P, A ) ) = S. The strategy with incomplete
markets is the same. (1)* Show that a pseudo-equilibrium exists. (2)* Show
that generically in a pseudo-equilibrium dim(V(p, A ) ) = J. The concept in
(1)* which generalises a GE equilibrium is defined as follows.
Definition 7. A pseudo.-equilibrium (~-equilibrium) for the economy ~(to, A)
is a pair (, P, 5f) E ~,+l x ~ + / GJ(~ s) which satisfies conditions (i) and (ii)
of an NA equilibrium of rank J (Definition 4), condition (iii) being replaced by
(V(/5, A)) C ~ .
(16)
Thus a pseudo-equilibrium is a constrained GE equilibrium: each agent

satisfies the standard GE budget constraint (under /5) and in addition for
agents i = 2 , . . . , I the date 1 excess expenditures (evaluated with the date 0
prices/50 must lie in the subspace fir. Just as in a GE equilibrium it can happen
that (V(/5, A)) ~ A s, so in a ~0-equilibrium it can happen that (V(P, A)) ~ Sf.
The transversality arguments in (2) and (2)* show that generically neither of
these strict inclusions can occur.
From the homogeneity of the budget equations (8) in a qJ-equilibrium, it is
clear that the prices P can be normalised to lie in the positive unit (n - 1)-
sphere
~ n+_p
-i=
PER++
P/=I
j=l
Since the GE budget constraint P(x i - toi) = 0 holds for each agent, Walras law
holds and we truncate the aggregate excess demand function (11): F---~ F =
(F 1. . . . ,F,,_I). Thus ( P , ~ ) ~ S e +n+- - 1 x G~(~ s) is a ~O-equilibrium price-
subspace pair if and only if

(i) p(/5, ~ , to) = 0
(ii) (V(/5, A)) C ~
(17)
1550
The first step is to show that there exists a pair (P, 3~) which is a solution to
(17). This is the key step in establishing the existence of a G E l equilibrium.
T h e o r e m 13. Let ~(u, oJ, A) be a G E l exchange economy satisfying Assumption 1, then a ql-equilibrium exists for all (w, A) E 12 d .
The second step is to show that generically the 0-equilibria are smooth
functions of the parameters and that 0-equilibria can always be perturbed so
that generically rank V(P, A) = J. These two properties may be summarised as
follows.
There exists a generic set A C 12 x s such that for each (w, A) e A

there are at most a finite number of qJ-equilibria, each of which is locally a c
function of the parameters (to, A).
Lemma 3.
There is a generic set A ' C A such that for each (w, A) EA',
( V(P, A)) = ~ for each t~-equilibrium.
Lemma 4.
Remark. When markets are potentially complete (17)(ii) is automatically

satisfied since 5 ~ = R s. Thus the conditions (17) reduce to the standard
aggregate excess demand equation characterising a GE equilibrium
F(P, w) = O.
(18)
The problem of proving the existence of a solution to (17) thus reduces to the
problem of proving that (18) has a solution. The classical GE argument uses
Brouwer's Theorem to prove that (18) has a solution.
Grassmanian manifold
The main difficulty in proving Theorem 13 is the presence of the complicated
set GJ(RS). The reader familiar with the concept of a manifold will note that in
the section Representation of subspaces, we performed the key steps in
constructing an atlas for a smooth manifold structure on GJ(R s) when we
showed how all subspaces c2 in the neighborhood of any subspace ~ E GJ(~ s)
can be put into one-to-one correspondence with ( S - J ) x J matrices E E
~(s-J)J. Consistent with its natural topology, the set GJ(~ s) can be given the
structure of a smooth compact manifold of dimension J ( S - J), called the
Grassmanian manifold of J-dimensional subspaces of ~s. The Grassmanian is a
canonical manifold which plays a key role in many parts of modern mathematics.
The presence of the Grassmanian makes it inappropriate to attempt to apply
1551
conventional fixed point theorems (Brouwer, Kakutani) to prove Theorem 13.

The convexity assumption that underlies these theorems is simply not relevant.
Grassmanian manifolds are in general not even acyclic, so that even the
Eilenberg-Montgomery fixed point theorem would not be applicable.
We outline two approaches to proving Theorem 13. The first is due to Duffle
and Sharer (1985) and gives L e m m a 3 as a by-product. The second due to
Husseini, Lasry and Magill (1986) and Hirsch, Magill and Mas-Colell (1987)
shows that Theorem 13 is a special case of a much more general theorem. This
theorem (which can be stated in a number of equivalent forms) leads to a
striking generalisation of the classical Borsuk-Ulam theorem and contains
Brouwers theorem as a special c a s e - we refer the reader to the above
mentioned papers for details. Before presenting these two approaches to the
existence problem it will be useful to introduce two additional concepts that
play an important role in the differential topology approach to general
equilibrium theory. The first is the concept of the equilibrium manifold, the
second is the concept of degree.
Debreu's regular economies

In studying the problem of uniqueness of equilibrium in the GE model, Debreu
(1970) was led to introduce a new approach to the qualitative analysis of
equilibrium which has proved to have far-reaching consequences. Previously
the analysis of equilibrium for an exchange economy ~(u, to) had focussed on
existence and optimality for fixed characteristics (u, to). Debreu conceived the
idea of leaving the profile of preferences u = (u 1. . . . . u ~) fixed, but allowing
the endowments to = (to' . . . . . tol) to be viewed as parameters. He was thus led
to introduce the approach of differential topology. Using Sard's Theorem and
the Implicit Function Theorem he showed that generically in to, there is at most
a finite number of equilibrium prices, each of which is locally a smooth
function of the parameter to. This established the property of local uniqueness,
but even more importantly it laid the correct foundation for carrying out
comparative static analysis in general equilibrium theory.
An abstract formulation of this approach was developed by Balasko
(1976, 1988). The key idea is the introduction of the equilibrium manifold
n-I
IF= {(P, 60) ~ b~++
x 12 [ F(P, to) = O}
(19)
induced by the excess demand equation (18) and the projection

7r : IF--~ O
(20)
defined by 7r(P, to)= to. The equilibrium prices are then given by 7r-l(to).
1552
Since ~ and g2 are smooth manifolds, differential topology is applicable and

since H: and g2 have the same dimension, the powerful tool of degree can be
applied. This approach to equilibrium theory provides a unified framework for
analysing the comparative statics properties of equilibria and their existence in a

setting of great generality. It is the contribution of Duffle and Shafer (1985) to
have shown almost ten years later that this abstract formulation provides a
natural setting for establishing the generic existence of equilibrium with
incomplete markets.
Just as in the G E model (18) leads to the equilibrium manifold (19), so in
the G E I model (17) leads to the qJ-equilibrium manifold
IF =
(p, 56, 09, A) E Set+' x G J ( ~ s) x g2 x .~/
F(P, 56, 09) = 0

(V(P, A ) ) C 56J
(21)
and the projection

7r : IF--> I2 x ,d
(22)
defined by ~r(P, 56, 09, A) = (09, A). Proving Theorem 13 is equivalent to proving rr 1(09, A) Q3 for all (09, A) E 12 x M. The idea is to apply m o d 2 degree
theory to the map 7r : E ~ 12 x ~ .
Mod 2 degree of map

Recall that if f : M---> N is a ~ l proper map between ~ I manifolds M and N
with dim M = dim N and N connected, then we can associate with f an
important topological invariant called the mod 2 degree o f f (written ~ 2 f ) such
that the number of points m o d 2 in the pre-image set f l(y) (written
~ 2 f - l ( y ) ) is the same for all y E R r (the set of regular values o f f ) . Furthermore if ~ 2 f 0 then f - ~ ( y ) ~ 0 for all y E N. The standard way of applying
degree theory is to make an astute choice of 37 E ~ f for which it is straightforward to show :~2f-1(37)= 1.
Let f = ~r, M = nz, N = 12 x M. It is clear that 12 x ~/is a smooth connected
manifold with dim(12 x M) = nI + JLS. Thus in order to prove T h e o r e m 13
(and L e m m a 3 by applying Sard's theorem) it suffices to show the following:
(i) Iz is a ~1 submanifold of Sen++1 x GJ(~ s) x g2 x ~g with dim E = nI +
LSJ;
(ii) 7r is proper;
(iii) there exists (09, A) E R , such that :~2~--1(09, A) = 1.
Proof. (i) Let (/6, 5~, o3, fi,) E nz, and let H ( p , E, w, A) = 0 denote the system
of equations (15) which represents ~: in a neighborhood of (/6, ~ , o3, ill).
1553
Direct calculation shows rank(D o AH(fi, E, ~3, .4 )) = n - 1 + J(S - J), so that

0 is a regular value of H. Thus ~/-~(0) C E is a manifold with dim H-~(0) =
dim(O x M). E is the union of all such H-~(0), so E is a manifold with
dim E = dim O x ~.
(ii) We need to show 7r-~(K) is compact for any compact set K C [2 s#.
Since GJ(R s) is compact, r-l(K) can fail to be compact only if 7r-l(K)f7
n-i GJ(~s) K ~ 0 . But this is impossible by the boundary behavior of
05++
P inherited from the boundary behavior of agent l's demand f ~.
(iii) Pick a Pareto optimal allocation d~ E 0 and let /5 E 5O+J denote the
unique associated price system. Pick A E ~1 so that V(P, A ) is in general
position. Let ~ = (V(P, A ) ) then (P, ~ , o5, A ) E E and (P, ~ ) is the unique
equilibrium price pair for (o5, fi~). Showing that (o3, fi~) is a regular value of ~reduces to showing that rank(Dp.EH(P, E, d~, A)) = n - 1 + J(S - J) where /~
represents ~.
Oriented degree
Mod 2 degree theory, rather than oriented degree theory was used in the above
argument because it is-not known, in general, if E is an orientable manifold. If
E is orientable the same proof which shows that :~:2"/T = i shows that the
oriented degree is 1 for a suitable choice of orientation. The advantage of being
able to use the oriented degree of ~- is that it would permit the construction of
an index theorem analogous to Dierker's index theorem for a GE exchange
economy and would permit a study of conditions under which equilibrium is
globally unique. E will certainly be orientable if V(P, A) always has full rank,
and an index theorem could be written out for this case (we do not know of
anyone who has done this). If A is such that V(P, A) can change rank with P,
then two problems arise in attempting to verify if E is orientable. The
construction of 1z in Duffie-Shafer simply shows that E can be locally represented as a solution of a transverse system of equations, from which it is
difficult to obtain information about orientability. Secondly, GJ(R s) itself is
orientable if and only if S is odd, although it is difficult to believe that being
able to write down an index formula should depend on the parity of S, which is
not of immediate economic significance.
Vector bundle approach

There is an abstract approach to the GEI existence problem which may prove
to have applications in other branches of equilibrium theory and to which we
would now like to draw the readers attention. The idea is to lift the problem
into an abstract setting where finding a solution of (17) can be viewed as
showing that a system of equations has a solution. The mathematical object
1554
which allows one to do precisely that is called a vector bundle and is a powerful
generalisation of the concept of a manifold. A (smooth) vector bundle is a
space which is locally homeomorphic to the cartesian product of a vector space
and a manifold. To each point in the manifold is associated a vector space
which "twists" in a certain way as we move over the manifold: but locally we
can always untwist the vector space so that the vector bundle looks like the
above mentioned product. By introducing this concept (as we show below) we
can reduce the existence problem to a simple topological property of an
appropriately defined vector bundle.
In the above analysis Walras Law led us to replace F by its truncation F.
Alternatively Walras Law (PF(P, ~ ) = 0 for all (P, ~ ) E ~r++l X G 1 ( ~ s ) ) implies that F defines a vector field on bo,++l for each ~ E G J ( R s ) . By a familiar
argument, the boundary behavior of F (namely (Pm, ~m) C 6 e l ) 1 G J ( R s ) ,
(Pro, ~m) ~ (P' ~ ) with P E 06e~-~ , implies IIF(Pm, ~m)ll ~ ~) implies that F
can be modified to a function/~ with the following properties:
(i) /3 is defined on 5e+-~ x GJ(R J)
(ii) /~ is inward pointing on the boundary 0ow+ 1 for each ~ E G J ( R s)
(iii) /~ has the same zeros as F.
The existence of a pseudo-equilibrium then follows from T h e o r e m 14 by setting
( 4 , q ' ) = (,~, V ) .
I f 5Q+-~ x G~(~s)--> ~" is a continuous vector field on 5P'+ 1

which for each fixed 5~ E G J ( ~ s) is inward pointing and if the S x J matrix
valued function ~F : SP+-Ix G J ( ~ s ) - - > ~ sJ is continuous then there exists
(/5, ~ ) ~ 5+-1 G J ( ~ s ) such that
T h e o r e m 14.
@(/5, ~ ) = 0 ,
(qt(/5, ~ ) ) C ~ .
(23)
T h e idea is to construct a vector bundle over the manifold O]-~

G J ( ~ s) and a section such that (P, Av) is a solution of (23) if and only if this
section intersects the zero section. The idea is then to show that the topological
structure of this vector bundle is such that every continuous section must
intersect the zero section. Hence the solution (23).
For a discussion of the properties of vector bundles we refer the reader to
BrOcker and Jfinich (1983) and Hirsch (1976). The following definitions may
help to make some of what follows intelligible. An m-dimensional vector
bundle ~ = (E, M, 7r) over a manifold M is a triple where E (the total space)
and M (the base space) are manifolds, ~- : E--> M is a continuous surjective
map and where 7r l(x) = E x (the fibre at x) is an m-dimensional vector space
for all x E M, which satisfies:
Proof.
1555
(a) for each x E M there exists an open set U containing x and a homeomorphism h : 7r-l(U)---> U x R m,
(b) the restriction h~ : E~ ~ x x R m is an isomorphism of vector spaces.
When the vector space E x is the tangent space to M at x, then the vector
bundle ~: is called the tangent bundle of M (we write = %4). A section of the
vector bundle is a map o- : M ~ E satisfying o-(x) E E , for all x E M. The zero
section o"o : M---> E is defined by o-0(x) = 0 E E x for all x E M. A vector field f on
a manifold M defines a section of the tangent bundle r M by o-(x) = (x, f(x)) for
all x E M.
Let r~,~-L denote the tangent bundle of 5e~-~ and let ys,s = (FS,S, GS(~s), ~r)
denote the vector bundle over the Grassmanian with total space
FJ,s={(~,w)EGJ(~s)~sJ
w = ( wl . . . . , w J ) , }
wJ~',j=l
..... J "
Let ~: = r~e~-~ yJ,s denote the cartesian product bundle and define the section
o- of ~ by
,,-(,o, ~ ) = (/,, ~, ,~(e, ~), n , l q,'(p, ~ ) , . . . ,
i i ~ ~'(/,, ~))
where Hz~ denotes the projection onto 5f . Clearly o-(P, S f ) = o-0(/5,5~ )

(where o-0 denotes the zero section) if and only if (P, ~7) solves (23).
Mod 2 Euler number of vector bundle

A vector bundle 77 whose fiber dimension equals the dimension of the base has
a numerical invariant associated with it called the rood 2 Euler number [written
e2(-q) ] such that the n u m b e r of points mod 2 at which any section o- transverse
to o-0 intersects o-0 (written 4~2(o-, o-0)) is the same for all transverse sections
(or f~ o-0) and :~:2(O', (TO) = e2(n). Furthermore if e2(r/) = 1 then cr fq o"0 # O for
all continuous sections o-. The standard way of applying the mod 2 Euler
n u m b e r is to make an astute choice of section & for which it is straightforward
to show 4+2(&, % ) = 1. In the case of a manifold with boundary (for example
5e+-1) the equality 4e2(o-, o-0) -- e2('r/) remains true provided the vector bundle
is the tangent bundle of the manifold and provided the sections are restricted to
vector fields which are inward pointing on the boundary. The two geometric
properties which explain why T h e o r e m 14 works are then following.
L e m m a 5.
(i) e2(r~,L-i ) = 1, (ii) e2(y J's) = 1.
Proof. (i) For any /5 E 50%-+1 the vector field ~b(P) = ( P / P . P) - P is inward
pointing and defines a section & of the tangent bundle r ~ - t which satisfies
&(P) = g0(P) if and only if P =/5. Since D#q5 has rank n - 1, ~ f~ o-0. Since we
1556
have exhibited a section ~ with a unique transverse intersection with the zero
section o-0, it follows that e2(r~,-~ ) = 1.
(ii) Pick any ~ E GS(~ s) and let u ~, . . . , u J denote J orthonormal vectors in
R s such that ~ = < U 1. . . . , uJ). Consider the section ~ of y~,s defined by
6 ( ~ ) = (~', Ilz~u l. . . . . H~e~u~). Clearly ~(oY) = tr0(~ ) if and only if 3? = c~.
It can be shown by calculation that ~ (~ tr0 so that ez(y J's) = 1.
F r o m the multiplicative property of the m o d 2 Euler number with respect to
a cartesian product of vector bundles, ez(.c~,~-~ T J's) = e2(%~,~-~) e2(TJ'S).
The p r o o f of T h e o r e m 14 follows by applying Lemma 5.
Geometric interpretation. Consider the case where n =-2, J = 1, S = 2 . yl,2 is

h o m e o m o r p h i c to the unit circle, ~'s~+is the tangent bundle to the positive part
of the unit circle, F 1"2 is the open M6bius band (see Figure 30.2). It is the
boundary behavior of excess demand @ which ensures e2(~-~-1 ) = 1 and it is
L__
-1-
Figure 30.2. a, b, c pseudo-equilibria.
1557
the twisting of the fiber as we move along the zero section (the basic
topological property of the vector bundle y 1,2) which ensures e2( T 1,2)= 1.
L e m m a 5(i) is the inward-pointing vector field theorem which gives
existence for the GE model (the A r r o w - D e b r e u theorem) and is equivalent to
Remark.
Brouwer's theorem. L e m m a 5(ii) is the new property induced by the G E I

model: it can be viewed as a subspace fixed-point theorem. The cartesian
product bundle
thus provides a geometric decomposition of the problem of existence of equilibrium when markets are incomplete: the first component is the vector bundle for
equilibrium with complete markets, or more generally for the real market
c o m p o n e n t of the q,-equilibrium, the second component is the subspace vector
bundle introduced by the incomplete financial markets namely the subspace
compatibility condition of a ~O-equilibrium.
References
The first existence results with incomplete markets without constraints on
agents' asset trades were obtained for the G E I model with nominal assets (see
References in Section 3). In the special case of numeraire assets an existence
theorem was given by Geanakopolos and Polemarchakis (1986) [see also Chae
(1988)]. In this case an equilibrium exists for all parameter values, since (with
prices nonnalised) the rank of the returns matrix V never changes. For the
general case considered in this section, in addition to the papers of Duffle and
Sharer (1985), Husseini, Lasry and Magill (1986) and Hirsch, Magill and
Mas-Colell (1987) mentioned above, Geanakopolos and Shafer (1987) have
presented a general existence theorem which includes T h e o r e m 13 as a special
case.
2.4. Stochastic exchange economy

The model of the previous sections can be enriched by viewing the equilibrium
in the economy as a stochastic process over many time periods, t = 0 ,
1 . . . . , T. The underlying exchange economy can be extended to a stochastic
economy by modelling the uncertainty via an event-tree. T h e r e is a finite set of
states of nature S = {1 . . . . , S} and a collection of partitions F = (Ft)t~ 0 of S
where F~+ l is a refinement of F t and Fo=S, Fr=({s}}s~ s. F defines an
information structure in that at each date t = 0 , . . . , T exactly one of the
"events" or @ F t has occurred and this is known to each agent in the economy.
1558
If tr E F~ has occurred the possible events tr' E F t + 1 that can occur at t + 1 are
those satisfying o-'C or. The filtration F then defines an event-tree as follows.
Let D = U ~r=0 F t (disjoint union) be the set of nodes. For each node ~ E D
there is exactly one t and one or E F t such that C = (t, o-). The unique node
~:0 = (0, o') is called the initial node. For each ~: E D\C0, s = (t, o-) there is for
t - 1 a unique o " ~ F~_ 1 such that o-'D o'; the node C- = ( t - 1 , o-') is called
the predecessor of ~. Let D - --- U rf0~ F t (disjoint union) denote the set of all
non-terminal nodes. For each C E D - with C = (t, o'), let ~ + = { C' - (t +
1, o-') ] o-' C o-} denote the set of immediate successors of C. The number of
elements in the set ~ + is called the branching number of the node C and is
written b ( ~ ) . Finally we say that ~ succeeds ~' (weakly) if C = (t, tr), ~' =
(~-, o-') satisfy t > ~- (t ~> r), o- C tr' and we write C > C' ( C ~> C').
With this notation
" the commodity
" space C(D, ~ L) consists
of all functions
f : D _ _ ~ L , namely the collection
of all N L-valued stochastic
processes, which
.
for brevity we write as C. Each consumer i (i = 1 . . . . , I) has a stochastic
e n d o w m e n t process t o i E C++ (the strictly positive orthant of C) and a utility
function u i : C + - - - ~ satisfying Assumption 1 on the commodity space C+.
Given the information structure F if we let (u, to) = (u ~, . . . , u I, w ~. . . . . to t)
then ~(u, to; F ) denotes the associated stochastic exchange economy.
G E and G E l equilibrium
As in Section 2.1 we can define two market structures for the economy
~(u, to; F ) , that of G E and that of GEI. If we define a contingent price process
P E C+ + then the contingent market ( G E ) budget set of agent i is defined by
O(P, 09i) = (xi E C+ [ P(x i -
(3) i) = 0 } .
A contingent market ( C M ) equilibrium is then given as before by Definition 1.

We also refer to such an equilibrium as a G E equilibrium.
T o keep the description of a G E I equilibrium simple we assume that there
are J assets all initially issued at date 0. With slight complication of notation
the case where assets are introduced at subsequent nodes ~ C0 can also be
treated. Real asset j is characterised by a map AJ: D---~ ~L with A*(~0)= 0.
One unit of asset j held at C0 promises to deliver the commodity vector AJ(C)
at node C, for ~ E D. Assets are retraded at all later dates, so that one unit of
asset j purchased at node C promises the delivery of AJ(C ') for all ~' > ~. We
let A = (A ~, . . . , A J) denote the asset structure and we let s denote the set of
all asset structures. If A(C) = [ A I ( C ) . ' .
AJ(C)], ~ E D and p E C+ is a
stochastic spot price process then
VJ(~)=p(~)AJ(C),
CED
(24)
Ch. 30: IncompleteMarkets
1559
is the dividend (in units of account) paid by asset j ( j = 1 , . . . , J) at node ~. A

security price process is a map q:D-->R ~ with q(~:)~-0 for ~ D (the
terminal value condition); q(se) is the vector of after-dividend prices of the J
assets at node ~. The trading strategy of agent i is a map zi: D---> ~s with
z~(~) = 0 for ~ ~ D - ; zi(~:) is the portfolio of the J assets purchased by agent i
at node ~ after the previous portfolio has been liquidated. With this notation
agent i's decision problem in the G E l model is:
ma x ui(x i) subject to
XI Z t
(~)
P(~o)( x (~:0) - t'(~0)) = - q ( ~ 0 ) z (~:0),

p(sC)(x'(~:) - w'(~)) = [p(~)A(~:) + q ( ~ ) l z ' ( { - ) - q(~)z'(~),
VfeD\f0.
Definition 8. Afinancial market (FM) equilibrium for the stochastic exchange
economy ~ ( u , w ; F ) is a pair ( ( , Y ) , ( f i , 4 ) ) = ( ( Y l , . . . , Y ' , Z I , . . . , Z / ) ,
(fi, 4)) such that
(i) (.~i ~i) solves ( ~ ) ,
(ii) Z~=, (i_ w')=0,
(iii) E~=, i= O.
i = 1,...,
I,
We also refer to such an equilibrium as a GEI equilibrium.
No-arbitrage equilibrium
As in the two period case, the asset price process 4 in an FM equilibrium
satisfies a no-arbitrage condition and this property allows the equilibrium to be
transformed into an analytically more tractable form. Let us show how this new
concept of equilibrium is derived. Given the asset structure A and a spot price
process p, we say that the security price process q admits no arbitrage
possibilities (NA) if there is no trading strategy generating a non-negative
return at all nodes and a positive return for at least one node. By the same
argument as in the two period case, q satisfies NA given (A, p) if and only if
there exists a stochastic state price (present value) process
/3 " D----~N++
such that
/3(~)q(~) =
~] / 3 ( ~ ' ) [ p ( ~ ' ) A ( ~ ' ) + q(~:')],

~,~+
V ~: ~ D
(25)
1560
so that the present value (i.e. the value at date O) of the asset prices at node ~ is
the present value of their dividend and capital values over the set o f immediate
successors ~ +. Solving this system of equations recursively over the nodes and
using the terminal condition q ( ~ ) = 0 , V { : ~ ' D - leads to the equivalent
statement
1
~]~ , 8 ( , 5 ' ) p ( ~ ' ) A ( , ~ ' ) ,
q( ~ ) - [3( ,~) ~'>e
V ~e D
(25)'
namely that the current value of each asset at node ~ & the present value of its
future dividend stream over all succeeding nodes ~' > ~.
It is clear from (24) that real assets yield a return at each node ~: which is
proportional to the current spot price p(~:). Thus the budget constraints in (@)
remain unchanged if the system of prices (p(~:), q({)), ~: E D is replaced by
the system of prices ( a ( ~ ) p ( ~ ) , a ( ~ ) q ( ~ ) ) , ~ E D for any positive scalar
process a : D--~ E++. In a stochastic economy with only real assets price levels
are unimportant.
As in Section 2.1 the key idea is to introduce what amount to generalized
A r r o w - D e b r e u (GE) prices so that the GEI equilibrium is transfornaed into a
constrained GE equilibrium. We define a stochastic date 0 present value
price process P: D--~ R L by
(26)
p = fl [] p = (/3(sC)p(~))teD
where the box-product now extends over all nodes in the event tree. For
P : D---)~ L and x:D---->~ L it is convenient to define for each ~ : E D - the
box-product over the successors of
P~x =
P ( ~ " ) x ( ~ " ) 'Ea+
P ~ x is thus the vector of present values of the consumption stream x, started

at each of the immediate successor nodes ~' of {:. For each ~: @ D - we may
define the b ( ~ ) x J matrix of asset returns
Ve(P, A) = (a,,~>~P( ~")A( ~")) a,ea +

where the jth column is the b(~:)-vector of present values of dividends from
the jth asset, starting at each of the immediate successors of sc, namely ~:' E ~ +.
If we let (V) denote the subspace of ~b() spanned by the J columns of the
matrix V and if we substitute (25)' and (26) into the budget constraints in ( ~ )
then we are led to the equivalent decision problem for agent i
1561
max u~(x i) subject to

Xt
P ( x - w ' ) = O,
P ? ( x i - to i) ~. ( V~(P, A) ) ,
~ED-
As in the two period case, the budget set implied by these constraints is the
same for all no-arbitrage state price processes/3. Let Ai: D---~ R++ denote the
multiplier process induced by the constraints in ( ~ ) . If we choose/3 = A~ then
agent l's budget set reduces to the GE budget set B(P, ooI) defined above.
We need to be able to consider equilibria in which for each non-terminal
node ~: E D - , the subspace of income transfers (V~) is of fixed dimension p(~)
with 0 <~ p(~) ~<min(J, b(~)). Define the product of the Grassmanian manifolds over the non-terminal nodes
G p'b = [I
GP(e)(~b(~)),
(p, b)=(p(s), b(~))e D
(27)
~ED-
then for any ~ E G 'b, 3? (~),~ED-" We define the NA budget set of agent i
for each (P, 3?, to i) C C++ x G 'b x C++ by
=
B(P,~9?,w')= x i ~ C +
pD(x.
toi)ES~,~
D-
which reduces to (9) when T = 1. Then a normalized no-arbitrage (NA)

equilibrium of rank p = (p( ~))~ED.b with 0 ~< p(~:) < min(J, b(~)), V~: E D -, is
a pair (2,/5, ~ ) E C~+ x C++ x G p" satisfying conditions (i) and (ii) of Definition 4 with (iii) replaced by
(V~(/5,A))=37~,
V~ED
(29)
Lemma 2 is again true: thus an FM equilibrium of rank p is equivalent to an

NA equilibrium of rank p. To prove the generic existence of a GEI equilibrium
one proceeds as in the two period case, defining a pseudo-equilibrium (q~equilibrium) as a normalized no-arbitrage equilibrium of maximal rank (i.e.
p(~)=min(J,b(~)), V ~ @ D ) in which (29) is replaced by the weaker
condition
(V~(/5, A)) C ~ ,
V ~ C D-.
(30)
The kernel of the proof of the existence of a GEI equilibrium lies in showing that
a qJ-equilibrium exists for all parameter values (to, A). Once this is established a
1562
transversality argument shows that there is a generic subset of the parameters

such that for all economies in this subset every ~0-equilibrium is an N A
equilibrium of maximum rank.
Generically complete markets

In a two period economy there are potentially complete markets if J>~ S,
namely when the number of assets is sufficient to cover the possible contingencies (see Section 2.2). In the stochastic economy there are potentially
complete markets if J ~> b ( ) (or more generally when the number of tradeable
assets varies over the nodes if J(~:) i> b(~)) for all E D - . Thus if we take J as
fixed, what matters is the amount of information revealed at each node ~:
measured by b(~). If assets can be traded sufficiently often and if at each
date-event ~c information is revealed sufficiently slowly then the condition can
in principle be satisfied: this of course is the idea of frequent trading in a few
assets which is the key idea underlying the Black-Scholes theory [for a
discussion of this in the context of finance see Chapter 31].
If J/> b( sc) for all non-terminal nodes then the budget set B(P, ~ , o~i) in an
N A equilibrium of maximum rank reduces to the G E budget set B(P, w i) so
that a S-equilibrium is a G E equilibrium. In this case the existence of a
~O-equilibrium follows from the standard G E existence theorem. To establish
the existence of a G E l equilibrium it thus only remains to find conditions on
the asset structure A which ensure that for most price processes P,
rankV~(P,A)=b(~),
V~ED
(31)
so that (29) holds. Just as in the two period case there is a notion of regularity
which does this.
Definition 9. The asset structure A in a stochastic economy is regular if for
each node ~: C D and each immediate successor sc'E ~:+ one can choose a
J-vector ~ ( ~ ' ) from the rows of the collection of matrices (A(~")),,>e, such
that the collection of induced vectors over the immediate successors
($(~'))e,~+ is linearly independent.
Remark. An asset structure A is regular if and only if there exists a price
process P : D ~ R L such that (31) holds. Thus regularity can only be satisfied if
J>~b(~),
V ~D-
(32)
when the number of assets is fixed and more generally if J ( ~ ) 1> b ( ~ ) , V~ E D

when the number of assets varies. When this condition holds it can be shown
Ch. 30: lncomp~ Marke~
1563
that regularity is a generic property of asset structures. In fact it is a generic

property of asset structures A for which the assets pay dividends only at the
terminal date T.
As in Definition 5 let EA(~0) denote the set of financial market equilibrium
allocations for the stochastic economy ~m(O~) and let Ec(~O) denote the set of
contingent market equilibrium allocations for the parameter value w. The
characterisation problem of Section 2.2 has also been completely solved for a
stochastic economy (recall Theorems 5 and 8).
Theorem 15.
There is a generic subset ~* C O such that
EA((.O ) = EC(O)),
V o) e ~'~*
if and only if the asset structure A is regular.

Remark.
The difficult part in proving T h e o r e m 15 lies in showing EA(w ) C
Ec(tO), Vto E ~2" (the analogue of T h e o r e m 3). It is here that the concept of an
N A equilibrium of rank p with p ( ~ ) < m i n ( J , b ( ) ) for some E D is used.
The key idea (as with Theorem 3) is that for such equilibria the number of
equations exceeds the number of unknowns and such systems of equations

generically have no solution.
Incomplete markets
When (31) is not satisfied we say that the asset markets in the stochastic
economy are incomplete. In this case there is at least one non-terminal node ~c
at which
rank V~(P, A) < b(~)
and at such a node agents have limited ability to redistribute their income over
the immediately succeeding nodes. Thus if A is not regular, which is the case if
J < b ( ~ ) for some ~: E D - , then the asset markets are incomplete. In this case
the G E existence theorem is not applicable to prove the existence of a
0-equilibrium. The two approaches outlined in Section 2.3 can be extended to
a stochastic economy.
If n = ( # D ) L denotes the number of spot markets over the event-tree, we
let 5e++
, 1 = { P E C++ ] E~,~ P~(~:) = 1} denote the associated positive unit
sphere in C and define G p'b as the product of Grassmanian manifolds (27) with
p(~:) = min(J, b(~:)), V~: ~ D - . The first approach is based on a consideration
of the 0-equilibrium manifold
-
1564
E=
n-1
{(P, ~ , oJ, A) (5 ~++
x G p'a x 12 x M
is a ~O-equilibrium for (oJ, A)}
I (A ~e)
and the associated projection map 7r : E--->O x M. The argument follows the
same steps as in the two period case. In the second approach the existence of a
~0-equilibrium is an immediate consequence of the following generalization of
Theorem 14.
Let (a, b) = (a(~), b(~))eo-, a ( ~ ) < ~ b ( ~ ) , V~ ~ D - and let

G "'b =IICe o- G"(e)(Rb(e)). I f q9 : 5e~+-1 X G"'b--->R" is a continuous vector
field on 5e~+-1 which for each fixed ~ E G "'b is inward pointing and if the
b ( ~ ) x a( ~ ) matrix valued functions
Theorem 16.
:.90+- l x G " ' b - - > ~ b(e)"(),
V~(SD-
are continuous, then there exists ( P, ~ ) E 5e~+ 1 x G "'b such that

q~(P,~)=O,
(q'~(/5,~)}C~, V ~ E D
Remark. Consider the collection of vector bundles ,ya(),b(,~),~ ~ D - over the

Grassmanians G"()(Rb(e)), ~: @ D-. The proof is based on the multiplicative
property of the mod 2 Euler number of the cartesian product and the use of
Lemma 5 which gives
The second step consists of using a perturbation (transversality) argument to

show that there is a generic subset of the parameter space g2 M for which
(29) holds at every ~O-equilibrium. For a fixed information structure F, let
E(oJ, A) denote the set of FM equilibrium allocations of the stochastic
economy with parameters (oJ, A).
Theorem 17. I f J < b ( ~ ) for some ~ E D - then there exists a generic set
A C 0 M such that E(oo, A) consists of a positive finite number o f equilibria
for each (w, A) ~ A.
Remark. The perturbation argument requires that at any non-terminal node ~:

for which J < b(~), there be J ( b ( ~ ) - J) free parameters in (A(~'))~,>~ in
order to perturb the matrix Ve(P, A). Thus, in particular, it is not possible to
replace M by the subset M' consisting of assets which pay dividends only at the
terminal date T. This is in contrast to Theorem 15 which permits such asset
1565
structures. It would thus be of considerable interest if the following conjecture

could be proved.
Conjecture. For all J and all asset structures A with J assets, there is a generic
set g2a C g2 such that E(oo, A ) ~ 0 for all o~ E OA"
Remark. This section has presented a brief summary of the GEI model with
real assets for the case of a multiperiod exchange economy. There is a wealth
of interesting properties of the underlying GEl model (such as the martingale
and volatility properties of asset prices [LeRoy (1989)] that we have not
attempted to analyse. The reader will recognise that in the one good case
(L = 1) the resulting GEl model is essentially the basic model of the theory o f
finance. In his analysis of the relation between the Black-Scholes theory and
the GEl model Kreps (1982) made clear that even in such a one good model,
when there are three or more periods one can at best expect to obtain a generic
existence theorem. The techniques and concepts of this section are thus likely
to provide an appropriate analytical framework for a broader class of GEl
models than might at first be expected.
References
The basic event-tree model of an exchange economy together with the concept
of a CM equilibrium was given by Debreu (1959). The idea that frequent
trading in a few securities can dramatically increase spanning was first systematically exploited by Black and Scholes (1973). Kreps (1982) presented a
general equilibrium model and showed that if the condition J>~ b(~) for all
holds then any CM equilibrium for ~(u, to, F) can be implemented as an FM
equilibrium for almost all A with J assets. The equivalence result (Theorem 15)
was given by Magill and Shafer (1985). The proof of existence with incomplete
markets was given by Duffle and Shafer (1986a, 1986b).
3. Nominal assets
The object of this section is to study the nature of GEI equilibria when some or
all of the assets are nominal. For simplicity we consider only the case of a
two-period economy. Asset j is called a nominal asset if it promises to deliver
an exogenously given stream N j = ( N ( , . . . , N~) ~ of units of account (dollars)
across the states at date 1. The riskless bond, for which N j = (1 . . . . ,1) r is the
simplest example of such an asset. It should not be surprising that the
equilibria of a model with nominal assets behave very differently from the
equilibria of a model with real assets. Basic economic intuition suggests the
1566
reason. Real assets are contracts promising dividends which are proportional to
the prices in each state: doubling prices in any state doubles the dividend
income that these assets generate. In short real assets are inflation proof. This
is not the case with nominal assets: if the spot prices (in some state) are
doubled since the dividend income remains unchanged, the purchasing power
of the nominal asset's return is halved. What are the consequences of this for
the resulting G E l equilibria?
Walras' test
A good way of obtaining a rough (and as we shall see, basically correct) answer
is to go back to an old idea of Walras: let's count the number of unknowns and
equations, being careful to factor out any redundancy. Let
.~i(p, q, toi), z~i( p , q , to'),
i=l,...,I
(33)
d e n o t e the I agents demand functions for L ( S + 1) goods and the J assets. A

vector of G E I equilibrium prices ( p , q) is a solution of the system of equations
1
F ( p , q, to) = ~ (~'(p, q, to') - toi) = O,

i=1
(34)
G ( p , q, to) = ~ U ( p , q, toi) = O.
i-I
Are the L ( S + 1 ) + J equations in (34) independent? Certainly not. Let

F = (Fo, F I . . . . , Fs), then the fact that each agent fully spends his income in
each state implies that we have S + 1 Walras' Laws
poFo+qG=O,
p,F,-VsG=O,
s=l .... ,S.
(35)
Thus there are at most L ( S + 1) + J - (S + 1) independent equations. This is

true regardless of the type of assets we are considering, whether real or
nominal.
What is the dimension of the set of prices ( p , q)? Let us lay aside the fact
that we need to restrict attention to no-arbitrage asset prices: this will not alter
the argument that follows. Consider first the case where all the financial assets
II~S + l
are real assets. Pick any vector of inflation factors ~ = (oe0, ~1, , as) E o~++
then we have seen that since each agent's budget set is independent of the price
levels
F(a [] p, aoq, to) = F ( p , q, to),

(36)
G(a [] p, aoq , to) = G ( p , q, to).
1567
These S + 1 homogeneity conditions correspond to the fact that there are S + 1

directions in which price changes have no real effects. If we factor out these
S + 1 dimensions of redundant prices then the equilibrium equations (34)
become a system of equations which typically has ( L - 1)(S + 1 ) + J independent equations in the same number of "relative" prices ( p , q). Hence
the conclusion: with real assets there is generically a finite number of G E l
equilibria (see Lemmas 3 and 4 in Section 2.3). Thus the concept of a G E I
equilibrium with real assets is well defined (determinate).
Suppose now that all the financial assets are nominal. Then provided the
matrix of nominal asset returns satisfies a non-degeneracy condition, there are
at least two directions (easily checked from the budget equations) and in fact
only two directions (proved in Section 3.1) in which price changes have no real
effects, namely those defined by the scalars ao, a 1 ~ ~++ with
(Po, q)--~(aoPo, C ~ o q ) , ( p , , q ) - - ~ ( a , p , , q ) ,
the vector Pl denoting the vector of spot prices at date 1. The equilibrium
equations (34) thus typically have L(S + 1) + J - (S + 1) independent equations in L ( S + 1) + J - 2 unknown prices. Walras' test applied to the GEI model
with nominal assets implies that there are S - 1 less equations than unknowns.
Hence the conclusion: with nominal assets the set of G E I equilibrium prices is
generically an ( S - 1)-dimensional set. Since we have factored out the price
changes which leave the budget sets unchanged it would seem that these S - 1
dimensions of prices should correspond to S - 1 dimensions of distinct real
equilibrium allocations. If this is the case, then surely we are led to conclude
that the concept of a G E I equilibrium with nominal assets as it stands is not
well-defined? We shall see that this is indeed the case (Section 3.1).
The Walrasian test applied to the G E I model reveals an essential distinction
between real and nominal assets. In the model with real assets since price
levels are unimportant there is no need to explicitly introduce a role for
money: indeed in such a model money is unimportant. However in a model
with nominal assets to obtain a well-defined concept of equilibrium we need to
explicitly introduce a role for money as a medium of exchange. Thus nominal
assets in the GEI model lead us to the concept of a monetary equilibrium in
which money influences the equilibrium allocation in an essential way. In this
way the indeterminacy of the nominal asset equilibrium is translated into the
property that money has real effects in the monetary equilibrium (Section 3.2).
3.1. Indeterminacy of G E l equilibrium with nominal assets

The object of this section is to make precise the sense in which there is
indeterminacy in the G E I model with nominal assets and to reveal why the
1568
indeterminacy arises We will see that the indeterminacy of equilibrium can be

traced to the conjunction of the following three properties of the model.
(1) Nominal assets are contracts which promise returns denominated in the
unit of account (say dollars)
(2) Variations in the purchasing power of the unit of account across the
states at date 1 give rise to different equilibria.
(3) T h e r e is no mechanism endogenous to the model which determines the
purchasing power of the unit of account across the states at date 1.
(1) is obvious and (3) is clear given (2). Understanding the indeterminacy of
equilibrium thus amounts to understanding (2).
When all the J assets are nominal the date 1 returns matrix (1) can be
written as
N1
V=N=
Nsl
We assume that there are no redundant assets so that rank N = J: our principal
interest lies in the case where the asset markets are incomplete so that J < S. A
G E l equilibrium in which all assets are nominal is called a nominal asset
equilibrium
Let ((x, z), ( p , q); N) denote such an equilibrium when the nominal asset
structure is given by N. The key to understanding (2) lies in noting that a
nominal asset equilibrium can be viewed as a G E l equilibrium in which all J
assets are real numeraire assets (Example 2). This is in fact immediate: for
nominal asset j pays N~ units of account in state s and this is equivalent to a
real numeraire asset which pays Ns/ps
J I units of good 1. Thus if we define the
diagonal matrix (representing the purchasing p o w e r of a unit of account across
the states at date 1)
vI
[vii =
0]
"'.
vs
1
where vs = - - ,
Psi
s = 1,... , S ,
(37)
then ((x, z), ( p , q); [ul]N ) is a real numeraire asset equilibrium with good 1
returns matrix
[Z '][
. . 4 1 ,
"1
As1
Vl
~__
...
"j
As1
0
",
Nll . . . . ,
vsL~[~,
...
;']
(38)
Js
Conversely if we pick any positive diagonal matrix [u d (i.e. u s > 0 , s =
1569
1,. , S) and if ((x, z), ( p , q); [Ul]N ) is a real numeraire asset equilibrium
with good 1 returns matrix defined by (38) which in addition satisfies (37) (we
can always assume this since with real assets we are free to adjust the
equilibrium price levels) then ((x, z), ( p , q); N) is a nominal asset equilibrium.
Thus ((x, z), (p, q); N) is a nominal asset equilibrium if and only if there exists
a positive diagonal matrix [v,] such that ((x, z), (p, q); [v,]N) is 'a real
numeraire asset equilibrium.

Let E'(w, N) denote the set of nominal asset G E l equilibrium allocations for
the returns matrix N and let E(w, [v~]N) denote the set of numeraire asset
equilibrium allocations for the matrix (38). The choice of a positive diagonal
matrix
[ v ~ l ~ N = acY++
~-~
lying in the positive (S - 1)-dimensional unit sphere corresponds to the choice

of a profile of purchasing power for the unit of account across the states at date
1. As we shall show below for most choices of the parameters (to, v,) we obtain
a finite number of equilibrium allocations. Thus for a given profile of purchasing power v, the GEl model becomes well defined. Since
E'(w, N) = U E(w, [v, l N ) ,

V I ~ ~"
analysing the G E I nominal asset equilibrium allocations reduces to studying

the family of real numeraire asset equilibrium allocations E(~o, [u~]N) as u~
varies in N. We shall view this as a problem of comparative statics of equilibria
for which the equilibrium manifold approach of Section 2.3 provides the
canonical framework.
To this end we transform the equilibrium into an NA equilibrium by
introducing (date 0) present value prices
P = [ 3 ~ p with / 3 = h 1
and define the diagonal matrix of present value prices of good 1 across the
states at date 1
[P,I =
"'"
0]
Psi
It is easy to check that since rank [P1][Vl]N = J for all vI E dV"and all strictly
positive matrices [P~], if we substitute equation (17)0 0 (which now holds with
equality) into equation (17)(i) by defining ~: : 9~+-+1 x 12 x N---> ~.-1 with
1570
~:(P, to, uz)
~'(p, ([PI][U, IN); to>,
then the equilibrium equations (17) reduce to

~:(P, to, ~,~) = 0.
(39)
The following result can be viewed as a consequence of Theorem 13; it can also
be established directly using the standard techniques of GE.
Under Assumption 1, E'(to, N) Q for all (to, N) E ,(2 x R sJ.
Theorem 18.
We now begin a study of the "size" of E'(to, N). A familiar argument shows
that equations (39) can be "controlled" by appropriately varying the endowments to, so that ~ Oh0. Thus the equilibrium manifold (21) reduces to
IF : {(p~ (.o, 121) .~++1 x a x .,~ I ~(P, o), /21) = O}
which is a manifold of dimension nI + S - 1. The projection ~- : ~---->12 x Y is
proper. Thus by Sard's theorem the set zi of regular values of Tr is a generic
subset of O 3 c. In a neighborhood A(~,,,) of each regular value (o3, if1) E A,
each equilibrium price vector P can be written as a smooth function P(to, ul) of
the parameters. Let 1(p, t o ) = f l ( p , o91) denote agent l's GE demand function and for i = 2 , . . . , I, let ~(P, to, u~) =f~(P, ([Pl][ul]N); toi) denote agent
i's demand function [where f i is defined by (10)], then the equilibrium
allocation x = (x l. . . . . x l) is a smooth function (P(to, ul), to, ul) of (to, ul).
Let ~'(P, to, u~) denote the portfolio which finances agent i's net expenditure
at date 1, i.e.
P1
~i
= [P,][v, lNz~ i (P, to,/21) ,
i = 2, . . . , I .
We want to show that if there are sufficiently many agents relative to the
number of assets (I > J) then there is a generic subset A* C A such that in an
equilibrium the J vectors
~.J + l'l
{~'(P(to, Ul), w, u,),= 2 1

are linearly independent. To this end for a E 5J 1 [the ( J - 1)-dimensional
unit sphere] consider the function g : 5f++~ A(~,~,) 5eJ-~---> E~ defined by
J+l
g ( e , to,
,,
E
i=2
aiz- ' (P, 02, 5)
1571
and h = ($, g): b++' x a(z,v,) x ~J-l...~n-I X ~J. The asset demands of the
agents can be "controlled" without affecting the demands for goods, by
appropriately redistributing endowments of the agents: thus h f~ 0.
If we consider the manifold
= {(P, 0), l,'l, 0~) (~ ~++1 X A(ts.~I ) X ,.~J-11 h(p, o~, ~,,
= 0},
then we find that the projection ~ : ~---> a(z.~,) is proper so that by Sard's
theorem the set of regular values a(* ~,) is generic. Since d i m ( R ' - ' x E l ) >
dim(O++' x owJ-'), i.e. the number of equations exceeds the number of
unknowns, ~'-'(oJ, h ) = O, V (to, u,) E A~'~,~,). Repeating the argument in a
standard way over a countable collection of regular values gives the desired set
A* on which the property of linear independence holds.
Consider (03, ~ , ) E A* and pick (03, v,) in a neighborhood of (03, 6,) with
u, # ,7,. We want to show that
(40)
~(P(03, v,), 03, v , ) # ~(P(03, g,), 03, g,)
so that for fixed 03, changing v, changes the equilibrium allocation. Suppose
that with uI # if, equality holds in (40). Then from the first-order conditions for
agent 1, P = P(03, v,) = P(03, if,) = P so that
( ( p , [] (xil
x'J+l >
0.)i1))i=2
= < (/~l D (.~il-
o o l )i )xi =, J + ' 2 )
(41)
Since the J vectors on the left and right side of (41) are linearly independent,
we will have arrived at a contradiction if we can show that
([u~lN) # ([ff~]N) .
(42)
Definition 10. An S x J matrix N with J ~< S is in general position if every

J x J submatrix of N has rank J.
Lemma 6. Let N be an S x J matrix in general position with J < S . _ I f 6,
6 E ~ s + satisfy ( [ 6 ] N ) = ([6]N) then there exists a E ~ such that 6 = a6.
Proof. Without loss of generality let 6 = ( 1 , . . . , 1). Let 6 E Es+ satisfy
([6]N> = (N>. Thus each column of the matrix [6]N can be written as a linear
combination of the columns of the matrix N. There is thus a J x J matrix C
such that [6]N = NC. Thus CTNs = 6sN s, s = 1 . . . . . S so that (6s, Ns) is an
eigenvalue-eigenvector pair for C / We want to show that there exists a E
such that 3 = ( 6 1 , . . . , 6 s ) = a(1 . . . . ,1). Since the subspaces spanned by
1572
eigenvectors associated with distinct eigenvalues form a direct sum, unless all
eigenvalues coincide, 8 1 . . . . .
8s = a, we contradict the general position of N.
Consider the projection ~ : 12 X---> 12. Since the projection of a generic set
is generic, 12" = zT(A*) is a generic subset of 12. For each 03 E 12" there exists
ffl ~ N s u c h that (03, if1)E A*. There is thus a neighborhood Y~ of ff~ such that
the equilibrium allocation map
x* : dV~,---~"',
x*(u,)=2(P(03, n ) , 03, ul)
is ~1 and injective. We have thus proved the following theorem.

Theorem 19. Let E'(to, N ) be the set of equilibrium allocations of the nominal
asset economy ~'(~o, N). I f Assumption 1 holds and (i) 0 < J < S, (ii) I > J,
(iii) N is in general position, then there exists a generic set 12" C 12 such that for
each 03 @ 12", E'(03, N ) contains the image o f a ~ injective map of an open set
of dimension S - 1.
Remark. If rank N = S then the subspaces satisfy [u~]N= ~s for all u1E
5es++l. The equilibria coincide with the G E equilibria and are thus generically
finite and locally unique.
Remark. There is a close connection between Theorem 19 and the earlier
Theorem 12: both assert that when markets are incomplete changing the asset
structure changes the equilibrium allocation. In both cases changing the asset
structure twists the subspace of date 1 income transfers so that some agent's
date 1 net expenditures (P~ [] (xi~ - oJ"l)) are no longer affordable. Theorem 19
however considers a restricted set of subspace changes, namely ( N }--~ ([u I]N)
with vI ~ N. It thus requires the additional assumption that if we exclude agent
1, there be enough agents ( I - 1 i> J) so that generically their date 1 net
expenditures span the subspace of income transfers. In this way any change in
the subspace is sure to leave some agent's date 1 net expenditures out of the
new subspace.
Remark. If N is not in general position or more generally if the returns matrix
V consists of a mixture of real and nominal assets then not every change in u1
changes the subspace of income transfers. Thus the equilibrium set E'(to, N)
contains the image of an injective map of an open set which is typically of
dimension less than S - 1: in most cases the dimension remains positive, Arrow
securities which pay a unit of account in one state and nothing otherwise being
an exception.
1573
References
The GEI model with nominal assets first appears in Arrow (1953) where N = I
(the S S identity matrix). It was extended to the case of a general returns
matrix N by Cass (1984) and Werner (1985) who proved Theorem 18 [see also
Werner (1989)]. The first example of indeterminacy with nominal assets was
given by Cass (1985). Theorem 19 is due to Geanakoplos and Mas-Colell
(1989) and Balasko and Cass (1989). The latter authors also show that if asset
prices are exogenously fixed then there is still indeterminacy of dimension
S - J. An important concept that we have not dealt with in this section is the
idea of restricted participation; that is, not all agents may have full access to the
asset markets. In the framework of the nominal asset model, Balasko, Cass
and Siconolfi (1987) have shown that even if the returns matrix N has full rank
if there is a subgroup of agents with restricted ability to participate on the asset
markets then there is still indeterminacy of dimension S - 1.
Remark. The authors cited above interpret Theorem 19 as the assertion that
when markets are incomplete the equilibrium allocations that arise in an
economy with nominal assets are seriously indeterminate: the dimension of
indeterminacy & of the same magnitude as the degree of uncertainty about the
future ( S - 1).
The different equilibria whose existence is asserted by Theorem 19 arise by
varying the purchasing power v~ of the unit of account across the states at date
1. As the proof of the theorem makes clear, a given equilibrium corresponds to
a particular profile ~ of purchasing power; to correctly anticipate equilibrium
prices (~, fi) agents must correctly anticipate the future purchasing power ~ of
the unit of account. But there are no data in the model of the economy which
indicate how the different profiles of purchasing power ~ E N come to be chosen
or are agreed upon by the agents; the parameters v1 @ N are simply free
variables. What is needed is clear; the purchasing power of the unit of account
must be determined by equilibrium equations just like any other variable in the
model.
3.2. Monetary equilibrium and real effects of money

In the nominal asset model originally introduced by Cass (1984) and Werner
(1985), the unit of account is typically viewed as the unit induced by money:
the bonds for example pay off in dollars. But the money thus introduced only
performs its first function, namely to act as a unit of account. Its second and
third functions, namely to act as a medium of exchange and a store of value are
left unmodelled.
1574
Magill and Quinzii (1988) have presented a model which preserves the basic
structure of the nominal asset economy but which adds a monetary framework
in which all three functions of money can be analysed, albeit in a stylised way.
They model the role of money as a medium of exchange via a cash-in-advance
constraint. To separate the activities of sale and purchase of commodities in
exchange for money they split each period into three subperiods. In the first
subperiod agents sell their endowments to a central exchange receiving in
return a money income. In the second subperiod they trade on the asset (bond)
markets and decide how to allocate the resulting money holdings between
precautionary balances (z 0 I> 0) to be used to date 1 and transactions balances.
These latter balances are then used to purchase their commodity bundles from
the central exchange. The same sequence is repeated in each state s at date 1,
except that in the second subperiod, assets pay dividends and the precautionary
balances are liquidated to finance the commodity purchases in the third
subperiod.
The central exchange is run by the government which injects an amount of
money M = (M o, M 1 , . . . , Ms) in the first subperiod of each state (s = 0,
1 , . . . , S) in exchange for the endowments. The statement that the transactions demand for money equals the supply in each state gives rise to a system
of monetary equations
1
Z p,x~=vsM ,,
s=O, 1 , . . . , S
(43)
i--1
akin to the quantity theory equations. The vector of velocities of circulation

v = (v o. . . . , Vs) is endogenously determined and depends on the precautionary holdings (z I . . . . . z/) of the agents. A monetary equilibrium is then
essentially a nominal asset equilibrium to which are added the monetary
equations (43). It is the latter system of equations which "closes" the model
and enables the purchasing power of money to be endogenously determined.
How does the Walrasian test of counting non-redundant equations and
unknowns apply to the concept of a monetary equilibrium? Briefly, excess
demand on the spot and asset markets leads to a system of equations akin to
(34). To this are adjoined the S + 1 monetary equations (43). Since equation
(35) continues to be valid there are still S + 1 Walras' Laws. However the
addition of the monetary equations (43) implies that there is now no
homogeneity property in the prices. The S + 1 equations (43) thus exactly
compensate for the equations missing by virtue of the S + l Walras' Laws. We
would thus expect that generically there are a finite number of monetary
equilibria (as is confirmed by the analysis of Magill and Quinzii).
The analysis of the agents ~recautionary demands for money is facilitated if
it is assumed that ( 1 , . . . , 1) E (N) or that the first asset is a riskless bond
1575
N ~ = (1 . . . . ,1) T. Its price then satisfies ql = 1/(1 + rl) where r 1 is the riskless
rate of interest. With this assumption it can be shown that generically there are
two types of equilibria: those in which r~ > 0 and v = ( 1 , . . . , 1) and those in
which r~ = 0 and u ~ ( 1 , . . . , 1). In what follows we concentrate on a qualitative statement for the positive interest rate equilibria: in these the precautionary demand for money is zero since money is dominated by the riskless bond as
a store of value.
For fixed N we let the economy be parametrised by the endowments and
money supply
(o~, M ) ~ 0 X d//
dg=
[~S+1
++
To factor out those monetary changes which are neutral, in a neighborhood

d / ~ of a monetary policy M ~ ~ we define the induced ( S - 1)-dimensional
neighborhood
~t
MEd/tMIM0=M0,
~'~ M, =~'~ Ms
s=l
(44)
s=l
The following result regarding the neutrality or non-neutrality of monetary

policy can then be derived [see Magill and Quinzii (1988)].
Theorem 20. Let Assumption 1 hold. There is a generic set A C g2 d/! for
which the monetary equilibria of the economy g(oJ, M; N) are regular.
(a) If rank N = S any positive interest rate equilibrium allocation x(03, M_)
with (03, M ) G A satisfies x(03, M) = x(03, M) for all M in a neighborhood of M.
(b) If (i) ( 1 , . . . , 1) ~ ( N ) , (ii) 0 < J < S, (iii) I > J, (iv) N is in_general
position, for any positive interest rate equilibrium allocation x(03, M) with
(03, M) E A there is an ( S - 1)-dimensional neighborhood d/l ~t of M ]defined as
in (44)] such that the image of the equilibrium allocation map
x(03,-) : ~t---~ R nl is a submanifold of ~nl of dimension S - 1.
Remark. This result is closely related to the policy effectiveness debate of
Sargent and Wallace (1975) and Fischer (1977). Theorem 20(a) may be viewed
as a general equilibrium version of the Sargent-Wallace neutrality proposition:
with rational expectations monetary policy is locally neutral if (i) asset markets
are complete and ( ii ) the velocity of circulation of money is locally independent
of M. Theorem 20(b) can be viewed as a general equilibrium version of the
Fischer critique: with rational expectations if (i) asset markets are incomplete
and (ii) nominal asset returns and the velocity of circulation are locally
independent of M, then generically monetary policy has real effects. Of course
for some types of contracts it may not be realistic to assume that nominal
returns are fixed independently of anticipated monetary policy.
1576
Remark. An important condition required for the validity of Theorems 19

and 20 is that there be sufficient diversity among agents in the economy. This
diversity is twofold. First there must be enough agents (I > J). Second the
agents must be distinct--more precisely genericity conditions are made to
ensure that the agents have distinct endowments and hence distinct income
profiles. The fact that the arguments depend in an essental way on diversity
among the agents places these results in sharp contrast with an important
strand of modern macroeconomics which is based on models of equilibrium
with a single representative agent. The redistributive income effects that lie
behind the real effects of money supply changes are necessarily absent in all
representative agent economies.
4. Production and the stock market
In the previous sections we have shown how the traditional (GE) theory of an
exchange economy can be extended to the framework of incomplete markets
(GEI). The key feature in this transition is a change of emphasis from reliance
on a system of markets for real goods to a division of roles between spot
markets for allocating real goods and financial markets for redistributing
income and sharing risks. Thus while GE theory views the economy as
consisting solely of a real sector, the GEI theory provides a symmetric role for
the real and financial sectors of the economy.
How is the traditional GE theory altered when we move to a production
economy? What new phenomena enter? Is the resulting theory satisfactory? It
will become clear in attempting to answer these questions that developing a
satisfactory GEI theory of a production economy presents much greater
challenges.
Two-period production economy

We consider the simplest two-period model of a production economy with
uncertainty. To this end we adjoin to the exchange economy ~(u, to) of Section
2.1 a finite number of firms j = 1 , . . . , J each characterised by a production set
YJC ~" and an initial endowment vector ~/J~R n. Each firm chooses a
production plan yJ E rJ, yJ = (y~, y ~ , . . , y~) where Y s~ -- ( Y s lJ . . . . .
Y ~ L ) denotes the vector of goods produced in state s: if Ys~< 0 (>0) then good I is used
in state s as an input (is produced in state as an output) The technical
conditions that we imposed on the agent's characteristics (u, to) in Section 2.1
are those that lead to a smooth exchange economy. The technical conditions
that we now add regarding the firms' characteristics (Y J, ~J) are those that lead
to a smooth production economy. The reader should not be upset if these
1577
conditions seem a little tricky to express: the role of each assumption is in fact
straightforward.
Fundamentally the production sets Y/ should be like the standard convex
production sets of GE. However, to be able to use the machinery of differential topology in the qualitative analysis of equilibrium we need two additional
properties:
(a) each production set Y~ has a smooth boundary 0 Y/,
(b) a convenient way of parametrising the decisions of firms.
So that (a) does not imply that the production set Y/ involves all commodities, we say that Y/is a full-dimensional submanifold of a linear subspace
E / C R n. However E / cannot be an arbitrary subspace of g~n _ it should involve
some activity in each state (i.e. for any non-trivial production plan y J, in each
state some good is input or output). The initial endowments 7/j are introduced
to obtain property (b). So as not to be arbitrary, they should be compatible
with the production sets Y / i n the sense of lying in the subspace E/. Finally
the production sets Y = (Y' . . . . , Y J) and endowment vectors (to,~/)=
( t o 1 , . . . , to~, ~ , . . . , J ) must be related in such a way that it is not possible to
produce an arbitrarily large amount of any commodity (aggregate output is
bounded). More formally
Assumption 2 (Firm characteristics). (1) Y / C ~n is closed, convex and 0 ~ YJ.
(2) There exist linear subspaces E~ C R L, s = 0, 1 , . . . , S with dim(E~) > 0
such that Y/ is a full-dimensional submanifold (with boundary) of E / =
Eo x E, " " E s.
(3) YJ satisfies free disposal relative to E j.
(4) The boundary OY j is a c2 manifold with strictly positive Gaussian
curvature at each point.
(5) There is a non-empty open set ~ C Rn(/+l) such that if we define
g2=\
++x
E / fqG
/=1
1 (jog +Ej=1
J ~ j @~ n + , V(to, r/)~12 and (~i=1
1 0i -]- Ej=
J 1 (YJ -[- '}~J)) n
then Ei=l
~ is compact V (to, ~/) E 12.
To complete the description of the production economy we need a statement

about the way the ownership of the J firms is distributed among the I
consumers. Let
-~l
"
. . .
1578
denote the matrix of initial ownership shares where ~'~.is the ownership share of
agent i in firm j. We assume
1
~'E~f,
~] ~ ' ~ = 1 ,
j=l,...,J.
(45)
i=1
If the agents' characteristics (u, w) satisfy Assumption 1, firms' characteristics

(Y, rl) satisfy Assumption 2 and the ownership shares ff satisfy (45) then we
obtain a production economy ~(u, Y, if; to, 7/) which forms the basis for the
analysis that follows. Whenever generic arguments are needed we parametrise
the economy by the initial endowments
(to, n ) E ~ 2 = \
o.i++x i E j ) n~?.
An allocation (x, y) = ( x 1
X I, y l , . . . , y J) for the economy ~(u, Y, ~';
to, 7/) is a vector of consumption x' @ ~"+ for each consumer (i = 1, . . . , I) and
a production plan yJ E YJ for each firm ( j = 1 , . . . , J). Equilibrium theory can
be viewed as the qualitative study of the allocations that arise when we adjoin
different market structures to the production economy ~(u, Y, (; to, 7). As in
the earlier sections we study two such market structures, that of classical G E
(contingent markets) and that of G E I (spot-security markets).
. . . .
Contingent markets ( GE)

Contingent commodities and the vector of contingent prices P E ~" were
defined in Section 2.1. Let
[y!
L)s
y01
'
denote the L(S + 1 ) x J matrix whose columns are the J firms production
plans. With contingent markets agent i's (GE) budget set becomes
B(P, y, rl, ~", w') = {x / @ ~+ I P(xi - w' - (y + '7)(') = 0}.

The shareholders of each firm j ( j = 1 . . . . , J) are unanimous that the firm acts
in their best interests (and more generally of all consumers) if it maximises the
present value of its profit P. yJ over its production set YJ. This leads to the
following concept of equilibrium.
1579
Definition 11. A contingent market (CM) equilibrium for the economy

g ( u , Y, ~; to, 77) is a pair of actions and prices ((Y, ~7), 15) such that
(i) ~, i = 1 , . . . ,
I satisfy
Y i= argmax{ui(x *) [xiE B(/5, )7, n, ~', wi)}

(ii) yJ, j = 1 , . . . ,
J satisfy
)7J = a r g m a x { / 5 , yJ I YJ E Y J}
(iii)
- o,') = E sj=, ( 7
+ n J).
We also refer to such an equilibrium as a G E equilibrium.
Stock-market (GEl)
As we mentioned before, a system of contingent markets is not the type of
market structure that we observe in an actual economy: it should be viewed as
an ideal system of markets. A more realistic market structure is obtained by
splitting the allocative role of markets between a system of real spot markets
on the one hand and a system of financial markets on the other. In this section
we restrict ourselves to the simplest class of financial contracts which allows us
to describe the functioning of the G E l model of a production economy. We
assume that the J financial assets consist of the J securities issued by the firms
in which the agents hold the initial ownership shares defined by the matrix ~.
Real assets such as futures contracts can be included at the cost of some
complication in the notation. A proper treatment of nominal assets such as
bonds calls for an analysis along the lines of Section 3.2.
We arrive however at an awkward problem of modelling. If we look at the
real world where time and uncertainty enter in an essential way then we must
recognise two facts: first, in terms of the risks faced and the resources and
ability to pay in all circumstances there are substantial differences between
(small) individual consumers and (large) shareholder owned firms: thus loans
will not be granted anonymously. Second, in practice not all consumers and
firms deliver on their contracts in all contingencies: there is frequently default.
The highly idealised model that we consider below abstracts from these two
crucial difficulties. Since we assume that consumers and firms have equal access
to the financial markets and since there is no default, under general assump-
tions regarding the behavior of firms, the equilibrium allocations that emerge do
not depend on the fnancial policies chosen by the firms. In short, to obtain
determinate financial policies which influence the equilibrium allocation further
imperfections need to be introduced.
1580
Since modelling necessarilyr proceeds by steps, let us try to make this clear.
Let O j = (Ok, D{ . . . . , O~) denote the vector of dividends paid by firm j
(where D~ is paid after the security has been purchased) and let qj denote its
market price ( j = 1 , . . . , J). We allow all firms free access to the equity
markets. This means that each firm can buy and sell the securities of all firms as
it wants. Suppose firm j has chosen its production plan yJ and its vector of
ownership shares in all firms ~J = ( ~ . . . . , ~ ) E R J. If we define the matrix of
stock market returns

DoI - ql
W(q'D)=
D o - q] =
D,
D 11
...
D .o - qj ]
...
DJ
(46)
. .
then each firm's dividend stream D r satisfies
D J = p u ( y J + B J ) + W ( q , D ) ~ ~,
j=l,...,J.
(47)
If we define the matrix of inter-firm shareholdings
then the system of linear equations (47) can be solved to give
o-- (.o,y
-1
provided the matrix ( I - ~) is non-singular (a sufficient condition is ~JE E J+,

J
Ek=
1 ~jk < 1, j = 1 , . . . , J). Equation (48) expresses the fact that when firms
are allowed to buy and sell shares in other firms then the dividends D j of firm j
depend not only its own production-portfolio decision (y J, ~J) but on the
production-portfolio decisions of all firms (y, ~).
Given the expression (48) for the dividends, the budget sets of the consumers can be defined. If agent i begins with the initial portfolio of ownership
shares in the J firms ~.i = ( f f i , . . . , ~ ) and z i= (zia,..., z~)E EJ denotes the
new portfolio purchased, then his budget set is given by
~(p, q, D; ~i, wi) = (xi E~+ l pD(xi
o)i)
=__
q~ieo + Wz,' z i ~ ~J)
where e 0 = (1, 0 . . . . ,0) E ES+l. The following preliminary concept of equilibrium describes how the stock market values the plans (y, ~) = ( y l , . . . , yJ,
~ 1 , . . . , ~j) chosen by the firms.
1581
12. A stock-market equilibrium with fixed producer pIans (y, ~) is a

pair ((Y, ), (/5, 4); (Y, ~)) such that
Definition
(i) (', ~'),
i = 1,...,
I satisfy
;i = arg max { ui(xi) [ xi E O3(15,4,ff), ~i, wi ) } ,

/5G( i - ~o') = q ( e o + # g i ,
(ii) (yJ, ~J), j = 1 , . . . , J satisfy (a) yJ E YJ, (b) (I - ~) is invertible,
(iii) E~= 1 ( ' - to')" = E jJ= ~ (yJ + ~/),
( i v ) Ei=
' 1
' ~
"4- Zi=
= e, e =
The following result shows that the equilibrium allocations and the
equilibrium prices (/5, q) are independent of the firms financial policies ~.
Proposition
21. I f ((, Z), (/5, 4); (Y, ~:)) is a stock market equilibrium with
fixed producer plans (y, ~) then ((2, E),(fi, 4); (Y, ~)) is a stock market
equilibrium with fixed producer plans ( y, ~ ) where E = (I - ~)( I - ~)-1~.
Proof. Consider
structure A = [y,
~s)~"i, s = 0, 1 , . . .
g(u, w; A) then
where
the induced exchange economy g(u, ~; A) with real asset

+ l] where agent i's endowment is given by ~ = ~o~ + (y~ +
, S, i = 1 , . . . , I. If ((, 0), (/5, 4)) is an FM equilibrium for
((, ~), (/5, ~)) is an equilibrium with fixed producer plans
qj = fioY~ + 4 j ,
i = [I - ~l(0 i + ~'~).
The proof then follows from the fact that g(u, w; A) is independent of .
Proposition 21 can readily be extended to the case where firms and consumers have access to K other real securities in zero net supply characterised by an
S x K date 1 returns matrix R 1. In this more general setting Proposition 21 is in
essence the Modigliani-Miller Theorem. In particular if we let borrowing and
lending be denoted by the numeraire asset which pays one unit o f good 1 in each
state at date 1 then we obtain the Modigliani-Miller proposition on the irrelevance of debt financing.
Note that if we impose short-sales constraints on agents (z i E ~J+) then the
market values 4 may depend on the choice of financial policies ~: for even if
~i + ~i E R J+, the matrix [I - ~] will not in general map ~J+ into ~J+. Similarly
if we allow firms to have access to financial policies which alter the span of the
financial markets then the market values 4 will be influenced by their financial
policies ~.
1582
Firms objective functions

The above analysis suggests that there is a broad class of models, where even
when markets are incomplete, while consumers view their own choices of
portfolios z as being of great importance, as shareholders of the firms they do
not view the firms' choices of financial policies as important. The choice of
particular financial policies by firms is simply a matter of packaging: if
consumers and firms have access to the same subspace of income transfers
( W ) , a consumer can always repackage the income streams offered by firms.
As shareholders however, the consumers view firms' choices of production
plans (y) as a decision of great importance. Do the spot and equity markets
provide firms with enough price information to be able to deduce what the
appropriate objective functions should be for making their choices of production
plans?
In the analysis that follows we restrict ourselves to the class of linear
objective functions. Since there are spot markets available in each state and
since the spot prices Ps guide the firm's decision within a state, the problem of
determining an objective function for firm j reduces to determining the relative
prices to be assigned to the states, namely the choice of a vector of present
value prices
[3i
"
~s+l
(1,[31 . . . . , [ 3 ~ ) E . . + + ,
j=l .... ,J.
Suppose for the moment [3 J has been determined.

We assume that firm j's manager chooses the production financing decision
( y J, J) C YJ x ~J which maximises the present value of its dividend stream
S
[3JD i = ~ [3sDs,
i J
j = 1,..., J
(49)
s--0
given the production-financing decisions (yk, ~k) of all other firms k C j. Since
the dividend stream D j satisfies (47) we can write (49) as
[3JDJ=[3J.(pD(yJ +~J))+ [3JW(q,D)~ j ,
j= l,...,J.
Suppose [ 3 J w o then there exists a sequence of portfolios ~ such that

/3 JD J ~ w as 1,--~ ~. Thus a necessary condition for each objective function (49)
~s+ 1 satisfy
to attain a maximum is that [3J E oo++
[3JW=O ~=~ [ 3 J E ( W ) A ~ s+~++,
j=l,...,J
(50)
so that [3j is a positive supporting state price to the attainable set ( W ) . But when
this property holds
1583
13JDJ=/3J.(pa(yJ+7J)),
j=l ..... J,
the present value of firm j's dividend stream equals the present value of its
profit. Thus with an objective function satisfying (49) and (50) firm j chooses its
production plan yJ to maximise the present value of its profit and its financial
policy ~J is irrelevant. (The fact that each firms' objective function is independent of its financial policy can be viewed as the second part of the
Modigliani-Miller Theorem. The first part is given by Proposition 21.)
With an objective function of the form (49) assigned to each firm the GEI
model becomes closed. Since each firm has a criterion for evaluating its
production-financing decision (y J, ~J) the concept of a stock market equilibrium with fixed producer plans (y, ~) can be replaced by the following
concept.
Definition 13. A stock-market equilibrium for the economy g(u, Y, ~'; to, 7) is
a pair ((.f, ), ()7, ~), (fi, 4)) such that the conditions of Definition 12 are
satisfied with (ii)(a) replaced by
(ii)(a)' there exist/3JE
~S~_1 satisfying (50)
)7j = a r g m a x { f i j - ( r i D y j ) l y j E Y j } ,
such that
j=l,...,J.
(51)
Generically complete stock market (J ~ S)

In the context of Definition 13 the GEI "theory of the firm" is reduced to a
theory of how/3 j is determined. Consider the simplest case first where there
are enough publicly traded firms for their equity contracts to span all possible
contingencies (J/> S). In this case for generic (w, 7) ~ O, for any stock market
equilibrium, rank fi~ [] (371 + 71) = S. Since the equilibrium does not depend on
we can set ~ = 0. Thus
/3Jff'=0 :> fl{(fi, a ( f i , + 7 , ) ) = q - p o Y o ,
j=l .... ,J
(52)
has a unique (normalised) solution

~J=(1,~)=(1,~,)=~,
(53)
j=l,...,J.
With a complete stock market each firm can deduce its vector of present value
prices /3J = ~r from a knowledge of the spot and equity prices (fi, 4) and the
outputs (fi + 7) of all firms [or more generally the dividend policies D defined
by (48)]. Since each consumer's present value vector ~i satisfies (52) we obtain
equality of the present value vectors of all consumers and firms
~i=/~j= ~,
i = 1. . . . , i , j = l , . . . , j
"
(54)
1584
The first-order conditions for consumers and firms on the spot markets then
imply that their gradients satisfy
(~o)D~iui=~GficNyjOY',
i=l,...,I,j=l,...,J
(55)
where Nyj OY j denotes the set of normal vectors to the boundary OY i at f (

(55) are the standard first-order necessary conditions for Pareto optimality,
which in view of Assumptions 1 and 2 are also sufficient.
The analysis of Section 2.2 can be extended to the production economy
~(u, Y, if; w, 7/)- Let Ec(w, ~1) denote the set of contingent market equilibrium
allocations and let Ev(w, ~1) denote the set of stock market equilibrium
allocations, then the following result can be established (see Theorem 5).
T h e o r e m 22. If Assumptions 1 and 2 hold and if .I >1S then there exists a
generic set g2* C g2 such that
E,.(.,, n) =
n),
v (,o, n) E a * .
There are a positive finite number of stock market equilibria each of which is
Pareto optimal and locally a smooth function of the parameters (oo, ~q).
R e m a r k . Three additional properties of the stock market equilibria of
Theorem 22 should be noted. Since
4=
b ,
each firm maximises its market value under the standard competitive assumption that firms ignore the effect of changes in their production decisions on the
prices ((r, fi). Since (r i= (r, i = 1 , . . . , I all shareholders (and consumers)
unanimously approve the production decisions f taken by the firms. Since the
stock market and contingent market equilibrium allocations coincide, the stock
market allocations do not depend on the financial policies ~ chosen by the firms
(which are therefore indeterminate).
Partial spanning
For simplicity we express the idea that follows for the case of a one good
economy (L = 1). We say that the technology sets and initial endowments
(Y, r/) satisfy partial spanning if there exists a linear subspace Z C Ns+l of
dimension K ~< J such that
YJcZ,
~J@z,
j=l,...,J.
1585
If this condition is satisfied then generically in any stock market, equilibrium

( 37 + 77) = Z. For any firm j, any alternative production yJ E YJ can be priced
by no-arbitrage since this output is a combination of the outputs of all firms
(securities) which are already priced in the market. Thus if y J = E kJ= 1 0 l k f i k then
the objective function (51) is defined by
S
s-O
J
k=l
k=l
S
s=O
fl,Ys = ~ a~qk"
k=l
Thus if the technology sets and initial endowments ( Y, 71) satisfy partial spanning
then even if the markets are incomplete (J < S), the firms' objective functions
(51) are generically uniquely defined by the stock market. Furthermore it can be
shown that generically the shareholders unanimously approve the production
decisions 37 of the firms.
Incomplete stock market (J < S)
When the condition of partial spanning is not satisfied, in any stock market
equilibrium each firm j will typically have access to dividend streams D j
satisfying
by changing its production plan. An incomplete stock market equilibrium

differs in two important respects from the complete and partial spanning stock
market equilibria.
(i) With an incomplete stock market the set of normalised solutions of (52) is
an affine subspace o f dimension S - J > O. The _firms can therefore not use
market observations on prices and dividends ( ~, D) to determine their present
value vectors fl J. Some extra-market information must be used to determine fl J.
(ii) Whatever flJ vector is chosen, generically for all shareholders ~ri ~ flJ.
Shareholders will thus disagree with the production plan 37J chosen by the firm.
In an incomplete stock market the decision problem faced by the manager of
a firm is essentially a public goods problem for its constituency of shareholders.
In view of (ii) whenever a firm's technology set permits it to consider
production plans which lie outside the current span of the markets, the firm's
manager cannot expect to obtain unanimous support for his choice of production plan. A standard way of resolving a problem of public choice when
unanimity cannot be expected is to resort to the Hicks-Kaldor criterion. Let us
see if applying this criterion can lead to a resolution of the firm's decision
problem.
1586
Let ((2, i ) , (17, ~),(/7, 7)) be a stock market equilibrium. Suppose the
manager of firm j envisions a change in the firm's production plan
~7j ~ 17J + dy j .
This changed production plan alters the equity contract that the firm places on
the market. Suppose all agents have competitive perceptions in the sense that
dp = 0 ,
dqk = 0,
k ~ j.
The basic premise of the Hicks-Kaldor criterion is that the marginal utility of
one unit of good 1 at date 0 is to be assigned the same value for all share
holders. The idea that the gains of the winners (resulting from the change dy j)
can be used to compensate the losers by means of a system of transfers at date
0 leads to the following criterion: the change dy j E T~ 0 YJ is to be accepted
' (1/20) du i > 0 (<~0).
(rejected) if ~i=1
Let (dq;) i denote agent i's perception of the change in the security price
arising from the changed dividend stream dy j. From agent i's budget constraints
/7 []
d x i = - (dqj)i( ~'~ - :?~) +/70 dy~ Z~ + (/7o(17o + 770) - q) dzi]

(/7, adY{) Zi +/7l(17, + 711)dzi
Since (1/2o) du i = (1/2o)(D~,u i) dx ~ = ( ~ c ~ / 7 ) dx i = #~. (/7 Edx ~) and since

7 = ~ i . (/7 D(17 + rt)) we obtain
(~o) dUi=(dqj)i(,)
- Sz:)+ "~'i'(/7[]dyj)Z: ,
i = l, . . . , ' .
Suppose agents' perceptions are competitive in the sense that the security price
is assumed to adjust to the changed dividend stream, the present value of the
changed dividend stream being evaluated with agent i's personal present value
vector 77i, then
(dqj) i - ~ ( / T a d y
j)=0,
i =1,...,I
so that the Hicks-Kaldor sum reduces to
i=1
i=1
i=1
This criterion, which was proposed by Grossman and Hart (1979), is equivalent
to the firm having a criterion of the form (51) with present value vector/3 j
defined by
1587
/~i=~
K~jff',
j=l,...,J.
(56)
i=1
We can argue that this case would seem natural if the shareholders are
perceived as monitoring the manager's production decision "before" the stock
market meets.
On the other hand if the shareholders are perceived as monitoring the
manager's decision "after" the stock market meets then
(dqj) i = 0 ,
i=l .... ,I
since with no further security trading there can be no change in the equity's
price. In this case the Hicks-Kaldor sum reduces to
1
i=1
(v0)
du i = E zjlr
-i -i ( f i ~ d y J ) .
'
i=1
This criterion, which was proposed by Dr6ze (1974), is equivalent to the firm
having a present value vector/3 j given by
I
-'-'
zjzr ,
j=l,...,J.
(57)
i=1
Since it is not economically meaningful to give negative weight to agents

holding a short position in firm j, Dr~ze suggested that all agents be restricted
to holding long positions in the equity contracts.
Definition 14. A stock market equilibrium ((, ~), (37, ~), (fi, ~)) in which
j~j
1
i -i
= E/=
1 ~iTr,
j = 1 , . . . , J is called a Grossman-Hart equilibrium. If firms do
not hold equity portfolios (~ -= 0), if consumers are restricted to non-negative
equity portfolios ( z @ ~ )
and if f i J = Zi=
i 1 zj~r,
- i - ; j = 1 , . . . , J then a stock
market equilibrium ((, ), (37, 0), (fi, ~)) is called a Dr~ze equilibrium.
A G r o s s m a n - H a r t equilibrium does not always exist. We have however the
following result ensuring the consistency of this equilibrium concept.
Theorem 23. Under Assumptions 1 and 2 there is a generic set ~ ' C g2 such
that for all (to, 7) E ~ ' there is a positive finite number of Grossman-Hart
equilibria, each of which is locally a smooth function of (to, rl).
Remark. A similar result can be established for Drbze equilibria. The Grossm a n - H a r t concept has the important property that it extends naturally to
framework of a stochastic production economy. The reader can readily spell out
1588
the details using the framework developed in Section 2.4. As pointed out by
Grossman and Hart (1979), the Dr~ze concept encounters problems in the
multiperiod case.
For the two firm criteria defined by (56) and (57) the "extra-market
information" referred to in (i) that is required to obtain a well-defined criterion
(i.e. a determinate fir vector for each firm) would have to be obtained from the
shareholders of the firm. Both these criteria can thus be viewed as formalisations of the idea that ownership implies control. The competitive assumption
that underlies the model however precludes shareholders from acting strategically in their purchase of firms securities. This is clearly a weakness of the
model since there are important situations where it is most unrealistic to
assume that shareholders do not take into account the effect that their security
purchases will have on firms' production decisions.
Market value maximisation

All the preceding analysis has been based on the competitive assumption that
consumers and firms do not take into account the effect of their commodityportfolio decisions on the market prices (p, q). For consumers this seems a
reasonable approximation since they are normally one of many buyers (sellers)
on the commodity and security markets (modulo the proviso made above). For
firms on the commodity markets where they are one of many buyers and sellers
this may also yield a useful first approximation. But for firms on the equity
markets the situation is quite different: since the firm is the sole supplier of its
equity contract it can be argued that the firm should act strategically with
regard to the equity contract that it markets.
We are thus led to a monopolistic concept of equilibrium which for simplicity
we express for the case of a one good economy (L = 1) in which ~-= 0.
Let ((Y, Y), q; Y) denote a stock market equilibrium with fixed producer
plans y for the economy ~(u, Y, ~; oJ,~) and let ()7, o3,~) be a regular
parameter value. Laying aside the difficulties posed by multiple equilibria (and
proceeding informally), for each y in a neighborhood of )7 the market value
c~(y) is well defined. In order for ((Y, ~), 4('); Y) to be a market value
maximising equilibrium each firm's production plan yJ must maximise its
market value ~r(yJ, Y-r) given the production plans 37_r = ( Y-~) ~ r for all other
firms. To our knowledge there is at present no theorem asserting the existence
of such an equilibrium. Hart (1979) however has studied this concept and has
argued that under assumptions ensuring that each firm is "negligible",
shareholders will agree that market value maximisation is in their best interests.
Is it possible to define a competitive version of the above concept of
equilibrium? Suppose firms make conjectures about the way the market values
1589
a dividend stream, i.e. they conjecture a present value vector/3 j ~ k s+l. If we

require that firms have common conjectures then we are led to the following
concept of equilibrium.
Definition 15. A stock market equilibrium in which /3/=/3, j = 1 , . . . , J is
called a competitive market value maximising equilibrium.
Such equilibria exist generically, but are indeterminate.
Theorem 24. If Assumptions 1 and 2 hold and if J < S then there is a generic
set g2'C g2 such that for all (to, 77)E g2' the set of competitive market value
maximising equilibrium allocations contains a set homeomorphic to a ball in
k s-].
Remark. It is clear from the analysis of this section that the problem of
formulating a consistent and satisfactory concept of equilibrium presents much
greater challenges for a GEI production economy than for the GEI exchange
economy analysed in Sections 2 and 3. In the section that follows we shall
examine the efficiency properties of these GEI exchange and production
equilibria.
References
The classic paper on stock market equilibrium with incomplete markets is due
to Diamond (1967), who also proves a version of the Modigliani-Miller
theorem. The concept of partial spanning was introduced by Ekern and Wilson
(1974) and further analysed by Radner (1974). It was Dr6ze (1974) who first
understood the public goods nature of the firm's decision problem when partial
spanning no longer holds. He introduced the objective function defined by (57)
and analysed the resulting concept of equilibrium (including existence). Grossman and Hart (1979) presented a systematic critique of the concept of a stock
market equilibrium and introduced the criterion (56) which seems to offer a
wider domain of applicability. A classic general equilibrium version of the
Modigliani-Miller theorem was presented by Stiglitz (1974): it was extended to
a wider array of assets and to the case of inter-firm shareholdings by Duffle and
Shafer (1986b) and DeMarzo (1988a). Theorem 22 is due to Duffle and Shafer
(1986b). Theorem 23 is a special case of a more general result on the existence
of a monetary equilibrium (i.e. an extension of the equilibrium of Section 3.2)
for a production economy given by MagiU and Quinzii (1989). Theorem 24 is
due to Duffle and Shafer (1986b).
1590
M. Magill and IV. Shafer
5. Efficiency properties of markets

Under what conditions does a market system function satisfactorily? This
question is given a precise answer by two basic theorems of GE under the
assumptions of convexity of preferences and technology sets, absence of
externalities, common information and price taking behavior. The Existence
theorem and the First Welfare theorem assert that a GE market system
"works" in the sense that for all economies
(i) it has a solution (existence),
(ii) the resulting solution is unimprovable (Pareto optimal).
A GEl market system works at least in the preliminary sense that (i) holds
generically (Theorem 9); (ii) however is generically not satisfied; GEl allocations are not Pareto optimal (Theorem 10). Should this inefficiency property of
G E l markets lead us to conclude that the GEl system is inadequate for solving
the problem of resource allocation? It is clear that whenever a system of
markets is incomplete the criterion of Pareto optimality is too demanding. Is
there a less demanding criterion which respects the intrinsic incompleteness of
the markets, with respect to which the GEI system can be judged as satisfactory? We will consider this question within the framework of an exchange
economy and then within the framework of a production (stock market)
economy.
5.1. Inefficiency in exchange

To simplify the analysis we restrict attention to the two-period model and
assume that the financial contracts consist solely of the class that we have called
real assets. We have therefore as the initial data an exchange economy
~(u, oJ; A) with real asset structure A. We are interested in analysing the
efficiency properties of the GEl equilibria of this economy. To this end it is
important to understand the following property of a real asset contract. The
purchaser (seller) of one unit of real asset j can take (make) delivery in state s
at date 1 in one of two forms:
(a) as the bundle of goods Aj E ~L or
(b) as the income value ps Aj E ~ of this bundle of goods.
If the commodity bundle A~ can be sold (purchased) freely on the spot
markets at the price Ps or if there is only one good (L = 1), then each agent is
indifferent between these two modes of delivery. In a GEI equilibrium, in view
of the way they enter agents' budget sets, real assets are taken as financial
instruments for redistributing income across the states: agents are thus viewed
1591
as accepting (making) delivery in the manner (b). If for some reason the
bundles A~ cannot always be freely traded on the spot markets then the manner
(a) of accepting (making) delivery makes the real asset contract much more
restrictive. In the analysis that follows we shall see that real assets have a
(weak) constrained efficiency property if and only if they are interpreted as
goods delivery contracts (a). When agent i buys the portfolio z ~ (zil .... , zij)
of the real assets then under the bundle of goods mode of delivery (a) he
receives the bundle of goods
=
Alzij = A z i e R Ls
j=l
at date 1. We are thus led to the following definition. (Notation: for 2 i ~ ~",
i
x~i C ~ L let [ ( x- i ~ ) , ~ , x~]
G ~" denote the vector which coincides with )~ except
i
for the component o- which is x~.)
Definition 16. Let ~w(u) denote an economy with utility functions u =
(u 1, . . . , u l) and total resources w = (Wo, w 1, . . ., W s ) E o4++~L(S+I).An allocation 2 = (~71,..., i f ) is weakly constrained ( W C ) efficient for ~w(u) if (i)
Z~_ 1 37~ = ws, s = 0, 1 , . . . , S; (ii) for each state o- = 0, 1 , . . . , S there does not
exist an alternative allocation x~ = (xl~,.. . , x~) satisfying E~=I~x~ = w~ such
that
i
--i
'
u([(x~)~,x~])>u'(2'),
'
i=l,...,I;
(iii) there do not exist transfers of goods at date O, % = (7~0,..., ~ / ) E E LI

with E ~ = 1 % = 0 and changes in the portfolios ~ = ( ~ , . . . , ~ z ) E E J I
with
Z[_a ~ i = 0 such that
i
-i
-"
"
"
U (X 0 q- "7"0, Xtl -~ A ~ i) ~" u t ( x t ) ,
i = 1,... , I.
The following result due to Grossman (1977) shows why the concept of WC
efficiency is of interest.
Theorem 25. (i) I f ((~?, Z), (fi, el)) is a G E l equilibrium then the allocation
is weakly constrained efficient.
(ii) If the allocation 2 is weakly constrained efficient for the economy $w(u)
and if ~ E R~+ then there exist a distribution of the goods ( t o 1 , . . . , w I) with
E ~ = 1 60 i = W , portfolios ~ = (~1 .. : , ~1) and prices (16, c~) such that ((~, i ) ,
(fi, ~)) is a G E l equilibrium.
Remark. Theorem 25 gives a characterisation of the efficiency properties
satisfied by GEI equilibria. For the case of an exchange economy with one
good (L = 1), it provides a natural extension of the two Welfare theorems to
1592
the case of incomplete markets when the concept of weak constrained efficiency is used instead of Pareto efficiency. However when there are two or more
goods ( L / > 2) the theorem does not have such a natural interpretation, since it
does not resolve the basic question of whether or not G E I markets are
"efficient".
First, the WC concept does not deal properly with the case where the asset
structure A is regular (the case of potentially complete markets) for in this case
the G E I equilibrium allocations are generically (fully) Pareto efficient
(Theorem 3). The definition of WC coincides with (full) Pareto efficiency only
when A has column rank SL; when L i> 2 this requires J >>-SL rather than
J/> S for regularity. Furthermore by insisting on a concept of efficiency which
holds not generically but for all economies (i.e. all o) E g2) one is forced to
make the concept sufficiently weak so that it applies to economies o5 E 12 which
have equilibria that can be Pareto ordered [as in Example 5 of Hart (1975)].
Second, when the asset structure A is not regular (so that the markets are
incomplete) we should stop looking for efficiency properties which hold for all
equilibria of generic economies. Hart (1975) has given a robust example of an
economy in which A is not regular in which there are equilibria which can be
Pareto ordered. For such economies, even if one has a notion of efficiency
which is only required to hold generically it must be sufficiently weak to permit
the Pareto dominated equilibrium to be efficient. When markets are incomplete the focus should shift towards better understanding why G E l equilibria
are inefficient.
To understand the reason why financial markets are inefficient it is helpful to
examine the concept of WC efficiency in Definition 16 more carefully. Consider condition (iii): when the portfolios are reallocated Z---~~ + ~ agents are
not allowed to retrade on the spot markets; they must accept physical delivery
of the entire bundle of date 1 goods implied by their changed asset position
A~:i. Thus while in the equilibrium the assets are treated as instruments for
allocating income, for the reallocation they are treated as instruments for
delivering bundles of goods. The reason is clear: if as a result of the portfolio
changes, agents are permitted to retrade on the spot markets, then spot prices will
change. This spillover effect from financial markets to the spot markets is
precisely the effect that the next concept of constrained efficiency seeks to
capture. Note of course that in an economy with only one good (L = 1) there is
no spiUover effect to consider since there are no spot markets (spot prices).
In studying a concept of efficiency it is useful to introduce the idea of a
fictional planner. The planner is viewed as having access to certain "feasible
allocations": if by choosing one of these he can make agents better off then we
say that the equilibrium allocation is inefficient. The problem is thus reduced to
defining the "feasible allocations": choosing the standard set leads to the
concept of Pareto optimality- but with incomplete markets this concept is
irrelevant: we are giving the planner much more freedom to allocate resources
1593
across states than is provided by the system of spot and financial markets. For
an economy with two or more goods the appropriate concept has been
introduced by Stiglitz (1982) and extended to the GEI model by Geanakoplos
and Polemarchakis (1986). The key idea is to subject the planner to constraints
which mimic those implicit in the system of financial markets. The planner can
thus choose a pair ( 3 ' i , z i ) consisting of a fee yi (payable at date 0) and a
portfolio z i for each agent i = 1 . . . . . I. The consumption allocation x =
(x ~. . . . . x ~) is then determined through spot markets at an appropriate market
clearing price (p). Let (% z)= (31 . . . . ,3,[, z l , . . . , z[), then we define the
feasible plans ((% z), (x, p)) as follows.
A plan ((~, ~?), (, fi)) is constrained feasible for the exchange
economy * ( u , tO; A) if
Definition 17.
(i)
Ei~ 1
~i
(ii) 2i= 1
=0
= 0
(iii) (, fi) satisfy Ei= 1 (' - to') = 0 and for i = 1 . . . . , I

i = arg
max
ui(x i)
subject to
i__
i = 3"P0e01,
iPo(Xo
tOo)
e01 = (1, 0, . . , 0.) E. L
fi, ~(x i, - tO;) = PlAZ- -'.

A plan ((~, ~?), (, fi)) is constrained efficient if it is constrained feasible and
there does not exist a constrained feasible plan ((3', z), (x, p)) such that
ui(x i) > u (~x-i ), i= l , . . . , l .
Remark. For convenience we assume that the fee is paid in units of good 1. If
we define the virtual endowments
i
= (tOo
-i
-3'eol
, tO1 + A~'i ),
i=1,...,I,
then in (iii), (, fi) is an equilibrium of the (virtual) exchange economy

~(u, w). Note also that if ((, ), (fi, t~)) is a GEI equilibrium, then ((q, ),
(,/~)) with = t ~ ( 1 , . . . , z), is a constrained feasible plan.
In the one good case constrained efficiency and weak constrained efficiency
are essentially equivalent concepts. However when there are two or more
goods they are quite different. In Definition 16 real assets are viewed as goods
delivery assets: in Definition 17 they are viewed as income delivery assets. Do
the price effects present in the latter definition create distortions which make it
impossible for a price taking equilibrium like a GEI equilibrium to be
1594
constrained efficient? For a marginal change in the consumers' portfolios (z)

will change demand and supply on the spot markets and hence the relative
prices. If markets are incomplete agents evaluations of rates of substitution for
income across the states are different and then such relative price changes may
have an effect on welfare. A planner who takes into account these price
changes thus has an additional instrument for redistributing income across the
states which is not available to the more myopic competitive system. This key
intuition was formalized by Stiglitz (1982) in the context of a particular
example: he stressed however the possibility that this is a general phenomenon.
That this is indeed the case was confirmed by Geanakoplos and Polemarchakis
(1986).
They consider a numeraire asset exchange economy (Example 2) in which
there is no consumption at date 0: it will be convenient to translate their result
into the context of the standard model we have been considering, in which
there is consumption at date 0. The following assumption is then useful.
Assumption 3 (separability). There exist differentiably strictly concave utility
i ~L_>~
i
SL
functions u 0 :
u I R+ ~ R such that
ui(x)
= U oi ( X o ) + u li( x l ) ,
VxE
~n
+,i=1,...,I.
It is also convenient to express the parametrisation of preferences that is

needed a little differently as follows. Let ~ denote the space of utility functions
satisfying Assumption 1 endowed with the ~2 compact open topology. For a
numeraire asset economy we let
A
rA A']
11
"
~SJ
denote the asset returns matrix. The Geanakoplos-Polemarchakis result can

then be stated as follows.
Theorem 26. Let ~(u, w; A) be a numeraire asset economy in which the
agents' characteristics (u, o9) satisfy Assumptions 1 and 3. If (i) the returns
matrix A is in general position, (ii) there exist z E R j with A z >t 0 and z' E ~
with A s z ' O, s = l , . . . , S ,
(iii) 2<~J < S , (iv) O < 2 ( L - I)<~ I < S ( L - 1 ) ,
then there exists an open dense set A C all x [2 such that for (ti, o3) E A every
G E l equilibrium ((~, Z), (fi, ~)) can be improved upon by a constrained
feasible plan ((y, z), (x, p)) satisfying ,/i = ~z', i = 1 . . . . , I.
Remark. To bring out the striking feature of this theorem the following
clarification is useful. We have seen that a G E I equilibrium yields a constrained
feasible plan ((,~, Z), (37, fi)) in which the fees charged to the agents satisfy
1595
-i
3' = qY', i = 1 . . . . . 1. In comparing such an equilibrium with any alternative

constrained feasible plan ((% z), (x, p)) it is useful to decompose the fee as
~1l i = q z t "~ Ti ,
i = 1, . . . , I ,
(58)
referring to the c o m p o n e n t ~.i as a transfer to agent i. With the decomposition

(58) the vector of transfers ~- = (~.1. . . . . z 1) must be chosen to lie in the space
of transfers
9-=
ti=o
tE~ l
i=1
We say that the alternative plan ((c] ~ z + ~-, z), (x, p)) is constrained feasible
with (without) transfers if ~- 0 (= 0). T h e o r e m 26 asserts that the welfare of
each agent can be improved without resorting to transfers provided there are not
too many agents (I < S(L - 1)). Since the welfare of the agents is changed by
inducing changes in the (S + 1)(L - 1) relative prices, it is clear that there must
be a bound on the n u m b e r of agents. Indeed Mas-Colell (1987) has given an
example showing that T h e o r e m 26 is not valid if the upper bound on I is
removed.
If the planner is free to choose not only the portfolios (z) but also any vector
of transfers ~"E 9- then we are resorting to the Hicks-Kaldor criterion, namely
the idea that welfare is improved if the gains of the winners are sufficient to
compensate for the losses of the losers. In this case there are I - 1 additional
control variables at the disposition of the planner and the welfare of an
arbitrary n u m b e r of agents can be improved after the payment of appropriate
transfers. In the following theorem we do not restrict ourselves to numeraire
assets, but consider rather the general class of real asset structures.
Theorem 27. If $(u, o~; A) be a real asset exchange economy in which agents
characteristics (u, w) satisfy Assumptions 1 and 3. If (i) 0 < J < S, (ii) L > 1,
(iii) I > (L - I)S, then there exists an open dense set A C OR x O ~ such that
for (u, to, A) E A every G E l equilibrium allocation is constrained inefficient with
transfers.
Remark. If A is restricted to being a numeraire asset structure and if we
assume A E EsJ is in general position then the genericity with respect to A can
be omitted (i.e. A C R X O).
Proof. We decompose the proof into two parts. Step 1: derive the first order
conditions for constrained efficiency. Step 2: show that there is an open dense
set A such that these conditions are not satisfied at any equilibrium of an
economy with parameters (u, ~o, A) E A.
1596
M . M a g i l l a n d W. S h a f e r
Step 1: When the planner chooses a fee-portfolio pair (3,, z) for each of the I
agents in the economy he in essence assigns a virtual endowment
w i = (o~oi - 3 " e o li,
o~il + Az i) ,
i =
l,
(59)
. . . , I
to each of the I agents. The plan (3', z) thus leads to the virtual exchange
economy ~(u, w). An allocation is then induced as a (pure) spot market
equilibrium of ~(u, 9). Thus each agent's demand function is given by
xi( p, p [] 9 i) ~-- arg max{ ui(x i) [ x i ~ ~ ( p , p [] 9 i ) ) ,

g~(p, mi)={xiElt~n+[pt~xi=m i}
mi~
S+l
++
(60)
and a spot market equilibrium price p @ R n.+ is a solution of the system of

excess demand equations
1
F(p, 9 ) = ~ (xi(P, P D 9 i ) - 9 i) = 0 .
(61)
i=l
Since the budget sets ~ ( p , p D 9 ' ) are independent of the levels of the spot
prices, we normalise the spot prices so that Ps, = 1, s = 0, 1 . . . . , S.
If ~ is a regular parameter value for the economy g(u, 9) then any
equilibrium price can be written as a smooth function p(w) in a neighborhood
of ~. A marginal change (d3', dz) in the planner's decision induces a marginal
change in the virtual endowments
(d3",dz)---~d9i=(d9o,d9i,)=(-d3"ieo,,Adzi),
i=1,...,I
(62)
where we assume that (dy, dz) satisfy

1
1
d'y i = 0,
i=1
~ dz i = 0.
i=1
(63)
As the economy moves to a neighboring virtual exchange economy
+ dg),
each equilibrium changes
(, fi)---~ ( + dx, fi + dp)
where fi + d p = p ( ~ + dw). Each consumer i adjusts consumption so as to
satisfy the changed budget constraints
1597
i=1 .....
fimdx~=fi~d~i-dpo(2~-~i),
I.
(64)
The first-order conditions at the spot market equilibrium (, fi) imply that for
each agent i there exist Xi E ~s+x such that
i
D~,u
~i
[]fi,
i=l .....
(65)
I.
The change in utility for agent i, du i =

dug= A ~ ' ( f i m d w i - d p c l ( . ~ -
(Diiu i) d x ~ can
~oi)),
i=1,...
thus be written as
,I.
(66)
Let Ai = (Ao, . . . , As) and let ~.i = (1, "/l'l)

i = ( 1 , h l i/ h O , i . . . , / ~ ' / h 0 ) " Using
(62), (64), (65) and Assumption 3 ( d u i = du o + d u ~i ) , (66) can be written as
(~)
-i
-i
duo=-dpo(Xo-~0)-dY
i,
i=1,...,I,
(67)
A ) d z i -- ~l(dpl
= 7rlV(Pl,
ff] (3~i1 -- O3il)) .
Let us again make use of Assumption 3. Suppose we can find a change in the
portfolios dz such that
~ (~) duil>0.
(68)
i=1
Since the period 0 economy ~(Uo, ~o) is a self-contained G E economy we can

generate any profile of date 0 utility changes du o = ( d u ~ , . . . , d u / ) satisfying
E~_~ ( 1 / , ~ 0 ) d u o = 0 , by an appropriate choice of fees d y = (dy ~ , . . . , d y x ) .
Thus if (68) holds then we can find du o such that
d u i = duo + duil > O ,
i = l, . . . , I .
H e n c e a necessary c o n d i t i o n f o r c o n s t r a i n e d efficiency is that
duil= 0
f o r all d z E N J~ s a t i s f y i n g ~] dz i = 0.
i=1
(69)
i=1
Assumption 3 implies that the virtual economy splits up into a date 0 and a
date 1 economy
~(U,
O.)) = ( ~ ( U 0 ,
O90) , ~ ( U l ,
O)1 ) )
with excess demand equations (61) written as
1598
F0(P0, eo) = O,
(70a)
F l ( p l , ~,) = 0.
(70b)
The spot price function of a regular economy can thus be decomposed as

=
Consider a GEI equilibrium ((2, , (fi, ~)) for which the induced virtual
endowment ~ is regular. The first-order conditions for agent i's portfolio
choice imply ~V(fi~, A ) = ~, i = 1 . . . . , L Thus using (67), the necessary
condition (69) becomes
1
dui
i=1
-i
= ~_~-i
7rl(dp, cJ(2; - o2_,)
) =0
(71)
"
i=1
for all price changes d/5~ achievable by the planner, namely those satisfying
=
', ,
i=1
0 ~OJl -I
'l = o ,
d~ E (A), i= 1,..., 1
(72)
i=1
w h e r e / ~ denotes the truncated system of prices obtained by omitting, the price

of good 1 in each state (recall dp, 1 = 0, s = 1 , . . . , S). Let (2~, &') and /71
denote the truncations of (2i, wi) and F~. Define the (L - 1)S S matrix of
differences in the income effects between agent a and agent I (truncated with
respect to good 1 in each state)
Q" =
om~ - Omll
Oms
~mm~J
Ot =
1,
I- 1
(73)
Differentiating the equilibrium equations (70b) and noting that OP~/0/SI is

non-singular at a regular value ~ gives
dpl
[ 0p~]-i z-,
--l-~l'J
,~=IEQ ~ V ( f i , ) d z ~ .
Thus if we define the weighted net trade vector (at the equilibrium)
1
=
-' 1
'71"
0) 1 ) ~
L-'s
(74)
,=1
and let (.,-) denote the inner product on a(L-1)s then the efficiency condition
(71), (72) reduces to the orthogonality condition
]-, ,-,
(-LO/~,J
~t=l
1599
)
Q~V(fi')dz"' ~ =0,
V ( d z 1, . . ,
dz x-l) E R J(1-1)
(75)
If we can show that the (L - 1)S x J ( I - 1) matrix
M = [Q1V(fi~)
...
Qt_av(fi,)]
(76)
has rank(L - 1)S then the only vector ~ that can solve (75) is ~ = 0. Since the
markets are incomplete the vectors (~.i)[=1 are generically distinct. This can be
used to show that generically ~ in (74) is not zero, so that the orthogonality
condition (75) is generically not satisfied in a G E l equilibrium.
Step 2: To complete the proof it suffices to show that there is an open dense
set A C o?/ / 2 x ~ such that for every (u, w, A) @ A there are a finite number
of equilibria at each of which:
(a) the induced virtual exchange economy
~(Ul,
o)i1)
is regular or equivalently
IoP,/op, I s0;
(b) ~ # 0 ;
(c) for some column VJ(fil) of the matrix V(fi,) the vectors { Q1VJ(fil),- ,
Q L(S_ I )V J( fil ) ) are linearly independent.
Since the negation of each of the statements (a), (b) and (c) can be written as
an equation or system of equations which is added to the existing G E l
equilibrium equations, to prove the result we need to show that in each case we
obtain a system of equations (h = 0) with more equations than unknowns
which can be controlled (h qb 0). A transversality argument then concludes the
proof.
To prove (a) and (b) we fix u E ~ and apply genericity arguments with
respect to (w, A). Thus we add the equation
= 0
to the G E l
equilibrium equations and show that the resulting system of equations can be
controlled. The argument can be repeated for a countable dense collection of
utility functions (un)~= 1 = {uln,.. . , un),=
i
1. Since the resulting property is
open, we obtain an open dense set A' C q/ x O x M at which (a) and (b) hold.
Showing that (c) is not true is equivalent to showing that the system of
equations
10P,/@,l
0)
L(8-1)
b ~ Q , V J ( ~ l ) = 0 for some b E 0 (L 1)s-1

~=1
(77)
1600
has a solution (where ~ o ( L - 1 ) S - 1 is the [(L - 1)S - 1]-dimensional unit sphere).

N o t e that adjoining (77) to the equilibrium equations involves adding (L - 1)
S - 1 new variables (b) and (L - 1)S equations. To prove that the system of
equations (77) can be "controlled" without affecting the equilibrium equations,
we note that if (77) is satisfied then b E ~p(L-1)S-1 implies b~ # 0 for some i:
"controlling" the equations then amounts to showing that it is possible to make
an arbitrary infinitesimal change in the matrix Q Y J ( f i l ) by perturbing agent i~s
utility function u i, the perturbation being effected in such a way that the
gradient D4Ul(Xl)
i -i remains unchanged, so that the equilibrium equations are
unaffected. The date 1 matrix of income effects for the problem in (60) [the
truncation of which appears in (73)] is given by
K i = [ O X ; ]
--1
LOm'IJ = (Uxx)
-1
[ p ' ] ([P,l(uxx)
T--I
[Pl] )
"'.
r-~2
iz - i "~
where uxx=-Uxi4U~X~) denotes the matrix of second derivatives of u~

-t
t
i -i
i
-i
evaluated at x~. Let ux = D 4 u ~(xl) denote the gradient of u~ at x~. The vector
of utility functions u E ~ can now be perturbed, u---~ t7 E 07/in such a way that
u ~ is unchanged for a # i, and tT satisfies Assumption 1 and
~i
U x
i
Ux
~i
(Uxx)
(Uxx)
- 1
C i
+
(78)
For such a change

dO/VJ(/~I)
d / ( i vJ(/~I)
Pick any vector c E R (L l)S with I[c[[ < e for e sufficiently small. We need to
show that there is a matrix C i satisfying (78) such that d g i v J ( f f l ) = C. We
leave it to the reader to check that C i can be chosen so that
[fi, lCi[fi,] r = 0
and
Ci[pl]Tv = c
where v = ([pl](Uixx)-l[pl] T)
tions (77) can be controlled.
This perturbation argument
that property (c) holds. Since
open dense set and the proof
1 v J ( f f l ) 5 ~ 0, showing that the system of equa-
shows that there is a dense subset A C A' such

this property is open A can be taken to be an
is complete.
Remark. A final comment on T h e o r e m 27 is in order. If J = 0 (spot markets

only) then d~il = 0 in (72) so that (71) holds; a GEI market structure consisting
1601
only of spot markets is constrained efficient. If J ~> S then generically the asset
structure A is regular so that generically ~'i1 = ~'1, i = 1 . . . . . I; thus not only
does (71) hold but in addition we have Pareto optimality (recall Theorem 3).
With only one good (L = 1) there are no price effects (dpl-= 0) so that (71)
always holds (see Theorem 25). The two special cases where (71) is satisfied,
namely when there is no net-trade in equilibrium ~71 - i = 0 (which arises if
the initial endowment to is Pareto optimal) or when the income matrices satisfy
Q~ -- 0, a = 1 , . . . , I - 1 (which arises if the utility functions uil are additively
separable and identical homothetic within each state) are eliminated by the
choice of the set A.
5.2. Inefficiency in production
In the previous section we have shown that in an exchange economy
~(u, to; A), a knowledgeable planner can in principle exploit differences in
agents' income effects in a G E I equilibrium to induce an improved allocation
of the portfolios z ~ , . . . , z z. In Section 4 we defined the concept of a stock
market (GEI) equilibrium for a production economy. Are there new sources of
inefficiency that arise when we consider a G E I equilibrium for a production
economy? This question is important since the stock market is one of the major
institutions on which society's risks in the activity of production are shared
among agents in the economy and which influences the production decisions of
firms. If we recognise the fact that the structure of markets is incomplete, can the
stock market be expected to perform its role of exchanging risks and allocating
investment efficiently?
To answer this question we need to extend the concept of constrained
efficiency to a production economy. The planner is now viewed as choosing not
only the fee and portfolio (7 i, z i) for each consumer but also the production
plan yJ for each producer. The consumption allocation (x) is then determined
as before through spot markets at an appropriate market clearing price (p).
Definition 18. A plan ((~, 2, fi), (Y, fi)) is constrained feasible for the production economy $(u, Y, ~'; to, ,/) (constrained feasible with no short sales) if
(i) Ei=
' 1 "y' = 0
~i) :0,
~ J l
(ii) ~ " '/ = 1 ( ~ t
( i i i ) ) T i E Y J, j = 1 , . . . , J
1
"
"
J
"
(iv) (,/~) satisfy ~'i=1 (t __ to,) = E j: 1 (.~J + 7/'), and for i = 1, . . . , I
x- i = arg max ui(x i) subject to
-
-i
po(Xo - to0) = P0(-3' e0x + (Y0 +
o)Z-i )
M . M a g i l l a n d W. Sharer
1602
A plan ((~, Y, 37), (E, fi)) is constrained efficient if it is constrained feasible

and there does not exist a constrained feasible plan ((% z, y), (x, p)) such that
ui(x i) > ui(xi), i = 1 , . . , I.
Remark. Diamond (1967) showed that if there is only one good and if firms'
production functions exhibit multiplicative uncertainty then every stock market
equilibrium allocation is constrained efficient. Dr~ze (1974) showed that in the
one good case, if firms have general neoclassical production sets, then a
necessary condition for constrained efficiency is that firm j uses the objective
function
1
vJ(yJ)
~_
f l J . y i with /3 j
z i iT.r
i=l
However as Dr6ze pointed out, since the constrained feasible plans of a

production economy are non-convex, the necessary conditions are not sufficient. In fact he gave examples of stock market equilibria which are constrained
inefficient when L = 1. Recently Geanakoplos, Magill, Quinzii and Dr6ze
(1987) have shown that if markets are incomplete and if there are two or more
goods then generically every DrOze equilibrium allocation is constrained inefficient (with no short sales). While their argument is carried out for the case of a
Dr6ze equilibrium their construction indicates that the result will surely hold
for any objective function implying price taking behavior on the part of the
firms.
First-order conditions for efficiency

When a planner chooses a triple (y, z, y) this is equivalent to choosing a virtual
endowment of goods
i
= (Wo - Y eo~ + (Yo + ~0) Zi, 0")1 "~- (Yl + ~71)z ) ,
i = 1,...,
(78)
for each consumer. The consumption allocation and price (x, p) are then a
spot market equilibrium of the virtual exchange economy ~(u, ~) defined by
equations (70). Let ((~, ~, 37), (E, fi)) be a constrained feasible plan for which
the induced virtual endowment w~defined by (78) is regular. A marginal change
(dy, dz, dy) in the planner's decision, which must satisfy the conditions of local
feasibility
1
dy i = O ,
i=1
~ dz i = O ,
dzij>~O if z,-i = O, dy j E T~j OY j,
i~l
j = 1. . . . , J
(79)
Ch. 30: IncompleteMarkets
1603
induces a marginal change in the virtual endowment
(dy, dz, d y ) - . d ~ ' = - d y ' e o + ( ~ + ~ 7 ) d z i + d y Z i,
i=1,..~,I
(80)
where e 0 = (1, 0 . . . . . 0) E ~LS. The resulting change in utility for each agent i
is given by (66). By the same argument as in the previous section, under
Assumption 3 a necessary condition for constrained efficiency is that
1
(1/J(o) du = 0 for all (dy, dz dy) given by (79).

i=1
Dividing (66) by ~o and summing over i gives the marginal change in social
welfare arising from the change (dy, dz, dy)
1
du'= ~ ff'.(fi[](37+~))dzi+ ~ ff~-(fi~dy)/'
i=1
i=1
i=1
I
Z - i7 r , "
O'l)l
[] ('~il -
[dpl
(81)
i=1
-i
-i
-i
-i
-i
where Zi= 1 ~r0 dp0 (x 0 - - _~o) = dp0 ~ ' i = l (x o - ~o)

. = 0 since spot markets clear
in the virtual equilibrium. The first two terms in (81) represent the direct
income effect of the change (dz, dy), the last term is the indirect price effect.
Let ((2, Z, 37), (fi, ~, if)) be a Dr6ze equilibrium (Definition 14). It can be
shown that there is a generic set O such that for every economy
~(u, Y, if; o9, ~7) with (w, ~/) E 12, in each stock market equilibrium ((2, i, 37),
(fi, ~, if)) the induced endowment o) defined by (78) with y = (ff - Z)c] is
regular for the spot market economy ~(u, o). Thus we can evaluate the
marginal change in social welfare arising from a change (d3,, dz, dy) in the
neighborhood of the stock market equilibrium. The first order conditions for
the portfolio choice Z ~of agent i imply that there exist rio =>0 such that
-i
~ (fi cl(37J + ~J)) =
qj
- p "- ' "
p '""= 0
-i
if zj
> 0
Multiplying by dz~ and summing over i and j gives

I
Z "~'i'(ffD(ffq-~)) dZi= - - Z Z Pqdzij = - f i d z .

i=1
(82)
i=1 j=l
The first-order condition for profit maximising by firm j implies

I
-i ~i
~'. zj"(fiDdyJ)=O,
VdyJET/OF j
(83)
i=1
Thus in a stock market equilibrium the marginal change in social welfare reduces
to
1604
M . M a g i l l a n d W. S h a f e r
du i = -~dz
--
i=1
-i
,.n-1.
[ d / 7 , E3 ( . ~ '", -
~-,i) ]
i=1
The first term represents the cost of the no-short sales constraints z~j _->0 and
this term is zero in an equilibrium where ~ > O, for all i, j. The second term is
the effect on welfare of the induced changes in spot prices; it is this term which is
crucial to our analysis.
/7(.) is a function of oJ, which in turn is a function of the planner's action
(% z, y). We indicate this by writing
(% z, y)---~ w---~/7 .
~
L e t apl/OZ j and O/7~lOyjt denote the partial derivatives of the vector valued
function/7~ with respect to z and Y,t,

i respectively, written as column vectors.
Thus
0/7,
Oy{
[ 0/7,
o/7, ]
[ Oy~
OyJsJ
is an SL x SL matrix. We thus have the following necessary conditions for

constrained efficiency.
Proposition 28 (efficiency conditions).
Under Assumption 3, if a Drdze

equilibrium ((2, Z, ~), (fi, q, ~r)) is constrained efficient then
(i)
.=
-i
,jJ (Xl
okj
=0,
j=l .... ,]
for all k and k' such that z- jk > O , Z~' > O,
(ii) 7r,.
-i
i=l
dy
Lkay{
n ( E ' , - ~ l-i ) = 0
f o r a l l d y i E T i j O Y j,
j=l,...
,J.
Remark. We call (i) the portfolio efficiency condition and (ii) the production
efficiency condition; (i) is the same as the efficiency condition (71), (72) of the
previous section. Consider the following cases for which (i) and (ii) hold.
(a) There is one good (L = 1). (i) and (ii) hold since the price effects vanish.
This explains the result of Diamond (1967), for with multiplicative uncertainty
the set of feasible allocations is convex and the first-order conditions are
sufficient. For the general (one good) case studied by Dr~ze (1974) the set of
feasible allocations is non-convex and the necessary conditions are not suffici-
1605
ent. As mentioned above Dr~ze gave examples with L = 1 which are not
constrained efficient.
(b) All agents' present value vectors coincide. This happens if the asset
markets are complete and the portfolio constraints zij >t 0 are not binding.
(c) There is zero net trade (2il - -i1 = 0, i = 1 . . . . . I) in the induced virtual
equilibrium. This occurs in the rather exceptional case where the induced
virtual endowment is Pareto optimal.
Case (c) is clearly exceptional; (a) and (b) suggest the possibility that if there
are at least two goods in each state (L >/2) and if markets are incomplete
(J < S) then Dr6ze equilibria are generically constrained inefficient. That this
is indeed the case was proved by Geanakoplos, Magill, Quinzii and Dr6ze
(1987) who established the following result.
29 (generic inefficiency of stock market equilibrium). Let
~(u, Y, ~; to, 71) be a production economy satisfying Assumptions 1-3. If (i)
I/>2, (ii) L/>2, (iii) I + J ~ < S + l , ( i v ) E ~--R n f o r s o m e f i r m j C { 1 , . . . , J } ,
then there exists a generic set ~2" C g2 such that for every (to, 71) E [2" each Drbze
equilibrium allocation is constrained inefficient with transfers.
Theorem
Proof. The idea is to write the system of equations satisfied by an equilibrium

and to show that any solution of these equations will generically not satisfy the
efficiency conditions (ii) of Proposition 28. Modulo some technical preliminaries involved in showing that generically equilibria are of full rank and
locally smooth functions of the parameters, the problem reduces to the analysis
of the local behavior of the spot market equilibrium price/7(w) of the induced
virtual economy ~(u, w).
Let
l
2(p, to) =
E (;'(p, p _to')- _to')= 0

i=1
denote the system of equations defining/7(~). The efficiency condition (ii) can
be written as the inner product condition
(r0
,l ~" ~-i, [](x,-i - ~i ) ) = O,
\L Oy~ J dy{, i=1
'
V dy[ ~ N Ls
(84)
In view of the normalisation of spot prices, d/~.~ = 0, s = 0, 1 , . . . , S. Thus if

we let
Q = [ 0/~l]0y~j:R L s - - ~ ( L - 1 ) s ,
QT : ~ ( L - O S __>~LS
1
U
=dy~
v =
E
i=1
- i [] ()~l
~' -93-1
hi
1606
then (84) reduces to
(Qu, v)=(u, Qrv)=O , V u E ~ L s cz>Qrv=O.
(85)
If we can show r a n k ( Q r) = (L - 1)S then v = 0 is the only solution of (85).

Since it can be shown that ~ 1 , . . . , # t are distinct, v ~ 0 generically.
We show rank Q r = ( L - 1)S. In view of the separability assumption A3,
the equation Z ( p , ~ ) = 0 splits into a pair of equations Zo(Po, i f 0 ) = 0 ,
2~(p~, ~ ' 1 ) = 0 . Differentiating the latter at w = Q and using the fact that
/71(~0~) = P l
gives
[ o 2 , 1 op,
~" _
L -O~l J OyJsl
' e".. -02~

Y~
- 7 A, + e;'
ares
/=1
s = 1,...,
S, Z= 1 . . . . .
(86)
where e]l E NLs is the vector whose c o m p o n e n t (s, l) is 1 and whose other
components are zero. Since o5 is regular the matrix B = [021/0/)1] has rank
( L - 1 ) S , so that B -I is well-defined. Thus (86) can be written as
Q=B
IC
where the matrix C is given by (recall fi, l = 1, s = 1 . . . . .

-i OX ,2
zj--
--
C=
i:,
am',
z j
o~'i=i
/=1
Om I
-i 0X12
....
fiSL
O m----~l
'=1 Zj
.
Ores I
/
-i OXsL
/),2 E Zj
/=1
Om I
-i OX sL
--
'
1 - / ) , 2 E zT~
S)
,=I
am~ J
C is a matrix with SL columns and ( L - 1)S rows. To prove that rank

Q = (L - 1)S it suffices to show that rank C = (L - 1)S. Let C~ denote column
(s, l) of C. If we subtract from each column C,), l/> 2, the multiple fi, lCs, of
column C , , , s = l . . . . . S t h e n w e obtain a n e w m a t r i x D = [ . . Csl C s 2 fi~2C~l . . . C~L--fisLCsl "-'] with the same rank as C
-i o~',
zi ~
i=1
Om I
+,
D = -~
i=1
_,
o~'~
-- ,=1 Z j Omiz
z~
i=1
<
zj am]
'
-~
o~',
Om 2
-z.~ z i
,=1
,=1
e5
z j ~
i~1
+-i <
0
_, 0 <
....
'
i
Om 2
,
Om2
....
....
-i
-i 0X2
zi -5
zj
,=1
i=1
Om s
Oms
Oms
where I is an (L - 1) x (L - 1) identity matrix. Clearly rank D = (L - 1)S.
1607
References
The need to formulate an appropriate concept of constrained efficiency in a
model with incomplete markets was first recognised by Diamond (1967).
Theorem 25 was proved by Grossman (1977). One of the earliest attempts to
formalise the constrained inefficiency of GEl is due to Stiglitz (1982). The first
fully articulated general equilibrium version of this result is due to Geanakoplos and Polemarchakis (1986). Theorem 29 is one of several inefficiency results
obtained by Geanakoplos, Magill, Quinzii and Dr6ze (1987).
6. Concluding remarks
6.1. Interface with finance

A key idea that emerges from the GEI model is the interdependence between
the real and financial sectors (markets) of the economy. In this survey we have
concentrated on the qualitative properties of the GEl equilibrium allocations
with real and nominal assets and with production. We have not stressed or
explored the qualitative properties of the asset prices in such equilibria. Such an
analysis leads us to the domain of finance. The one good model can be viewed
as the basic equilibrium model of finance. Under the assumption of quadratic
utilities it leads to the classical capital asset pricing model (CAPM). The
no-arbitrage pricing formula
S
qj= ~ ~SsV~ ,
j= l,. . . ,J
(87)
s--1
is used as the point of departure for exploring the relation between asset prices
and risk characteristics of the economy. In the CAPM model it leads to the
famous beta pricing formula relating asset prices to their volatility relative to
the market portfolio. The principle of no-arbitrage which underlies (87) forms
the basis for a rich and varied analysis in the theory of finance - indeed it can
be viewed as the central principle of modern finance. The Black-Scholes
theory of derivative asset pricing is one of the most striking applications. For
this and related issues in the theory of finance we refer the reader to Chapter
31.
6.2. Secondary assets

An important family of securities are the various secondary (derivative) assets,
in particular options. Ross (1976) was the first to point out that introducing a
sufficient number of option contracts might in principle provide a relatively low
1608
transaction cost way of achieving full spanning. Friesen (1979) has described in
detail how to implement any complete markets equilibrium in a multiperiod
model by constructing options on stocks. McManus (1986) has shown that in a
real asset model with enough options to potentially span, equilibria exist
generically.
When the financial markets (including options) are incomplete, the presence
of options causes difficulties. It is useful to distinguish two cases. Those in
which the striking prices are denominated in a numeraire commodity (or
commodity bundle) and those in which the striking prices are denominated in
nominal terms. In the first case Polemarchakis and Ku (1986) have exhibited a
robust counterexample to existence of equilibrium using European options. In
such a model, pseudo-equilibria always exist under standard assumptions; the
difficulty is that it may not be possible generically to perturb the parameters of
the model to force the pseudo-equilibria to become true equilibria. In a model
which includes Polemarchakis-Ku type counterexamples Krasa (1987) has
shown, that in a precise sense the "likelihood" of non-existence is smaller the
more variable the aggregate endowment vector. Kahn and Krasa (1990) have
exhibited robust examples of non-existence with American options. These
counterexamples only require L = 1 and do not appear amenable to the
analysis of Krasa (1987).
In the case where the options have nominal strike prices, Krasa and Werner
(1989) have shown that equilibria always exist, and that the dimension of the
set of equilibrium allocations may in some cases be equal to the number of
states S, rather than S - 1 as in the nominal asset case of Section 3; thus,
absolute price levels may matter as well as relative price levels across states.
Even if there are enough assets (including options) to span all states, not only
are complete market allocations achievable, but also many inefficient equilibrium allocations will be present. Kahn and Krasa (1990) have shown that with
American options with nominal strike prices, even if there are enough options
to potentially span, only inefficient equilibria may rise. The basic difficulty with
American options is that an agent, with the choice of early exercise of the
option, can affect the span of markets. Clearly much research remains to be
done to properly integrate options into the GEl model.
6.3. Endogenous asset formation
This survey has concentrated on models in which the asset structure is taken as
exogenous (with the exception of firms' equity contracts). It is essential to the
continuing study of GEI models to obtain an understanding of the types of
assets that are likely to be introduced and successfully traded. On the empirical
side a useful survey of innovation in publicly traded security markets is given
1609
by Miller (1986). On the theoretical side there is a paucity of research; Silber

(1981) and Duffle and Jackson (1988) have examined the problem of designing
and marketing futures contracts; Allen and Gale (1988) have analysed a GEI
model in which firms design optimal securities in the presence of transactions
costs; Cuny (1989) has studied a strategic model of exchanges designing
securities to maximize their brokerage fees.
Related to the issue of endogenous asset formation and whether or not it will
lead to complete markets, is the problem of demonstrating that "almost"
complete markets will lead to "almost" Pareto efficient allocations. Consider a
model in which the number of states is countably infinite and there are only a
finite number of securities. With less assets than states, the markets can in
general never be complete, but one can ask whether equilibrium allocations
approach Pareto efficiency as the number of traded securities approaches
infinity. The initial research by Green and Spear (1987) has been generalized
by Zame (1988). Zame has shown that in a precise sense generically, Pareto
efficiency will fail in the limit as the number of securities approaches infinity if
there is no provision for default.
6.4. Bankruptcy
Bankruptcy and default like limited liability can be viewed as contractual
arrangements designed to augment the span of markets. When properly
formulated they should play a central role in the GEI model. Although
bankruptcy has been studied in the context of temporary equilibrium models
[Green (1973), Stahl (1985a, b)], there have so far been only a few studies
[Dubey, Geanakoplos and Shubik (1989), Dubey and Geanakoplos (1989b)] in
the framework of the GEI model. The difficulty lies in satisfactorily modelling
the phenomenon of default without breaking the basic GEI equilibrium
concept in the process. By introducing the idea of default penalties and an
equilibrium default rate on each contract the above authors have shown how
the concept of a GEI equilibrium can be extended to include the phenomenon
of default. An interesting result which makes use of this default-GEI equilibrium has recently been obtained by Zame (1989). He shows in a model with an
infinite state space that equilibrium allocations are approximately Pareto
efficient if the default penalty is large and the assets "almost span" all
uncertainty, a conclusion which is false if default is not permitted.
6.5. Alternative approaches to firm behavior

In Section 4 we examined only a few approaches to modelling the problem of
decision making by firms. An approach we did not discuss, but which is
1610
important in practice is to incorporate into the model the voting process by

which corporate firms are typically controlled, that is shareholders vote for a
board of directors and the board hires a manager. Initial studies of this
corporate voting mechanism as a pure majority voting problem are those of
Gevers (1974), Benninga and Muller (1979, 1981), Winter (1981) and
Sadanand and Williamson (1988). Dr6ze (1985) has developed a model in
which the board of directors has veto power and demonstrates existence of
equilibrium. DeMarzo (1988b) has studied the relation between voting mechanisms and value maximization: he shows that any production equilibrium which
satisfies the Pareto criterion with respect to the shareholders must be a stock
market equilibrium (as in Definition 13), with each firms' /3 j being a convex
combination of shareholder present value vectors ~.i (as in the Dr6ze and
Grossman-Hart criteria).
An understanding of the phenomenon of takeovers must play an important
role in a more complete theory of firm behavior. Hart (1977) has formulated a
GEl model in which takeover bids are possible and examines whether the
possibility of takeovers leads to value maximization. A related problem has
been studied in the framework of incomplete contracts and asymmetric information by Grossman and Hart (1988) and Harris and Raviv (1987), who
analyse the one s h a r e - o n e vote rule in the context of corporate takeovers.
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Chapter 31
THE THEORY
OF VALUE
IN SECURITY
MARKETS
DARRELL DUFFIE*
Graduate School of Business, Stanford University
Contents
1.
2.
Introduction
Early milestones
2,1.
2.2.
2.3.
3.
4.
5.
Arrow's "Role of Securities" paper

Modigliani-Miller's irrelevance of corporate financial structure
The capital asset pricing model
1617
1618
1618
1620
1622
Basic asset pricing techniques
1625
3.1.
3.2.
3.3.
3.4,
1625
1627
1629
1631
Arbitrage pricing
Representative-agent pricing
Recursive representative-agent pricing
Extended recursive preference models and time consistency
Continuous-time equilibrium in security markets
1633
4.1.
4.2.
4.3.
4.4.
1633
1637
1639
1642
General equilibrium in continuous-time

The dynamic spanning condition and Girsanov's Theorem
The representative-agent asset pricing formula
The consumption-based CAPM
Continuous-time derivative asset pricing
1646
5.1.
5.2.
5,3.
5.4.
5.5.
5.6.
5.7.
5.8.
5.9.
1646
1647
Prologue
The setup
Arbitrage and self-financing strategies
The arbitrage pricing functional
Numeraire-invariance
Equivalent martingale measure
Alternate sufficient conditions for equivalent martingale measures
Equivalent martingale measure and the state price process
Arbitrage pricing of redundant securities
1648
1649
1650
1650
1653
1654
1655
*Support from Batterymarch Financial Management from Deutsche Forschungsgemeinschaft,

Gottfried-Wilfielm-Leibniz-F6rderpreis and typesetting by Shellee Wiedemeier are both gratefully acknowledged. I have benefited from comments by Costis Skiadas, Steve Ross, Monique
Jeanblanc-Picqu6, Steve Shreve, Lars Nielsen, Kristian Miltersen, Ayman Hindy, Ravi Myneni,
Gerard Debreu and Rose-Anne Dana.

5.10. The Brownian case: spanning and Girsanov's Theorem

5.11. The Markov case: the PDE for derivative asset prices
5.12. Approximate solution of the arbitrage PDE
5.13. Extensions of the PDE method
6. F u r t h e r r e a d i n g
6.1. General references
6.2. Finite-dimensional general equilibrium in security markets
6.3. Spanning and the behavior of the firm
6.4. Mutual funds and factors in asset prices
6.5. Asymmetric information
6.6. Equilibrium asset pricing models
6.7. Extended notions of spanning
6.8. Asset pricing with "frictions"
6.9. Technical references on continuous-time models
6.10. Derivative asset pricing
6.11. Infinite horizon recursive models
6.12. Estimation
Appendix:
Stochastic integration
References
1656
1659
1664
1665
1665
1665
1666
1666
1667
1667
1668
1668
1668
1669
1669
1670
1670
1670
1673
Ch. 31: The Theory of Value in Security Marke~
1617
I. Introduction
General equilibrium theory, as summarized for example in Debreu's (1959)

Theory o f Value, can be applied wholesale to obtain a theory of value for
security markets, as shown by Arrow (1953). The modern theory of value for
security markets, however, elaborates or extends general equilibrium theory in
at least the following major ways:
(1) It explicitly treats general multi-period trading opportunities under
uncertainty and in incomplete markets.
(2) It investigates, in remarkable depth, implications of the law of one price,
that is, of arbitrage-free prices.
(3) In order to represent security returns in convenient and testable ways, it
places strong restrictions on preferences and exploits a great deal of probability
theory, especially the theories of Markov processes and stochastic integration,
separately and together.
By looking in these and other directions, finance theory has been a catalyst
for further developments of the general equilibrium model, particularly for
equilibrium existence theorems with incomplete markets, infinite-dimensional
consumption spaces or asymmetric information. In the other direction, general
equilibrium theory has offered financial economists a benchmark for market
behavior that was missing before Arrow (1953) and Arrow and Debreu
(1954).
As financial market theory grows, it laps over the boundaries of the general
equilibrium paradigm in order to focus on the process of price formation. The
"microstructure" of security markets has come under increasing scrutiny; the
theory of specialist market makers, for example, is gradually being filled out.
The need to address asymmetric information, in particular, has led to strategic
models of investment behavior.
For conventional purposes such as asset pricing, however, general competitive equilibrium models are still the norm. Indeed, it may be argued that the
Walrasian notion of price-taking suits large financial exchanges better than
most other markets. Thus, despite the diverse aims of financial economic
theory, in this chapter we summarize developments in finance that rest or
build on general equilibrium theory, emphasizing the valuation of financial
assets.
This chapter is organized into four sections: Early milestones, Basic asset
pricing techniques, Continuous-time general equilibrium and Derivative asset
pricing. The chapter concludes with further notes to the literature on these
topics and references to related topics.
D. Duffle
1618
2. Early milestones
We review in this section some of the major milestones along the path of early
theoretical developments to models of security market equilibrium: (i) Arrow's
"Role of Securities" paper, the central paradigm of financial market equilibrium theory, (ii) the Modigliani-Miller theorem on the irrelevance of corporate financial policy, and (iii) the Capital Asset Pricing Model (CAPM) of
Sharpe (1964), Lintner (1965) and Black (1972).
2.1. Arrow's "Role of Securities" paper

The first major milestone is Arrow's (1953) paper, "The Role of Securities in
the Optimal Allocation of Risk Bearing," still a standard reading requirement
for doctoral finance students. Among others, Hicks (1939) had earlier worked
toward general models incorporating markets for claims to future value, that is,
securities. Arrow (1953), however, had the first general closed model of
equilibrium for markets in which both spot commodities and securities are
traded. This milestone preceded even the presentation by Arrow and Debreu
(1954) as well as McKenzie (1954) of techniques suitable for demonstrating the
existence of equilibrium in such a model.
We follow here with a reprise of Arrow's model in a slightly extended form.
There are S possible states of the economy, one of which will be revealed as
true. Before the true state is revealed, n securities are traded. Security number
j is a vector d r E ~s, representing a claim to dsj units of account ("dividends")
in state s, for each s E { 1 , . . . , S}. A portfolio 0 E ~" of securities thereby lays
claim to 0- ds = 2j=~ 0/d~j units of account in a given state s E {1 . . . . , S}. A
portfolio 0 is budget-feasible given a vector q E ~n of security prices if
0- q ~<0. After the true state is revealed, agents collect their dividends and
trade on spot commodity markets. In each state s, each agent i ~ {1 . . . . , m} is
endowed with a bundle e~ E ~t of 1 commodities, whose respective unit prices
are given by some vector Ps ~ ~t.
A consumption plan is a vector c in ~ ' , written {c~ E 0~+ - 1 ~<s <~ S} for
convenience, with c~ denoting the planned consumption vector in state s. (In
looking at consumption sets defined only by non-negativity, we are letting
generality slip through our fingers in orders to focus on a few main ideas, and
will continue to do so.) Given security prices q ~ ~n and spot commodity prices
p E ~ , a pair (0, c) is a budget-feasible plan for agent i if 0 is a budget-feasible
portfolio and c is a consumption plan satisfying
n
ps.(Cs-e's)<~O.ds,
s@{1 . . . . , S } .
Ch. 31: The Theory o f Value in Security Markets
1619
Each agent i has a utility function U~ :R~s-->E. Given prices (q, p ) E

~"x~S,
a pair (0, c ) ~ R " x R 's is an optimal plan for agent i if it is
budget-feasible and if there is no budget-feasible plan (0', c') such that
Ui(c' ) > Ui(c ). A security-spot market equilibrium for the economy ((Ui, el),
(di)), i @ { 1 , . . . , m } ,
jE{1,..,n},
is a collection (( q, p), (Oi, ci)), i E
{1 . . . . . m}, satisfying:
(1) for each i E {1 . . . . , m},__(O' c i) is an optimal plan for a g e n t / g i v e n the
security-spot price pair (q, p) ,__u~" ~,s;
(2) markets clear: E i 0 i = 0 and Z i (c ~ - e i) = O.
For purposes of comparison, a complete contingent-commodity market
equilibrium for the economy (Ui, ei), i E {1 . . . . . m}, a concept also appearing
for the first time in Arrow's paper, is defined as a collection (/~, (ci)),
i~{1,...,m},
where / 7 @ R ~ and, for each i E { 1 . . . . , m } , c i E
arg maXceu~ Ui(c ) subject to ~ . c <~/7. e i, with E i c i - e i -- O. We t r e a t / 7 as the
price, before the true state is revealed, of a contract promising delivery of one
unit of commodity number c if state s is revealed to be true, and nothing
otherwise.
It is widely felt that Arrow showed a security-spot market equilibrium to be
Pareto optimal provided that securities span, in the sense described below, a
first welfare theorem for security markets. This is essentially the stated goal of
his paper. In fact, however, Arrow proved a second welfare theorem for
security markets: if an allocation {c ~@ E~s: 1 ~< i ~< m} is Pareto optimal, then
it comprises the consumption plans of some security-spot market equilibrium,
under the conditions:
(1) spanning: span({dj : 1 ~<j <~ n}) = Rs;
(2) convexity: for each i E {1 . . . . , m}, U i is quasi-concave;
(3) strict monotonicity: for each i E {1 . . . . , m } , c > c' => Ui(c ) > Ui(c' ).
(Arrow's specific assumptions were slightly different.) The proof is in two
steps. First, given the Pareto optimality of (ci), the usual second welfare
theorem [Arrow (1951), Debreu (1951)] implies the existence of contingent
commodity prices/7 C R~ supporting the allocation ( c ) in a complete contingent-commodity market compensated ~ equilibrium (/7, (ci)). The second step is
to implement the contingent-commodity compensated equilibrium (/7, (ci)) as
a security-spot market compensated equilibrium. This implementation is easily
s
done, after choosing an arbitrary "state-price" vector 7r C E++,
as follows:
(1) let qj = EsS=a 7rsdj~, j E {1 . . . . , n};
(2) letp~=/TsTrs, s E { 1 . . . . ,S};
(3) for i E (1 . . . . , m - 1}, let 0 i solve the system of linear equations
I T h e c o l l e c t i o n (,6, ( c i ) ) is a c o m p e n s a t e d
e q u i l i b r i u m if t h e r e is a v e c t o r w ~ E " ( o f w e a l t h
t r a n s f e r s ) s u c h t h a t Y.~ c ~ - e i = 0 a n d , f o r all i, c ~ ~ a r g m a x c U~(c) s u b j e c t t o p . c ~ ~< w~ + p e ~.
D. Duffle
1620
Ps (c~ - e~) = j~= l O j'd # ,
(1)
l<-s<-S;
(4) let 0 " = --Ei=lm-I oi.

The reader can quickly verify as an exercise that (q, p, (0 i, ci)) is a bona fide
security-spot market equilibrium provided the wealth transfers making (/7, (c~))
a compensated contingent-commodity equilibrium are again applied, before
security trading. The spanning condition on securities provides for the existence of solutions to the system of equations (1) defining 0/.
Of course, there is also a First Welfare Theorem: Any security-spot market
equilibrium for an economy with strictly monotone utilities and spanning
securities involves a Pareto optimal allocation of contingent commodities.
Arrow's (1951) simple "adding-up" argument suffices for proof; convexity is
not required. Moreover, with the additional assumptions of continuous quasiconcave utility functions and interior total endowments, security-spot market
equilibria exist. The existence proof proceeds by demonstrating the existence
of a complete contingent-commodity market equilibrium, and then implementing the allocation in a security-spot market equilibrium by the above four-step
procedure.
The theory of existence and optimality of equilibria is quite different,
however, without spanning, as explained in Chapter 30. Briefly, if individual
endowments are interior, in addition to the other assumptions, then equilibria
always exist, but are generically inefficient without spanning. If security
dividends are defined instead, in terms of commodity bundles, then equilibria
may exist only generically, that is, except for a closed set of measure zero of
endowments and securities, under regularity conditions on utility functions.
2.2. Modigliani-Miller's irrelevance of corporate financial structure
Modigliani and Miller (1958) demonstrated the irrelevance of corporate financial structure in the absence of such market "imperfections" as taxes, transaction costs, bankruptcy costs, asymmetric information, and so on. It is instructive to view a version of their results in the setting of Arrow's model of security
and spot markets.
First, we extend Arrow's model with the addition of a firm, characterized by
a production set Y C ~ts and a vector 3' @ ~ of initial shareholdings of the
firm among agents, normalized so that E;=~ 3'i = 1.
We take the firm's production choice y E Y as given. The firm is also free to
choose a portfolio 0 E ~" of securities. Given a spot commodity price vector
p E R~, the firm's total dividend is the vector 6(y, p, 0 ) E ~s defined by
m
Ch. 31: The Theory of Value in Security Markets

6(y,p,O).~=ps.ys+O.ds,
1621
sE{1,...,S}.
The firm finances its portfolio 0 by issuing the dividend - 0 . q in the first
period. The firm's shares are traded, like any other security, at some price v. A
portfolio in this setting is a pair (q~, 0) E ~ x ~" representing q~ shares of the
firm and a portfolio 0 of the other n securities. A budget-feasible plan for agent
i, given prices (v, q, p ) E ~ ~ " ~ , is therefore some triple (q~, 0, c ) E
~" ~ satisfying
(q~- 7i)v + q~(-O . q) + O" q<~O ,

Ps" (cs - e~) <~ ~o6(y, p, O)s + 2 Off#,
s e {1 . . . . .
s}.
j-I
The budget constraint for the initial period reflects the share -q~0 . q of the
firm's initial dividend allotted to the shareholder. A budget-feasible plan
(~o, 0, c) is optimal for agent i if there is no budget-feasible plan (q~', 0', c') with
Ui(c' ) > Ui(c). A security-spot market equilibrium, given the firm's production
and financial plan (y, 0 ) Y x E", is a collection (v, q, p, (q~g, 0/, c~)), i
{ 1 , . . . , m}, satisfying:
(1) for i @ { 1 , . . . , m } ,
( i,o i,c i) is an optimal plan for agent i g i v e n the
prices (v, q, p),
(2) markets clear: E i q i = 1, Z i 0 i = 0 and Y'i ci - ei = Y.
By the "irrelevance of corporate financial structure," we mean a result of the
following sort, a version of Modigliani and Miller's assertions found, in a more
general form, in DeMarzo (1988).
Proposition 1. Suppose (v, q, p, (~i, 0 i, ci)), i @ { 1 , . . . , m}, is a security-spot

market equilibrium given the firm's choice (y, 0 ) E Y x ~n. Let ~o @ ~ , be any
other portfolio choice by the firm, and let ~i= oi + i(oO - ~o) be revised
portfolios for the agents, i E {1 . . . . , m}. Then (v, q, p, ( i, ~i, ci)), i@
{ 1 , . . . , m}, is an equilibrium given the firm's alternate choice (y, 0o)@
YxR".
Proof is left as an easy exercise. Interpreting, an adjustment in the financial
policy of the firm causes no change in its market value v. Moreover, every
shareholder is indifferent to changes in the firm's financial structure, given the
ability of each shareholder to adjust his or her own portfolio strategy so as to
exactly offset any changes in the firm's financial structure.
The notes in Section 6 indicate a number of directions that one can take in
order to overturn the irrelevance of corporate financial policy. The notes also
D. Duffle
1622
introduce the literature on the role of spanning in shareholder unanimity, or

lack thereof, concerning the production policy of the firm.
2.3. The capital asset pricing model ( C A P M )

Due to Sharpe (1964), Lintner (1965) and, with no riskless asset, Black (1972),
the Capital Asset Pricing Model ( C A P M ) can also be viewed in Arrow's (1953)
setting. First, we suppose there is only one commodity consumed in each state.
Second, we fix this spot commodity, usually called "consumption," as the
numeraire, so that Ps = 1 in each state s E {1 . . . . , S}. This allows us to view a
security d r as a claim to units of account or to units of consumption. Finally, we
append to the state set J2 = {1 . . . . . S} the o--algebra o~ = 2 of all subsets as
well as a probability measure P on ~ , which (for concreteness and fairness to
the strength of the preference assumptions to follow) is taken to represent the
c o m m o n probability assessments 2 of the agents. In fact, for the CAPM, we
could let (J2, o%, P ) be an arbitrary probability space, provided one restricts
attention in the following calculations to r a n d o m variables with finite variance.
For convenience, the utility function U~ is defined on the whole space Es. For
each agent i, the restriction of Ui to Z = s p a n ( { d ~ : l < . j < ~ n } ) is varianceaverse if, for any c and c' in Z with E(c)= E(c'), we have Ui(c ) > Ui(c' )
provided v a r ( c ) < var(c'), where var(-) denotes variance, treating a consumption vector c in Es as a random variable c : g2--->E. In infinite-state settings, if
{dj} is jointly normally distributed, variance-aversion is implied by expected
concave utility. This implication is generalized from normally distributed to
spherically distributed dividends by Chamberlain (1983a).
We adopt the following principal assumptions.
Assumption
1 (variance-aversion). For all i E { 1 , . . . , m}, Ui is varianceaverse when restricted to the span of security dividends, Z = span({dj : 1 ~<j ~<
n}).
Assumption 2 (endowment-spanning).
For all i ~ { 1 , . . . , m}, e i ~ Z.
For the economy ((U~, e i ) , (at/)), we take as given an equilibrium (q, (Oi)),
i E (1 . . . . , m}, notationally suppressing the spot price Ps = 1 in each state s
and the consumption plan c i = e i + Z~.=1 0jdj of each agent i. Equilibrium
existence results can be found in Nielson (1985, 1987, 1989a,b).
2From an axiomatic point of view, probability assessments are properties of preferences with
Savage's (1954) framework, which calls for an infinite set of states, but we shall merely take
probabilities as given.
1623
Security pricing is arbitrage-free if O ' q > 0 for any portfolio 0 with total
dividend ET= 1 0jdj > 0 and O . q = 0 whenever ET= ~ 0jdj = 0 . For example, if Ui
is strictly increasing for some agent i and there is a security with non-zero
non-negative dividends, then security pricing is arbitrage-free. Security pricing
is risk-neutral if there is a constant K such that qj = KE(dj) for all j.
Risk-neutral pricing is possible, but somewhat pathological with varianceaversion, 3 so we consider the following.
Assumption 3. Security pricing is arbitrage-free and not risk-neutral.

The following proof of the C A P M allows for, but does not require, the
presence of a riskless asset, some portfolio 0 whose total dividend Ej 0jdj is a
non-zero constant. The result applies to an arbitrary probability space
(J2, o%, P), and to a (closed) possibly infinite-dimensional linear subspace Z
defining the span of security dividends. We first prove the "price form" of the
CAPM, later reducing the CAPM to its return (or " b e t a " ) form.
Proposition 2 (CAPM: price form).
Under Assumptions 1-3, for any equilibrium ( q, (oi)), there are constants k and K such that the equilibrium security
prices satisfy
qj=kcov(e, dj)+KE(dj),
jE(1,...,n},
(2)
where e = E i e i is the aggregate consumption.

Proof. We take the case of no riskless asset, leaving the easier case with a
riskless asset for the reader. Our proof is inspired by Chamberlain's (1988). We
can endow Z = s p a n ( { d j : l < ~ j < ~ n } ) with the Hilbert-space inner product
(c, c')~-~cov(c, c'). (Assumption 3 implies that Z is at least 2-dimensional.)
Since security pricing is arbitrage-free, the linear functional r l : Z--~ ~ defined
by
= 2 q,o,,
j=l
z: 2
j-1
is represented [as in Luenberger (1969)] by a unique 1r E Z in the form

//(z) = cov(z, ~'),
z ~ z.
Likewise, let the expectation functional E : Z--~ ~ be represented by ~/E Z.

3For
example, let e1= d 1= - d 2 =
-e 2
and U1= U2, which implies risk-neutral pricing.
D. Duffle
1624
For any agent i, let ~ denote the orthogonal projection of c ~ onto

span({~r, r/}), and let 0 i denote any portfolio satisfying
î
e ~+
~i
Ojdj = c .
/=1
By the definition of orthogonal projection, H(O ~ - Ci)

feasible. Since E(6 i - c i) = 0 and cov(6 i, 6i _ c i) = O,
0,
SO
Oi
is budget-
v a r ( c i ) = v a r [ 6 i + (c i - 6 i ) ] = v a r ( d i ) + v a r ( c i - ~i)>~var(~i).
We therefore know that Ci= ~i, for otherwise ~ i is strictly preferred to c i and is
achieved by the budget-feasible portfolio 0i. Thus e = E i c i E span({~-, ~7}).
Using Assumption 3, ~- = ke + K~? for some constants k and K with k ~ 0. It
follows that, for any c C Z,
H ( c ) = k cov(e, c) + K covQ/, c) = k cov(e, c) + K E ( c ) .
This produces the result in the absence of a riskless asset. With a riskless asset,
the proof uses the inner product (c, c ' ) ~ E ( c c ' ) .
The return of any portfolio 0 @ En of securities with non-zero market value
q 0 is defined as the random variable
Ro-
o,4
q'O
By the endowment-spanning assumption, there is a portfolio M ~ E ~ of

n
~
m
securities with total dividend E j= 1 Mjdj
e ---- Ei= 1 Ci, the equilibrium aggregate
consumption. We refer to M as the market portfolio.
Assumption 4 (non-triviality).
q" M ~ 0 and var(RM) 0.
U n d e r Assumption 4, the beta of any portfolio 0 (of non-zero market value)

is defined by
cov(Ro, RM)
to
var(RM )
Corollary (CAPM: return form). Under A s s u m p t i o n s 1-4, there is at least one

portfolio q~ with non-zero market value and with 18 = O. Fixing q~, f o r any
portfolio 0 with non-zero market value,

e(Ro)
- e(R
) =/30[e(nM)
1625
(3)
I f there is a riskless asset with non-zero market value, we can take ~ to be that
riskless asset.
Proof. The fact that there exists a "zero-beta" portfolio q~ follows from
Assumption 3, which implies that Z is at least 2-dimensional and that some
point in Z is uncorrelated with R M and has non-zero price. Equation (3)
follows from (2) and a few algebraic manipulations.
The proof of Proposition 2 also shows a "mutual fund theorem." There exist
two portfolios of securities, say ~0z and 8 , such that, for each agent i, the
equilibrium consumption c i is financed by some portfolio ai~o z + bi~ B of these
two mutual funds. For example, we could l e t m and B be portfolios such that
n
n
B
Zj=~
q~jA dj =~7 and E~=
1 pjdj
= ~-. This follows from the fact that, for all
i, c' Espan({Tr, r/}). A more natural choice would be to let one of the two
mutual funds be M, the market portfolio. If a riskless asset exists, it would
serve as the other mutual fund.
3. Basic asset pricing techniques

In this section, we review two basic theoretical techniques used in pricing
securities. The first, arbitrage pricing, is transparent in concept, but deep in its
application, for example, in continuous-time settings such as those illustrated in
Section 5. The second, "representative-agent pricing," is merely a simple
application of the standard formula equating ratios of prices with marginal
rates of substitution. We will see representative-agent asset pricing first in the
two-period setting of Arrow (1953) and then in an infinite-horizon setting. In
Section 4, representative-agent pricing reappears in a multi-agent continuoustime setting.
3.1. Arbitrage pricing
Still maintaining the structure of Arrow's (1953) model as outlined in the

previous section, consider a security-spot market equilibrium (q, p, (0 i, d)) for
the economy ((dj), (U/, ei)), j E {1 . . . . , n}, i E ( 1 , . . . , m}. As in the CAPM,
arbitrage-free security pricing implies the existence of a unique linear functiona l / / o n Z = s p a n ( { d j : l < - j < - n } ) by
j=l
j=l
D. Duffle
1626
Arbitrage-free pricing also implies that H is strictly positive, that is, any
portfolio with total dividend z > 0 has a positive total price H ( z ) > 0 (throughout, "z > 0" means z/> 0 and z # 0.)
A n y strictly positive linear functional II on a linear subspace Z of a
Euclidean space R s has a strictly positive linear extension ffl : ~s___~~.
Lemma.
This well known result, found for example in Gale (1960), can be proved by
using the theorem of the alternative, and yields the following state-pricing
result, which first appeared in Ross (1976c, p. 202).
Corollary (state-pricing). If security pricing b arbitrage-free, there is some
(state-price) vector cr E ~s++ such that
S
z@Z.
s=l
The state-price vector ~r is uniquely determined if and only if Z = R s.

Suppose some portfolio 0 has a dividend z = E~= 1 ~dj >>0 (me_aning z s > 0
for all s). Assuming that (d, q) is arbitrage-free, we know that q- 0 = H(z) > O.
We can therefore normalize prices and dividends relative to the price and
dividends of O, respectively, by defining
qj
it# -
,,
~j=l
j E ( 1 . . . . . n},
d#
s@(1 .....
S},jE{I
....
,n}.
t~djs
Security pricing for the normalized pair (c), d) is also arbitrage-free, implying
an associated state-price vector ~- @ ~ s + with
S
Oj --
j E (1, . . . .
n}.
s=l
For the portfolio O, we have O. c) = 1 and ~;=10jCljs ] for all s. This implies
S
that Es=~ ~rs = 1, so we may treat ~- as a vector of probability assessments of
the states. Endowing ~Q = { 1 , . . . , S} with the o--algebra ~ consisting of all
subsets, and giving (~, ~ ) the probability measure Q defined by Q({s}) = ~rs,
we have
=
c~j=EQ(d~),
j~E{1,...,n},
(4)
1627
where E Q denotes expectations under Q. (As with the CAPM, we are treating
an element of R s as a random variable on g2 into E.) In summary, by choosing
an appropriate numeraire and probability assessments, one can always view the
price of an asset as the expected value of its dividends.
The measure Q is called an equivalent martingale measure by Harrison and
Kreps (1979), who extended this idea to a continuous-time setting, as explained in Section 5. There is no general infinite-dimensional result, however,
guaranteeing the existence of strictly positive linear extensions, which is
annoying, since many financial models are by nature infinite-dimensional.
There are, however, results such as the K r e i n - R u t m a n Theorem implying
(weakly) positive linear extensions of positive linear functionals on a linear
subspace with a positive interior point. Ross (1978a) was the first to apply this
sort of result to infinite-dimensional asset pricing. For a strictly positive linear
extension, it is typical, instead, to follow the lead of Harrison and Kreps (1979)
and Kreps (1981) in assuming the existence, for some agent with convex
continuous strictly increasing preferences, of an optimal consumption choice in
the interior of a convex consumption set. The separating hyperplane theorem
then produces a satisfactory strictly positive continuous linear extension of the
price functional. Because of technical issues, even a strictly positive continuous
linear extension does not guarantee the existence of an equivalent martingale
measure. Rather than reviewing the infinite-dimensional case in more detail
here, we refer readers to Section 5.
3.2. Representative-agent pricing

The object here is a formula relating the aggregate consumption level of the
economy (which is, arguably, an observable macro-economic variable) to the
linear functional H that prices securities. An example is the CAPM.
Suppose, to begin, that there is a single commodity (l = 1) and a single agent
( m = l ) with a differentiable strictly monotone concave utility function
U" ~s---> E and a consumption endowment e >>0. As with the CAPM, we
normalize so that the equilibrium consumption price is Ps = 1 in each state
s E {1 . . . . , S}, and assume that the security dividends (dis) are defined in
terms of this same numeraire. By inspection, an equilibrium is given by the
consumption choice c = e, the portfolio choice 0 = 0, and the security price
vector q E ~" defined by
qj=VU(e)dj,
j~{1,...,n},
where VU(e) denotes the vector of partial derivatives of U at e. Suppose, as

previously, that O = { 1 , . . . , S} is endowed with the structure of a probability
D. Duffle
1628
space and that vectors in R s are treated as r a n d o m variables. We consider the

utility function U defined by U ( c ) = E [ u ( c ) ] , for some differentiable
u : ~+ ~ R. In this case
qi = E [ u ' ( e ) d j ] ,
j ~ {1 . . . .
, n}.
(5)
Despite its simplicity, this is a basic asset pricing formula used in much of
financial economics and macro-economics. A multi-period analogue, suitable
for econometric analysis, is reviewed in the next subsection.
Turning to the case of heterogeneous agents, we assume spanning:
span({dj: 1 ~<j ~< n}) = I~s .
As stated in Section 2, with this spanning assumption an equilibrium consumption allocation (c ~) = {c ~E ~ s : 1 ~< i ~< m} is Pareto optimal for the agents
(U~, ei), i E { 1 , . . . , m}, provided, for example, that, for all i, U i is increasing
and strictly concave.
For any given "utility weights" A E ~ , let U~ : R s --~ ~ be defined by
U~(x) =
max
~ t~iUi(xi).
xl+'"+xm~x i-1
By the Pareto optimality of (ci), we can choose A so that U~(e) = ziml t~iUi(ci),
m e i. In order to give an interpretation of prices in terms of
where e = Zi=l
marginal uti!ity, we want to guarantee that the equilibrium consumption
allocation (c') is interior. For this, it is enough that IIvu,(c)ll-- ~ for c in the
boundary of the positive cone. Pareto optimality then implies the co-linearity
of {VUi(ci): 1<_ i <_ m } . The implicit function theorem 4 implies that U~ is
differentiable, and the equilibrium security price vector is then given by
qj = kVUA(e)dj,
j ~ {1,...,
n},
for some constant k > 0. Again, we have related security prices to aggregate
consumption.
In order to exploit the special case of von N e u m a n n - M o r g e n s t e r n (expected
utility) preferences, we let O = {1 . . . . . S} be given the structure of a probability space (12, ~ , P), and treat any x E R s as a random variable x : g2--* ~.
We assume, for each agent i, the preference representation Ui(x ) = E[ui(x)] ,
where u,. is differentiable, increasing and strictly concave. The representativeagent utility function Ux is then of the form
4For details and the required regularity on utility functions, see Mas-Colell (1985).

V~(x)= E[u~(x)I,
1629
x~S,
where u A : R+ ~ N is defined by
u~(a) =
(al .....
max
~, )tiui(ai)
am)~-~r~ i = I
subject to al + . . . + a , , < ~ a .
It follows that
qj = kE[u'~(e)d~] = k l E ( d j ) + k 2 cov[u~(e), dr],
j E {1 . . . . .
n},
(6)
for positive constants k, k I and k 2. Constantinides (1982) developed a finitedimensional multi-period version of this construction.
If u i is locally quadratic at the equilibrium consumption level c i, then
u~(c i) = a i + bic i for some constants a i and bi, and thus u'a(e ) = a + be for some
constants a and b. We then have
q~ = kEIu'~(e)di] = k,E(dj) + k2b cov(dj, e ) ,
j~ (1,...,
n},
from which we recover the CAPM. O f course, we could have obtained the
CAPM directly from the fact that concave quadratic expected utility is variance-averse.
3.3. Recursive representative-agent pricing
The work of L e R o y (1973) and Rubinstein (1976) on asset pricing in an

infinite-horizon setting was capped off by Lucas (1978) with a simple recursive
pricing relation known as the "stochastic Euler equation." As shown by
Kandori (1988), few assumptions are required for the existence of equilibria
with this pricing formula, given the usual outright assumption of a single agent.
In order to see this model in a simple form, let (J2, o%, P ) be a probability
space and let gr = { ~ : t ~ N} denote a sequence of sub-o--algebras of ~ that is
increasing in the sense that t/> s implies that ~, C ~,. The set o~ of events
represents information available at time t. A sequence { X , } of random
variables is adapted if, for all t, X t is o~t-measurable. Naturally, all economic
processes in the model are adapted.
Let L denote the space of bounded adapted sequences, with the usual
positive cone L+. The single agent in the model is represented by an
endowment sequence e ~ L and a utility function U : L + ~ [~, There are n
securities represented by a collection d = (d 1. . . . , d n) ~ L n of dividend sequences. The economy is therefore completely specified by the list
1630
D. Duffle
((g2, ~ , P), U:, (U, e), d ) .

As in the CAPM, we take it that the securities' dividends are paid in units of
the single consumption commodity. Given a vector of security price processes
S = (S ~, . . . , S ' ) E L", a budget-feasible plan for the agent is a security trading
strategy 0 = ( 0 1 , . . . , on)~ L" satisfying, for all t E N ,
c~=--et+Ot_ ~ . d , - S , . ( O , - O t _ , ) > ~ O ,
with 00 = ( 1 , . . . , 1). That is, 0 is feasible if the associated consumption

sequence c o is non-negative. A budget-feasible trading strategy 0 is optimal if
there is no budget-feasible strategy q~ such that U(c ~) > U(c). A n equilibrium
is a security price process {S,} such that the (no-trade) strategy 0", defined by
0* = ( 1 , . . . , 1) for all t, is an optimal trading strategy.
For simplicity, we suppose that
U(c) =
(7)
tEl~
where u : + ~ E is, say, bounded and measurable and/3 E (0, 1). Extensions
are discussed at the end of this subsection.
The following proposition states that an equilibrium is defined by a separating hyperplane argument. Since there is but a single agent, there is no need to
apply (as is commonly done) fixed point theory, Markovian assumptions, or
Bellman's principle of dynamic programming.
Proposition 3. Suppose u is increasing, bounded, differentiable and strictly

concave. Let c* = e t + E~ d/ define the total consumption process c*. I f c* > 0
almost surely for all t, then equilibrium is defined by
St
Izs,,
u'(e,) E L S > t /3
U (cs)d ,
W*t ,
a.s., t E N .
(8)
Proof. For the given price process {St}, we need only show optimality of the
trading strategy 0". The associated consumption process is c*. The proof here
is the same as that used in Duffle, Geanakoplos, Mas-Colell and McLennan
(1988). Let q~ be an arbitrary budget-feasible policy.
The first step is to show that, for any given T E N,
T
+/3TE[u'(C~c)Sr " (r -- 0})1.
(9)
1631
We prove (9) by induction. For T = 1, (9) is true since concavity of u i implies

that u(cT) >-- u(cq~) + u'(cT)(cT - c~). Next, we show, for any ~-E ~, that if (9)
is true for T = ~-, then (9) is true for T = ~- + 1. By the construction of S,
u'(c*AS,
( ~ - o7) =/~e[u
' (C+l)(S,r+
*
1 -'b de+l)
[ ~.~r] " (~. - 0~.) ,
a.s.
In addition, concavity of u implies that
u(c;+~)/> u ( C + , )
u'(c:+,)(c;+, - C + , ) -
Then (9) follows for T = ~-+ 1 by combining the last two relations with the
identity
( S t + 1 "l- dr+l).
(~Or -- 0"~) Jr- e ; + 1 -- c ~ + 1 = S~_+l (~t)~.+l - - 0 ~ + 1 ) .
Thus (9) follows for all T by induction. Since u and c* are bounded and u is
concave, { u ' ( c * ) c * } is bounded. Thus {St} is (as presumed) bounded. Since
{~Pt- 0"} is also bounded, it follows that { u ' ( c * ) S t (q~t- 0")} is bounded.
From this, [ 3 r E [ u ' ( c ~ ) S r ( q ~ r - 0~)]---~0 as T--.oo. Combining this fact with
(9), we have U(c*) >~ U(c). Since ~p is arbitrary, 0* is optimal, so {St} is an
equilibrium. Uniqueness is shown with an argument by contradiction that we
leave to the leader.
Corollary (stochastic Euler equation). Under the s a m e conditions, f o r the
unique equilibrium {S,} a n d any time t,
S,
fl
u'(c*)
E [ u (Ct+l)(St+ 1 + d,+,)
ffS]
a.s.
Proof. This follows from substitution of the equilibrium equation (8) for S,+ 1
into the equilibrium equation (8) for S t , and by applying the law of iterated
expectations.
Just as in the previous subsection, one can extend the representative-agent
asset-pricing formula shown here to economies with heterogeneous agents,
provided the securities are spanning and all consumption choices are interior.
Rather than pursue this here, we return to it in the continuous-time framework
of the following section.
3.4. E x t e n d e d recursive preference models and time consistency
The additively separable utility criterion (7) is restrictive. For example, this
utility criterion cannot reflect any attitude toward the timing of the resolution
D. Duffle
1632
of uncertainty, as pointed out by Kreps and Porteus (1978). For settings like
the present, a utility model developed by Epstein and Zin (1989a) retains the
recursive structure of the additively separable model while admitting preferences for early or for late resolution of uncertainty, and for independent
adjustment of intertemporal elasticity of substitution and risk aversion. The
two basic primitives of the Epstein-Zin utility model are:
(i) a certainty equivalent functional m : ~ ( ~ ) - - ~ ~ (where ~ ( ~ ) denotes the
probability measures on the real line) and
(ii) an aggregator W : ~ ~---~ ~.
The certainty equivalent m is defined so that m(Sx) = x for any dirac measure
tSx, consistent with indifference between any distribution/z of utility in the next
period and the deterministic utility m(/z). An adapted stochastic process V is
by definition the utility process for a consumption process c if V uniquely
satisfies, for all t,
V, = W[c,,
m(-V~,l~,)],
where -V,+ 1[fit is the conditional distribution of V,+ 1 given ~ . (We could also
append the condition that Vt = lira r V,r, where V r is the utility process for c in
a T-horizon model with Vrr = 0.) We then have the utility function U on L+
defined by U ( c ) = 1/1. As a special case, we can recover the additively
separable criterion (7) W ( x , y) = x + f l y and re(u) = ~ x d/z(x) (expectation).
The relaxation of the additively separable criterion (7) to general recursive
utilities, such as the Epstein-Zin model, opens the way to a rich set of
implications of attitudes towards risk for security pricing. For example, one can
immediately study, using an appropriate certainty equivalent m, various forms
of Machina's (1982) relaxation of the independence axiom of expected utility,
or an alternative axiomatization of risk preferences such as that of Dekel
(1986) and Chew (1989). Other extensions of the additively separable criterion
(7) are cited in Section 6.6.
In a multi-period model, one reconsider the optimality of an initially chosen
strategy at intermediate dates, after the passage of time and revelation of
information, setting up the issue of "time consistency" examined by Johnsen
and Donaldson (1985). In treating this problem, one usually restricts attention
to preferences defined at each date and each state of the world that are
time-consistent, in the sense that: for any c and ~"in L and any stopping time T,
if c t = ~, for all t ~< T and if the continuation of c beginning at time T is strictly
preferred to the continuation of ~" beginning at time T, then c is strictly
preferred to ~"beginning at time zero. If we denote by V c the utility process for
c under recursive preference primitives (m, W), we can then define c to be
preferred to ~ at time t if V t > V~ almost surely. Monotonicity conditions on m
and W are then sufficient for the time-consistency of recursive preferences,
including the additively separable criterion.
1633
4. Continuous-time equilibrium in security markets

This section reviews the main concepts of general equilibrium and equilibrium
asset pricing models in a continuous-time financial setting.
4.1. General equilibrium in continuous-time
The objective in this first subsection is to formulate and demonstrate general

equilibria in a continuous-time setting with security markets. The approach is
basically an extension of Arrow's model of Section 2. We will eventually
presume that the available securities are dynamically spanning; that is, given
the possibilities of continuous trading, markets are effectively complete. By
using recent infinite-dimensional conditions for (static) complete contingentcommodity market equilibria discussed in Chapter 5, we can then implement a
complete contingent-commodity equilibrium consumption allocation within a
continuous-time security-spot market equilibrium.
The setting for uncertainty is a filtered probability space ( ~ , if, U:, P ) for the
time set 9 - = [0, T], as described in the appendix, where U:= {~t: t E [0, T]}
satisfies the usual conditions and if0 contains all subsets of zero probability
events. The o--algebra fit represents the information available at time t. A
cumulative dividend process is an integrable predictable semimartingale. For a
dividend process D, the random variable D t represents the cumulative number
of units of account paid by the security in dividends up to and including time t.
A semimartingale is right continuous with left limits, so D t = limsu D s for all t
almost surely and D,_ ~ limst , D s exists for all t almost surely. The difference
A D t = D , - O t _ is the jump of D at t, a lump sum dividend. Let @ denote the
space of dividend processes. If S is the stochastic price process of a security
with the dividend process D, then G, = S, + D, represents the number of units
of account at time t due to an agent holding one unit of the security from time
0 to time t. We call the process G = S + D the gain process of this security. If
one holds 0t units of the security from time t until time ~-, one realizes a
dividend gain of O t ( D ~ - Dr) and a capital gain of Ot(S~ - St), adding up to the
total gain O,(G~ - G,). If one varies one's holdings of the security at times
to, tl . . . . . t~ (with 0 = t o < t~ < < tk), then the total gain through time t k is
k-1
E o,,(o,,+,- G,).
/-0
Extending to the case of "continual trading," if G is a semimartingale and one

chooses, as a strategy for the number of units of the security to hold at each
time in [0, T], some process 0 from the space L I [ G ] (the space of predictable
1634
D. Duffle
processes described in the appendix), then the total gain between any times t
and ~- is the stochastic integral J'[ 0s d G s.
One of the primitives of our economy is a vector D = ( D , . . . , D N) E @N+I
comprising N + 1 dividend processes. With only a small loss in generality, we
take D O to be a unit discount bond payable at T; that is, D t = 0 , t < T and
D T = 1. Letting 5e denote the space of semimartingales, a gain operator is a
linear function H : ~ - - - ~ b mapping each dividend process D to its gain
G = I I ( D ) . Given H, we can define the gain process G = ( G O . . . , G N) by
G ' = H ( D ' ) . Given (H, D ) , a trading strategy is an ~u+l-valued process
0 = (0 , . . . . ON) in L ~[G], with 0, representing the portfolio of securities held
at time t. The total gain process for 0 ~ L I [ G ] is .f 0, dG,.
For 1 given commodities, a consumption process is a predictable process
c : O [0, T]---~ R l with E ( f o r c,. c t dt) < ~. As usual, two consumption processes are treated as equivalent if they are equal almost everywhere on
O [0, T]. We let L denote the space of (equivalence classes o f ) c o n s u m p t i o n
processes. For a given consumption process c E L, the vector c, represents the
rate (per unit of time) at which the ~e commodities are consumed at time t.
Likewise, a spot price process is some element p of L, with p, representing the
vector of unit prices of the l commodities at time t. Given p , a consumption
process c is therefore financed by paying units of account at the rate p , . c, at
time t. Each agent i E {1 . . . . , m} is defined by an endowment e i in the usual
positive cone L+ of L and by a utility function U i : L+ ~ ~.
Given a gain operator 1I, which defines the security price process S =
H ( D ) - D, and given a spot price process p E L , a trading strategy Ofinances a
consumption process c E L at an initial cost of ~b(c) if:
(i) Oo.S o = O(c);
(ii) for all t C [0, T], O,.(S, + A D , ) = Oo. S o + .[o O~d G s - fo Ps .c~ ds;
(iii) 0 T . ( S v + A D T ) = O.
The cost O(c) represents the required initial investment; the terminal constraint (iii) requires that the terminal market value of the trading strategy is
zero; while the intermediate constraint (ii) requires that the interim value of
the trading strategy is precisely that generated by security trading gains net of
consumption purchases. If, as in the equilibria we are about to describe,
S r = O, then (iii) is superfluous.
Given (//, p), a budget-feasible plan for agent i is a pair (0, c) consisting of a
trading strategy 0 and a consumption process c such that 0 finances the net
consumption purchase c - e i at an initial cost of zero (since there is no initial
endowment of securities). A budget-feasible plan (0, c) is optimal for agent i if
there is no budget-feasible plan (0', c') such that Ui(c' ) > Ui(c ).
A security-spot market equilibrium for the economy
~=((~,~,F,P),D,(U~,e~)),
iE{1,...,m),
1635
is a collection (1I, p, (0 ~, ci)), i E{1 . . . . , m}, such that, given the gain
o p e r a t o r / / a n d spot price process p, for each agent i E { 1 , . . . , m}, the plan
(0', c') is optimal, and markets clear: Zi~ ~ c i - e' = 0 and Elm1 0 / = 0.
This is clearly a continuous-time analogue of Arrow (1953). Just as in that
model, sufficient conditions for an equilibrium are conditions ensuring a (static)
Walrasian equilibrium for the complete contingent-commodity markets
economy (U i, ei), i E {1 . . . . . m}, as well as a spanning condition on the
security dividends D.
Since L is a Hilbert lattice under the inner product ('1") defined by
T
lc,=E(f
0
we can exploit utility conditions developed by Mas-Colell (1986) for the

existence of a (static) contingent-commodity market equilibrium. Let Ilcll 2=
(clc) define a topology on L, and define a utility function U to be v-proper on
X, for some v E L+ and X C L+, if there exists a scalar e > 0 such that, for all
x in X, a in [0, o~), and z in L+,
For further details, see Chapter 34. We have the following variant of MasColell's (1986) Theorem.
Theorem 1. Let e = Eirn=l e ~. Suppose, for each agent i ~ { 1 , . . . , m}, that U~ is
quasi-concave, continuous, locally non-satiated in the order interval [0, e], and
e-proper on [0, e]. Then (U i, e ~) has a complete contingent-commodity market
equilibrium (~b, (ci)), where ~b : L--~ ~ is a continuous linear price functional
and the allocation (c ~) is Pareto optimal.
The properness assumption is satisfied, for example, if Ui has an additive
representation of the form
T
E[f
L+,
(lo)
U i : ~ l X [0, T]--~R is strictly increasing and concave such that

D+~ui(O, t), the right derivative of ui(., t) at zero, is bounded in t. For later
purposes of pricing securities, however, we will need to work with a pointwiseinterior equilibrium allocation (c I > 0 a.s. for all t for all i), and will therefore
where
D. Duffle
1636
later cite an alternative existence result using the Inada condition D c+ ui(O, t) =
+do for all t.
In order to formulate a dynamic spanning condition, we consider first the
following related definition. An NN-valued martingale M = (M a. . . . , M N) is a
martingale generator for (12, ~ , g:, P) if, for any martingale X, there exists
q~ E L l [ M ] such that for all t, X t = X o + ~o q~s dM, almost surely.
Assumption (dynamic spanning). There exists a probability measure Q on
(12, i f ) , uniformly equivalent 5 to P, such that the martingales M7 =
EQ(DrlffS), t E [ 0 , T], n E{1 . . . . , N ) , form a martingale generator for
(12, o%,D:, Q).
The dynamic spanning assumption is discussed in the setting of Brownian
Motion in the next subsection. The semimartingale property and the definition
of f 0 dS are invariant under the substitution of an equivalent probability
measure. The definition of L~[G] is also invariant under the substitution of a
uniformly equivalent measure Q for P, and vice versa. Likewise, the definition
and topology of the consumption space L is invariant under substitution of Q
for P, and vice versa. Consider the gain operator H Q defined by H O ( D ) t =
EQ(D~I~,).
Lemma (spanning). Suppose D satisfies the dynamic spanning condition under
the probability measure Q. Given the gain operator FI ~ and a spot price process
p, any consumption process c is financed at the (unique) initial cost ~bo (c) = E Q
p , . c, a t ) .
Proof. Let (p, c) E L x L be arbitrary. Under the dynamic spanning condition, the Q-martingales M = (G 1. . . . , G N) defined by G n = IIQ(D ~) form a
martingale generator for (g2, ~-, Y, Q). Let
T
Since X is a Q-martingale, by dynamic spanning there exists p =

(q 1,..., ., q s ) E L I[M] such that X t = X o + So q~sdM, almost surely, t ~ [0, rl.
Let 0 n = p", 1 ~ n ~ N, and let 0 be defined by
Ot = X , -
ps'csds0
~, O;(S t + A D t ) ,
t~[O,T].
(11)
n=l
5A probability measure Q is uniformly equivalent to P if the Radon-Nikodym derivatives
dQ/dP and dP/dQ are essentially bounded.
1637
The predictability of D implies, by an argument left to the reader, that 0 is

predictable. Since G O= H ( D ) is identically equal to 1, we know that
S 0 d G - - 0 . By construction, conditions (ii) and (iii) for 0 to finance c are
satisfied, and 00 S O= X o = ~bp(C). The uniqueness of 0o S O (over all 0 financing c) follows immediately.
Suppose that (U i, ei), i E {1 . . . . . m}, has a (static) complete

contingent-commodity market equilibrium (~b, (ci)). (For this, it suffices that U~
satisfies the regularity conditions of Theorem 1.) If the dividend process D
satisfies the dynamic spanning condition, then ((qt, ~, ~:, p), (Ui, ci), D) has a
security-spot market equilibrium with the same consumption allocation (ci).
Theorem
2.
Let Q be uniformly equivalent to P such that G - - H Q ( D ) is a

martingale generator. Since L is a Hilbert space, the given contingentcommodity market equilibrium price function ~b has a representation of the
form
Proof.
@(c)=
EQ(fp,.c,dt), c L,
(12)
for a unique spot price process p ~ L+. Since D satisfies the dynamic spanning
condition, by the previous lemma the consumption process c' - e ~ is financed
Q
i
i
Q
i
by some trading strategy 0 at the unique cost ~p(c - e ). Since (~bp, (c)) is a
contingent-commodity market equilibrium, however, q , p ~ ( i e i ) = 0 . Thus
(0', c') is a budget-feasible plan for i. We can choose O' in this fashion
for i < m. Since c m__ e m =--Eg=
,,-x1 Ci - e,i and by linearity throughout, the
m-11 0 i finances C m - e m at an initial cost of zero, so
trading strategy 0 m = - E i =
(Om, Cm) is a budget-feasible plan for agent m. The plans (0 i, ci), i ~
{ 1 , . . . , m}, are market clearing. It remains to show optimality: that there is
î
Ai
Ai
i
no budget-feasible plan (0, c ) for some agent t such that Ui(c ) > Ui(c ).
We will show a contradiction, assuming that such a superior plan (0~, 6i)
exists. Since Ui(~ i) > Ui(c i) and (g,p~, (ci)) is a complete contingent-commodity
market equilibrium, gtQ(O
: i) > tpOp(Ci). If b i finances o i _ _ e,i however, it does so
at the unique cost ~b~(~' - e') > q,p(c- e i) = 0, which contradicts the assumption that (0 i, oi) is budget-feasible This proves optimality
4.2. The dynamic spanning condition and Girsanov's Theorem

This subsection discusses sufficient conditions for a dividend process to satisfy
the dynamic spanning condition.
D. Duffle
1638
As explained in the appendix, an integrable semimartingale X is characterized by the fact that it can be written as the sum M + A of an integrable
process A of finite variation and a martingale M. If D is an EN-valued
semimartingale of the form M + A, where M is a martingale generator, there is
no guarantee that the ~N-valued process X defined by X t = E ( M T + Arl~,),
t E [0, T], defines a martingale generator. On the other hand, under technical
regularity conditions, one can apply the Girsanov-Lenglart T h e o r e m for the
existence of a new measure Q under which D is a martingale and inherits the
martingale generator property of M. Further discussion of this appears in
Section 5.9.
For a concrete example, suppose that Y is the standard filtration of a
Standard Brownian Motion B in ~d, for some dimension d. Then B is itself a
martingale generator, as is any martingale in ~ N of the form X, = f0 q~s dBs,
t E [0, T], if and only if {~s} is a (N d)-matrix-valued process of essential 6
rank d. Now, suppose that d D , = bt, d t + o-tdB . where f o'tdB t has the
martingale generator property (that is, o- has essential rank d.) U n d e r technical
regularity conditions on or and /x, there exists an equivalent probability
measure Q and a Brownian Motion /~ in R a under Q such that d D t = o-t d/3,,
which implies that D is itself a martingale generator for (12, o%, ~, Q). With
d = N for instance, it is enough that /x and or are bounded and that o-~ has a
uniformly bounded inverse. In that case, Q is defined by
T
d P = exp
q~1dBl - ~
0
~,. q~, dt ,
(13)
where q~t = o ' t l / ' L t " Moroever, /~ is defined by /~, = B t - f o ~s ds. Indeed this
construction o f / } and Q succeeds under the weaker regularity conditions of the
following theorem.
Suppose ~ is an ~d-valued predictable process for

(12, ~, ~:, P), where ~: is the standard filtration o f a Standard Brownian Motion
B in R d. Provided E[exp( for q~t" q~, dt)] < ~, the R a d o n - N i k o d y m derivative
given by (13) defines a probability measure Q such that
Theorem 3 (Girsanov).
/3,=B,-fqsds,
t@[0, T ] ,
is a Standard Brownian Motion on (O, 0%, ~:, Q).

6The essential rank of ~ is d if rank[q~(w, t)] = d almost everywhere on 12 [0, T].
1639
As pointed out by Harrison and Kreps (1979), and further illustrated in

Section 5, Girsanov's Theorem can sometimes lead to an explicit calculation of
the arbitrage price of securities.
Aside from the case of Brownian filtrations, well known examples of
filtrations with an identifiable martingale generator include the standard filtrations of event trees (including finite-state Markov chains), point processes
(such as a Poisson process) and Azema's martingale.
4.3. The representative-agent asset pricing formula
Here, we specialize to a setting that produces a continuous-time multi-agent

analogue to the multi-period representative-agent formula of Section 3. This
subsection and the next are based on Duffle and Zame (1989). We take our
original definition of a continuous-time security-spot market model
((J2, o%, I:, P), (U~, e/), D), i E { 1 , . . . , m}, but adopt the assumption that
there is only 1 = 1 commodity, and that for all i, U~ has a utility representation
of the form
T
c~_L+ ,
0
where u i : ~ + x [0, T]--> ~ is regular, in the sense that ui is smooth (say C 4)

restricted to (e, oo) for any > 0, and, for all t, u~(-, t) : ~+ --> R is increasing
and strictly concave with unbounded derivative uic(-, t). Under all of these
conditions, we say that U~ is additively separable and regular (us). As mentioned previously, the Inada condition of "infinite marginal utility at zero"
implies that Pareto optimal consumption levels must be strictly positive almost
everywhere, which is useful for our purposes. Unfortunately, the unboundedhess of uic is also inconsistent with the properness condition used in Theorem
1. Nevertheless, we can exploit the additively separable restriction on utility for
the following result, which was independently shown by Araujo and Monteiro
(1989) and Duffle and Zame (1989). This type of result was later given new
and successively simpler proofs by Karatzas, Lakner, Lehoczky and Shreve
(1988) as well as Dana and Pontier (1989).
Proposition 4.
Suppose, for all i, that U i is additively separable and regular. I f

the total endowment e = Ei~=l e i is bounded away from zero, then the economy
(Ui, ei), i E {1, . . . , m}, has a complete contingent-commodity market equilibrium (~, (ci)), i E {1, . . . , m}, with c i bounded away f r o m zero for any agent i
having e i ~ O.
D. Duffle
1640
Uniqueness of equilibria is discussed by Karatzas, Lakner, Lehoczky and

Shreve (1988). Araujo and Monteiro (1987) have pointed out the restrictiveness of assuming that e is bounded away from zero. One may relax this
assumption in a production economy.
Given an equilibrium (~b, (c~)) for the complete contingent-commodity market economy (U, ei), a representative agent is a utility function UA : L+ --->~ of
m
the form, for some A E R+,
Ux(x) =
max
xicL+, i E { I
.....
~ l~iUi(x i)
subject to ~ x i <~x,
m} i=l
(14)
i=1
such that (g,, e) is the (no-trade) equilibrium for the single-agent economy
(Ua, e). Equivalently, a representative agent for (~b, (ci)) is defined by agent
weights A ~ ~7 such that e E arg max c U~(c) subject to ~b(c) ~ ~(e).
Proposition 5.
Suppose, for all i, that U i is additively separable and regular

(ui), and that e = ~ i ei is bounded away from zero. There is a completecontingent commodity market equilibrium (~b, (ci)) with a representative agent
Ua for some A ~ ~"~. Let u A : ~+ x [0, T]---~ ~ be defined by
m
Ua(a, t ) = max 2.~ Aiui(ai, t)
lCR~ l i=1
subject to ~ a i <~a .
(15)
i=l
Then, U~ is additively separable and regular (u a), and A can be chosen so that,
for any c E L, ~b(c) = [for uAc(e,, t)c, dt].
The representative-agent part of the proof, due to Huang (1987), is an
extension of the representative-agent construction of Section 3.2 to this
infinite-dimensional setting.
Combining Proposition 5 with Theorem 2 of Section 4.2, we have the
existence of a security-spot market equilibrium (II, p, (0 i, ci)), i ~ {1 . . . . , m},
provided the dividend process D satisfies the dynamic spanning condition.
Given an equilibrium (1I, p, (0 i, ci)), i E { 1 , . . . , m}, we now study the
"real" security price process S defined by S, = S,/p,, t E [0, T]. By "real," we
mean the price relative to the numeraire defined at each time t by the
consumption commodity. If the integral /9, = f0 (1/Ps)dDs is well-defined,
t h e n / 9 is the associated real dividend process. We can also define a real security
to be a finite variation dividend process Y representing a cumulative claim to Y,
units of the consumption commodity through time t. If the integral D r =
fo Ps d Ys is a well-defined 7 (nominal) dividend process, we say that Y is
7If Y is an integrable semimartingale, then, under the conditions of Proposition 4 S P, dY, is
automatically well-definedsince the spot-price process p is predictable and bounded.
1641
admissible. Any consumption process c E L, for example, generates an admissible real dividend process Y defined by Y, = J'0 cs ds, which has the corresponding nominal dividend process D Y defined by D tY = .fot psc~ ds. The introduction
of any admissible real security Y has no effect on the equilibrium shown in the
proof of Theorem 2.
Proposition 6. Suppose ((12, o%, 0:, P), (Ui, ei), D ) is a security-spot market
economy such that:
(i) for all i, U i is additively separable and regular (ui),
(ii) the aggregate endowment e = ~,,im_l e i is bounded away f r o m zero,
(iii) the security dividend process D satisfies the Dynamic Spanning condition.
Then there is a security-spot market equilibrium (H, p, (0 i, ci)), i E {1 . . . . . m},
with a representative agent Ux that is additively separable and regular (uA), and
for which the real price process S y o f any admissible real dividend process Y
satisfies
T
Sv, - u,c(e,,t ) E
if u,c(e,,s) d Y , ~, ]
a.s., t e l 0 , T].
(16)
Proof. The existence of an equilibrium (H, p, (0;, c;)), i E {1 . . . . . m}, is

guaranteed by Proposition 5 and Theorem 2 of Section 4.2, with the gain
operator
II(D) = HQ(D) =
E(DTI~,),
t ~ [0, T],
for an appropriate probability measure Q. From Proposition 4, we can also

take it that the underlying complete contingent-commodity market equilibrium
(q,, (c;)) has a price functional of the form
T
4'
We know that, for a unique p in L,

T
o(f
c@L.
It follows that Pt U,c(e,, t)/~:,, t @ [0, T], where { ~,} is the density process for
Q; that is, ~, = E ( ( d Q / d P ) t ~ , ) . [One can review Duffle (1986) for the details
on this last point.]
=
1642
D. Duffle
Let Y be an admissible real dividend process. The (nominal) gain process of

Y is defined by
T
0
T
~s
t
T
t ~ [0, T].
t
The last equality relies on an application of Fubini's Theorem for conditional

expectations, which can be found in Ethier and Kurtz (1986, p. 74). Since
(j, = uac(e,, t)/p,, the corresponding real price process S Y is therefore given by
T
p,
- uA~(e,, t) E
ua~(e ~, s) d
~,
tE[O, TI,
which completes the proof.

The representative-agent real security pricing formula (16) is an obvious
analogue of the discrete-time single-agent multi-period asset pricing formula of
Section 3.
Example (the term structure). As an application of this asset pricing model, let
Y denote the cumulative dividend process representing the payoff of a zerocoupon default-free bond of unit principal maturing at time ~-E [0, T]. This
means that I1, = 0 for t < r, while Yt = 1 for t/> r. Equation (16) then implies
that the price of this bond is zero after maturity, and at any time t before
maturity has the price E[uac(e ~, r)l fft]/uac(e ,, t). Various parametric assumptions concerning the distribution of the aggregate endowment process e and the
representative-agent utility u, are sometimes used to calculate this conditional
expectation. The most famous example is the term structure model of Cox,
Ingersoll and Ross (1985a).
4.4. The consumption-based C A P M

Continuing to narrow our focus, we restrict ourselves in this subsection to the
standard filtration Y of a Standard Brownian Motion B in ~u, for some
1643
dimension d. With additively separable and regular utility, this produces the
Consumption-Based Capital Asset Pricing Model ( C C A P M ) of Breeden
(1979). Breeden's original proof assumes the existence of an equilibrium with
pointwise interior consumption choices and optimality characterized by a
smooth solution to the Bellman equation for Markov dynamic programming.
This subsection shows that that representative-agent pricing approach allows
for primitive conditions leading directly to an equilibrium satisfying the
CCAPM.
Before proceeding, we need to record the following version of Ito's Lemma.
In this setting, an Ito process in R" is a semimartingale of the form
Xt=x+iixsds+fo'~dB,,
0
t E [0, T ] ,
where ix is an R"-valued adapted process and o- is an n x d matrix-valued

predictable process. The stochastic differential form for X, which is purely
formal notation, is
dX t = / x t dt + ~rt dB t .
It is a common abuse of the meaning of this representation of X to treat ixt as
the "instantaneous conditional expectation of d X , , " and likewise to treat o-to-t
as the "instantaneous conditional covariance matrix of dXt." Of course, this
can be justified for square integrable X by passing to limits the mean and
covariance matrix of Xt+ ~ - X t, conditional on oft, as 6 --->0. For the following,
fx denotes the partial derivative of a function f : ~" x [0, T]---> ~ with respect to
x, and likewise for f, and fx~.
Ito's Lemma. For any ~n-valued Ito process X with d X t = ix, dt + or, dB, and
any C 2 function f " ~" x [0, T] ~ ~, the process Y defined by Yt = f ( X t , t),
t@ [0, T], is also an Ito process with d Y t = ixf(t) dt + fx(X,, t)o-t dB,, where
Ixr(t) = fx(X,, t)ix, + f,(X,, t) + tr[~rlr f~x(X,, t)o',].
The conditions for Ito's Lemma can be weakened in many directions.
We now fix an economy ((2, .~, ~:, P), (Ui, ei), D ) , i @ { 1 , . . . , m}, satisfying the conditions of Proposition 5, where F is the filtration generated by a
Standard Brownian Motion B in ~d. By that proposition, there exists an
equilibrium satisfying the representative-agent real asset pricing formula
T
SVt -
' E [I Uac(e s, s) d
uAc(e,,-----~)
t
t E [0, T],
1644
D. Duffle
for any admissible real dividend process Y, where ua defines the associated
representative-agent utility function.
Since the C C A P M is by nature a statement about the "instantaneous
covariance of de," with other variables, we need something like the following
condition on the aggregate endowment.
Ito Endowments.
The aggregate endowment e is an Ito process.
It is in fact enough for most of the following that e is a semimartingale. We

henceforth write de, =/~e(t) dt + (re(t) dB,. Using Ito's Lemma and the fact
(verified with the Implicit Function Theorem) that u~c is a C 2 function, the
process ~-, Uac(et, t) has the stochastic differential representation
=
d~rt = [uAc,(e,, t)tze(t ) + u~t(e,, t) + uxc~c(e ,, t)oT(t ) ~r~(t)] dt

+ ua~(e,, t)o'e(t) d B , .
For any admissible real dividend process Y, with real equilibrium price process
V = S v, the process Z defined by Z, = f0 Its dYs + 7rtV, is a martingale since, for
any interval [t, s],
1 E
7r~ dY" + Trs 7r~
7r~ d Y , + E
E(Z~]o%,) =
0
~r~dY~ ~-~ ,~,

s
= f 7r~ dY~ + 7rtE = Z,

0
Suppose Y is an Ito process of the form d Y t = izv(t ) d t + ~ry(t) dB,. This

implies (by Ito's Lemma) that the real price process V is also an Ito process,
with a representation of the form dV, =/Xv(t ) d t + O-v(t ) d B , . Again applying
Ito's Lemma,
d Z t = [Trtlxr(t ) + ~,l.tv(t ) + Vtlx (t ) + u~c(et, t)(re(t ) Cry(t)] dt

+ '~z(t) d B , ,
for some O-z(t ) that we need not calculate here. An Ito process dX, =
izx(t) dt + O'x(t ) d B t is a martingale if and only if iZx(t ) = 0 almost everywhere.
Since Z is a martingale, we therefore have, almost everywhere,
,rrtI/~y(t ) + ~v(t)] + V d ~ ( t ) + mcc(e,, t)o-e(t ) O-v(t ) = O .
1645
Assuming that lit ~ 0, we can divide through by 7r,V~ and rearrange to obtain
t ~ ( t ) + lxy(t)
-uxcc(et, t) fiv(t)
Vt
- r,= ua~(et , t )
Vt . ~ ( t ) ,
(17)
where r, = - g , ~ ( t ) / T r t . Formally speaking, if we treat (d E + dY~)/V~ as the

"instantaneous real r e t u r n " on the security, it is natural to treat
R, -
v(t) +
y(t)
V,
as the "instantaneous mean rate of return" and (trv(t)/V~). fie(t) as the
"instantaneous covariance between the return dV~/V~ and aggregate consumption increment det," following the heuristic conventions outlined earlier. If the
return is "riskless," that is, if trv(t ) = 0, then we h a v e / ~ = r,, so we call r~ the
riskless rate of return. Since ~', = uAc(e,, t) is the "representative-agent marginal utility," we can therefore view the riskless rate r, = - t z ~ ( t ) / c r , as the
exponential rate of decline of the representative-agent marginal utility, a
characterization uncovered (in a more narrow single-agent Markov setting) by
Cox, Ingersoll and Ross (1985b). The difference R t - r t is known as the excess
mean rate of return of the asset, and based on (17) satisfies the proportionality
restriction
gt- rt-
-Uxcc(et, t)
Uxc(et ' t)
oR(t ) fie(t),
(18)
where fiR(t) = fiv(t)/V,. In words, the mean excess rate of return on a security
is proportional to "instantaneous covariance" with aggregate consumption
increments. The constant of proportionality is the risk aversion coefficient of
the representative agent. This is a form of the CCAPM. We summarize as
follows.
Proposition 7 (CCAPM).
Suppose the conditions of Proposition 5 are satisfied, that ~ is the standard filtration of a Standard Brownian Motion B in ~a,
and that the aggregate endowment process e is an Ito process. Then there exists a
security-spot market equilibrium in which, at any time t, the return of any
security (with non-zero price) satisfies (18).
We can also view the C C A P M in a traditional " b e t a " form. Because of the
dynamic spanning condition, one can assume without loss of generality that
there is some security whose real price process, say V*, has a diffusion process
or* with o-* = kto-e for some positive predictable k, characterizing the security
1646
D. Duffle
as one whose return is "instantaneously perfectly correlated" with aggregate

consumption increments. For such a security, the instantaneous mean rate of
return, denoted/~*, satisfies the CCAPM, implying that
R* - r t
_ Ua~c(e ,, t)
uac(e,, t) ~rR*(t)''e(t)'
(19)
where trR.(t ) = ~r*(t)/V*,. One defines for any given security the "instantaneous regression coefficient"
~rR(t)" ~rg.(t)
fin(t) = o_R.(t), o.R.(t )
(assuming that ~rn.(t ) ~ 0), as the beta of that security relative to aggregate
consumption. Combining this expression with the originally stated form (18) of
the CCAPM, we have the traditional "beta form"
R,-
r, = f l g ( t ) ( R * - r , ) ,
(20)
satisfied by all securities (with non-zero market values). The beta form (20) is
implied by, but does not imply, the representative-agent form (18) of the
CCAPM since (20) applies even if the representative-agent risk aversion
coefficient defined by -uAcc(e t, t)/u~c(e,, t) is replaced in (18) by any other
coefficient. For example (under strong conditions on an equilibrium), a version
of the beta form of the CCAPM is satisfied even without dynamic spanning.
The supporting arguments may be found in Breeden (1979). At this writing,
however, primitive conditions for multi-agent equilibrium that do not require
dynamic spanning remain to be shown.
Of course, Sections 4.3 and 4.4 are based on the strong assumption of
additively separable utility; for extensions, see Section 6.6.
5. Continuous-time derivative asset pricing

5.1. Prologue
This section characterizes, with the aid of martingale theory, the arbitrage-flee
pricing of derivative assets, those whose dividends can be financed by trading
other "primitive" securities. Under the assumption of no arbitrage opportunities, the price of a derivative asset is the initial investment cost in primitive
securities required to replicate the dividends of the derivative asset. If this were
not the case, a position in the derivative asset combined with an offsetting
1647
position in the replicating trading strategy would produce an arbitrage. This

obviously ignores transactions costs.
Of course, the primitive securities must themselves be priced, say by an
equilibrium asset pricing model or even by actual financial markets, but it is
nevertheless useful to have a model that prices some (derivative) securities
relative to other (primitive) securities. The most famous example of this is the
Black-Scholes (1973) formula for the price of a European call option on a
security whose price process is a geometric Brownian motion. Arbitrage pricing
is perhaps the most actively used asset pricing technique in practical applica-tions.
A large part of this section follows the lines of Harrison and Kreps (1979),
establishing, in the manner of Section 3.1, that the absence of arbitrage implies
the existence of an equivalent martingale measure. From this, any derivative
security price can be calculated as the expected discounted present value of the
security's dividend stream, substituting the equivalent martingale measure for
the originally given probability measure in calculating the expectation.
5.2.
The setup
A basic primitive is a filtered probability space (/2, o%, ~:, P), where 0: =
{o%,: t E [ 0 , T]} is an augmented filtration of it-algebras satisfying the usual
conditions, as explained in the Appendix. The o--algebra ~t is the set of events
characterizing information held by investors at time t. For simplicity, we take it
that o%0 is almost trivial, in that it includes no events with probability in (0, 1),
and without loss of generality take f f = o%r.
The s h o r t - t e r m rate, if it exists, is an adapted process r satisfying ~0c Ir,] d t <
almost surely, with r t interpreted as the dividend rate demanded at time t on
a security whose price is always equal to 1. That is, r t is the continuously
compounding interest rate on riskless deposits at time t. The existence of the
short-term rate is itself an assumption that can be avoided for the following, at
some cost in concreteness. We actually assume, henceforth, that the short-term
rate exists and is bounded.
By initially investing one unit of account at the short-term rate and continually reinvesting the original deposit and accumulated interest dividends at the
short rate, the total balance Z t held at time t is determined by the ordinary
differential equation
dZ t
dt
- r~Z~ ,
Z o=1.
The solution is of course Z, = exp(f0 r s ds).
D. Duffle
1648
Likewise, investing one unit of account at any time t in the same short-rate
investment strategy yields by time ~"
=exp(f rs4
l
Also given are N securities with cumulative dividend processes D ~ , . . . , D u

and price processes S 1, . . . , S N. By definition, these are integrable semimartingales, with D predictable. We let {D O = f 0 r s d s : 0 ~ < t ~< T} denote the
cumulative interest dividends on the short-term deposit security, with associated price process S Oidentically equal to 1. This makes for the vector dividend
process D = (D . . . , D N) and price process S = (S , . . . , Sn). The associated
gain process is G = D + S.
Unless otherwise stated, we continue to use the convention that the price
processes are ex dividend, meaning that the cum dividend market value of a
unit of security n at time t is S7 + ADT, the price plus any lump sum dividend
paid at that time t.
As in Section 4, a trading strategy is an ~N+l-valued process 0 E LI[G].
Aside from the natural informational constraint, the restriction that 0 E L I[G]
is technical, mildly limiting the speed and sizes of trades, and is automatically
satisfied in a finite-dimensional setting. Several alternative sets of technical
assumptions will lead to the basic conclusions of this section, as shown for
example by Dybvig and Huang (1988).
5.3. Arbitrage and self-financing strategies

A dividend process C is financed by a trading strategy 0 if
O,.S,=Oo. S o + f O s d G s - C , _ ,
t E [0, T ] ,
(21)
meaning that the current market value O,.S, of the strategy at time t is the
initial investment value 00 So, plus the trading gains fo Os dGs, less the
cumulative dividends C t removed from the strategy by time t.
A n arbitrage is a trading strategy 0 with initial investment value 00 S O~<0,
financing a non-negative dividend process D , and having a non-negative
cum-dividend final value Or.(S r + ADr), with one of these three non-zero.
The basic goal of this section is to characterize the prices of securities under an
assumption of no arbitrages.
1649
A trading strategy 0 is self-financing if it finances a zero dividend process,

meaning that the strategy neither generates nor requires income during (0, T).
Lemma 1.
There is an arbitrage if and only if there is a self-financing arbitrage.
Proof. A self-financing arbitrage is an arbitrage. Suppose there is an arbitrage

0. By the definition of a dividend process, the dividend process D o financed by
0 is a semimartingale. Consider the trading strategy q~ = (q0, . . . . q N) defined
by q~ = 0, j ~ 0 and ~o = J'0 fs., dD. In other words, ~pre-invests the dividends
financed by 0 at the short rate. The strategy 0 + ~o is then a self-financing
arbitrage. (It is clearly an arbitrage, and is self-financing by a calculation using
Ito's Lemma.)
If T is the terminal date of the economy, it seems compelling that S T = 0
since there are no dividends after time T. As pointed out by Ohashi (1987),
this is actually an assumption that goes beyond the absence of arbitrage, since
it may be impossible to carry out an arbitrage with S T ~ 0 if S T is not
measurable with respect to ~ r - , the left limit of the filtration at T. This may be
viewed as a technical limitation of the model that can be eliminated by any of
several minor assumptions. For example, we could allow an extra round of
~r-measurable trades at time T, or could extend the time horizon of the
economy to [0, ~). Unless otherwise stated, we do not assume that S T = 0.
5.4. The arbitrage pricing functional

Let O denote the space of self-financing trading strategies and M = {0T (S T +
ADT): 0 U O) C L l(p), the marketed subspace of potential final values.
Proposition 8. There is no arbitrage if and only if there is a unique strictly

positive linear functional 4' : M---> defined by 4'[0T (S T + ADT) ] = 00 S 0.
Proof. Suppose there is no self-financing arbitrage. For two self-financing
strategies 0 and q~ satisfying 0T (S T + ADT) = q~T"(ST + ADT), we claim that
00" So = q~0"So- If not, say if 00 S O> q~0"So, then ~o - 0 is a self-financing
arbitrage. Thus ~bis well defined. Strict positivity of 4' follows directly from the
definition of an arbitrage. Conversely, if 4' is uniquely well defined and strictly
positive, there is no self-financing arbitrage. By Lemma 1, it suffices to
examine self-financing arbitrages.
Our objective now is to characterize, under the assumption of no arbitrage,
the arbitrage pricing functional 4' given by Proposition 8.
D. Duffle
1650
5.5. Numeraire-invariance
Before proceeding, we will put in place for later use a natural fact: changing
the numeraire for prices and dividends has no real effects. A price deflator is a
positive predictable semimartingale/3 that is bounded and bounded away from
zero. For example, /3, could be the reciprocal of the price of a particular
security (such as a foreign currency) or commodity (such as gold). The
following proposition states the obvious fact that re-expressing all prices and
dividends with respect to a price deflator has no impact on the ability of a
trading strategy to finance a dividend process, nor on the real price at which it
is financed. First, let D e be the deflated dividend process defined by Dff =
S0 [3s dD~, and S e be the deflated price process defined St~ = [3tSt.
Let [3 be any price deflator. Suppose 0

finances a finite variation dividend process C, given securities defined by the
dividend process D and price process S. Then, given the securities defined by the
deflated dividend process D t3 and deflated price process S t3, the same trading
strategy 0 finances the deflated dividend process C e defined by C~ = So [3s dCs.
Proposition 9 (numeraire-invariance).
The proof by Huang (1985a) is a lengthy application of lto's Lemma for

semimartingales and is not repeated here. The following corollary is immediate
from the definitions of M, 6) and ~0.
If (D, S) admits no arbitrage, then (D e, S e) admits no arbitrage.

The marketed subspaces M under (D, S) and M e under (D t~, S t~) are related by
x E M if and only ifx[3~ E M e. The respective spaces 6) and 6)e of self-financing
trading strategies are the same. In the absence of arbitrage, the respective
arbitrage pricing functionals ~Oand ~e are related by [3oqJ(x) = t,oe(x[3~).
Corollary.
5.6. Equivalent martingale measure

We now consider the price deflator 6 defined by 6t = Z t 1 ~-- e x p ( - f 0 r s ds), and
define the deflated gain process G ~ by G ~ = D ~ + S ~. This is merely the gain
relative to the numeraire defined by the market value Z of the short-rate
re-investment strategy. An equivalent martingale measure is a probability
measure Q, equivalent to P, such that G ~ is a Q-martingale. That is, under an
equivalent martingale measure Q, for any times t and ,r >i t, EQ(G~I,~t)---- G~,
where E ~ denotes expectation with respect to Q, implying that
T
s, = g, e Q
dD, +
l
a useful formula.
(22)
1651
In spirit, based on the same arguments used in Section 3.1, the existence of
an equivalent martingale measure is equivalent to the absence of arbitrage.
Unfortunately, in an infinite-dimensional setting, this equivalence can be upset
by various technical problems, as explained for example by Back and Pliska
(1989). The principal difficulty is that there is no general result guaranteeing
that the arbitrage pricing functional ~b can be extended to a strictly positive
linear functional on L~(P). If o%is finite, the extension follows immediately
from the finite-dimensional lemma of section 3.1. For now, we will merely take
:T to be finite, and later return to provide other sufficient conditions for a
strictly positive linear extension. The following theorem is conceptually the
same as the main result of Harrison and Kreps (1979).
Theorem 4 (Harrison-Kreps). Suppose ,~ is finite. Then there is no arbitrage if
and only if there is an equivalent martingale measure.
The following proof is written as though o%is general, since the arguments
are general, with the exception of the extension result, and can be used again
later.
Proof. (Only if): Suppose there is no arbitrage. Let q, be defined by
Proposition 8. By the extension lemma of Section 3.1, q, has a strictly positive
linear extension qt : LI(P)--*ffL By a result sometimes known as Choquet's
Theorem, any non-negative linear functional on L I(P) is continuous, so that
is continuous. [See, for example, Schaefer (1974).] By the Riesz Representation Theorem for L t(P), there is a unique bounded strictly positive random
variable 7r such that
=
We define a measure Q on (O, if) by
Q ( A ) = E(1AZTTr ) ,
A E ~.
We have Q ( O ) = E(ZrTr)= ~b(ZT)= 1, since Z T is by definition the final

payoff of a strategy requiring an initial investment of 1 unit of account. Thus Q
is a probability measure, and is equivalent to P since ZTTr is strictly positive
almost surely. For any random variable x integrable with respect to P, the
expectation of x with respect to Q is well defined since the Radon-Nikodym
derivative d Q / d P = ZTIr is bounded.
For any security j, we will show that {J'0 6s dD~ + ~,S~: t E [0, T]} is a
martingale under Q, completing the "only if" portion of the proof. This is
trivial for j = 0. For any j 1> 1, it is enough to show, for any times t and s > t
and any event A E ~ , that
1652
D. Duffle
s
EQ(1AC tS{) = E[1A(f 8o dD{+ 6sS{)]
(23)
To this end, consider the trading strategy 0 defined by:

(1) at any time r <~ t, let 0, = 0;
(2) at any time r E (t, s], let
(a) 0{ = 1 A,
(b) 0~ = 0, k ~ ' { 0 , j},
(C)
0 r0 = 1 A (
J
StL,r
-~- f;
fo. dD~);
(3) at any time ~-E (s, T],

(a) 0~ = 0 , k 0 ,
(b) 0 : Vsfs.,, where Vs = IA(S ~ -ft,sS{ --]-f; fv.s dD~).
The strategy 0 merely holds one share of security j between times t and s in
event A, financing the cost S{ by borrowing at the short rate, and continually
re-investing the dividends at the short rate. At time s, the unit of security j is
sold, and the entire resulting balance Vs is re-invested at the short rate until
time T.
The final market value of the strategy is 0 . Since the initial investment is
0o S o = 0, we have, by definition of ~0,
0 = q,(0 ) - E(
0 ) :-
(24)
The definition of 0 in 3(b), however, implies that (23) and (24) are equivalent, proving the "only if" part of the result.
(If): Suppose Q is an equivalent martingale measure. Let 0 be a selffinancing trading strategy. The numeraire-invariance Proposition 9 implies that
T
8T[Ov'(S y + A D r ) ] = O o" S o + f 0t d G ~ .
(25)
Since d Q / d P is bounded (because o% is finite) and 8 is bounded, 0 is in

L~[G~], where the notation indicates expectation relative to Q. That is,
J" 0 d G ~ is a martingale with respect to Q. Taking expectations with respect to
Q on each side of (25) leaves
EQ[6rOT (S T + ADT) ] = Oo. S o .

This defines the pricing functional q; of Proposition 8 by qJ(x)= EQ(STX),
X E M. As such, q; is linear and strictly positive, implying the absence of
arbitrage.
1653
5. 7. Alternate sufficient conditions for equivalent martingale measures

Theorem 4 is the main result of this section, but relies on the assumption that
there is only a finite number of distinct events. There are at least two other
sufficient conditions that have been studied in the literature:
(1) the existence of an optimal policy for some agent whose preferences
satisfy regularity conditions;
(2) the absence of a free lunch, an approximate notion of arbitrage due to
Kreps (1981).
We will state the sufficiency of these conditions in turn. We omit proofs,
since these alternative sufficient conditions for equivalent martingale measures
merely shore up the natural intuition of Theorem 4 with the technical
qualifications required in an infinite-dimensional setting for a strictly positive
linear extension of the arbitrage pricing functional.
Consider some agent with a utility function U : L I ( P ) - - ~ N facing the
problem
max U[OT (S T + ADT) ] .
0EO
(26)
Proposition 10. Suppose U is quasi-concave, continuous and strictly increasing. Then there exists an equivalent martingale measure if problem (26) has a
solution.
Harrison and Kreps (1979) call the existence of a solution to (26) viability.
Their proof of a result essentially the same as Proposition 10 will also suffice
here. Naturally, the proof first uses the fact that viability implies lack of
arbitrage. The arbitrage pricing functional ~0 has a strictly positive linear
extension given by a re-scaling of the linear functional defining a separating
hyperplane between:
(1) the upper contour set {x E L1(P): U(x) >! U(x*)} at x* = 0~- (S~ +
ADr), the final wealth financed by a solution 0* to (26), and
(2) the budget feasible set {x E M: 0(x) ~< ~0(x*)}.
Given this extension of 0, the proof of an equivalent martingale measure
follows the "only if" part of the proof of Theorem 4. The basic idea of the
result extends to a model with preferences over multiple commodities and over
consumption processes on [0, T]. Essentially, the desired extension of 0 is a
shadow price or Lagrange multiplier for the final wealth budget constraint.
Now we record the fact that the absence of a free lunch, a construction due
to Kreps (1981), is also a sufficient condition for the existence of an equivalent
martingale measure. In the context of securities with no arbitrage, with
associated marketed subspace M and arbitrage price functional ~0, a free lunch
is a sequence {(m,, x,)} in M L I ( P ) satisfying:
D. Duffle
1654
(1) m. >i x,,,

(2) x. converges in L~(P) to some non-zero k ~ LI(P)+, and
(3) lim inf ~(m.) <~O.
The three conditions suggest the possibility, in a limiting sense, of obtaining a
payoff k "better than zero" at a zero or negative price. The absence of free
lunches implies the absence of arbitrages, and a bit more.
Proposition 11. Suppose (O, o%, P) is separable. If there is no free lunch, then
there exists an equivalent martingale measure.
The separability of (O, o%, p) is a mild regularity condition that is satisfied,
for example, if ~ is the o--algebra generated by a Standard Brownian Motion
in some Euclidean space. The proof by Duffle and Huang (1985) shows that
the absence of free lunches implies that the arbitrage pricing functional 0 has a
strictly positive linear extension.
In general, we can draw on the following result for other possible sufficient
conditions.
Proposition 12. Suppose there is no arbitrage and the arbitrage pricing functional qJ has a strictly positive linear extension to L i(p). Then there is an
equivalent martingale measure.
Again, the proof is the "only if" portion of the proof of Theorem 4.
5. 8. Equivalent martingale measure and the state price process

Given the setup ((~, if, D:, P), (D, S)) of Section 5.2, suppose the hypotheses
of Proposition 12 are satisfied. Then there is an equivalent martingale measure
Q, where the Radon-Nikodym derivative d Q / d P is bounded. Recall from
Section 4 that the density process ~: for Q is defined by s~t = E((dQ/dP)/,~).
We now pick a particular security of the N + 1, with price process, say V,
and dividend process, say C. For the next result, we will use the assumption
that C is of finite variation. For example, C is of finite variation if defined by
C, = fo Ps "cs ds for some multi-commodity consumption process c and spot
price process p whose product is integrable. More generally, as described in the
Appendix, a finite variation process is a semimartingale that can be written as
the sum of an increasing and a decreasing process.
From (22), for any times t and ~- with r 1> t,
7
1 if 6sdCs +6.~V.~ '~t]
Vt=~tEQ
(27)
1655
The following result s makes a connection between the equivalent martingale

measure and the state price process.
Proposition 13.
Let 7r be the process defined by 7"Ft =

variation, then for any times t and ~">i t,
6t~ t If
C is
of
finite
x if
V, = - - E
lr,
~r, d C~ + ~r V, ~ ,
The p r o o f follows the lines of the proof of Proposition 6, where the state
price process ~r is identified as the marginal utility process {uxc(e t, t)} for a
particular representative-agent equilibrium with additive separable utilities.
5.9. Arbitrage pricing of redundant securities

Once again, consider the setup described in Section 5.2, with the no-arbitrage
hypotheses of Proposition 12. An equivalent martingale measure Q for (D, S)
is fixed for this subsection. In addition to the given set (D, S) of securities,
consider a new security with a dividend process C and price process V. We are
interested in knowing whether the same equivalent martingale measure Q will
also serve to price C, that is, whether (27) applies for all t and ~-i> t. In that
case, we say that C is priced by Q. A n obvious sufficient condition is the
existence of a trading strategy 0 that finances C.
Lemma 2. Suppose ((D, C), (S, V)) admits no arbitrage. I f (ST, VT) = 0 and
there exists a trading strategy 0 that finances C, then C is priced by Q.
Proof. Suppose that 0 finances C. Pick any time t. By writing down the
financing condition under the deflator 6, taking expectation at t given ~t, and
using S T = O, we have
T
oC if,).
t
It remains to confirm (27) by showing that V, = 0,- S t. If this is not the case, say
if Vt > 0t S t on some event A in o%t with P ( A ) > 0, consider the following
trading strategy. Let q~ be the trading strategy that invests at the short rate, at
any time s, ft,s(V~--Ot'St)l(t,T)z(S), plus the RN+2-valued trading strategy
1A (t.T](0, -- 1), holding - 1 units of C and adopting the strategy 0 from time t.
8At the author's request, Steven Shreve constructed a counter-example for the case of a dividend
process C that is not of finite variation.
1656
D. Duffle
Then ~ois a self-financing arbitrage, with zero initial investment and final value
equal to ft,r(V~ - 0,. St)l A > 0. This contradicts the assumed absence of arbitrage, proving the result.
The lemma suggests that we can price C according to the same equivalent
martingale measure Q if C is redundant, in the sense that it can be financed by
trading the original securities. (The qualification that ($7-, Vr)= 0 is to be
expected given the discussion at the end of Section 5.3.) It is natural to expect
redundancy of any dividend process C given (D, S) if D satisfies a dynamic
spanning condition like that described in Section 4. The next result develops an
alternative spanning condition directly on the martingale component of the
gain process G = D + S. As an integrable semimartingale, each gain process
G j can be written as the sum of a martingale M / and a bounded variation
predictable process A j with A~ = 0. A special semimartingale is a semimartingale (or vector of semimartingales) with a unique such decomposition. For
example, any semimartingale with bounded jumps (in particular, any continuous semimartingale) is special.
Proposition 14. Suppose the gain process G is special and d P / d Q is bounded
or every Q-martingale has bounded jumps. If the martingale component of G is
a martingale generator under P, then G ~ is a martingale generator under Q and
any dividend process can be financed by some trading strategy.
Proof. Let M be the martingale component of G. It is immediate that Y is a
martingale generator when defined by Y, = J0 6s dMs. By Lemma 3.2 in Duffle
(1985), Y is special under Q. By the uniqueness of the decomposition of Y
under Q, it follows that G ~ is the martingale component under Q of Y, which
by Theorem 3.2 in Duffle (1985) implies that G ~ is a martingale generator
under Q. The remainder of the proof is an obvious extension of the proof of
the spanning iemma of Section 4.1.
Corollary. Under the assumptions of Proposition 14, there is a unique equivalent martingale measure.
Proof. The fact that G ~ is a martingale generator under an equivalent
martingale measure Q implies that M = L I(p). This requires that, for any
event A E ~, Q(A) = ~ ( Z T I A ) , which fixes Q.
5.10. The Brownian case: spanning and Girsanov's Theorem

This subsection explores the implications of the last in a setting of Brownian
information. We continue under the hypotheses of Proposition 12 and fix an
1657
equivalent martingale m e a s u r e Q. T h e h y p o t h e s e s of P r o p o s i t i o n 14 are easily

c h e c k e d if 0: is g e n e r a t e d by s o m e S t a n d a r d B r o w n i a n M o t i o n B, say in R d. In
that case, let M d e n o t e the martingale part of G. As stated in Section 4.2, B is
itself a martingale g e n e r a t o r , so we can always write, for s o m e predictable
process o" that is K x d matrix-valued, M, = J'0 's dBs, 0 <~ t ~< T. P r o v i d e d the
rank of o- is d a l m o s t e v e r y w h e r e , M is a martingale g e n e r a t o r , and the
conditions o f P r o p o s i t i o n 14 are satisfied since every martingale on a B r o w n i a n
filtration has c o n t i n u o u s sample paths (almost surely).
T h e B r o w n i a n case is also particularly nice because it allows us to calculate
Q. S u p p o s e , for e x a m p l e , that G is an Ito process. In that case, we can always
write
d G 7 = bet dt + 6,o-, d B , ,
for some a d a p t e d (vector) drift process be, with o- as described in the last
paragraph. A s s u m i n g that or has r a n k d almost e v e r y w h e r e , we can define an
Ra-valued a d a p t e d process ~o w i t h otq~t = - b e , ~ 6 t almost e v e r y w h e r e . I g n o r i n g
integrability for the m o m e n t , let B t = B, - .fo ~s ds. T h e n 9
d G 7 = bet d t + ~,o-7 d B t
= bet dt + 6,o-,(d/~ t + q~t dt)

= be, dt + 6,o"t d / ) t - bet dt
= 6,o-, d B , .
Since Q is uniquely defined, according to the corollary to P r o p o s i t i o n 14, Q
must be that m e a s u r e o b t a i n e d by an application of G i r s a n o v ' s T h e o r e m . T h a t
is, it must be the case that d Q / d P is defined by (13) and t h a t / 3 is a S t a n d a r d
B r o w n i a n M o t i o n u n d e r Q.
In short, this provides us with a direct calculation of d Q / d P , which can then
be used to calculate the price of any security, say by (27). T h e qualification in
L e m m a 2 that " V T = 0" is automatically satisfied in this setting, since every
semimartingale on a B r o w n i a n filtration is predictable. 1
F o r example, consider an additional security with dividend process C defined
by C t = O , t ~ ' ,
and C t = H ,
t i > % w h e r e ~- is a stopping time and H is
9For disciples of semimartingale theory, a more direct way to see this representation of G ~under
Q is to check that the matrix-valued "sharp brackets" process (G ~, G ~) is preserved under a
change of equivalent measure. Since this process is differentiable with respect to time and G ~ is a
martingale under Q, there exists a Brownian motion /) under Q such that dG7 = ~to~tdJ~,. For
details, see, for example, Jacod (1979).
1This predictability is proved in a written communication from Kai Lai Chung and Ruth
Williams. See also Proposition 4 of Ohashi (1987), which is relevant since the Brownian filtration is
left-continuous.
1658
D. Duffle
o ~ - m e a s u r a b l e . In o t h e r w o r d s , C p a y s a l u m p sum d i v i d e n d o f H at t h e
s t o p p i n g t i m e r. A s s u m i n g o- has r a n k d a l m o s t e v e r y w h e r e , (27) i m p l i e s t h a t
t h e u n i q u e a r b i t r a g e f r e e - p r i c e p r o c e s s V o f t h e a d d i t i o n a l s e c u r i t y satisfies
v,=g, 1 Eo_(6~HI~t ) ,
t<'c
(28)
where
T
Q exp(f d t if
dP
- ~
Ct" q~t d t
a n d w h e r e q~ is d e f i n e d b y cr, q~t = - t x t / 6 ,.
In m a n y a p p l i c a t i o n s , D = 0
and H=g(S~,~')
for s o m e g : ~ N + l
[0, T]----> R. W e can t a k e it t h a t d S t = ut d t + o"t d B , for s o m e drift p r o c e s s u. W e
k n o w t h a t S a = G a is a m a r t i n g a l e u n d e r Q , so an a p p l i c a t i o n o f I t o ' s L e m m a
implies that
(29)
d S t = r t S t d t + o"t d[~, ,
w h e r e / ~ is t h e S t a n d a r d B r o w n i a n M o t i o n u n d e r Q c o n s t r u c t e d a b o v e . R a t h e r
t h a n using d Q / d P e x p l i c i t l y as in (28), w e c a n i n s t e a d use t h e e x p r e s s i o n (29)
for dSt u n d e r Q to r e p r e s e n t t h e a r b i t r a g e - f r e e p r i c e of t h e a d d i t i o n a l s e c u r i t y
in t h e f o r m
V,=
[6
g(ST, "r)lo ] ,
t< r .
A s a s p e c i a l case, s u p p o s e N = d = 1, r t ~-/~ for s o m e c o n s t a n t /~ a n d

o-t = ~ S , for s o m e c o n s t a n t ~. B y I t o ' s L e m m a , S T = S O exp[(/~ - ~ 2 / 2 ) r + / ~ ] ,
y i e l d i n g t h e a r b i t r a g e free initial p r i c e
Vo -- EQ[e-R g(S ,
T h e b e s t k n o w n e x a m p l e is t h e B l a c k - S c h o l e s (1973) o p t i o n p r i c i n g f o r m u l a ,
for w h i c h ~- = T a n d g ( x , T ) = (x - 2 ) + is t h e e x p i r y v a l u e 11 o f a E u r o p e a n call
o p t i o n with e x e r c i s e p r i c e 2. In t h a t case, w e h a v e t h e explicit c a l c u l a t i o n ,
11Theoption gives its owner the right, but not the obligation, to purchase the underlying asset at
the exercise price ~ fixed in advance. If the underlying price X T at the expiry date T of the option
exceeds the exercise price, the option holder will exercise the option for a net payoff of X T - ~.
Otherwise, the option expires with no value. Thus g(x, T) = (x - )+ =- max(x - ~, 0).
1659
known as the Black-Scholes option pricing formula,

V0 = S0~(da) - e-kr~q'(dl - & V ~ ) ,
where @ is the standard normal cumulative distribution function and
1
/ S e kr\
d~- ~ W l o g ~ - - ) +
t~V~
~-
The Black-Scholes formula was originally computed more tediously by a direct

solution of a partial differential equation studied in the next subsection.
If the dividend g(ST, r) is paid at a stopping time r chosen by the owner of
the security, the absence of arbitrage implies that T is rationally chosen so as to
maximize the market value of the security. That is,
V0 = sup E O [ g ( S ~ , ~-)].
T
For instance, an American put option has payoff g ( S , , .c) = ( - ST) + at an

exercise date ~- chosen by the holder of the option. Progress on this problem
has been made in sources cited in Section 6.10.
5. 11. The M a r k o v case: the P D E f o r derivative asset prices
This subsection characterizes arbitrage-free derivative asset prices in a Markov

state space setting. We will derive a partial differential equation (PDE) for the
derivative asset price, and then provide sufficient conditions for the existence
of a smooth solution. Of course, the solution is exactly that defined by the
conditional expectation (27), but the equivalent martingale measure Q is
implicit, rather than explicit, in the PDE. Finally, we mention several techniques that are commonly used for solving the PDE, at least numerically. In
practice, a Markov setting is the most commonly found in application because
of its computational and econometric advantages.
The state of the market model is defined by an ~K-valued process {X,}
satisfying the stochastic differential equation
d X t = l,(Xt, t) dt + ~l(Xt, t) d B ' ,
Xo= x ,
where B is a Standard Brownian Motion in ~d and u : ~ [0, T]--~ I~r and

~ : E r [0, T]---~E Kd satisfy regularity conditions ensuring existence and
strong uniqueness of solutions. Details can be found, for example, in Chung
and Williams (1989); it is enough that both v and r/are Borel measurable and
D. Duffle
1660
satisfy a Lipschitz 12 condition as well as a growth 13 condition, both with respect

to their first (state) argument.
The "primitive" securities are defined by functions (6e, 8, R) on K >~ [0, T]
that satisfy regularity conditions to be added later. Specifically, the RN-valued
,,.. . ,
function 9 defines the N "risky" security prices by ~ ( X t , t) = ( S1
The corresponding N dividend processes are defined by D~ = J'0 ~ ( X s , s ) d s ,
j/> 1. As usual, security number zero has price identically equal to 1 and a
dividend rate equal to the short rate process r, in this case given by r, =
R ( X , , t). For convenience, we depart from our usual convention and take the
cure dividend security pricing convention.
For a full general equilibrium setting with this form of price behavior,
consider the equilibrium described by Proposition 6. Suppose the exogenous
Markov process X determines the aggregate e n d o w m e n t process e for that
economy by e, = h(Xt, t) for some smooth function h, and suppose each
primitive security j ~ 1 has a real dividend process of the form D~ =
f0
(xs, s) ds, t < r and
= for
(Xs, s) ds +
gj(XT,
for measurable fj
and gj. Relation (16) and the calculation r, = - I ~ ( t ) / ~ ( t ) of the short rate
imply that S t = (1, 6e(Xt, t)) and that r t R ( X , t) for measurable functions 6e
and R. See Huang (1987) for extensive analysis of such a Markovian
equilibrium.
An additional security, to be priced, has a dividend process C defined by
C, = So f ( X s , s) ds, t < T and C r = for f(X~, s) ds + g ( X r , T), where f and g
are real-valued functions on E r [0, T] with properties to be specified. In
many applications, such as the original Black-Scholes model, the state process
X is actually the security price process S itself. In that case, the additional
security to be priced is called derivative because its dividends are functions of
the underlying asset price process. For example, in the Black-Scholes call
option pricing model, X is a geometric Brownian Motion describing the price
of a given security (that has no dividends), and the derivative dividend process
is defined by f = 0 and g(x, T ) = (x - 3?) +, where J? is the option's exercise
price, as explained in Section 5.10.
We presume that the dividend process C defined by f and g can be financed
given (D, S), and later return to provide sufficient conditions for this assumption, as well as several other assumptions made (rather loosely) along the way
to a conjectured solution for the price process V. At the final stage, w e c a n
state a formal theorem.
The absence of arbitrage implies restrictions on the price process V for C.
Rather than pursuing the existence of an equivalent martingale measure,
however, we will use the redundancy of C and the absence of arbitrage to
=
~2There exists a constant k such that IIn(x, t) - "q(y, t)ll ~ kllx - yH for all x andy and all t.
13There exists a constant k such that IIn(x, t)H ~<k(1 + Ilxll) for all x and all t.
1661
derive a PDE in R E [0, T] whose solution J, if sufficiently well behaved,

evaluates V as Vt = J ( X t, t).
Assuming that J is sufficiently smooth for an application of Ito's Lemm&
V t = J ( X t, t) implies that
d V t = ~ J ( X t , t) dt + J~(Xt, t)r/(Xt, t) dBt ,
(30)
where, for any smooth function H,

~ H ( x , t) = Hx(x, t ) v ( x , t) + Ht(x, t) + 1 tr[~?(x, t ) V H ~ ( x , t)*l(x, t)],
with subscripts indicating the obvious partial derivatives.

By assumption, a trading strategy 0 finances the dividend process C. Barring
arbitrage, this means that, for all t,
s, = v ,
(31)
and
(32)
0,- S t = 00-S O+ f 0s d G s - C t .
0
Substituting the various functions applied above, and denoting 0 = b, and

(01. . . . . ON) = a t, relation (31) implies that
a t 5e(Xt, t) + b t = J ( X t , t ) ,
t E [0, T].
(33)
From (31) and (32), with the obvious notational shorthand,

d V t + f ( X t , t) dt = a t [6(Xt, t) dt + ~5t(Xt, t) dt + 5ex(Xt, t)(Xt, t) dBt]
(34)
+ b t R ( X , , t) d t .
Ito processes are special semimartingales and can therefore be uniquely

decomposed as the sum of a constant, a stochastic integral with respect to the
Brownian motion B and an ordinary Lebesgue integral with respect to " t i m e "
t. This means that we can equate the coefficients of dB, and dt separately in
(34), using (30), to derive several necessary conditions for no arbitrage and the
fact that 0 finances C. First, equating coefficients in dB t from (34) leaves
(almost everywhere)
a,bx(Xt, t)rl(X t, t) = J~(Xt, t)r/(X,, t ) ,
t E [ 0 , T].
(35)
D. Duffle
1662
In order to find a t satisfying (35), it is enough (and close to necessary) that bx

is everywhere of rank K, in which case
a, = J~(X,, t)f~x(Xt, t)T[sex(Xt, t)Sfx(X,, 07] -1 .
(36)
Next, (33) and (36) imply that

b t = J ( S t , t) - J~(S,, t)~x(St, t ) [ ~ x ( S t , t ) ~ x ( X . t)T]-~Se(X,, t).
(37)
Finally, equating the coefficients of dt in (34), using (36) and (37), leaves
R(Xt, t)J(X,, t) = Jx(X,, t)lx(X,, t) + J~(X,, t)

+ tr[n(X,, t)TJxx(X,, On(X,, t)] + f(X,, t),
(38)
where IX : ~ : x [0, T] ~ R K is defined by
Ix(x, t) = Sx(x, t)T[sex(X, t)fPx(X, t) TI-'[R(x, t)Se(X, t) -- 6(X, t) -- oWt(X,t)

-- q(x, t)],
(39)
and where q/(x, t) = tr[~/(x, t) J

t),7(x, t)].
Of course, (38) is automatically satisfied if J solves the parabolic PDE in
R/~ x [0, T] given by
R(x, t)J(x, t) = J~(x, t)Ix(x, t) + Jr(x, t)

+ tr[n(x, t)TJxx(X, t)rl(X, t)] + f(X, t).
(40)
The boundary condition imposed on (40) by equating the cum dividend final
market value J(Xr, T) with the final payoff g(Xr, T) is
J(x, T) = g(x, T ) ,
x E ~K.
(41)
We can immediately conjecture a solution to (40), (41) by applying Ito's

Lemma. For each (x, t ) E RKX [0, T], assuming the expectation is well defined, let
T
r
where {Ysx., : t ~ < s ~ T )
solves

ix(Y~X , t , r ) d r +
yx,t = x +
t
r/( Y ,"" , r ) d B , ,
1663
s~ t,
(43)
and where
$
," , r) dr
o(s) = f R( Y x,
t
A unique solution to (43) exists under the usual conditions on ix and ~7

mentioned above. If J is indeed well defined by (42) and smooth enough for an
application of Ito's Lemma, it follows immediately from Ito's Lemma that J
solves the PDE (40) with boundary condition (41). This is often called the
Feynman-Kac solution of the PDE.
All of the above calculations can be justified with known conditions on the
functions (ix, r/, 6, R, f, g) under which (42) is well defined and generates the
unique solution J to (40), (41) satisfying a growth condition in the state
variable. Typical alternative sets of conditions are due to Dynkin (1965),
Freidlin (1985) and Krylov (1980). The following result is representative.
Suppose ix and ~ satisfy a Lipschitz condition in the state
variable, and that all of the functions (t,, 77, 6, R, f, g) are Borel measurable,
have two continuous derivatives with respect to the state variable, and that the
functions and their first and second derivatives with respect to the state variable
satisfy a growth condition with respect to the state variable. Then (42) defines a
solution J to the P D E (40), (41), the unique solution satisfying a growth
condition with respect to the state variable.
Krylov's Theorem.
I f ~ v has eigenvalues bounded away from zero (or "uniform ellipticity"),

Krylov's smoothness conditions can be weakened significantly. Our prior
analysis now justifies the following claim.
Suppose ( ( D , C ) , ( S , V ) )
admits no arbitrage, rank(bx)=K
everywhere, and (ix, ~7, 6, R, f, g) satisfies Krylov's conditions. Then J is well
defined by (42), C is financed by the trading strategy (b, a) defined by (36) and
(37), and the price process V o f C is given by V t = J(X,, t).
Corollary.
As an example, we can take the case 6 = 0 and 5(x, t) = x, in which case

Ix(x, t) = R(x, t)x. Then
T
J\
0
t'
(44)
D. Duffle
1664
where Y is the "pseudo-price process" defined by the stochastic differential

equation
dYt=r(Yt, t)Ytdt+tT(Yt, t)dBt,
Y0 = X0,
(45)
and where ,p(t) = J'0 r(Ys, s) ds. Of course, the distribution of the pseudo-price
process Y under P is the same as that of the price process S itself under the
equivalent martingale measure Q, as shown by comparing (29) and (45), and
the solution given here for V0 is exactly that obtained in Section 5.10.
In particular, we can easily recover the Black-Scholes formula in the case
K = 1, R(x, t) = R, f = O, g(x, t) = (x - a?)+ and tr(x, t) = ~x, where/~, 2? and t~
are positive constants. It follows from (44) that
v0 = E [ e - k T ( V T -- g ) + ] ,
(46)
where YT = X0exp[(R-t~2/2) T + &B~]. Relation (46) defines the BlackScholes option pricing formula, as stated in the Section 5.10. Of course, the
payoff function (x, t ) ~ ( x - ) + is not as smooth as required by Krylov's
conditions, being non-differentiable at , but those conditions can be extended
to incorporate a function g that is continuous with finitely many pieces that are
smooth in Krylov's sense, yielding a solution J that is smooth in R/< [0, T),
but not of course at T.
5.12. Approximate solution of the arbitrage PDE

The Black-Scholes option pricing formula is one of several closed-form
solutions available for arbitrage pricing of particular derivative securities in this
setting. (Some of the other examples are cited in Section 6.10.) As a practical
technique for pricing many different forms of derivative securities, however,
one typically relies on approximate solutions, usually obtained with the aid of a
computer. Commonly used algorithms involve Monte-Carlo simulation of the
expectation in (43) or direct numerical solution of the PDE (40), say by
finite-difference or finite-element algorithms (see Section 6.10 for references).
For simple problems based on a geometric Brownian price process, solutions
are also frequently estimated by approximating the "pseudo-price" process Y
with a binomial process, calculating the discrete analogue to (42) by a
backward recursion, and then improving the approximation error by reducing
the length of a trading period. The latter approach was popularized by Cox,
Ross and Rubinstein (1979), who showed by an explicit calculation (involving
the central limit theorem) that a natural binomial approximation of the price
1665
process X leads to a sequence of option prices converging, with the number of

trading periods per unit of time, to the Black-Scholes formula.
5.13. Extensions of the P D E method
The same PDE approach can be extended so as to allow T to be replaced by a

stopping time z defined as the hitting time of (Xt, t) on some regular set, or
"liquidation boundary." Dynkin (1965), for example, shows sufficient conditions on the coefficient functions and the liquidation boundary for an analogue
to Krylov's Theorem.
In principle, although there are few available results, the PDE (40) also
extends to the pricing of securities that the holder may exchange at any time
for a pre-arranged liquidation value, the classic example being an American
put option, whose liquidation value is the excess (if any) of the option's
exercise price over the current price of the underlying security. Recent
literature on the American put is cited in Section 6.10. Although it is
unrealistic to expect a closed-form solution for the American put, there has
been much progress in defining the optimal liquidation boundary in the
Black-Scholes setting. The optimal liquidation boundary is that yielding the
supremum arbitrage-free value for the derivative security. The PDE (40), with
the associated free boundary, is often termed a Stefan problem.
The PDE approach can also be extended in like generality to the pricing of
continuously re-settled securities, such as futures and futures options, as shown
by Black (1976), Cox, Ingersoll and Ross (1981b) and Duffle and Stanton
(1988).
6. Further reading
This section points to additional sources of reading on the topics presented in

this chapter, as well as a range of literature on related topics that have not
been reviewed.
6.1. General references
There are a number of monographs presenting the topics of this chapter at

various levels, including Fama and Miller (1972), Mossin (1973), Fama (1976),
Ingersoll (1987), Jarrow (1988), Huang and Litzenberger (1988) and Duffle
(1988). Survey articles include those of Kreps (1979), Merton (1987),
Rothschild (1986), Marimon (1987), Radner (1988), DeMarzo and Van Nuys
(1988) and Constantinides (1989).
1666
D. Duffle
6.2. Finite-dimensional general equilibrium in security markets

Chapter 30 reviews the literature on existence, optimality, and multiplicity of
finite-dimensional security-market equilibria. We will therefore limit ourselves
here to mentioning, in addition to Arrow (1953), the key contributions of
Debreu (1953), Radner (1967, 1972) and Hart (1975) in formulating the
central issues. For existence of equilibria with references defined directly on a
linear space of portfolio choices, see Hart (1974), Nielson (1986b) and Werner
(1987).
6.3. Spanning and the behavior of the firm

The Modigliani and Miller (1958) results on the irrelevance of financial policy
are given a general finite-dimensional treatment in incomplete markets by
Duffle and Sharer (1986) and DeMarzo (1988). Financial policy is relevant
under almost any departure from the neo-classical assumptions, such as taxes
[Miller (1977)], asymmetric information [Jensen and Meckling (1976), Ross
(1977), Myers and Majluf (1984), Duffle and DeMarzo (1988)], introduction of
options on the firm [Detemple, Gottardi and Polemarchakis (1989)] or bankruptcy [Hellwig (1981)].
There is not yet a generally accepted paradigm for the production decisions
of the firm without some sort of spanning condition. Arrow and Debreu (1954)
merely took it as an axiom of competitive behavior that firms maximize their
market value. With complete spanning, of course, shareholders unanimously
support this objective, since it generates maximal budget-feasible choice sets
for shareholders. This unanimity result was extended by Diamond (1967) and
Ekern and Wilson (1974) to the case of security markets that span the set of
feasible dividends of the firm. Makowski (1983) pointed out that this spanning
condition is automatically satisfied if shareholders act as though the span of
security markets is fixed, independently of the firm's choice. Duffle and Shafer
(1986) showed that, if shareholder's do not treat the span of markets as fixed,
then, generically, all but at most one shareholder objects to maximizing market
value. Of course, the very objective of value maximization is not well defined
unless firms have conjectures concerning the value of securities outside of the
current span of markets. Duffle and Shafer (1986) show generic existence of
equilibria when conjectures are defined by state-prices, in the sense of Section
3.1. Dr6ze (1974), instead, takes it as an axiom that firms maximize according
to state prices defined by a weighted sum of agents' marginal rates of
substitution (given by the vector VUi(ci), in the notation of Section 3.2), with
weights proportional to shareholdings. This objective generates constrained
Pareto optimal allocations with a single spot consumption commodity, although
Ch. 31: The Theory of Value in Securi~ Markeu
1667
Geanakoplos, Magill, Quinzii and Dr~,ze (1987) overturn this optimality

property with multiple spot commodities.
Further characterization of the theory of the firm in incomplete security
markets is provided by Aghion and Bolton (1986), Allen and Gale (1987),
Bester (1982), Brealey and Myers (1984), Burke (1986), DeMarzo (1987),
DeMarzo and Duffle (1988), Fama (1978), Gevers (1974), Grossman and Hart
(1979, 1987), Grossman and Stiglitz (1976), Harris and Raviv (1987), Hart
(1977, 1979, 1987), Jensen and Long (1972), Kreps (1979), Leland (1973,
1974, 1978), Marimon (1987), Merton and Subrahmanyam (1974), Myers
(1984), Radner (1974), Satterthwaite (1981) and Stiglitz (1972, 1974, 1982)o
6.4. Mutual funds and factors in asset prices
The CAPM is a single-factor pricing model; the factor is the market portfolio.
The CCAPM is also a single-factor model; the factor at each point in time is
the growth rate of consumption over the next "instant." A general multiperiod single-factor model always applies under mild regularity conditions, as
shown, for example, by Hansen and Richard (1987); the general problem is
econometric identification of the factor. The CAPM is based on the sufficiency
of two mutual funds for Pareto optimality; further sufficient conditions are
given by Cass and Stiglitz (1970) and Ross (1978b); additional recommended
readings are the papers by Rubinstein (1974), Nielson (1986a) and Stiglitz
(1989).
Ross (1976a) described a multi-factor asset pricing model called the APT;
sufficient conditions are provided by Huberman (1982) and Connor (1984).
Approximate multi-factor models are characterized by Chamberlain (1983b)
and Chamberlain and Rothschild (1983).
6.5. Asymmetric information
Most of the available asset pricing results with asymmetric information are
based on strong parametric assumptions, as in Admati (1985), Bray (1981),
Carino (1987), Dothan and Feldman (1986), Gennotte (1984) and Grossman
(1976). Hindy (1989) presents a non-parametric but "bounded rationality"
model.
Examples of the literature on asset valuation with a specialist market maker
and asymmetric information include the work of Admati and Pfleiderer (1988),
Glosten and Milgrom (1985) and Haggerty (1985). This is a very small sample;
Bhattacharya and Constantinides (1989) have edited a selection of readings on
the role of information in financial economics.
1668
D. Duffle
6.6. Equilibrium asset pricing models
Further examples of asset pricing models under the additive separable preference assumptions of Sections 3.2, 3.3 and 4.3 include the papers of Back
(1988), Breeden (1986), Breeden and Litzenberger (1978), Grauer and Litzenberger (1979), Kraus and Litzenberger (1975), and Merton (1973a).
By relaxing the additively separable model of preferences described in
Sections 3.3 and 4.3, a range of alternative asset pricing formulas can be
achieved. Asset pricing models based on alternative preference specifications
have been described by Bergman (1985), Constantinides (1988), Duffle and
Epstein (1989), Epstein and Zin (1989a) and Sundaresan (1989). Hindy and
Huang (1989) formalize the notion of intertemporal substitution of consumption, relaxing the continuous-time assumption of consumption at rates.
6. 7. Extended notions of spanning
Models of general equilibrium based on multi-period notions of spanning have

been developed by Friesen (1974), Kreps (1982) and Duffle and Huang (1985),
which introduces the dynamic spanning condition of Section 4. For technical
results on the closely associated problem of "martingale multiplicity," the
reader is referred to Clark (1970), Davis and Varaiya (1974), Kunita and
Watanabe (1967) and Jacod (1977).
Static notions of spanning based on the formation of options and compound
options are due to Ross (1976b), Breeden and Litzenberger (1978), Brown and
Ross (1988), Jarrow and Green (1985) and Nachman (1988).
6.8. Asset pricing with "frictions"
The majority of this chapter is based on the costless formation of unrestricted

portfolios. For asset-pricing models incorporating one or more of transactions
costs, taxes, cash-in-advance constraints, credit constraints, and so on, please
see Back (1986), Back and Pliska (1986), Constantinides (1986), Dybvig and
Huang (1988), Grossman and Laroque (1987), Lucas and Stokey (1987),
Leland (1985), Prisman (1985), Ross (1987), Svensson (1988), Scheinkman
and Weiss (1986) and Townsend (1984). Svensson (1988) and Scheinkman
(1989) discuss the limited results available on asset pricing results that explicitly
incorporate the incomplete markets constraint.
1669
6.9. Technical references on continuous-time m o d e l s
Brownian motion was actually formulated by Bachelier (1900) as a model of

stock prices. On diffusion processes and stochastic differential equations~
standard references include Arnold (1974), Freedman (1983), Friedman
(1975), Gihman and Skorohod (1972), Ikeda and Watanabe (1981), Karatzas
and Shreve (1988), Krylov (1980) and Lipster and Shiryayev (1977). More
abstract treatments of stochastic integration are provided by Chung and
Williams (1983), Dellacherie and Meyer (1978, 1982), Durrett (1984), Ethier
and Kurtz (1986), Jacod (1979), Kopp (1984) and Protter (1989). The
central results on the behavior of semimartingales under a change of prob-o
ability measure are given by Girsanov (1960), Lenglart (1977) and Memin
(1980).
The technical foundations of continuous-time security prices and trading in
an abstract setting has been developed in a series of papers by Harrison and
Kreps (1979), Harrison and Pliska (1981, 1983), Huang (1985a,b) and Pliska
(1982).
6.10. Derivative asset pricing
Varian (1987) is a useful introductory exposition of the arbitrage notion of

derivative asset pricing. The literature that applies the arbitrage approach to
the pricing of derivative securities (that is, securities whose dividends are
functions of the prices or dividends of other securities) is far too voluminous to
even list here. The most famous example is the option pricing formula of Black
and Scholes (1973), which is given a detailed treatment in the book by Cox and
Rubinstein (1985). Other prominent examples are the papers by Breeden and
Litzenberger (1978), Brennan and Schwartz (1977, 1979), Carr (1987), Cheng
(1987), Cox, Ingersoll and Ross (1981a,b), Cox and Ross (1976), Cox, Ross
and Rubinstein (1979), Duffle and Stanton (1989), Geske (1979), Goldman,
Sosin and Gatto (1979), Heath, Jarrow and Morton (1987), Hemler (1987),
Ho and Lee (1986), Hull (1989), Ingersoll (1977), Johnson (1987), Margrabe
(1978), Merton (1973b, 1974, 1976, 1977), Mfiller (1985) and Richard (1978).
Numerical solution methods are described by Boyle (1977), Jones and
Jacobs (1986), Miltersen and Nielsen (1989) and Geske and Shastri (1985).
Progress on the pricing of American options can be found in Geske and
Johnson (1984), Parkinson (1977), Jamshidian (1989), Carr and Myneni
(1989), Carr, Jarrow and Myneni (1989), Barone-Adesi and Elliott (1989) and
Kim (1989).
D. Duffle
1670
6.11. Infinite horizon recursive models

The model in Section 3.3 is usually presented in a Markov setting, as in Lucas
(1978) and Prescott and Mehra (1980). The determination of an equilibrium is
more interesting with production, as shown by Brock (1979, 1982). The
monograph by Stokey and Lucas (with Prescott) (1989) is a good source for
details.
6.12. Estimation
The many papers on econometric estimation of the asset pricing models
presented in this chapter include those of Breeden, Gibbons and Litzenberger
(1986), Brown and Gibbons (1985), Epstein and Zin (1989), Hansen (1989)
and Hansen and Singleton (1982, 1983). Singleton (1987) surveys some of the
econometric work on asset pricing models.
Appendix: Stochastic integration

This appendix is provided for the convenience of those readers interested in
the definition of stochastic integration and the underlying technical details.
Before beginning, however, we assure the reader that, limiting attention to a
large subclass of integrands (0) and integrators (G), the stochastic integral
0 d G is nothing more than the limit in probability of the obvious sum,
k-1
jE o,,( c,,+, -
c,),
as the maximum length of a time interval tj+ 1 -- tj converges to zero. For this
limited but easy definition of the stochastic integral, see Protter (1989).
As primitives, we have a probability (g2, ~-, P), a time interval 3- = [0, T] or
3 - = [0, oo), and a family ~: = {o%,: t E 3-} of sub-o--algebras of 0%satisfying the
usual conditions:
(1) o%t C o%s whenever s i> t (increasing);
(2) o%0 includes all subsets of zero-probability events in o% (augmentation);
(3) for all t E 3-, ~ = ~ s > t f f s (right-continuity).
A stochastic process is a family X = (X,: t @ 3-} of random variables. Unless
otherwise stated, we take a stochastic process to be real-valued. A process X is
adapted if X t is o%,-measurable for all t. An adapted process X is integrable if
E(Ixt[ ) is finite for all t. A martingale is an adapted integrable stochastic
process X with the property:
E(X,]~) =
&,
1671
a.s. whenever s ~< t ,
where E ( . i ~ ) denotes conditional expectation.

Example ( B r o w n i a n motion). A stochastic process B on some probability
space is a Standard Brownian Motion if:
(a) for any 0 ~< s < t < ~, B, - B s is normally distributed with zero expectation and variance equal to t - s;
(b) for any 0 ~< t o < t 1 < - . . < t t < ~, the random variables {B(t0) , B(t~) -B(tk_l): 1 <<-k <~ l}, are independent; and
(c) P ( B o = O) = 1.
For d E N , a Standard Brownian Motion in R d is an Rd-valued process
( B (1), . . . , B (d)) made up of d independent Standard Brownian Motions.
It is normal to use a filtration U:with respect to which the Standard Brownian
Motion B is a martingale. For example, we could take ~, to be the it-algebra
generated by { Bs: 0 <~ s ~< t} as well as the subsets of zero-probability events in
~. The resulting filtration U:= {o~,: t E 3-} is called the standard filtration of B.
This ends the example.
A process X is left-continuous if limtv~X , = X , for all s almost surely. The
predictable o--algebra on 2 3 - i s that generated by the left-continuous
adapted processes. A stochastic process 0 is predictable if 0 : O if---> R is
measurable with respect to the predictable o--algebra. In continuous-time
settings, it is natural to restrict agents to predictable strategies.
A martingale X is square-integrable if {X~: t ~ 3-} is an integrable process.
The quadratic variation of a square-integrable martingale S is the unique
increasing process denoted [S] such that, for each t @ J-,
2n
[S,]= lim ~
n ~
[S(t~+l)-S(t~)] 2 ,
i=0
where t~' = i2-nt for 0 ~< i ~<2". [The limit is in the space L I ( P ) . ] Roughly
speaking, [St] is the limit of squared changes of S during [0, t], where the
length of time intervals over which the changes are measured shrinks to zero.
For a Standard Brownian Motion B, [Bt] = t almost surely for all t.
Let M 2 denote the space of square-integrable martingales. For each S ~ M 2,
let L2[S] denote the space consisting of any predictable process 0 with
t
E(I0:
0
for a,, in
D.
1672
Duffle
(Since [S] is increasing and 0,2 is positive, the integral 50 0,z dlS], is always well
defined, although possibly + % for each t and each w in O as a Stieltjes
integral.) We will next define a stochastic integral J" 0 dS for S ~ ~ z and
0 E L2[SI .
We first take the case 3--= [0, T]. A stochastic process 0 is elementary if in
each state 0o E 12 there is partition {(0, q], (t~, t2] . . . . . (t k, T]} such that 0 is
constant over each set in the partition. That is, an elementary process is
piecewise constant and left-continuous. The stochastic integral f0~ 0t dS t is
easily and intuitively defined for any elementary process 0 as a sum of the form
T
foldS,= E
o(t~_,)Is(t,)
s(t,_,)].
( k : tk<-T }
This defines a process y 0 dS = {J'o T dS~: t C 3-}. Let L2[S]~ = {0 E L2[S]: 0

is elementary}. The following lemma can be proved as an exercise.
Lemma.
IfS~M
2 a n d O @ L 2 [ S ] ~ , then S O d S @ ~ 2 .
We next define a norm 11"11~2 o n M 2 (that gives M 2 the structure of a Hilbert

space) by
IlSll~2 = V v a r ( S 0 ,
s~
Likewise, for each S @ j/2, a semi-norm II'lls is defined on L2[S] by
[(f
II011,= E
,11,2
0~dlS],)]
, OEL2[S].
It turns out that
I[01ls=
rOdS ~2, O~L2[SI~, S~/~2,
which defines an isometry that can be extended to L2[S], allowing us to define

the stochastic integral f 0 dS for any 0 ~ L2[S] as follows.
Theorem (definition of stochastic integration). For any S E ~ 2 and any
2
2
0. E L. [S],
there
extsts a sequence
{On} m L [S]~o such that II0n - 011,~ o . There
.
.
2
ts a untque martmgale m ill , denoted f 0 dS, such that for any such sequence
{0,}, {j" 0ndS} converges in 11-11~2 to y o as.
1673
This definition of the stochastic integral is extended from i f = [0, T] to

i f = [0, ~) by defining J" 0 dS on [0, ~) via its restriction to [0, T] for each T.
While the above definition is perfectly satisfactory for many applications, it
must be extended to handle more general processes 0 and S. In order to do
this, we next define the most general class of such S for which a stochastic
integral can be defined with reasonable properties; this is the class of semimartingales. We first need a few additional definitions.
A if-valued random variable ~- is a stopping time if the event {to
g2: r(to) ~< t} is in o%tfor all t in if. For an adapted process X and stopping time
z, the stopped process X ~ is defined by X~(t) = X ( t ) , t <~ z, and X~(t) = X('r),
t > ~'. An adapted process X is a local martingale if there is a sequence { % } of
stopping times with % ~< %+, and limn__,~ % = ~ almost surely such that X ~" is a
martingale for all n. (In particular, a martingale is a local martingale.)
A stochastic process X is a finite variation process if X = A - B, where A
and B are adapted processes that are increasing (almost surely). A stochastic
process S is a semimartingale if S = M + A for some local martingale M and
finite variation process A.
A stochastic integral ~ 0 dS is defined, for predictable 0 and semimartingale
S, if there is a decomposition S = M + A of S as the sum of a local martingale
M and a finite variation process A such t h a t j" 0 d M and J" 0 dA are well
defined. In that case, J ' 0 d S = J ' 0 d M +
f 0 d A does not depend on the
decomposition. While we do not define ~ 0 d M and J" 0 dA explicitly, the
former is a natural extension of the integral f 0 d M for M C ~ 2 and 0 E
L2[M], while j'0r 0t d A , is the classical Stieltjes integral for each to G O.
For any semimartingale S, we let L ~[S] denote the set of predictable 0 such
that the stochastic integral .~ 0 dS is a well-defined and integrable process.
Given an ~N-valued process S = ( S ' , . . . , S N) for which S = is a semimartingale,
n~{1,...,N},
we can define 0 = ( 0 1 , . . . , 0 N ) @ L I [ S ] and . ~ 0 d S by a
natural extension of the one-dimensional case. For a precise definition, see
N 1 f On da n, although, in
Jacod (1979). One should think of ~ 0 dS as En=
pathological cases, this is only true in a limiting sense. (If I: is the standard
filtration of a Brownian motion, J" 0 dS = E~_, ~ 0 ndS".) Protter (1989) is an
excellent introduction to stochastic integration.
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Chapter 32
SUNSPOT EQUILIBRIA
MARKETS
MODELS
IN SEQUENTIAL
P I E R R E ANDRI~ CHIAPPORI and R O G E R GUESNERIE
D E L T A , unite mixte CNRS-ENS-EHESS, Paris
Contents
1.
Introduction
1.1.
1.2.
1.3.
2.
3.
4.
7.
1684
1686
1693
1697
2.1.
2.2.
1697
1701
The model
Rational expectations and sunspot equilibria
Existence of sunspot equilibria: invariant set arguments
1706
3.1.
3.2.
1706
The invariant set argument: weak version

The invariant set argument: strong version
Indeterminacy of the stationary state and local sunspot equilibria

Sunspot equilibria in linear models
Equivalence between indeterminacy of the steady state and existence of
local sunspot equilibria
Existence of sunspot equilibria: other arguments

5.1.
5.2.
6.
1684
The framework under consideration
4.1.
4.2.
5.
Sunspot equilibria in the broader perspective of general equilibrium with

rational expectations
May sunspot matter? An overview
Sunspot equilibria in infinite horizon sequential models: an introductory
example
Continuity arguments: the implicit function theorem

Dynamical systems and heteroclinic sunspot equilibria
1708
1715
1716
1721
1726
1726
1729
Structure of sunspot equilibria: the differential approaches
1734
6.1.
6.2.
1734
1741
Differential topology and the Poincar6-Hopf theorem

Bifurcation theory
Extensions
7.1.
7.2.
7.3.
Intrinsic versus extrinsic uncertainty

Learning
Models with memory
Appendix: Some examples of the general model

References
1744
1744
1748
1751
1754
1758
*This paper was presented at BoWo'89. We benefited from helpful comments from the
participants and from J.P. Benassy, S. Burnell, J.M. Grandmont, J. Laitner, K. Shell and
M. Woodford. Support from Deutsche Forschungsgemeinschafl, Gottfried-Wilhelm-LeibnizF6rderpreis is gratefully acknowledged.

Elsevier Science Publishers B.V., 199i
1684
P.A. Chiappori and R. Guesnerie
I. Introduction
Equilibrium with rational expectations is a central construct of modern

economic theory. The studies that are surveyed here are primarily aimed at
assessing the properties and relevance of this construct in a general equilibrium
framework; in particular, they are related to the issue of multiplicity (and,
more specifically, "indeterminacy") of rational expectation equilibria. The
present text thus belongs to the broader category of contributions to general
equilibrium with rational expectations. The viewpoint that is taken is associated with the so-called concept of sunspot equilibrium. It leads to focus on
aspects of general equilibrium with rational expectations that have been given a
central role in recent literature.
In Section 1.1, we present the problem of sunspot equilibria in the broader
perspective we have just stressed. Section 1.2 provides an overview of issues
relating to the sunspot literature. Section 1.3 discusses an example of sunspot
equilibrium in a framework analogous to the one that will be adopted in the
following sections.
1.1. Sunspot equilibria in the broader perspective of general equilibrium with

rational expectations
In the Arrow-Debreu world, all transactions and plans are decided at the
outset on the basis of the prices which clear future and/or contingent markets.
Actual trade can take place later, when time passes and/or contingencies
obtain; but it does not depart from the decisions initially taken.
Actual markets substantially differ from the idealized Arrow-Debreu markets. They do not take place once for all; on the contrary, they open in
sequential order. In particular, spot markets open at successive calendar dates
for transactions concerning commodities available at these dates. These spot
markets coexist with other markets, often referred to as financial markets, that
allow agents to redistribute wealth, at least to some extent, across periods and
across contingencies.
Expectations have necessarily a key role in the modeling of the sequential
structure that has been just sketched. The concept of equilibrium of plans,
prices and price expectations proposed by Radner (1972) assumes that agents'
expectations will be exactly fulfilled. At each "date-event", the equilibrium
prices that clear markets at any successive "date-event" (i.e. for any succession
of periods and contingencies along the tree of possible histories of the system)
are perfectly foreseen by all economic agents. This general equilibrium version
Ch. 32: Sunspot equilibria in sequential market models
1685
of the perfect foresight hypothesis allows a bridge to be established between

the Arrow-Debreu world and the world of sequential markets just considered.
In fact, it turns out that in finite horizon models and when "enough" financial
markets are open, equilibria of plans, prices and price expectations are Pareto
optimal; moreover, there exists a one-to-one correspondence between Radner
equilibria and Arrow-Debreu equilibria. This idea originated in the pioneering
work of Arrow (1953). 1 A systematic presentation leading to statements of
significant generality had to rely on the concept of Radner equilibrium [see
Guesnerie and Jaffray (1974)]. The theme has been abundantly illustrated by
subsequent literature which, in particular, made clear that the "enough markets" condition could be met through frequent trading [see Kreps (1979) or
Chapter 2].
Three modeling ingredients are used in order to obtain the conclusion that
the evolution of consumption and production in a sequential economy is similar
to the one predicted by the intertemporal Arrow-Debreu model: (1) the
horizon is finite, (2) the market structure is rich enough, and (3) future prices
are correctly foreseen. The failure of one of these conditions alone may lead to
the consideration of economic paths which are no longer Pareto optimal.
For example, consequences of the failure of condition (1) have already been
faced by capital accumulation or growth theory [Malinvaud (1953), Cass
(1972)]. The overlapping generations (OLG) model of Samuelson raises
specific questions that have been addressed in the early contributions of
Diamond (1965) and Gale (1973) as well as in more recent literature (cf. for
example the systematic analysis of Balasko and Shell (1981), or the synthesis of
Tirole (1985) for the elucidation of the role of bubbles in the process of
efficient accumulation).
The incompleteness of markets, i.e. failure of condition (2) above generated
a series of literature which is surveyed in this volume (see Chapter 1).
The discussion of condition (3) also opened a large area of research. The
validity of the perfect foresight hypothesis - or more generally of the rational
expectations hypothesis - has been the subject of intensive scrutiny. Two main
lines of investigation, that can be referred to the general categories of
"internal" and "external" criticism, have developed. External criticism leads to
consider whether and under which circumstances, the hypothesis can be
justified, la The internal criticism viewpoint takes the hypothesis for granted,
but puts emphasis upon the non-uniqueness (and "indeterminacy") issue.
Specifically, it investigates the possible occurrence of extraneous, stochastic
equilibria when Radner's original framework is perturbed by the introduction
1See also Baudier (1959).
l~Specifically, justifications can either be based on "evolutive" (learning) arguments [see for
example Kirman (1983), Grandmont and Laroque (1986), Woodford (1990)], or on "eductive"
arguments [cf. Guesnerie (1989b)].
1686
of what the popular terminology originating in the pioneer work of Shell (1977)
and Cass and Shell (1983a, b) has labeled "extrinsic" uncertainty. Such uncertainty is unrelated to the fundamentals of the e c o n o m y but occurs "far away"
from the economic world (sunspot) or in people's minds. It has been argued
that such extraneous equilibria might jeopardize both the predictability of the
system and its welfare properties.
As the title of the paper indicates, we are mainly concerned here with the
analysis of the consequences for the rational expectations hypothesis of the
so-called sunspot phenomenon. Note however that if our survey is directly
connected with the discussion of point (3) above, it also branches to discussion
of some aspects of points (1) and (2). Indeed our emphasis will be mainly on
sunspot equilibria (point 3) in infinite horizon models (point 1) in which some
form of incompleteness (absence of insurance against sunspot events) occurs
(point 2). 2
1.2. May sunspot matter? A n overview

We provide, in this section, a first analysis of the sunspot p h e n o m e n o n within a
general equilibrium framework. The argument is presented in an (almost)
atemporal context in which the sunspot p h e n o m e n o n can only take simplistic
forms. However, the so-called "ineffectivity t h e o r e m " that is stated below has
broad scope; its discussion allows a rather comprehensive appraisal of one of
the central theoretical issues associated with the sunspot phenomenon, i.e. the
insurability issue.
Also, the ineffectivity theorem is a good starting point for providing a
general perspective on the sunspot literature and for understanding its branching points. We present different lines of investigation, as well as a brief
overview of one part of the sunspot literature, the detailed analysis of which is
outside the scope of the present survey.
The ineffectivity theorem and the insurability issue
Let us consider an exchange economy in an n-commodity world. Consumers
indexed by i = 1 , . . . , m are endowed with a vector of initial resources
w i E R~. T h e y have preferences associated with the Von N e u m a n n - M o r g e n stern utility function u;: ~ ~ ~.
2Then the three themes just evoked are not mutually exclusive. For other existing literature
relating to several of these themes, let us quote for example Lucas' influential paper (1972). The
latter studies a model which combines an infinite horizon (OLG model) together with a form of
incompleteness (the "island" structure together with the generational structure prevents insurance
markets against uncertainty, which is both of demographic and monetary type). There, it is the
signal extraction problem that leads the economy to experience rational fluctuations.
Ch. 32: Sunspot equilibria in sequentialmarket models
1687
T h e r e is one period, with three subperiods indexed by ~- = 0, 1, 2. At ~-= 0,

markets open and transactions are decided upon. At ~-= 1, an exogenous
random variable 0 E 6) is observed. A t ~-= 2, trade takes place as decided at
I"~0.
The r a n d o m variable observed at ~-= 1 is "extrinsic". It does not influence

either initial endowments or preferences. It can take k values, i.e. 6 ) =
{01, , Ok}, and its occurrence follows a probability distribution (~rI . . . . . ~k)
which is objective, i.e. agreed upon by all agents.
Assume first, as it seems natural, that agents disregard the extrinsic variables
and that trade occurs on competitive markets. Market outcomes are then
competitive equilibria. Formally stated: a competitive equilibrium consists of a
price vector/~ and a sequence of commodity bundles (Ei) such that
(El) E arg max{ui(xi) I fi" xi <~fi" wi} ,
(1.1)
Z xi ~ Z wi.
(1.2)
H o w could sunspots matter here? As sunspots do not affect the fundamentals, there will be no reason, after their occurrence, to reconsider the transactions decided upon at the outset. Also as sunspot events do not precede the
determination of transactions, they cannot play the role of a selecting device in
the case when there are several competitive equilibria. 3 Nevertheless, if
sunspot events are contingencies which are considered by the agents, they, a
priori, should be incorporated in a full A r r o w - D e b r e u model with contingent
markets. Let us consider the case where indeed a complete set of markets for
the sunspot contingencies does exist. The corresponding equilibrium concept is
the concept of *-complete (read sun-complete) equilibrium. 4
A *-complete competitive equilibrium consists of price vectors contingent on
0, fi(0l), 1= 1 , . . . , k and of consumption bundles contingent to 0, E~(01),
1=1 ..... k,i=l,...,n,
suchthat
l=k
{xi(01), . . . , Ei(Ok) } E arg max ~] ZCkUi(xi(Ot) )
l=1
k
Z ff(Ol)Xi(Ol)~ [l~1 P(Ol)]'Wi,
(1.3)
Z xi(O,) ~ Z Wi.
(1.4)
l=1
3The role of multiplicity of non-sunspot equilibria for the existence of sunspot equilibria is often
over emphasized. The present survey shows that such multiplicity does not necessarily play a
central role in the occurrence of sunspot equilibria (see however the discussion in Section 3.2).
4For details of a sun complete equilibrium, see Guesnerie and Laffont (1988).
1688
A * -complete set of markets, as described above, allows the agents to insure

themselves against the extrinsic contingencies. May such a possibility, which
seems a priori irrelevant in the case of a complete set of markets, actually
affect the allocation of resources?
We should first make clear that the answer to the above question is positive
if and only if the allocation of the *-complete equilibrium is random, i.e.
i(Oi) ~ i(Oi,) for some i, l ~ l'. Indeed, if the allocation is random, it certainly
does not coincide with the competitive equilibrium which has been defined
above. Conversely, if the *-complete equilibrium allocation is not random,
then one can easily check, looking through the definitions, that it does coincide
with the competitive allocation (with /~= E t/~(0t)). In summary, extrinsic
uncertainty matters if and only if the *-complete competitive equilibrium is
actually stochastic. In the contrary case, extrinsic uncertainty would be "ineffective". This indeed occurs under a number of circumstances.
Theorem 1 [Ineffectivity theorem, Cass and Shell (1983a, b)]. Assume that the
utility functions are strictly concave; then sunspots "do not matter". More
precisely, a *-complete competitive equilibrium is a competitive equilibrium.
Proof. The proposition is established by contradiction. Assume that sunspots
matter, i.e. from the above argument, that the complete competitive allocation
is random for some agent i.
Consider then E(i) = Zt~=l 7rt i(Ot), Vi. nz(i) is the average bundle of agent
i, across states of nature. We then note:
(1) the allocation {(E()~i))i=l . . . . . . } is feasible;
(2) the strict concavity of u~ insures that u~(n:(Y~)) El=
k 1 "ITl U i ( X i ( O l ) ) , with
one strict inequality at least.
But (1) and (2) imply that the new allocation is Pareto-superior to the
previous one. This contradicts the fact that the initial allocation was, from the
first welfare theorem, Pareto optimal (in the set of stochastic allocations).
The above proof relies on a variant of Cass and Shell's original argument
(which was formulated in a two period model). Such an argument can be
extended straightforwardly (the difficulty is mainly notational) to a finite
horizon economy. Also, a careful reading of the argument will convince the
reader that the expected utility hypothesis is not fully needed. Separability
across states of nature of the utility function, together with some "generalized"
notion of risk aversion would be enough. Balasko (1983) has investigated the
extension of the ineffectivity theorem to cases when consumers do not have
Von Neumann-Morgenstern utilities. 5
5This idea stresses the symmetry properties of preferences over contingent bundles. For a
systematic exploitation of this idea, see Balasko (1990).
1689
The simple and general message associated with T h e o r e m 1 can be loosely

summarized as follows. A priori, the rational expectations hypothesis is
compatible with the garbling of expectations by extrinsic noise. However, the
additional noise so introduced is undesirable on welfare grounds. Hence, such
a noise cannot have real effects on the allocation of resources when adequate
insurance markets are open. 6
The ineffectivity t h e o r e m stresses a crucial question behind all modeling
choices. This question: to what extent are sunspots events insurable?, may not
have been addressed by the literature as systematically as would have been
desirable. Such a lacuna is unsurprising; it reflects a more general difficulty. In
spite of recent attempts to devise theories of existing markets based either on
transactions costs [see Gale (1988)] or on the analysis of contracts (there is a
voluminous literature from which it is difficult to single out one contribution),
our understanding of the conditions of existence of markets is still limited. Let
us suggest some facts relevant to the insurability issue. Clearly, if sunspot
events are "states of minds" or "animal spirits" as argued by Azariadis
(1981b), they are not verifiable, in the language of contract theory, 7 and hence
not insurable (independently of any restricted participation constraint). At the
other extreme, sunspot may be observable and verifiable and a priori insurable.
In intermediate cases, insurance possibilities will be more or less severely
limited by transaction costs, verifiability conditions, participation conditions
etc., but possibly enlarged by the existence of additional financial assets
(options).
A n overview o f the sunspot literature
Let us now explain how the sunspot literature has developed. The first series
of literature, following Azariadis (1981b) and then Azariadis and Guesnerie
(1982), focuses attention on sunspot equilibria arising in simple sequential
models whose structure is similar or reminiscent to that of the overlapping
generations model ( O L G model). Their line of analysis has two main specificities, that drive it out of the scope of the ineffectivity theorem 8. First, it
considers an infinite horizon framework. Such a framework is likely to be
better adapted to the study of expectations formation than a finite horizon
setting, that would anchor expectations in some hypothetical final period (an
argument reminiscent of the objection to using finite horizon models for
monetary theory). Second, sunspot events are not supposed to be insurable. In
6Note however that if the present model captures the essence of our argument, there is a sense
in which it is very special: here sunspot equilibria cannot exist in the absence of insurance.
7As is well known, the notion of verifiability is a central concept of contract theory.
8This issue is discussed in Burnell (1989), Cass and Shell (1989). For earlier related literature,
see Shell (1977).
1690
fact, in a two-period O L G model with representative consumer, a strict

interpretation of the demographic structure rules out insurance against sunspots (since trade and delivery of claims must take place within the intersection
of life times of contractors). But even in the literature that does not stick to a
strict interpretation of the O L G model (for example, as in Woodford (1986a),
where the basic period is short), sunspot events are more or less explicitly
assumed to be non-insurable. A sample of contributions of the strand of the
O L G type sunspot literature includes Azariadis and Guesnerie (1986), Burnell
(1989), Chiappori and Guesnerie (1989a, b, 1991), Farmer and Woodford
(1984), H a m m o u r (1988), Howitt and McAffee (1988), G r a n d m o n t (1986,
1989), Guesnerie (1986), Laitner (1989), Matsuyama (1989a, b), Peck (1988),
Spear (1984), Woodford (1984, 1986a, b, 1988). This segment of literature has
natural connections with the literature on O L G models (see Chapter 6 ) - in
particular with the literature on periodic equilibria in such models [see
G r a n d m o n t (1985a, b)] - but also with the literature on linear national expectations models.
The second series of literature takes a different option. Along the same lines
as Cass and Shell's (1983) study of restricted participation, the framework of
finite horizon general equilibrium models is adopted and (at least partial)
insurance is assumed to be available. The spirit of this line of research is
exposed for example in Shell's contribution to the new Palgrave [see Shell
(1989)]. Its themes are restricted participation and incompleteness of markets.
A sample of contributions include Balasko (1990), Balasko, Cass and Shell
(1988), Cass (1984), Cass and Polemarchakis (1989), Guesnerie and Laffont
(1988), Mas-Colell (1989), Peck and Shell (1985, 1988, 1989). These contributions have closer connections with the literature on incomplete markets in
general equilibrium (see Chapter 1).
Both traditions have a common core. Indeed, Shell's (1977) original argument for sunspot equilibria was presented within an O L G framework9; and the
restricted participation to insurance markets in finite horizon models is a
natural variant of the no participation idea in O L G type models. However,
Azariadis (1981b) and Cass and Shell (1983) can be seen as the branching
points of two different traditions, that have later diverged in terms of concern,
methodology and even techniques. Here, we have chosen to provide a detailed
account of the findings of the first series of literature. Our choice reflects our
biased knowledge and competence as well as space limitation and coherency
91n a very stylized OLG model without intrinsic uncertainty and with risk-neutrality, Shell (1977)
stressed that rational expectations were consistent with random price behavior. Contrary to first
reaction, risk-neutrality is not crucial, and the argument does suggest a more systematic method for
exhibiting non-stationary sunspot equilibria. The argument, however, is not directly relevant to the
study of stationary sunspot equilibria, which has become the main subject of subsequent literature
in OLG type models. Also, though Cass (1984) considers a short horizon model, the introduction
of the so-called financial assets leads to an argument whose flavor is somewhat reminiscent of Shell
(1977).
1691
considerations. We however present a brief review of the developments of the

second series. This review is organized around a discussion of the circumstances when the ineffectivity theorem ceases to apply in finite horizon
contexts, and for this purpose we return to the main ingredients of the proof of
the ineffectivity theorem.
The first ingredient is strict concavity of the VNM utility functions. In its
absence, the feasible deterministic allocation constructed in the proof would
not be necessarily Pareto better than the *-complete equilibrium allocation
and the argument would fail. It is indeed the case that in exchange economies
where consumers are not risk-averse, sunspot may matter. Guesnerie and
Laffont (1988) have given an example of an economy in which the *-complete
equilibrium is really stochastic and, furthermore, Pareto-dominates the initial
competitive equilibrium. Also, in case of indivisibilities of consumption, randomization devices may restore ex-ante efficiency [Rogerson (1988), Shell and
Wright (1989)]. However, Cass and Polemarchakis (1989) have noted that
non-convexities in production alone cannot cause "welfare relevant" sunspot
equilibria.
Second, the proof crucially relies upon the fact that the * -complete equilibrium is Pareto-optimal. This requirement does not look too strong in the
simple world in which Theorem 1 is proved. In more complex settings,
however, it may be an extremely demanding requirement. We will discuss two
aspects of this claim at length.
(1) In the absence of complete markets, the competitive equilibrium again
may not be Pareto optimal. In view of the above proof, this means that the set
of markets should be * -complete. But this condition cannot be met if the set of
initial markets (in the reference framework, without extrinsic uncertainty) is
not itself complete. This condition looks rather innocuous in the simple model
underlying the proof of Theorem 1. It is not in general, where existing assets,
even in the absence of sunspots, may be too few. Moreover, the existence of a
complete set of initial markets is not enough for having *-complete markets.
Insurance markets against sunspot should also be introduced to allow full
insurance.
The failure of the ineffectivity theorem in circumstances where the set of
markets is not *-complete has indeed been analyzed in the literature. We can
stress two possible directions for the reflection.
(i) Looking at the consequences of the incompleteness of the set of initial
markets, Guesnerie and Laffont (1988) have exhibited a simple class of
two-period economies where the structure of assets is incomplete and where
sunspots matter when the existing assets can be traded conditionally on the
sunspot events. Their analysis, together with that of Mas-Colell (1989), sheds
light on the role of multiplicity of spot markets equilibria for the existence of
sunspot equilibria when insurance for sunspots is precluded but leaves open the
same question when sunspots are insurable. The analysis of Hens (1990) shows
1692
that spot multiplicity is not needed but that sunspot equilibria, then, cannot be
local in a sense introduced later. A related contribution by Prechac (1990)
suggests that some conditions, that could be labelled "conditional completeness", rule out sunspot equilibria in an incomplete markets setting.
(ii) The initial examples of sunspot equilibria in Cass and Shell (1983)
exploited the idea that participation in the insurance markets against sunspots
was restricted. The restriction under scrutiny was reminiscent of that arising in
the overlapping generations model, where the demographic structure does not
allow agents to participate in markets which take place when they are not born.
Balasko (1985) and Balasko, Cass and Shell (1988) have more systematically
analyzed the structure of sunspot equilibria originating in restricted participation (of O L G type) in two period models. In particular, the latter study stresses
the robustness of the ineffectivity theorem to the introduction of frictional
non-participation.t
(iii) Incomplete insurance against sunspots when initial markets are complete can also generate sunspot equilibria. However, assets that are redundant
in the initial markets can then eliminate sunspot equilibria, as pointed out by
Mas-Colell (1989).
(2) Even in a finite horizon model with complete markets, the first welfare
theorem only holds when certain restrictive organizational and behavioral
conditions are satisfied. Non-competitive producers' behavior, for instance, is
an obvious cause of departure from first best conditions and invalidates the
proof of the ineffectivity theorem. Indeed Peck and Shell (1985, 1988, 1989)
have studied sunspot equilibria in Shubik-type markets where participants, in
finite number, have some market power. 1 0 a
There are many other reasons for "second best" constraints. For example,
the basic informational conditions that constrain income redistribution justify
government intervention through distortionary taxation. H In such a world,
extraneous noise is not necessarily undesirable. There is indeed a subset of the
optimal taxation literature 12 that addresses the question of the desirability of
stochastic schedules [see Arnott and Stiglitz (1986) for an attempt at synthesis
in the framework of the non-linear income tax model]. The results obtained in
this section of the second best literature often predates the sunspot literature.
However, while sunspot models usually occur in an incomplete market framework, this literature rules out any insurance against sunspot [noise is voluntari~For another proof of this proposition, see Prechac (1990).
laFor a useful additional discussion of the insurance issue, the reader should refer to Peck and
Shell's papers, where the distinction between correlated equilibria and equilibria with contingent
claims markets is investigated.
HSee Hammond (1979), Guesnerie (1981), Diamond and Mirrlees (1971).
12A similar question is often raised in the literature concerning the theory of contracts. There is
often a close connection between the argument made (here in a partial equilibrium framework)
and the (general equilibrium) argument of the second best literature.
1693
ly created by the principal (who may be the Government) and cannot be

eliminated by agents (who may be citizens)].
1.3. Sunspot equilibria in infinite horizon sequential models: an introductory

example
We now introduce the discussion of a preliminary example of sunspot equilibrium (and precisely of stationary sunspot equilibrium), that is intended to give
the flavor of the forthcoming analysis, using the framework of a simple O L G
model.
Consider an economy with one perishable good, produced from labor under
a constant return to scale technology (one unit of labor produces one unit of
good). Agents live for two periods, an equal number belonging to each
generation; at each period, two generations thus coexist. Young agents only
supply labor in quantity y, while old agents only consume. Intergenerational
transfers of wealth are possible only through fiat money: young agents receive
a wage in money that is used to buy the consumption good during the next
period. All agents have the same preferences, described by a utility function
U(c, y) (where c denotes consumption when old), with the usual properties.
Lastly, in period one, in addition to the young agents of generation one, there
exist a group of "old" agents living only at period one. These agents hold a
certain quantity M > 0 of fiat money at the beginning of the period; the stock
of money in circulation is never altered.
In this economy, young agent's labor supply at date t, assuming perfect
foresight, is a solution of
max U(c,+I, y,)
Pt+lCt+l = PtYt
where Pt, P,+I are the money prices of the consumption good at time t and
t + 1.13
This program generates a labor supply function II(pt/Pt+ 1)" Demand is equal
to the real value of the money stock held by old agents; hence, excess
demand 14 is
Z(p,, p,+l) = M _ y ( Pt ).
Pt
\Pt+l /
(1.5)
13In fact, the consumer faces one budget constraint per period but these reduce (because money
can be eliminated) to the single budget constraint given here.
~4In this formula, as in the definition of Z, we use the general notation that will be introduced
later (see also the Appendix).
1694
Assume now that future prices are random. The young agent's program
becomes
max
~_,(U(c,+~, y,))
(1.6)
Pt+lCt+l = PtYt
or
m a x ~ t [ U ( Pt
Yt
\Pt+l
Y,, Yt)]
(1.7)
Let /zt+1 denote the conditional probability distribution of Pt+l at date t.

The solution of (1.7) is a function ~'(Pt,/Zt+l)- We denote Z(Pt,/xt+l) ~f
(M/pt) - )-'(p,, tXt+a).

In this model, there are several types of deterministic stationary equilibria.
First, a steady state fi (or 37) is defined by
M
-:- = Y(1)( = y ) .
P
(1.8)
Second, a periodic equilibrium of order k (or, for short, a k cycle) consists of

k different prices ill, , fik satisfying
y(fil)M
y(P2),
y(~k t
(1.9)
But there can exist stochastic stationary equilibria as well. Assume there is
some random process in the economy, and that this process is extrinsic (in the
sense defined above). For instance, it follows a stationary Markov chain, with
two possible states, a (sunspot) and b (no sunspot); the transition matrix is
M=(m,a
\mba
mab]
mbb]
(with ma, + mab = 1 and mba + rnbb = 1), and is known by the agents. Assume
now that for some reason, the agents of the economy believe that there is a
perfect correlation between the price that clears the market and the state of the
sunspot. Specifically, they believe that whenever the process is in state a, then
the price is necessarily Pa; whenever it is in state b, the price is necessarily Pb"
When these beliefs are self-fulfilling, they define a rational expectation equilibrium; if paV~Pb, the latter is truly stochastic. This is indeed a sunspot
equilibrium.
Let us now translate this intuition in formal terms. Assume that the process
is in state a. According to the beliefs, the price tomorrow will be either p,, with
1695
probability maa , or Pb, with probability mab. Let /z, denote the probability
distribution (on future prices) just described. If the relation
M = l~(p,, l%)
Pa
(1.10)
holds true, then the price that clears the market today is p,, just as predicted
by the beliefs. Of course, the same argument applies to the other state, and
leads to an analogous relation, namely
M = ~(pb, m ) "
PO
(1.11)
In other words, equations (1.10) and (1.11), when they hold for Pa ~ P b ,
mean that the "theory .... pa if a, Po if b" is exactly true. They define a "sunspot
equilibrium", whose stochastic properties exactly reproduce those of the
Markov chain on {a, b}. The associated fluctuations are endogenous, stochastic and stationary. Actually, such stationary sunspot equilibrium (SSE) can be
viewed as prototypes of stationary rational expectation equilibria in this model
(of which steady states and periodic equilibria are only particular cases).
Do such SSE exist? This is the topic of much of this survey. Let us attempt
here an illustrative discussion of the self-fulfillment mechanisms underlying the
concept of sunspot equilibrium.
A first idea would be to relate existence of sunspot equilibria to multiplicity.
Assume for example that /x~ = t% = ~ (as it has to be in the case when the
random signals are time independent)_ Then the existence of sunspot equilibria
requires that the equation M / p = Y ( p , tz) has several solutions, i.e. with
another terminology that there exists multiple temporary equilibria of the
system for given expectations /~. Naturally it is unclear so far whether
multiplicity of temporary equilibria, even if it held for every possible/z, would
be sufficient for the existence of sunspot equilibria; but the conjecture makes
sense (for precise statements along this line, see Section 5.2).
A second argument however suggests that the kind of multiplicity just
suggested is not needed for the existence of sunspot equilibria. The idea is as
follows. Once they have observed the state of the process today, agents know
the probability distribution of the state tomorrow. But given their belief, this is
also the probability distribution of the price tomorrow. Hence, when the
random variable is not time independent, the observation of the state today
brings information on future prices; and since agents' behavior depends upon
expectations, it will actually be influenced by the state of the process. Selffulfillment of beliefs can then obtain.
A third (and in fact related) intuition is the following. Assume that the
process generates strong negative correlation beftween states, i.e. that when it
is in state a today, it will very likely be in state b tomorrow. Then the
1696
fluctuation that would be described by a sunspot equilibrium would be somewhat similar to the deterministic fluctuations associated with a cycle of order 2.
The three stories above provide valuable intuition. However, in the particular version presented, multiplicity of temporary equilibria (with deterministic
expectations) does not obtain when the consumption good is n o r m a l ) 5 Hence
existence of sunspot equilibrium has to be intuitively related to the second and
third stories. It turns out that, again in the model under consideration, these
stories are intimately related; specifically, sunspot equilibria of order 2 (those
which we have described) exist if and only if cycles of order 2 exist [Azariadis
and Guesnerie (1986)]. ~Sa Hence, the existence of sunspot equilibria and that
of periodic equilibria have close connections in the present model. In more
complex versions, however, the connection will be more tenuous.
The previous sections were aimed at putting the subject in appropriate
perspective. They stressed the status of the sunspot literature in the research
on general equilibrium (Section 1.1), emphasized the insurability issue and
argued that there was no unified literature on the sunspot issue but several
different strands (Section 1.2). Finally the preliminary example of the present
section has given the flavor of the forthcoming analysis.
We can now present the options that are adopted throughout the survey.
First, we focus attention on a simple economic system, namely a sequential
e c o n o m y with infinite horizon and time independent structure. Furthermore,
this e c o n o m y is one step f o r w a r d looking and has no predetermined variable.
We then adopt a framework that allows a coherent coverage of a significant
n u m b e r of specific contributions (see Appendix) starting from Azariadis
(1981). Many specific models that we cover explicitly adopt a generational
framework that forbids the creation of active insurance markets. For other
models the impossibility of insurance against sunspots events, which is a
feature of our general model, has to be assumed or deduced from specific
considerations.
Second, we put emphasis on the general analytical results rather than on
specific economic interpretations. This option is in some sense in line with the
first one which led to the focus of attention on a well defined mathematical
structure encompassing many specific contributions. Accordingly we stress the
variety of the different techniques that have been used in this literature. Our
~SSee Azariadis and Guesnerie (1982).
15~Theequations determining cycles of order 2 are written M/p~ = Y(PJP2), M/P2 = Y ( P J P l ) ,
they can be viewed as the equations determining the Walrasian equilibrium of a two period
economy, in which two agents with symmetric utility functions u(cl, c2) and u(c 2, c~) supply labor
at times 1 and 2, respectively. Cycles of order 2 obtain when this symmetric Walrasian economy
has several equilibria [see Maskin and Tirole (1987)]. A similar argument leads to view sunspot
equilibria as correlated equilibria of a similar game. Then the multiplicitywhich is associated with
the existence of cycles or of sunspot equilibria reflects multiplicity of Walrasian equilibria within
the associated fictitious economy.
1697
aim is to show how they are complementary for a comprehensive analysis of

the subject. Also, we conjecture that the techniques can be exported, maybe
more easily than some results, to contexts or models that are more complex
than the one under consideration.
Third, attention is (almost) entirely focused on existence and characterization
questions. Understanding the structure of the set of sunspot equilibria, i.e.
their multiplicity or indeterminacy, or their stochastic properties, is our main
purpose. Some of the equilibria may however be less likely than others, for
example when learning considerations are taken into account. This "selection"
issue is only briefly evoked here (in Section 7).
Fourth, we have gathered existing analytical results around a few theorems
with scope and generality as broad as possible. Propositions and corollaries
present complementary views; in order to provide some information on the
historical background, they are often associated with specific contributions
around which the subject has developed.
2. The framework under consideration
We first present the basic abstract model under consideration.
2.1. The model
We consider an n-dimensional, one step forward looking dynamical system.

The state vector is denoted by x and belongs to some closed subset X of ~" (of
non-empty interior). The system is one step forward looking in the sense that
the state at each period is influenced by expectations on the state variables at
the next period only. Such expectations, which are assumed to be commonly
held by all agents, may in general be stochastic; they are described by a
probability distribution on X denoted by/z. Furthermore, the system entails no
memory and is time-independent_A formal definition of the system leads us to
consider the following mapping Z:
2: x
(x0, tx)----~Z(x 0, t~)
(2.1)
where ~ ( X ) is the set of probability measures on X.

A couple (x0,/z) is called a temporary equilibrium of the system if
Z(x 0,/~) = 0, following standard terminology. When this equality holds, we
shall also say that t~ rationalizes x o.
In the sequential framework we adopt in the following, we assume that
equilibrium at each period is determined from the same Z, i.e. that the system
1698
is time-independent. A sequence of temporary equilibria is a sequence

(x,,/Xt+l), t = 1, 2 . . . . of states and expectations such that the equation
Z(x,,/x,+ 1) = 0
(2.2)
is fulfilled at each period. H e r e , /-t+l has to be interpreted as a probability

distribution on the state variable at date t + 1 that is commonly held by the
agents at date t. Note that this distribution reflects an uncertainty originating in
the beliefs of the agents (rather than in some intrinsic fluctuation of the
fundamentals). Also, at this stage, we do not impose any link between beliefs
at period t and realizations at period t + 1; in particular, we do not assume yet
that expectations are rational.
In what follows, we shall often refer to Z, for the sake of convenience, as an
-excess d e m a n d function, although as will be seen in the Appendix, the model
applies to a variety of different contexts in which this interpretation is not
adequate (in particular, state variables are not necessarily prices).
A particular case of interest is when expectations on future state variables
are deterministic point-expectations. Then ~ is simply the Dirac measure at
some x denoted 6x- The specification of Z to this case yields the deterministic
excess d e m a n d function Z (by opposition to Z, the stochastic one).
Z :XxX---~
Z(x0 '
clef ~
x) = Z(xo,
(2.3)
A deterministic (temporary) equilibrium is reached for the present value x 0

and the future value x whenever Z(x0, x) = 0. In that case, we also say that x
deterministically rationalizes x o (by opposition, a "truly r a n d o m " variable
stochastically rationalizes Xo). If agents commonly believe that the future state
will be x, then x 0 clears the market today.
This general abstract framework will be considered throughout this survey.
T h e r e are a large number of economic models that have been studied in the
literature and that fit this framework. Appendix A provides an overview.
We now state some basic assumptions that are used in what follows.
Basic assumptions
In the following, we will always assume that the functions Z and Z, have
continuity properties. Formally:
Assumption (C) (continuity). Z is a continuous function from X ~ ( X ) in
~n, when ~ ( X ) is endowed with the standard weak-topology) 6
16Note that then, ~ ( X ) is metrizable if and only if X is compact.
Then the rationalizability correspondence p, x e

Z(x,/~) = 0} has a closed graph.
Sometimes, we will also assume the following.
1699
p(x) = {
Assumption (CVR) (convex valuedness of rationalizing measures). The

rationalizability correspondence is convex-valued, i.e. if /xl E p(x) and /z2 E
p(x), then oq.h + (1 - a)~ 2 ~ p(x), where a/x~ + (1 - a)/x 2 is the convex combination of m e a s u r e s / ~ a n d / x 2.
The convex valuedness of the rationalizability correspondence appears in
applications as intimately related to the fact that agents maximize expected
utility; in such a case, an individual agent equilibrium involving present
variables x and a distribution/x I of expected variables on the one hand, x and
the distribution /z2 on the other hand, is typically maintained with x and a
random choice between/xl a n d / z 2. However, such a property is not necessarily
preserved by aggregation, so that CVR typically holds for models with a
representative consumer. In particular, to the best of our understanding,
(CVR) holds in all the specifications of the model that are presented in the
Appendix, when the representative consumer hypothesis is made.
Lastly, we shall assume that Z, the deterministic excess demand function, is
continuously differentiable. In addition, we shall often need the following
regularity assumption.
Assumption (R) (regularity at the stationary equilibrium). At a deterministic,
stationary equilibrium
(i) OoZ is of full rank,
(ii) matrix B = -(OoZ) -1 alZ has no eigenvalue of modulus one; the eigenvalues of B outside the unit disk (if any) are all different; B is diagonalizable.
Here, (OoZ) and (01Z) are straightforward notation for Jacobian matrices
taken in (, ). Clearly, Assumption R is "generically" fulfilled if Z (hence Z)
is picked up from a "rich enough" set of excess demand functions. It can also
be noted that we do not require B to be invertible.
Deterministic dynamics and determinacy

We shall now introduce some restrictions, reflecting the general idea that
people are "rational" when they formulate their expectations, or, more
specifically, that the latter are "linked", in a sense that will be defined, with
actual realizations of the future variables. Beginning with the case of nonrandom beliefs, this leads to the concept of perfect foresight equilibrium.
A perfect foresight equilibrium consists of a sequence {xt}, t >10 such that
Vt,
Z(xt, x,+,)=O.
(2.4)
1700
That is, a perfect foresight equilibrium occurs when agents, at each period,
predict exactly the future equilibrium value of the state variable. Of course,
perfect foresight equilibria may be stationary. Specifically, a steady state 2 is a
stationary equilibrium such that x, = 2, Vt; hence it satisfies:
z(2,
= o.
A periodic equilibrium of order k, or a deterministic cycle of period k is a

sequence (2 ~ . . . 2 k) of different states such that
Z(.,~l, .~2) = 0, Z(.~ 2, .~3) = 0, . . . , Z(.~ k - l ,
.~k) = O, Z(2 k, 3~1)
= 0.
These concepts are classical and will not be discussed further.

In the infinite horizon model under consideration there may exist a number
of perfect foresight equilibria. Whether many of them can be found "close" to
the steady state (or to the periodic cycles) will play a role in the following. Such
a property - called indeterminacy when there are many equilibria, determinacy
if not - can be defined precisely as follows.
Definition 1. A steady state (stationary equilibrium) 2 is indeterminate if, for
any e > 0, there exist an (uncountably) infinite set of perfect foresight equilibria {xt} such that Ilxt - 211 < e, for all t in N. (A similar idea applies for the
definition of indeterminacy of periodic equilibria).
The local dynamics associated with perfect foresight equilibria around the
steady state is governed by
(a0Z)(x, - 2) + (a,Z)(x,+, - 2) = o.
With Assumption (R), the latter equations read
x,
--
2 -~- - - (OoZ)-l(OlZ)(xt+,
-- X)
def
= n(xt+
1 -
2).
(2.5)
The following well known results follow from the theory of dynamical
systems and from the above definition) 7
Result 1. Let be a steady state such that Assumption (R) is fulfilled. Then, 2
is indeterminate if and only if B has at least one eigenvalue outside the unit
disk.
17A study of the perfect foresight dynamics is a more complex non-linear system (memory
system) has been completed first by Kehoe and Levine (1985). See also Geanakoplos and
Polemarchakis, Chapter 35. An in-depth analyses of indeterminacy in systems having both
finite-lived and infinite-lived agents is in Muller and Woodford (1988).
1701
Note that when (bxZ) -1 exists, then B - x = -(Oxz)-l(~o Z) exists and the
above condition is equivalent to the fact that B - x = A has at least one
eigenvalue inside the unit disk. As will be seen later, the properties of B and
B -~ which govern the perfect foresight dynamics of the system, are often
relevant to the study of sunspot equilibria.
2.2. Rational expectations and sunspot equilibria

In the definition of a temporary equilibrium given above, the agents' beliefs, as
represented by the probability distribution /x, could be taken arbitrarily
(provided that they did not contradict market clearing). In particular, they
were not required to be "accurate" or "rational" in any sense. On the
contrary, the concept of perfect foresight relies implicitly upon a strong
accuracy hypothesis, namely, that agents are able to perfectly forecast the
future. The concept of rational expectations equilibrium ( R E E ) is an immediate
generalization of this idea to the case of stochastic beliefs. Assume that the
state variable (x,) follows a random process over (a subset of) X. Then a R E E
is a sequence (xt,/xt+ 1, t = 1, 2 , . . . ) of values and expectations of the state
variable, such that:
(i) /zt+ 1 is the (true) distribution of x,+ x conditional on the past history of
the process;
(ii) (x,, ixt+~) is a t e m p o r a r y equilibrium for each t (i.e. markets clear at
each period).
In other words, a R E E is a sequence of temporary equilibria (as defined
above), with the additional property that agents' beliefs coincide, at each
period, with the true (conditional) probability distribution of the future state
variable.
In this survey, we shall concentrate upon a specific subclass of R E E ,
characterized by two additional properties, namely, they are Markovian and
they are time independent. This means that the predictions at each period only
depend on the current state of the process, and not on the date itself nor on
past history. Formally, this leads to the following formal definition.
Definition 2. A (time independent) sunspot equilibrium (SE) is a Markov
process 18 on a subset X o C X ,
with a transition function /2 : X 0 x
~(X0)---~ [0, 1] (where ~ ( X o ) is the Borel field of X0), such that:
(i) for at least one x0, ~x0 =/2(x0, .) is truly stochastic (i.e. it is not a Dirac
me asure);
(ii) for each x 0 E X0,
18AMarkov process over [Xo, ~(X0) ] is defined by a transition function/.~such that: (i) for each
x0 ~ X 0, /Xx0=/.7(x0, .): ~(X0)~--~[0,1] is a probability measure; (ii) for each A ~ ~(X0) , the
mapping/2(. , A) : X0~ [0, 1] is ~(Xo)-measurable.
1702
Z(xo,/xx o) = 0.
(2.6)
Thus, a sunspot equilibrium is defined as a Markov process over some X 0,

with the transition probability function/2. T o each today variable value of the
state variable x0,/2 associates a (conditional) probability measure/~x0 over X 0
that "rationalizes" x. At least one of the distributions must be truly stochastic
(i.e. it must "stochastically rationalize" x0).
This abstract definition should be reconciled with the more standard version
of the sunspot concept that was alluded to in the preliminary example of
Section 1. T h e r e (and in fact in the standard presentation), a sunspot equilibrium was an equilibrium which was perfectly correlated with an "extrinsic"
r a n d o m p h e n o m e n o n , so that the equilibrium values of the state variables
could be viewed as " d e t e r m i n e d " by the random p h e n o m e n o n , although such a
p h e n o m e n o n did not affect the fundamentals of the economy. Following this
view, one could give the following, alternative definition:
Definition 2bis. A sunspot equilibrium is associated with a set E of "extrinsic"
states, a Markov process with time-independent transition function v : E
~3(E) ~ [0, 1] and a homeomorphism f : E---~ X 0 such that
Ve o E E ,
2 ( f ( e o ) , u,/o)
(2.7)
where u~o is the distribution induced over X 0 by the composition of v,0 =

v(E0, .) and f.
According to this definition, the agents have the common belief that the
state of the system is determined by the value of e, though the process e is
"extrinsic". Then f is viewed as a " t h e o r y " or a "forecast function" used to
predict x at any date from E at the same date. Given this forecast function and
the Markov process on E, the knowledge of E0 today brings information on
future E, hence, through f, on future x (technically it defines a probability
e
distribution v,0 ). Beliefs corresponding to such a forecast function may or may
not be systematically fulfilled; when they are, a sunspot equilibrium obtains.
The equivalence of both definitions can be checked intuitively as well as
formally. Intuitively, in both cases the definition associates with any x 0 E X 0 a
probability distribution over X 0 that stochastically rationalizes x 0. The first
definition focuses direct attention on this fact, whereas in the second one such
an association obtains indirectly: the present state of the extrinsic process
determines the current equilibrium variables, and the distribution of the
extrinsic process tomorrow (conditional on its present state) determines the
distribution of tomorrow state variables. Formally, any space homeomorphic to
1703
X0 and on which/7, would be " t r a n s p o r t e d " through the h o m e o m o r p h i s m could

be identified with the (probabilistic) space of extrinsic states of nature. 19
Lastly, let % be some probability m e a s u r e upon X 0 (that would describe the
initial r a n d o m n e s s of x 0 itself). F r o m u0 and /x we can deduce a probability
measure v (with support (included) in X0) by
VA E ~ ( X o ) ,
v ( A ) = S it(x' A)~ dx"

Xo
In words, ~, is the probability distribution of the future state, given the

transition function and given that the present state is drawn r a n d o m l y (with the
probability distribution v0). In particular, a sunspot equilibrium is said to be
stationary if there exists a m e a s u r e v0 over X 0 that is invariant through this
transformation, i.e. such that
VA
E ~(Xo),
~o(A) = f /~(x o, A) vo dx o .
Xo
A stationary sunspot equilibrium will often be referred to as a SSE.
Sunspot equilibria with finite support

A particular case, which has been abundantly studied in the literature, is when
the support X 0 of the " s u n s p o t " stochastic process is finite; then we shall speak
of sunspot equilibria of finite order or, for short, of finite sunspots. T h e r e are
several reasons for focusing upon finite sunspots. T h e y are simpler to handle,
they are m o r e spectacular, and they m a y be m o r e credible.
T h e y are simpler to handle: SE with finite support can be analysed as the
zeros of a (conveniently defined) vector field in W, for some s E [~; in
particular, such traditional (and powerful) tools as bifurcation theory or
differential topology on finite dimensional spaces can be used.
T h e y are m o r e spectacular: their existence demonstrates that, under rational
expectations, even such simple r a n d o m processes as finite M a r k o v c h a i n s say, the apparition of spots on the sun, or alternate waves of optimism and
p e s s i m i s m - can generate self-fulfilling beliefs in endogenous fluctuations.
t9Another approach is the following. Take a sequence (~:t) of iid n-dimensional random
variables, and define recursively the random process (x,) by x,+~ = q~(x,, t+l), where ~ maps
X x R" into X. Then (x,) is obviously Markovian; again, (,) can be interpreted as an extrinsic,
"sunspot" process that generates the beliefs. Of course, equilibrium conditions can be translated
into conditions upon the mapping .
1704
Finally, they may be more credible in the sense that the type of coordination
between agents that sunspot equilibria a s s u m e - and that can be explained,
as in Section 7.2, as the outcome of adequate learning p r o c e s s e s - may be
more likely for sunspots of finite order.
The previous definitions can easily be transposed to finite SE. H e r e ,
X 0 = {x 1, . . . . xk}, and the probability distribution conditional to any current
value of x (say x ' ) is described by a vector of the (k - 1)-dimensional simplex
S k-1 - s a y ~ M i = ( m il, ",'k" ' m i k ) " The corresponding measure is denoted
( x ~ , . . . , x , m il . . . . . m ); and the restriction of Z to measures with finite
support of cardinal k is denoted ~ k Definition 2 then becomes:
Definition 3. A sunspot equilibrium with finite support is associated with a
finite set X 0 = { x ~. . . . , x k} and a Markov matrix M, with M ' =
( M r, . . . . M ~') (where v' is the transpose of v), such that
(i) for some i, j, m 'j is neither zero nor one,
(ii) for all i, Zk(x i, x 1. . . . . x k, M i) = O.
H e r e , the Markov process is a Markov chain associated with the Markov
matrix M. Note that a finite sunspot equilibrium is necessarily a stationary
sunspot equilibrium (SSE) in our terminology, since it has (at least) one
invariant measure.
At this stage, let us introduce some definitions, notation and assumptions
which are tailored for the finite sunspot case.
A finite sunspot is degenerate if the matrix M has at least a zero element; it is
non-degenerate if not. A sunspot with support {x 1. . . . , x ~} (where the x i are
by definition different) is of order k.
Given the mappings Z and its restriction Z~ to measures with finite support,
k on S k as follows:
we can define for every Markov matrix M a vector field Z^ M
( X 1. . . .
, X k) ~ X k---> [ Z k ( x l
' X1,
. . . ,
X k,
MI),
. . . ,
Z k ( x k,
XI,
. . . ,
X k, M k ) ]
@ Nnk .
~k
A (finite) sunspot equilibrium of order k is a zero of the vector-field Z M

^k
where the x / are all different Conversely, every zero of Z M, if it has at least
two different states x t x r, will be called a sunspot equilibrium of cardinal k.
Such sunspot equilibria of cardinal k may be of order strictly smaller than k
(but greater than 2). Lastly, we define the mapping 2 k by
X k x ~k__.> ~nk
(X1,
.
.
, x k , M)'-'~ Z^ kM ( X ,1.
.. , X k)
where ~ ~ is the set of k x k Markov matrices.
1705
For some of the approaches that will be described below, specific regularity
conditions will be needed. Namely, Z may be required to be smooth, and its
derivatives be related with those of Z in the neighborhood of any non-random
future state. Precisely, we may use the following assumptions.
Assumption (SM)
(smoothness).
V k >! 1, z~k is a C 2 smooth function (of all of
his arguments).
With the above form of the smoothness assumption, which concerns the
maps ~k, we need not introduce a concept of differentiability in functional
spaces, as would have been the case if we had considered Z itself. It turns out
that this simple (SM) (together with Assumption CD) will fit our needs.
Assumption CD
(rail,...
( c o n s i s t e n c y o f derivatives).
m ik) in S k - l , and all x0, x in X,
a~oZk(xo, x . . . .
For all k ~> 1, for all M i =
, x , M i) = OxoZ(xo, x),
OxjZk(Xo, X, . . . , X, M i) = m i] Ox Z ( x o , x ) .
The first relationship above says that, whenever the value of the state
variable tomorrow is known with certainty to be x, not only Z coincides with
Z, but their derivatives with respect to x 0 also coincide. This property is stated
here for convenience; it could be deduced from the definition of Z. Also,
consider, at the margin of this certainty situation, an infinitesimal change dx j in
x j. Since this only introduces infinitesimal uncertainty, it has to be equivalent
to a s u r e change of magnitude m ;i dx j (i.e. the expected value of the change).
This property is expressed by the second relationship; it can be formally proved
for the models presented in Appendix A. Incidentally, it could be derived from
adequate, general differentiability assumptions upon Z.
The next three sections are concerned with existence results in the general
(non-linear) case. Section 3 presents general existence statements based on the
existence of some invariant set; limited emphasis is put on the structure of
equilibria. Section 4 concentrates upon local sunspot equilibria (i.e. equilibria
located in a neighborhood of a steady state); specifically, it highlights the links
between indeterminacy of the steady state and existence of sunspot equilibria.
Section 5 reviews some other existence arguments; in particular, it presents a
class of heterodox sunspot equilibria, which we call the heteroclinic sunspot
equilibria, whose study requires the analysis of dynamical systems. More
information on the structure of sunspot equilibria is given in Section 6. Finally
Section 7 discusses three questions that go beyond existence, namely:
the connection between equilibria based on intrinsic phenomena and the
equilibria based on extrinsic phenomena,
the learning questions,
the extensions of the present results to more complex settings.
1706
3. Existence of sunspot equilibria: invariant set arguments

I n this section, we shall present in a systematic and explicit w a y an existence
a r g u m e n t that a p p e a r e d in the s u n s p o t literature in different specific contexts.
F o r e x a m p l e , m o r e or less explicit versions o f this a r g u m e n t have b e e n
p r o p o s e d by F a r m e r and W o o d f o r d (1984), G r a n d m o n t (1986), P e c k (1988).
B r o a d l y speaking, the a r g u m e n t applies in situations w h e r e the s u p p o r t of
s u n s p o t equilibria can be " g u e s s e d " a priori. M i n i m a l invariance properties are
r e q u i r e d for the c a n d i d a t e support; we exhibit here cases w h e r e such invariance p r o p e r t i e s are sufficient.
We p r o v i d e two versions o f the a r g u m e n t : a w e a k version that applies w h e n
the invariant set is o p e n and a strong version showing the existence of
stationary s u n s p o t equilibria with c o m p a c t support.
3.1.
T h e invariant set argument: w e a k version
W e first p r e s e n t a generalization of an a r g u m e n t p r e s e n t e d by P e c k (1988) in a

simple, o n e - d i m e n s i o n a l version o f the O L G m o d e l . In what follows, we call r
the " d e t e r m i n i s t i c " rationalizability c o r r e s p o n d e n c e ; i.e. we define
x E r(Xo) ~ Z ( x o , x ) = O.
(3.1)
We can n o w introduce a first abstract a s s u m p t i o n
Assumption 1.
Let x 0 and x be interior points of X such that x E r(Xo). T h e n ,

for any n e i g h b o r h o o d N of x, there exists a truly stochastic probability
distribution/~xN with s u p p o r t within N such that Z(x0, /~N) = 0.
T h a t is, w h e n e v e r x 0 can be rationalized by s o m e deterministic future value
x, t h e n it can also be rationalized by a "slightly r a n d o m " future value, i.e. by a
probability distribution with support arbitrarily close to x.
A s s u m p t i o n 1 is n o t very restrictive. F o r instance, in the case w h e r e O,Z is of
full r a n k , the a s s u m p t i o n follows f r o m A s s u m p t i o n C D (consistency of derivatives). 2 C o n d i t i o n ( C D ) , is stronger than A s s u m p t i o n 1. In particular, it
2To see that, consider the equation, Z2(xo, x', x", a, 1 - a ) = 0, where x o and 0 < a < 1 are
fixed. This equation holds true for x ' = x"= x. Now from (CD), 02Z.Z(Xo,x , x , a, 1 - ~)=
(1 - a) OtZ(xo, x). As the right-hand side is invertible, O2Z2 is of full rank in a neighborhood of
(x0, x, x). From the implicit function theorem there exists a function x"(x') and a neighborhood N'
of x such that Vx' E N', Z2(x o, x', x"(x'), a, 1 - a) = 0. Moreover, for any neighborhood N of x,
we can choose N' such that x"(x') belongs to N for all x' in N'. Also, x"(x') ~ x' as soon as x' # x;
indeed, the solution of the equation (in x) Z(x o, x) = 0 is locally unique since 01Z is invertible.
Hence the distribution is truly stochastic.
1707
guarantees not only the existence of/ZxN but also continuity of this distribution
as a function of x0 .21
Assume, now, that the following holds true.
Assumption 2. There exists an open subset X o such that each x o in X o is
(deterministically) rationalized by some x' in X o
VxoeXo, 3x'EXo,
Z(xo,X')=O
or, equivalently,
Vx0 ~ X 0 ,
r(Xo)AXo~O.
Then we have the following result.
Suppose that Assumptions 1 and 2 hold. Then, for any x o E )to, there
exists a truly stochastic probability measure tzxo on X o such that Z(xo, txxo) = O.
Result 2.
The proof is immediate. For any x 0 E 2(0, there exists from Assumption 2
some x' such that Z(xo, x ' ) = 0. Take a neighborhood N of x' such that N C X 0
(this is possible because X 0 is open). From Assumption 1, there exists a
probability distribution p% with support within N, such that Z(xo,/xx0 ) = 0. 21"
The intuition behind Result 2 is simple: each x 0 in X 0 can be rationalized by
some random value close enough to x', provided that the probability
distribution of is "well chosen"; and this can be done for every x 0 in X 0. As
an illustration, consider the simple, one-dimensional overlapping generation
example of Section 1 (see Figure 32.7 in the Appendix); if 37 is the nondegenerate stationary equilibrium, then X 0 = (0, 37) satisfies Assumption 2.
Also, Assumption 1 is trivially fulfilled. Then Result 2 applies; this is exactly
Peck's (1988) example.
The condition stressed h e r e - " r a t i o n a l i s a b i l i t y " within an open s e t - i s
21Specifically, (CD) implies the following property (1SS): let xc~ and x be interior
points of X such that Z(xo, x) - 0 and alZ(xo, x) is full rank. Then, there exists a neighborhood N O
of x 0 such that, for any x~ in No: (i) there exists a x ' such that Z(xo, x ' ) = 0; (ii) For any ~ > 0,
small enough, there exists a continuous mapping, x0---~/x~6 such that the probability measure
/x~6 stochastically rationalizes x0, has its support within a bowl of center x' and radius e, and is
such that the probability of being outside a bowl of center x' and radius E/2 is greater than 1/3.
The interest of property (ii) will appear in the next subsection.
Z~"Note that Result 1 does not quite establish the existence of a sunspot equilibrium. Conditions
(i) and (ii) of the definition hold true, but the measurability properties required for the mapping
x0----~/xx to define a random process are not demonstrated (and would indeed require some
additional structure).
1708
weaker than most conditions that will be given later. Not surprisingly, the
sunspot equilibria so constructed is not necessarily "well behaved". For
example, with the above construction it is not always possible to find a
probability distribution with support X 0 that is invariant. As a consequence,
the stochastic dynamic associated with the sunspot equilibrium may be unsatisfactory. For instance, in the particular construction proposed by Peck, a
given level x of labor supply is deterministically rationalized by a smaller level
x' of labor supply, and stochastically rationalized by levels of labor supply that
are "close t o " x'; hence, in general, smaller than the initial one. A consequence is that the trajectories of the process typically converge "quickly" to
autarky.
3.2. The invariant set argument: strong version

Result 1 relies on the existence of an open set that is invariant (in the sense
that each point in the open set can be rationalized by a distribution with
support in the set). The analysis of the present subsection will require a
stronger property, namely, the existence of an invariant compact set. The
statement we give directly exploits a theorem that originates in the work of
Blume (1982); 22 we use here the generalization due to Duffle, Geanakoplos,
Mas-Colell and McLennan (1988). To the best of our knowledge, this theorem
has not been used as such in the sunspot literature [although related results by
Futia (1982) have been extensively used; see Farmer and Woodford (1984),
Spear (i989)]. It allows a simple derivation of Theorem 1, and the latter allows
a more synthetical assessment of some of the results of this literature.
Let us first introduce an assumption on the rationalizability correspondence
that strengthens Assumption 1.
Assumption 1S. 3 , / > 0 and q > l such that, for any e, 0 < e < 7 / , every
(x o, x), x o E X , x E r(xo) A X there exists (at least) one probability measure
that has the following characteristics:
(i) its support is in a bowl B(e, x) of radius e and center x;
(ii) the measure of the set B(E, x ) \ B ( e / q , x) is at least 1/q.
Assumption 1S is stronger than Assumption 1 in the sense that the truly
stochastic measure that rationalizes x 0 has not only an arbitrary small support
but is also "sufficiently stochastic" (i.e. far enough from a Dirac measure).
In the same way, let us introduce an assumption that strengthens Assumption 2.
22Related work includes Grandmont and Hildenbrand (1974), Green and Majudrnar (1975).
1709
Assumption 2S.
T h e r e exists a c o n n e c t e d c o m p a c t set K C X such that each x 0

in K is "deterministically" rationalized by some x ' i n / ( . M o r e precisely:
Vxo E K ,
3x' E I( s.t. x' E r(Xo) ,
z~'x' ~ Fr K s.t. x ' E r(Xo).

In o t h e r words, Vx o E K, r(Xo) f q / ( ~ 0 and r(Xo) fq Fr K = 0.
We can n o w state the following.
Assume that the rationalizability correspondence is upper hemicontinuous and convex valued ( CVR) and satisfies Assumption 1S. Suppose that
there exists a compact set K for which Assumption 2S holds. Then there exists at
least one sunspot equilibrium with support in K that is stationary, i.e. associated
with an invariant (ergodic) measure.
T h e o r e m 2.
P r o o f (sketch). We use the variant of B l u m e ' s t h e o r e m [Blume (1982)]

p r o v e d in Duffle, G e a n a k o p l o s , Mas-Colell and M c L e n n a n (1988) as Corollary
1 o f T h e o r e m 1; this s t a t e m e n t is given below. 23 W i t h their t e r m i n o l o g y and
A s s u m p t i o n 2S, K is a self-justified set; we n o w have to build w h a t t h e y call an
" e x p e c t a t i o n c o r r e s p o n d e n c e " . We p r o c e e d as follows:
(1) 3 g > 0 such that the distance b e t w e e n r(K) f3 K and Fr K is at least g.
This c o m e s f r o m A s s u m p t i o n 2S and f r o m the fact that rK, the restriction of r
to K, is u p p e r h e m i - c o n t i n u o u s .
(2) T h e c o r r e s p o n d e n c e pg,q,
x o E K--> {/x E ~ ( K ) I Z ( x o , / z ) = 0, s u p p o r t /z C B(g, x) for s o m e
x E r(Xo) and tz(B(g, x ) \ B ( / q , x)) >I 1 / q } ,
is u p p e r - h e m i - c o n t i n u o u s (uhc).
This c o m e s f r o m the fact that p,,q, as an intersection of two uhc c o r r e s p o n d ences, is uhc.
N o w let us call ~,q(X) the c o n v e x hull of p~,q(X). T h e c o r r e s p o n d e n c e t~.q is
uhc and convex valued; m o r e o v e r , f r o m ( C V R ) , it is an e x p e c t a t i o n correspondence. C o r o l l a r y 1 m e n t i o n e d a b o v e applies and the conclusion follows.
23For Duffle et al. (1988), an expectation correspondence is a point to set map G : S--~ ~(S)
which has a closed graph and is convex. A self-justified set for G is a non-empty measurable set
J E S such that G(s) f3 ~(J) ~ 0 for all s ~ J. The statement we use here (Corollary 1) is: if J is a
compact, self-justified set, then there is an ergodic measure for J.
1710
In particular, this result has an immediate consequence on the existence of

SSE that are local, i.e. with support in a neighborhood of the steady state.
Specifically:
Corollary 1. Assume that Assumptions CVR, CD and R are satisfied at some
steady state . If all eigenvalues of matrix B are located outside the unit disk,
then for any open neighborhood ~ ( ) of the steady state, there exists a
stationary sunspot equilibrium over some compact set K included in ~ ( ) and
containing .
Proof. Note, first, that if all eigenvalues of B are outside the unit disk, then
B, hence OlZ, are invertible. This is sufficient to show that (a stronger version
of) Assumption 1S holds true in a neighborhood of the steady state (just apply
property 1SS of footnote 21). Consider, now, the equation Z(xo, x) = 0. From
the implicit function theorem, it can be locally inverted into x--~p(x0).
Moreover, Oq~()= B - l ; since all eigenvalues of B -1 are of modulus smaller
than one, there exists a compact K, containing in its interior, and included in
V() upon which q~is a contraction. This shows that Assumption 2S is satisfied.
A version of Theorem 2 could be derived, without (CVR), from stronger
continuity requirements on the rationalizability correspondence; specifically,
the existence of a continuous selection would then be needed. In fact, around a
steady-state, (CD) is sufficient to guarantee this stronger property (see statement ii of footnote 21). Hence, Corollary 1 does not actually require (CVR).
Applications
We give here examples drawn from existing literature where all or part of the
results can be viewed as applications of Theorem 1 (most of which refer to
models with representative consumer) or Corollary 1 above.
Example 1. Let us begin with some consequences of Corollary 1, that we
label Corollaries 1', 1" and 1". In one-dimensional models, matrix B is a real
number b =-O~Z/OoZ(, ), hence has (trivially) a unique eigenvalue. It
follows that:
Corollary 1' [Chiappori and Guesnerie (1989)].
I f X C , and if (CD) and

(R ) are satisfied at some steady state such that tOog[ < [01g[, then there exists
SSE.
As indicated above, Corollary 1' holds without (CVR) and is indeed proved
under the preceding form by Chiappori and Guesnerie (1989b), but with a
different argument (that will be exposed later).
1711
In the simple OLG model, Corollary 1' implies the existence of local SSE, in
a "high" steady state with backwards-bending labor supply as well as in a
"low" steady state [which with government expenditures is not autarkic; a fact
that is compatible with earlier results, due to Farmer and Woodford (1984) and
Grandmont (1986), see below].
Let us give the precise result for the "high" steady state of the basic,
one-dimensional O L G model without government expenditures, discussed in
Section 1.3. Here,
Z ( P t , Pt+l) - Pt
\P,+I/ '
where Y is the labor supply function. Matrix B is the real number

b_
OZ/Op,+l
Y(1)
OZ/Opt (fi' fi) - Y(1) + Y'(1)
e(1)
1 + E(1) '
where e is the wage elasticity of labor supply; and the condition of Corollary 1
gives E(1) < - 1 / 2 . Hence:
Corollary 1" [Azariadis (1981), Azariadis and Guesnerie (1982)]. In the onedimensional O L G model, a sufficient condition for the existence o f local S S E is
that e(1) < - 1 / 2 .
That is, labor supply must be "enough backward bending" at the stationary
equilibrium.
Example 2. Still in the one-dimensional case, assume in addition that the
excess demand function is such that
=0
(3.2)
v(x,) = E[u(x,+,)],
where v and u are smooth real functions, and the expectation is taken with
respect to /x,+l, hence is conditional on x, (one sees easily that Assumptions
CVR, 1S and CD are satisfied in this example). Then another particular case of
Corollary 1 (and also of Corollary 1') obtains:
Corollary 1" [Peck (1988), Spear
takes the f o r m (3.2). Then if
(1988)].
Assume that the excess demand
lao(z)[ < 10u(Z)l

there exists a S S E over some compact set K containing ~.
1712
For the sake of completeness, we give the proof used by these authors [this
proof is derived from Farmer and Woodford (1984)]. The trick, borrowed from
the literature on linear rational expectation models (see Section 5.1), is to
consider a sequence (~t) of iid random variables with zero mean and "sufficiently small" compact support. Then, a sufficient condition for (3.2) to be
satisfied is that
Vt,
u(X,+m)= v(x,)+ ~,+~.
(3.3)
In a neighborhood of the stationary state Y, and provided that u'(Y) is

non-zero, this relation can be inverted:
Vt,
x,+ 1 = ~(x,, ~:t+l).
(3.4)
A sufficient condition for the existence of an invariant distribution is

[01~0(Y, 0)l < 1 (i.e. q~ is locally a contraction; this condition is equivalent to
that given in the statement of the corollary). This follows for example from
Futia (1982).
A slightly different technique is used by Woodford (1986a). The idea goes as
follows. Start from equation (3.4), and search for a solution of the form
x, = qJ(~'), where t = ( , , ~t-l''" ")' and ~0 is a mapping from the set of
histories to X. Then (3.4) becomes
'+l) =
,+11
(3.5)
Hence, qJ is a fixed point of the functional operator T, defined by

T ~O(~'+1) = ~o[~b(~'), ,+1]- Again, the existence of such a fixed point is due to
the fact that, whenever 101~0(, 0)1 < 1, then T is a contraction. This argument,
moreover, can be extended to models with memory (see Section 7).
The previous results 23a establish the existence of an invariant compact set
around , but do not provide indications upon the size of this set (with another
terminology, they allow us to prove the existence of local sunspot equilibria).
Examples 3 and 4 are related to one-dimensional variants of Theorem 1 (rather
than of Corollary 1), and give examples where the support of non-local SSE
can be exhibited.
Example 3. First, following Farmer and Woodford (1984), consider a version
of the O L G model with government expenditures g (constant in real terms)
where the basic equation Z(x o,/Xx0) = 0 reduces to
23aOur record is not exhaustive. For results with a similar flavor, see for example Woodford
(1988b).

2
X 0 -=-
~:(xix0) - g ,
where
E(xlx0) = f
t d/Zxo(t) .
1713
(3.6)
Assume
that g < l / 4
and consider the compact set K = [g, 1/2]. Consider
Xo E K and associate with x 0 the random variable x =- ~x0z + g where e is a well
behaved r a n d o m variable (sunspot) with support within [0, 2 - 4g] and Ee = 1.
The corresponding distribution "rationalizes" any x0 ~ K and it varies continuously with x 0. It remains to check that the support of x' is in K; indeed
g ~< x <~ 1/2 follows from the definition of the support of e. Then we have:
Corollary 2 ]Farmer and Woodford (1984)]. Consider the specification (3.6)

o f our general model and consider any one-dimensional random variable e such
that 0 ~ < e ~ < 2 - 4 g and I F = I . Then the mapping Xo---~tZxo where ix~o is the
distribution o f the random variable ex o2 + g defines a stationary sunspot
equilibrium.
Example 4. A last example is provided by G r a n d m o n t (1986). Assume that
the equation Z ( x , x ' ) = 0 can be written
x = X(X'),
where X is a continuous mapping defined on E+ .
(3.7)
This form obtains in particular in the simple O L G model with a representative consumer and separable utility function considered by Grandmont. The
state variable is one-dimensional and we have:
L e m m a 1.
Under (3.7), Assumption 2S is equivalent to
3 x ' , x n' s.t. X(X') <
' < X ( x " ), i = m, n .
X i
Proof. Assume that there exists a connected compact set K (of Assumption
2S); let us put K = [a, b]. T h e r e exists x " which rationalizes b and x'n which
rationalizes a with x " and Xn' E / ( . Then
a = x (X' )n < x i <, b = x
(X' )m
Reciprocally, let us assume that
3 x ' , x" s.t. X(X'n) < X,t < X ( X ' ) .

When x' varies between x " and X'n, X(X') takes any value between X ( x ' )
def
and X(X'). Then, any x belonging to K = [X(x'), X ( x ' ) ] is rationalized by some

x' (between Xm' and x" in K).
1714
Now the analysis requires an additional ingredient which easily obtains in an

O L G model with representative consumer and a separable utility function.
Assumption 3. (o0 Let x 1 be rationalized by x '1 and x 2 be rationalized by x~.

T h e n any x belonging to [xl, x2] is stochastically rationalized by a measure
putting a well chosen probability 7r to x~ and 1 - 7r to x~.
(13) T a k e any given x 3 and the preceding x of condition (c0. Then for e small
enough there exists 7r(e, x3, x) close to 7r such that x is also rationalized by x 1
with probability 7r(e), x 2 with probability 1 - 7r(e) - e, x 3 with probability e.
T h e n we have:
Proposition 1
[Grandmont (1986)].
S u p p o s e A s s u m p t i o n 3 holds, and assume
that:
(C) there exist x I < . . . < x k such that f o r s o m e m , n( <~ k ) x ( x n ) ~ x i <~ X(Xm)
for i = 1 , . . . , k. Then there exists a S S E o f order k with s u p p o r t ( x l , . . . , x k } .
Yt+l
i
~,t
i~ I
%(Xn)
~
I
I
C.(x~ )
rCK)
Figure 32.1
Yt
1715
Proof. From the proof of Lemma 1, it follows that any x E [x 1, x~] can be
rationalized by some x' C[Xm, xn]. Hence from Assumption 3(a), it can be
rationalized by a probability distribution with support (xn, Xm). Lastly, the
degenerate SSE so constructed can be perturbed using Assumption 3(p).
The structure of Grandmont's O L G model is such that (C) is also necessary.
However, this need not be the case in general and not even in O L G models.
Also, the geometric intuition behind this result is illustrated by Figure 32.1.
Clearly, the image of the compact set K = [X(X'), X(X')] by the deterministic
rationalizability correspondence r is interior to K, hence Proposition 2 applies;
note, however, that the steady state need not be indeterminate (it is not in
Figure 32.1).
4. Indeterminacy of the stationary state and local sunspot equilibria

In this section, we investigate the links between indeterminacy of the steady
state (in the sense defined above) on the one hand, and existence of stationary
sunspot equilibria "close to" the steady state on the other hand. As we have
seen in the previous section, the earlier literature on sunspot equilibria in the
simple, one-dimensional overlapping generations models [Azariadis (1981),
Azariadis and Guesnerie (1982)] has established that local SSE could be
constructed when labor supply was backwards bending enough, i.e. when the
steady state was indeterminate. Further results of Farmer and Woodford
(1984) and Grandmont (1986), have also shown the existence of SSE in the
neighborhood of a "low" steady state of the OLG model (with government
expenditures). In parallel, a different but related strand of the rational
expectations literature, analysing the solutions of dynamic linear models, has
highlighted the relationship between indeterminacy of the steady state and the
multiplicity of rational expectations equilibria. But there should be links
between the local behavior of a non-linear system and the properties of the
tangent linear system. This remark suggests that the general connection
between indeterminacy and multiplicity in the linear model may have a
counterpart in the non-linear framework; specifically there should be a relationship between indeterminacy of the steady state and the existence of local
sunspot equilibria. Indeed this fact was stressed by Woodford (1984) in a
survey where he conjectured that the previous conclusions of Azariadis,
Azariadis and Guesnerie and Farmer and Woodford should have broad
validity. What can be referred to as Woodford's conjecture has indeed been
proved for the one-dimensional version of our model: it is Corollary 1'. We
shall show here that the conjecture holds true in the general version. We
1716
proceed as follows. We first state the main results of the linear framework,
then consider the general model.
4.1. S u n s p o t equilibria in linear models

The linear m o d e l
Let us assume that Z is linear; i.e. there exists a vector and two (n x n)
matrices A and A' such that
f
V x o E X , Vl~ E ~ ( X ) ,
Z ( x o, t-t) = A ( x o - .~) + J A ' ( x - .~)l~ d x .
(4.1)
The deterministic excess demand Z then takes the following form:

VXo, x E X ,
Z(xo, x) = A ( x o - .~) + A ' ( x - .~).
(4.2)
From Assumption R, A = OoZ is of full rank; we may thus define, as above,

B =-(OoZ) -10~Z=-A-~A
'. Obviously, is a steady state of the model;
furthermore, from (R), 1 is not an eigenvalue of B, hence is the only steady
state. In what follows, for notational convenience, we put ~ = 0.
Again, a temporary equilibrium of the system is a pair (Xo, tx) such that
x = S Bxlx dx = ~[Bx],
(4.3)
where the expectation E is taken with respect to the probability distribution p~.
Lastly, a sunspot equilibrium is defined as in Section 2.2; in particular, its
support X 0 and transition function/2 satisfy
Vx o E X o ,
x o = E[Bx/xo],
(4.4)
where the (conditional) expectation operator E[./Xo] is taken with respect to

the (conditional) probability distribution/zx0 =/2(x0, .).
As announced above, there will be a very close link between this existence
problem and the properties of the associated deterministic dynamical system.
Indeed, let us consider
x t = Bxt+ 1 .
(4.5)
1717
Specifically, let s be the number of eigenvalues of B of modulus greater than

1, and let S be the subspace of ~" spanned by the corresponding eigenvectors.
If s = 0, then the only non-exploding perfect foresight equilibrium is x, = 0 for
all t (the steady state is then determinate, according to the previous terminology). If s > 0, there exists a continuum of perfect foresight equilibria converging
to zero, all of them remaining within S (the steady state is indeterminate).
Blanchard and Kahn (1980) have shown that these results have a counterpart
in the stochastic version (4.3). More precisely let us consider the stochastic
dynamics associated with (4.3):
(4.6)
x, = E(Bx,+,/I,).
Here, (xt, t ~ N ) is a random process on S 0 and / t = { x , , x , _ l , . . . } .

A
solution of (4.6) is a process (x,) that (i) satisfies (4.6), and (ii) does not
"explode too fast"; say, is bounded in absolute mean or variance. Of course,
(x t = 0, Vt) is a solution of (4.6). The existence of other solutions is characterized by the following result.
Proposition 2 [Blanchard and K a h n (1980)24]. The stochastic dynamics (4.6)
has a non-zero solution if and only if s > O, i.e. if and only if B has at least one
eigenvalue outside the unit disk.
Proof. Assume, first, that s = 0, and let (xt) be a solution of (4.6) such that
sup~ ~lx~[ < +oo. Let A be an eigenvalue of B with maximum modulus; from
(R), IAI < 1. Then, for any t, we have that
u (Ixtl) =
E[IIE(Bx,+,/I,)I]
IE[IE(IBX,+ll//,)l
rF(IBx,+,l).
Moreover,
ricO,
~(IBx,+ll) ~< IAI E(tx,+,l);

IE(Ix,+il)~(Ix,
this shows that
t)/IAI i .
Since l/ta] i tends to infinity with i, the right-hand side cannot be bounded
unless ~:(]xt])=0; but then x, is zero a.e. This argument can easily be
transposed to variances. Note, also, that since nZ]x,t2 is constant for any weakly
stationary process, this implies that (x, = 0, Vt) is the only stationary solution
of (4.6) [see Gouri6roux, Laffont and Montfort (1982)].
a4Blanchard and Kahn actually consider a more general framework that includes predetermined
variables. We give here the restriction of their result to our setting (see, however, Section 7.3).
1718
P . A . Chiappori and R. Guesnerie
Conversely, assume that s
> 0. 24a
Take any s-dimensional random process
( w t ) o n the s t a b l e s u b s p a c e S, such that (i) w t is bounded in mean or variance

and (ii) Vt, ~_(w,+l/w ~, wt_ 1 . . . . ) = 0; then ( w t ) is a m a r t i n g a l e d i f f e r e n c e .
Define the process (x,) by 25 x, = E~=
t 0 B -i-1 Wt_i, in particular, B x t + 1 =
x t + w,+ 1. This process has its support within S, and is bounded in mean or
variance, since the norm of the restriction of B -1 to S is strictly smaller than
one. Also, (4.6) is satisfied:
~_[BXt+l/X,] = x , + ~-[Wt+l/It] = x t .
H e n c e , (x,) is a solution of (4.6).

Finally, we can choose (wt) such that the process (xt) is Markovian and
stationary; for instance, take the (w,) to be independent, with compact
support; then, for any measurable set ~/,
P [ x t + 1 E ~1 I xt = Xo, x t - t , " "] = e [ w t + l E n s ~ - x 0 I x t = X o , x t - I . . . .
is independent of (Xt_l,...), hence the process is Markovian; and stationarity

can be easily derived [see Broze, Gouri6roux and Szafarz, (1988)]. We can
hence state the following corollary.
Corollary 4.
T h e r e exists a n o n - z e r o stationary M a r k o v i a n p r o c e s s s o l u t i o n o f
(4.6) i f a n d o n l y i f B has at least o n e e i g e n v a l u e o u t s i d e the u n i t disk.
Lastly, note that such a solution can be considered as a stationary sunspot

equilibrium, since the process (w,) is extrinsic by construction.
Finite s t a t i o n a r y s u n s p o t equilibria
The previous results extends to finite SSE as well: whenever the linear
admits SSE, then it admits finite SSE. Since the proof of this result
lemma that will be useful in the next section, we shall present it in some
Specifically, a SSE of cardinal k will be defined here by a n o n - z e r o
x = (x'1, . . . , x~)' of ~,k and a (k k) Markov matrix M = ( m i j ) , such
Vi = l, . . . , k ,
model
uses a
detail.
vector
that
x i = ~ mijBx j,
i
or, in matrix notation (and using the tensorial product ),

24aBounded sunspot equilibria are clearly solutions of (4.6). The existence of such equilibria (and
also of stationary SE) could be deduced from the invariant compact theorem given in the previous
section. We provide here an alternative proof, based upon Blanchard and Kahn's initial argument.
ZSNote that the process is defined even if B is not invertible, since the restriction of B to S is.

(Ink - M B ) x = 0
1719
(4.7)
where Ink is the nk nk identity matrix. In other words, x must be an

eigenvector of M B, associated with the eigenvalue 1. The set of such
eigenvalues is characterized by the following lemma.
A n eigenvalue (resp. eigenvector) of M B is of the f o r m mb

(resp. v w), where m is an eigenvalue of M (resp. v an eigenvector of M ) , and
b an eigenvalue of B (resp. w an eigenvector of B).
L e m m a 2.
In particular, (4.7) cannot have a non-zero solution unless b = 1 / m for some

eigenvalue m (resp. b) of M (resp. B). Since m, as an eigenvalue of a M a r k o v
matrix, is within the unit disk, b must be outside (it cannot be on the unit circle
by (R)).
Conversely, assume that B has some eigenvalue b outside the unit disk. If b
is real, we can find SSE of any finite cardinal k I> 2. Indeed, it is always
possible to find a M a r k o v matrix of any dimension k/> 2 with 1/b as an
eigenvalue; take
o) '
M=
M"
where M" is any (k - 2) x (k - 2) M a r k o v matrix, and
M,=
l +__21/b 1 - 1/b
2
11-
1+1'
F o r such a matrix, 26 the determinant of I - M Q B is zero, hence (4.7) has a

continuum of non-zero solutions that have to be SSE vectors. Lastly, such a
vector x = ( x ~ , . . . , x~,)' is colinear to v w, where w is an eigenvector of B
associated with b; this means that each x i, i = 1 , . . . , k, is colinear to w, hence
belongs to the stable subspace S. The case of a complex eigenvalue b is m o r e
tricky, since, for any given integer k, one can always find a complex n u m b e r
1/b, of modulus smaller than one, such that no (k x k) M a r k o v matrix has 1/b
as an eigenvalue. 26a This means, in particular, that the existence of a complex
eigenvalue of B with modulus greater than one is not sufficient, in general, for
26Strictly speaking, this matrix is degenerate in the sense of our previous definition, but a
continuity argument can be used.
z6aThis is well known for complex numbers of modulus one, and extends by continuity to
numbers of modulus smaller than one.
1720
SSE of any finite order to exist. However, it still ensures the existence of SSE
of sufficiently large order. Precisely 26b, the following result can be shown.
Lemma 3.
Let A be any complex number of modulus smaller than one, and let
k be an integer such that cos(Tr/k) > [A[. Then A is the eigenvalue of some k k
Markov matrix.
As before, this immediately shows the existence of non-zero solutions of
(4.7), i.e. of SSE of cardinal k; moreover, the corresponding sunspot values of
the state variable, xa . . . . , xk, belong to the stable subspace S. We can thus
state the following result.
Proposition 3.
(i) If B has no eigenvalue of modulus greater than one, there

exist no SSE for the linear system. If B has a real eigenvalue of modulus greater
than one, then for every k >>-2 there exists a SSE of cardinal k. If B has a
complex eigenvalue b of modulus greater than one, then there exists a SSE of
cardinal k for any k such that Ib] cos (Tr/k) > 1.
(ii) The Markov matrices associated with SSE of cardinal k necessarily have
(at least) one eigenvalue that coincides with the inverse of an eigenvalue of B.
Conversely, to any Markov matrix satisfying the latter property, one can
associate a SSE of cardinal k.
(iii) For any SEE of cardinal k, the corresponding vectors Xl,. . . , x k belong
to the "stable" subspace of the associated deterministic dynamics, i.e. to the
(s-dimensional) subspace generated by the eigenvectors of B with eigenvalues of
modulus greater than one.
Lastly, though this proposition only states the existence of SSE of cardinal k,
it can be generalized to SSE of order k, i.e. such that the x i are all different.
Propositions 2 and 3 express an important fact, namely that, in the linear
model, stationary sunspot equilibria exist if and only if, in the corresponding
deterministic dynamics, the steady state is indeterminate. As we shall see, this
result will have a (local) counterpart in the non-linear case. We may present
briefly the geometrical intuition that lies behind it. Consider, first, the case
when some real eigenvalue b of B has modulus greater than one; let S b be the
space spanned by (one of) the corresponding eigenvector(s). The restriction of
B to S b is a homothecy of scale b. Since b > 1, we can find two vectors x 1 and
x 2 in S b such that x I and x 2 belong to (Bx~, Bx2) (see Figure 32.2). Then both
x I and x 2 can be written as convex combinations of Bxa and Bx2, say,
x i m i l n x 1 -t- mi2Bx2, with m~l + mg2 = 1. This means exactly that the vector
=
Z6bSee Chiappori, Geoffard and Guesnerie (1989).
1721
x' = (X'l, x~), associated with matrix M = (mq), is a SSE of order 2. O f course,
this argument can be transposed to SSE of any order k ~> 2.
Let us come now to the case where b is complex, say, b = r e i. Now, S b will
be the (two-dimensional) stable subspace spanned by the real and the imaginary parts of (one of) the eigenvector(s) associated with b. The restriction of B
to S b is the composition of a rotation of angle 0 and an homothecy of scale
r > 1. In particular, this restriction is one to one; moreover, for any vector y on
the unit circle, the inverse image of y by B belongs to the disk of radius 1/r.
Now, take some k such that cos(Tr/k) > 1/r, and take k vectors Yl, , Yk, on
the unit circle, such that their convex hull includes the latter disk; for instance,
we may take the vertices of a regular polygon (Figure 32.3). If xl . . . . . Xk are
the respective inverse image of yl . . . . , Yk, each x i can be written as a convex
combination of the y j, say
k
Xi
~ mijY/= ~ m i i B x / ,
j=l
j=l
with E mij = 1.
j=l
Again, this generates a SSE of order k.
4.2. Equivalence between indeterminacy o f the steady state and existence o f

local sunspot equilibria
The basic result conforms, in our setting, to Woodford's (1984) conjective.
Theorem 3. A s s u m e that Assumptions CD and R hold true at some indeterminate steady state E o f the deterministic model. Then, for any neighborhood O(E)
o f the steady state, there exists a S S E with support in O(E).
i
Bx 1
i
x1
i
i
x 2 Bx 2
b>O
I
Bx 1
I
x2
b<O
Figure 32.2
I
I
x I Bx 2
1722
II
Figure 32.3
Proof. Note, first, that in one-dimensional systems, T h e o r e m 3 reduces to

Corollary 1' of the previous section. In n-dimensional systems, however,
Corollary 1 requires in order to show the existence of SSE, that all eigenvalues
of B are outside the unit disk, whereas T h e o r e m 3 asserts that o n e such
eigenvalue is enough. Clearly, we need here a different argument. The proof
we give here relies upon bifurcation theory, and follows Chiappori, Geoffard
and Guesnerie (1989). In fact, it shows a stronger result than the one stated
above, namely that f i n i t e SSE of a n y "sufficiently large" order can be found
within any neighborhood of the steady state as soon as the latter is indeterminate.
The basic idea is the following. Let k be some positive integer (precise
conditions upon k will be given below), M some (k k) Markov matrix, and
^k
~nk
consider the vector field Z M on
that has been defined in Section 3.3 by
(xl,...,
X k) ~ ~nk_..._~ [2k(x1,
xl, . . . ,
X k, M1), , , , ,
Z k ( x k , Xl, . . . , X k, M k ) ] e ~ n k .
1723
R e m e m b e r that the ith component of the right-hand side parentheses gives

the excess demand when present state is x/, and there are k possible future
states x ~. . . . , x k, with probabilities of occurrence given by the ith row of
matrix M, i.e. M i. A n obvious zero of this vector field is ( 2 , . . . , 2). Moreover,
Assumption R implies local uniqueness of the steady state; hence, any zero of
^k
Z m in a neighborhood of 2 and different from 2 must be a stationary sunspot
equilibrium of cardinal k. The idea, now, is to show the existence of such a
zero using a bifurcation argument; specifically, we shall vary matrix M within
the set d/k of (k x k) Markov matrices, along some well chosen path, and show
that the vector field bifurcates at some point of the path.
T o reach this goal, we must first derive some information on the Jacobian
matrix of 2 k at the steady state (and more precisely on its Jacobian determin^k
ant AxZM). T o do this, we simply use (CD), which relates the derivatives of
~k
Z u to those of Z. Specifically, the following can be proved.
Under Assumptions CD and R,
L e m m a 4.
^k
A ~ Z M ( X , . . . , 2 ) = (det OoZ(2, 2)) ~' det[I,k -- M B]

where I t is the (l l) identity matrix.
A bifurcation can only occur at a singularity of the vector field; i.e. matrix M
must be such that the above determinant is zero. Since OoZ is invertible, we are
actually looking for a matrix M such that det[Ink -- M Q B] = 0. The result is
intuitively plausible. Assumption CD ensures that in some sense the stochastic
excess demand of the non-linear system "behaves as" its counterpart in the
linear system (4.1). H e n c e , the fact that the bifurcation condition is similar to
that of the linear case [condition (4.7)] is not surprising. In the linear case,
moreover, we have seen that the eigenvalues of matrix M B are the products
m.b, where m is an eigenvalue of M and b an eigenvalue of B. Hence, a
bifurcation cannot occur unless some eigenvalue of M "crosses" the inverse of
an eigenvalue of B; as in the linear case, the latter must then be of modulus
larger than one. 27
We shall now show that, conversely, such a crossing generates a bifurcation
at the steady state. Just as in the linear version, two cases have to be
distinguished, according to whether the eigenvalue b is real or complex.
27This argument shows in particular the following result: if the steady state is not indeterminate,
i.e. if all eigenvalues of B belong to the unit disk, then for any integer k there exists a
neighborhood 0 k of .f such that no sunspot of order less than k can have its support included in Ok
(just apply the implicit function theorem to the vector field: the zero, considered as a function of
M, is unique, hence it can only be ( . ~ , . . . , J?)).
1724
Case 1: Real crossing. Assume, first, that b is real. Consider a differentiable path M(s) of Markov matrices, indexed by s ~ (-7/, 7/) for some "small"
positive r/, and such that:
(i) for any s # 0, for any eigenvalue m(s) of M(s) and any eigenvalue b' of
B, m(s)b' # 1;
(ii) M(0) has a simple eigenvalue m equal to 1/b; for any eigenvalue
m ' # m, of M(0) and any eigenvalue b' of B, m'b' # 1; M(0) is diagonalizable
in a basis of eigenvectors {v I . . . . , vk}, where v 1 is associated with m;
(iii) in the basis { v l , . . . , vk}, the matrix M ' ( 0 ) = dM/ds (0) has a non-zero
upper diagonal term ("transversal crossing").
Such a path can be shown to exist and is such that 1 + bm(s) changes sign
when s crosses zero. Then the following result obtains.
Under Assumptions CD and R, and if matrix B has a real
eigenvalue b outside the unit disk, then one can construct a path M(s) such that
the vector field Zk(xl . . . . . x k, M(s)) bifurcates at s = O. For any s in (-~l, 0),
there exists a SSE of cardinal k associated either with matrix M(s) or with matrix
M(-s).
L e m m a 5.
A consequence is that whenever B has a real eigenvalue outside the unit

disk, then the system has SSE of any finite cardinal; it can also be shown that
the SSE can be found of any finite order. L e m m a 2 derives from classical
results in bifurcation theory (the bifurcation is either transcritical or pitchfork).
It can be demonstrated in different ways. A first line relies upon Morse's
lemma. The first step is to reduce the dimension of the bifurcation set (either
by the local center manifold theorem or by the L y a p u n o v - S c h m i d t procedure).
H e r e , only one of the eigenvalues of DxZM~s)(x,...,
Ak
) crosses zero at the
^k
bifurcation point s = 0 . Hence, the kernel of DxZM(s)(x
. . . . , ) is onedimensional; the idea is to use a "projection" upon this kernel (by any of the
techniques just mentioned) to restrict the problem to the study of a bifurcation
in R. Now, the transversal crossing condition can be shown to be sufficient for
Morse's lemma to apply. An alternative proof relies upon index type arguments (that have the same flavor as the P o i n c a r 6 - H o p f approach described
below), used for example by Guesnerie (1986).
Case 2: Complex crossing. Assume, now, that b is a complex eigenvalue of
B within the unit disk. Again, we must consider a path of matrices M(s) such
that one eigenvalue, say re(s), crosses 1/b for s = 0. But, here, two difficulties
appear. First, since M(s) and B are real matrices, rfi(s) and 6 are also
eigenvalues of M(s) and B, respectively and, of course, rh and 1//~ also cross at
s = 0. H e n c e , the kernel of D~Z~s)(,..., ) is two-dimensional (equivalently, the bifurcation is of codimension two); this raises technical problems,
since most results in bifurcation theory deal with bifurcations of codimension
1725
one. z8 In addition to this essentially technical difficulty, the existence of the

matrix path itself is no longer guaranteed. The reason is that, as we have seen
in the linear case above, for any given k, there exist complex numbers b
outside the unit disk such that no (k x k) Markov matrix has an eigenvalue
equal to 1/b. We have seen, however, that, for any b outside the open unit
disk, it is possible to find a Markov matrix M in .//~ with eigenvalue 1/b,
provided that k is "large enough" (namely, k must be greater than ~'(arc
cosll/bl)-'. The existence of a path of matrices with adequate properties can
then be derived; and a direct analysis shows the existence of a bifurcation,
hence of SSE in any neighborhood of the stationary equilibrium. Formally:
Lemma 6. A s s u m e that Assumptions R and CD are satisfied, and that B has a
complex eigenvalue b outside the unit disk. Let k be any integer greater than
1r(arccosll/bl) -1. Then it is possible to construct a path M(s) such that the
vector field Zk(xl, . . . , x k, M(s)) bifurcates at s = O. For any s in (-~!, 0), there
exist a S S E associated either with matrix M(s) or with matrix M ( - s ) .
Again, it can be shown that the SSE can be found of any order
k > ~'(arccosll/bl) -~. In addition, the approach provides some insights upon
the form of the bifurcation. For instance, when s tends to zero, so that M(s)
tends to the bifurcation matrix, it can be shown that the corresponding SSE
tend to some SSE of the tangent linear system; in particular, its support tends
to belong to the stable subspace of the tangent, deterministic linear system.
Theorem 3 is also a consequence of a result of Woodford 28a (1986). We shall
sketch how the latter (rather complex) argument can be used in the present
context.
(1) Consider a sequence of independent random variables {ut} and consider
the history of the ut as the sunspot phenomenon. A sunspot equilibrium is
associated with a function
4" u'= (u,,
u,_l""
.)--, x = 6(u')
(2) Consider the sunspot equation 5 ( . ) = 0 as an equation in ~b. Write

f(~b) = 0; note that the function @ defined by ~(u') = Y for all u t is a solution.
(3) Compute (D6f)~ (this is the tangent linear mapping of function f,
defined on an infinite dimensional space, at ~). The crucial point is to show
that the non-invertibility of this mapping is equivalent to the indeterminacy of
2SEven Morse's lemma does not immediately apply, so that a more detailed investigation is
needed.
ZS"Woodford's argument establishes existence of local SSE in the sense of Theorem 3, and
extends to models with memory (see Section 7).
1726
(4) To f ( 4 ' ) = 0, add some arbitrary equation g(4')= a (where a is a

parameter) such that [D~(f, g)]$ is invertible. The generalized implicit function theorem allows us to solve the system locally around a 0 = g(4'); for any
a ~ ot0, the solution defines a SSE.
Woodford's approach also allows us to address the converse question. If ~?is
determinate_, then (D4,f)$ is invertible; and the implicit function theorem
shows that 4' is locally the unique solution to f(4') = 0. Hence, no local SSE can
exist, at least within the class of stochastic processes "generated" by the initial
process (ut). In fact, this class is in general large. For instance, if the (ut) are
uniformly distributed, it includes all Markovian processes with finite support.
Hence indeterminacy is necessary and sufficient for the existence of Markovian
SSE with finite support, a fact to be compared to the findings of Laitner
(1989). Finally, it must be stressed that indeterminacy is by no means needed
for the existence of global SSE, as has been known since the early work of
Azariadis (1981b), and as is confirmed by previous and further statements in
the survey.
5. Existence of sunspot equilibria: other arguments

In the previous sections, we have provided two types of existence results for
sunspot equilibria. The former relies on an invariant compact argument, when
the latter follows from the analysis of the non-linear system around the steady
state. Other existence arguments have been used in the literature; we review
two of them here. The first [see Azariadis and Guesnerie (1986) and Peck
(1988)] is merely based on a continuity argument that is technically straightforward; it however provides some basic conceptual insights. The second [Chiappori and Guesnerie (1989a)] exhibits a class of sunspot equilibria for which the
system "wanders" between two deterministic stationary states. The study of
these heterodox sunspot equilibria is based on the more complex analysis of a
dynamical system; the equilibria under consideration appear as heteroclinic
orbits of this dynamical system, hence the name of heteroclinic sunspot
equilibria.
5.1. Continuity arguments: the implicit function theorem

Some existence results on SSE obtain from mere continuity arguments. Specifically, some deterministic equilibria can be viewed as limit cases of sunspot
equilibria; then continuity may be invoked (in general, with the help of the
implicit function theorem) to show the existence of non-degenerate SSE. In
1727
addition, the properties of the sunspot process will also be "close", in some
sense, to those of the degenerate initial equilibrium. We give two examples
illustrating this method.
Sunspots and cycles

First, consider a periodic equilibrium of the deterministic system. For simplicity, we take a cycle of order 2; the argument, however, is clearly general. We
thus have
Z(21,22) ~- Z(22, 21) = 0.
(5.1)
These relations can, equivalently, be written
22(21, Xl, X2, 0, 1) = 22(22, 2,, 22, 1, 0) = 0.
(5.2)
That is, the 2 cycle can be viewed as a degenerate SSE, associated with a
particular transition matrix, namely
The idea, now, is to show that a SSE can also be associated with the Markov
matrix
M~,~,=
(1,- e ' 1,)

'
for and E' small enough.

To see this, assume that 21 and 2 2 are interior to X, and consider the
I acobian matrix
{ Oo2 2 + o12 2
J-- ~
0122
022 2
0022 + 0222 ]
(the derivatives being taken respectively at (21 , 21 , 22) for the first row and
(22, 21,22) for the second row). If J is invertible, then, from the implicit
function theorem, there exist two functions Xl(, ' ) and x2(, ' ) such that
xi(O, O) = 2 i for i = 1, 2, and, for and ' small enough,
2~[x1(, '), xl(, 3 , x~(, 3 , , 1 - 1 = o ,
(5.3)
22[X2(, t), Xl( ' ,), X2( ' t), t, 1 - '1 = O.
1728
H e r e , {Xl( , E'), X2(~ , E')] is the support of a sunspot equilibrium of order 2,

associated with the matrix M,,,,; and stationarity is immediate. Of course, the
SSE is "close to" the initial cycle.
Clearly, the invertibility of matrix J is "generic". There are many possible
(and m o r e or less satisfactory) meanings that could be given to the latter
assertion. A quick cost/benefit analysis, however, suggests that the exercise
would not be worthwhile for our purpose. We limit ourselves to the following
result.
Proposition 4 [Azariadis and Guesnerie (1986)].
Consider a periodic equilibrium (xl, , Xk) o f order k which is in generic position (i.e. such that the
corresponding Jacobian matrix is o f full rank). For any e > O, there exists a
Markov matrix M = (mis) such that
(i) mi.i+ l > l - ( k - 1 ) e , i = l
.... ,k-I
andmk, l>l-(k-1)e,
(ii) O < m i s < e f o r j ~ i +
l,
(iii) there exists a S S E associated with M.
Periodic equilibria describe expectations-driven deterministic fluctuations,
when sunspot equilibria describe expectations-driven stochastic fluctuations.
This intuitive connection is given a more formal content here. The argument,
although straightforward, stresses the close link between the literature on
sunspot equilibria and that on periodic equilibria, z9 originating in Gale (1973)
and for its m o d e r n developments in the pioneer work of G r a n d m o n t (1985a,
b).
Also, note that, as is well known, periodic equilibria may exist in our setting
without the steady state being indeterminate. The above result then confirms
the fact that indeterminacy of the steady state is not a necessary condition for
the existence of (not necessarily local) SSE.
The case o f two steady states

As a second example, consider a system with two stationary equilibria J? and ~,
both interior to X. Assume that there exists a state 37 that can be rationalized
by a distribution with support {~?,x}; formally:
29In the more restrictive setting of the basic, one-dimensional OLG model without government
expenditures, as we have already mentioned, Azariadis and Guesnerie (1986) actually showed a
stronger link, namely, that SSE of order 2 exist if and only if cycles of order 2 exist. This
conclusion, however, is not robust to a complexification of the setting; for instance, when
government expenditures are added, we know from previous theorems that SSE of order 2 may
exist though no 2 cycle does.
1729
Assumption 4. There exists ] E X and 0 < rr < 1 such that

23(~, ~, , x , It, 0, 1 - ~r) = 0 .
Then there exists a SSE with support {, ~, x} associated with the matrix
M=
1
rr
0
0
0
0
0 )
1-rr
.
1
This SSE is degenerate; however, we can apply the implicit function theorem
in a similar way and show the following.
Proposition 5 [Peck (1988)]. Assume that the system has two deterministic
stationary equilibria interior to X, and that Assumption 4 holds. I f the triple
(~, ~, ~,) is in generic position, then for any Markov matrix close enough to M,
there exist a S S E with support (x l, x 2, x3), where the triple (x 1, x 2 x 3) is close to
(~, ~, x).
In the limit SSE, corresponding to matrix M, the system could move from
the intermediate state to the limit states; but it was trapped forever in one of
the stationary states afterwards. In neighbor, non-degenerate SSE, however,
the states close to Y and x respectively are no longer absorbing, and the system
will fluctuate forever between the three states. Also, it can be stressed that the
stationary points must be interior to X, otherwise one (or both) of the x i given
by the implicit function theorem could be outside X.
5.2. Dynamical systems and heteroclinic sunspot equilibria

A quite different perspective, that leads to "non-traditional" sunspot equilibria, relies upon the theory of dynamical systems. Specifically, in this section we
shall consider sunspot equilibria with the following properties:
(i) The support X 0 of the SE is countable, indexed by some integer s in Y.
(ii) When the corresponding random process ("sunspot") is in state s, it can
only reach one of the (2k + 1) "neighbor" states {s - k, s - k + 1 . . . . . s,
s + 1 . . . . . s + k} for some fixed k E [R. Moreover, the probability of reaching
state s + l from state s, with [l[ ~< k, is s o m e / / t independent of s (of course,
E~*__~//l -- 1).
In other words, we consider, as an underlying "extrinsic" random process, a
discrete Markov chain such that:
(i) The transition probabilities are stationary (the chain is homogeneous).
1730
(ii) E a c h r o w of the transition matrix has only ( 2 k + 1) n o n - z e r o elements;

specifically, the transition probability f r o m state i to state j is z e r o w h e n e v e r
li-jl>k.
(iii) T h e process is isotropic, in the sense that the transition probability f r o m

i to j o n l y d e p e n d s o n (i - j) ( " r a n d o m w a l k " p r o p e r t y ) .
A n a t u r a l i n t e r p r e t a t i o n o f this r a n d o m process is as a " m o n e y " process,
along t h e lines of L u c a s ' (1972) p a p e r 29a (see also Section 7.1). F o r the sake of
expositional simplicity, let us take k = 1. C o n s i d e r an e c o n o m y with a r a n d o m
m o n e y supply. In state s, by definition, the q u a n t i t y of m o n e y is M (for s o m e
g i v e n A > 1); at the next period, it can be either in state s + 1 (i.e. have g r o w n
at rate A - 1 to reach the value As+l) or in state s - 1 (i.e. have d e c r e a s e d at
rate 1 - 1/A to As-l). It grows (resp. decreases) with probability H I = o~ (resp.
H 1 = 1 - tz); again for the sake o f simplicity, we take H 0 to be zero. Such
processes h a v e often b e e n considered in the literature in m o n e y in rational
e x p e c t a t i o n m o d e l s ; a f r e q u e n t assumption is that the e x p e c t e d value o f the
q u a n t i t y o f m o n e y t o m o r r o w , conditional on p r e s e n t quantity, is equal to the
p r e s e n t q u a n t i t y ( " m a r t i n g a l e " p r o p e r t y ) . I n o u r simple m o d e l , this m e a n s that
~A + (1 - ~ ) / A = 1, h e n c e a = 1/(1 + A) < 1/2.
I n w h a t follows, we assume that Z has (at least) two stationary equilibria
and x (one o f t h e m m a y be " d e g e n e r a t e " in the sense of Section 3); a n d we
c o n s i d e r S E b a s e d u p o n the " m o n e y p r o c e s s " described above. W h e n s u n s p o t
is in state s (or, equivalently, w h e n the q u a n t i t y of m o n e y is As), the state
variable takes the value xS.3 T h e s u p p o r t o f the s u n s p o t equilibrium is thus a
s e q u e n c e X 0 = ( x s, s ~ 71) that satisfies the relationship
VS~-,
22(xS, xS+l , X s 1, a , 1 -
a) = 0.
(5.4)
If, in addition, we have

lim x ~ = 37,
~-~
o~
lim x s = x
s--->
(5.5)
'
the s u n s p o t equilibrium is heteroclinic. 31
29aln Lucas' framework, the process followed by the log of the money stock is a random walk;
i.e. the quantity of money at date t, M,, satisfies M, = M,_l.x ,, where the x, are iid random
variables. The stylized fact captured by this setting is that the probability distribution of the
inflation rate should not depend primarily on the stock of money. This formulation seems more
adequate than any alternative setting in which, say, the money process would have a compact
support. Also, this process is non-stationary; a consequence is that any sunspot type fluctuations
generated by beliefs that "money matters" are likely to inherit this non-stationarity property.
3In the remainder of this section, an uppercase index refers to a state of the process, whereas a
lowercase index denotes the period. For instance, "x, = x reads "at date t, the state variable is in
state s".
31A trajectory of a dynamical system is heteroclinic (resp. homoclinic) when it links two different
stationary points (resp. a given stationary point with itself).
TM
1731
It is useful, at this point, to distinguish between the properties of the
sequence of possible states, Xo, on the one hand, and the stochastic properties
of the time evolution of the system governed by the corresponding SE, on the
other hand. In particular, though the sequence X 0 converges to (resp. x)
when s tends to -oo (resp. +~), the evolution of the system through time
essentially depends on the stochastic properties of the underlying random
process. In our simple random walk example, the process is non-stationary (it
does not admit an invariant distribution over X0). Also, it is such that from any
present state x s, any other value x" will be reached at least once with positive
probability. A consequence is that the process will enter any given neighborhood of any of the stationary state with positive probability; and, in the same
way, it will leave any such neighborhood, once entered, with positive probability .32
It remains to show that such heteroclinic sunspot equilibria may actually
exist. To see why this is the case, assume, first, that we can invert equation
(5.4) and write it as
x '+~= /~ (x',x ~-x, a) .
(5.6)
Then if x is n-dimensional, we can associate with (5.6) a (2n)-dimensional

dynamical system:
=
tx, x
x ~ = x s
'
ol)
or
X'
= 4 , ( x ~-1)
(5.7)
where
/
s+l\
, )
It is clear, at this stage, that establishing the existence of a SE requires the
study of a dynamical system. Also, the terminology can be understood: the
support of a heteroclinic SE must belong to a heteroclinic orbit of the system
(5.7).
How can we demonstrate the existence of such a heteroclinic solution? A
possible line is provided by an example, within the simple OLG framework,
studied in Chiappori and Guesnerie (1989). There, equation (5.4) was
x'V'(x')
= ax s*x + (1 -
oOx ~-'
(5.8)
32These properties, in particular, are in sharp contrast to the example of Peck (1988) discussed
in Section 3, where trajectories were converging to one of the stationary state with probability one.
1732
where x was a one-dimensional variable (that could be interpreted as labor

supply); V is strictly increasing, C 1 and strictly convex, with V ' ( 0 ) 1.
This equation can be solved as
x,+, = 1 x~V,(x s ) _ 1 - a x~_, .
ot
ot
(5.9)
T h e two stationary equilibria are 2 = 0 and x such that V ' ( x ) = t.

Proposition 6 [Chiappori and Guesnerie (1989a)]. Assume V'(O) >
X/4a(1 - 0). Then equation (5.9) has a heteroclinic solution with the following
properties:
(i) lim . . . . . x s = 2, lim,~+~ x" = x;
(ii) x ~ ' > x S i f s ' > s .
A brief sketch of the proof is the following:
(i) Show that 0 is a source of the two-dimensional system (5.7) if V'(0) >
~/4~(1 - ol).
(ii) Show that x is a saddle-point of (5_.7).
(iii) Show that the stable manifold at 2 goes to 0 by backward dynamics.
Steps (i) and (ii) only require a study of the linearized system around one of
the steady states. The tricky point is to show (iii), which is a global property of
the (non-linear) system. The form of the heteroclinic orbit is illustrated in
Figure 32.4; in this example, it turns out that any trajectory starting from a
point within the shaded area of the figure remains within this area by backward
dynamics; this, together with the orientation of the stable manifold, can be
used to show (iii).
Lastly, the stochastic process followed over X 0 by the state variable x t has
properties that are directly inherited from the underlying m o n e y process. First,
neither process is stationary; this is due to the random walk property of the
m o n e y process. 33 Also, it can easily be shown that, starting from any state x',
the process will return to x s at least once with probability 20/.
Heteroclinic solutions link, in the sense which has been defined and comm e n t e d upon here, fixed points of the dynamical system. One of the fixed
points under consideration might be at infinity. This is indeed the case for some
heteroclinic solutions that have been exhibited in the literature under an
explicit analytical form.
33An invariant measure should, because of isotropy, give to each state the same probability. But
then probabilities cannot add up to one.
1733
yk A
(_
B
'D
-~
Ira,
yk+l
Figure 32.4
Considering the functional equation which describes equilibrium labor supply as a function of present money supply, in a specification of the simple OLG
model where utility is separable as above and quadratic as in [Azariadis
(1981a)], and the money growth rate is lognormal, Chiappori and Guesnerie
(1989a) have found an analytical solution, under the form of a power series in
M, which is indeed an example of a heteroclinic solution a fixed point of which
is at infinity. In fact, the analytical expression found here is a special case of
the analytical solutions of Lucas equation [Lucas (1972)], which mix extrinsic
and intrinsic uncertainty and which were derived, using similar techniques in
Chiappori and Guesnerie (1990, 1991).
If heteroclinic solutions provide a coherent and non-empty concept of
rational expectations equilibrium, they raise questions concerning economic
relevance, methods of existence proofs, etc. which are far from being solved.
However, the idea that a rational expectation model which might wander
between fixed points, with the type of recurrent behavior imbedded in the
definition of a heteroclinic solution, is attractive and in our opinion worthy of
an in-depth explanation.
1734
Note that the above analysis, which transforms the existence problem in the
study of the trajectories of an associated dynamical system, suggests the
existence of not just one but several new classes of solution. For example
"homoclinic" solutions would be associated to homoclinic trajectories of the
dynamical system in the same way as heteroclinic solutions are to heteroclinic
orbits; other solutions would be associated with strange attractors, etc. [see
Chiappori and Guesnerie (1989a) for an attempt of classification along these
lines]. The fact that several of the conceivable boxes are now empty may be a
challenge for the reader of the present text!
6. Structure of sunspot equilibria: the differential approaches

The existence proofs presented above may bring different information on the
nature of the sunspot equilibria they detect. For example, while the previous
method using dynamical systems exhibits both the support and the stochastic
characteristics of the equilibria, the invariant compact argument gives much
less insight on the set of stochastic processes that can sustain sunspot equilibria.
It thus provides an incomplete story in view of the emphasis that standard
interpretation puts (rightly in our view) on the extrinsic sunspot phenomena as
coordinating devices, but also in view of the important interpretation stressed
in Section 7, concerning the role of intrinsic variables in triggering beliefs of
extrinsic type.
We review here studies that will improve our present understanding of the
structure of the set of sunspot equilibria. These studies go in two directions.
The first one following Azariadis and Guesnerie (1982) and then Spear (1984),
Azariadis and Guesnerie (1986), Guesnerie (1986), Chiappori and Guesnerie
(1989b), Woodford (1990), uses index theorems to characterize a class of
stochastic processes that may govern the evolution of the system under sunspot
equilibria. The second one following Grandmont (1989) refers to bifurcation
arguments to shed more light on the support of a category of sunspot
equilibria.
6.1. Differential topology and the PoincarO-Hopf theorem

In what follows, we shall consider a given Markov process of finite support, and
investigate whether it can generate SSE. This, as was shown in Section 4,
requires looking for zeros of the vector field Z^~M (where M is the Markov
matrix of the process), other than the steady state itself.
1735
For this purpose, index theorems can be u s e d . 34 Whenever a zero of a vector

field is known (as, for example here, the steady state), it is generally possible to
compute its index. If the latter does not coincide with the index of the field, as
given by index theorems, then it must be the case that other zeros exist within
the domain.
Specifically, we shall use the following result. Consider a manifold S C ~n
with boundaries, and let F be a smooth vector field on S with regular, isolated
zeros. Assume that F points inward at all boundary points of S. Also, if is a
zero of F, define the index i() of F at E by
i()=+1
ifAxF( ) > 0 ,
i()=-1
if A x F ( ) < O ,
where AxF is the Jacobian determinant of F at .

P o i n c a r 6 - H o p f t h e o r e m states that the sum of the indices at the various
zeros of Z is a topological invariant of S that does not depend on the particular
(inward pointing) vector field. If, in particular, S is diffeomorphic to the
m-dimensional disk, this sum is ( - 1 ) m. Hence, should the index at any
particular zero be ( - 1 ) re+l, then this zero is not unique.
In order to apply this technique, we must first assume that conditions (CD)
and (R) are fulfilled. Also, we need two specific assumptions, about the
behavior of ZM
^ g "at the boundaries" on the one hand and about uniqueness of
the (non-degenerate) deterministic stationary equilibrium on the other hand,
the latter condition ensuring that if multiple zeros are found to exist, all (but
one) must be SSE.
Assumption BC [Boundary conditions]. ~For any k i> 1, for any given Markov
matrix M in ~ k , consider the rectangle X = X~= 1 [b i, B i] C ~k+. For b 1, . . . , b k
small enough and B 1 , . . . , B k large enough, the vector field Z~t points inward
on the boundaries of X.
Assumption UDSE ]Uniqueness of the deterministic stationary equilibrium].
T h e r e is a unique in X such that ( , . . . , ) @ X, and
34For previous applications of index theorems to economics, see for example Dierker (1972) and
Varian (1975); for applications to the sunspot problem in an incomplete market context, see
Guesnerie and Laffont (1988).
1736
These assumptions characterize a broad but specific subclass of models

within the general framework we are considering. For instance, they can be
shown to hold in the simple version of the O L G model (with separable utility
functions and without government expenditures); a general discussion is in
Guesnerie (1986). In the remainder of this section, J~ is fixed in such a way that
Assumptions BC and UDSE are satisfied.
These two assumptions, together with (CD) and (R), provide us with the
minimum structure that is needed for deriving the following result.
Theorem 4. Assume that the system has a steady state satisfying assumptions of
consistency of derivatives ( CD ), regularity (R), ( BC) and ( UDSE). Define, as
in (R) above, B =-(OoZ)-t(O1Z). Then
(i) I f matrix B has at least one real eigenvalue of absolute value greater than
one, then for all k >i 2, there exists a Markov matrix M E ill k and a stationary
sunspot equilibrium of cardinal k associated with 1(4.
(ii) In this case, if M is any Markov matrix in J/tk, let SR(M) (resp. SR(B))
denote the set of real eigenvalues of M (resp. B).
If the two products
P=
H
bESR(B)
(l-b) k
and
PM=
[I
(1-bm)
b~SR(B)
mESR(M)
have opposite signs, then there exists a SSE of cardinal k associated with M.
Part (i) is also a consequence of Theorem 2. Part (ii) characterizes a set of
stochastic processes that can generate self-fulfilling sunspot expectations. In
particular, whether M E Mk can be associated with a stationary sunspot
equilibrium only depends, from this viewpoint, on the respective position
(upon ( - 1 , +1)) of the real eigenvalues of M, on the one hand, and of the
inverses of the eigenvalues of B, on the other hand (remember, however, that
the conditions given here are sufficient but not necessary).
Proof. We shall indicate an outline of the proof, which is based on Guesnerie
(1986), Chiappori and Guesnerie (1989b) and Chiappori, Geoffard and Guesnerie (1989). Also, we shall use some results already stated in the study of the
linear version of the model (see Section 4.1).
From the above argument, we just need to show that, under the conditions
given in the statement, the sign of the Jacobian determinant zaxZi(x, X) is
(--1) nk+l. This requires computing the Jacobian matrix of 2 ~ at the steady
state. This has already been done in Lemma 4 which showed that
^ k

^k
A x Z M ( X 1 "" x ) = (det
1737
OoZ(Y, ~?))k det[l, k _ M B ] .
(6.1)
Also, it has been proved in the same section that the eigenvalues of matrix
(I - M B) are the (1 - bm), where m (resp. b) is any eigenvalue of M (resp.
B). Since the determinant of a matrix is equal to the product of its eigenvalues,
this shows that the second determinant of (6.1) is the product of the (1 - bin),
when m (resp. b) varies within the spectrum of M (resp. B).
The next step is to derive the sign of det OoZ(. . . . , Y). This is possible
because of the uniqueness assumption ( U D S E ) . Specifically, define the vector
field q~ on R" by q~(x) = Z(x, x); ~o points inward on the boundaries of a well
chosen domain. From uniqueness, then, the index of ~ at ~ must be ( - 1 ) n. By
straightforward computations:
Lemma 7.
Under (R), (BC) and (UDSE)
sign{det(OoZ(2 . . . . , 2 ) )
1~
(I-b)}=(-1)
n.
b(ES(B)
L e m m a 7 implies that
sign[det(00Z(Y, J?))]~
[]
(1-
b) k = (-1) ~ .
b~S(B)
Also, note that we can restrict ourselves to real eigenvalues; if either b or m

(or both) are complex, then 6 or rfi (or both) are also eigenvalues of the
matrices, and the product (1 - bm)(1 -/~rh) = I1 - bml z, being positive, does
not alter the sign of II(1 - bin). This, together with (6.1), is sufficient to prove
(ii).
Application 1: the one-dimensional case

This general result has a few interesting consequences. Consider, first, the case
when the state variable is one-dimensional. Then matrix B is the real number
b = -O1Z/OoZ, and the result becomes:
In the one-dimensional case

with b > 1, for any (k x k) Markov matrix M having an odd number of
eigenvalues below 1/b, there exist a SSE of cardinal k associated with M.
Corollary 5 [Chiappori and Guesnerie (1989b)].
If, in particular, we consider SSE of cardinal 2, associated with some Markov

matrix
1738
M =
1 - ml2
m12 1
m21
1 - m21 / '
we obtain:
Corollary 6 [Azariadis and Guesnerie (1982), Spear (1984)]. In the onedimensional case with b > 1, for any (2 2) Markov matrix M such that
m12 + m21 > 1 "q- 1/b, there exists a SSE of order 2 associated with M.
That is, if b > 1, a sufficient condition for any two-states extrinsic random
process to be associated with a SSE is that the states change between periods
with a high enough probability.
Application 2: cycles in the n-dimensional case
The Poincar6-Hopf method can also be used to detect cycles. We know from
the previous section that a cycle can be seen as particular sunspot equilibria,
associated with Markov matrices the elements of which are 0 or 1. Specifically,
a cycle of order 2 is associated with the matrix
the eigenvalues of which are 1 and - 1 . Let us now apply Proposition 4. The
two products that have to be compared are written as
P=
H
bESR(B)
( l - b ) 2 and
PM =
[J
(1-b2).
b~SR(B)
Note that P is always positive; the sufficient condition of Proposition 4 thus

states that PM is negative, i.e. that the number of real eigenvalues of B outside
( - 1 , 1) is odd. Formally:
Corollary 7 [Guesnerie (1986)]. Assume that the system has a steady state
satisfying the assumptions of Theorem 4. If the number of real eigenvalues of B
outside ( - 1 , 1) is odd, then there exists a cycle of order 2 in the economy.
Also, the condition upon the eigenvalues of B can be expressed in different
equivalent ways. For instance, it is equivalent to det(00Z + 01Z ) d e t ( a 0 Z ~ I Z ) < 0 (this was actually the original statement in Guesnerie (1986)).
Indeed,
1739
det(aoZ + O,Z) = det(OoZ ) det(I - B) = det(Oo Z )
[I
(1 - b),
I-[
(1 + b ) .
b~SR(B)
and, in the same way,

det(OoZ - O1Z ) = det(OoZ ) det(I + B) = det(OoZ )
b~SR(B)
Application 3: non-informative sunspots

An interesting question is whether the sunspot process that generates the
beliefs has to be "informative", in the sense that it exhibit some autocorrelation property (in which case the state today does bring information upon the
probability distribution of the state tomorrow), or whether a sequence of
independent variables could do as well. To answer the question, we need first
to introduce a new definition. We shall say that a stationary state has the
unique backward equilibrium (UBE) property if the following holds true: for
any x different from , Z(x, 2) is non-zero (i.e. should agents believe that the
future value will be with probability 1, then 2 is the only market-clearing
value today). Now, we have the following result.
Corollary 8 [Guesnerie (1986)]. Assume that the system has a steady state
satisfying assumptions ( CD ), (R ) and ( BC). In either of the following situations
(i) there are several stationary equilibria, each of them satisfies (UBE),
(ii) there is a unique stationary equilibrium, such that sign det(O0Z ) =
(--1) n+l,
any independent, identically distributed process with an even number of states

can be associated with a (non-informative) SSE.
The proof is as follows. An iid process with finite support of cardinal k can
be viewed as a degenerate Markov process, in which the (k x k) Markov
matrix has identical rows. In particular, the only eigenvalues of such a matrix
are one (multiplicity one) and zero (multiplicity k - 1). The two products of
Proposition 4 become
P=
Y[
b@SR(B)
(l-b) ~
and
PM =
[I
bESR(B)
(l-b).
If k is odd, the signs will always be identical. If k is even, P is positive, hence

SSE exist if PM is negative.
When does this occur? Note, first, that uniqueness of the steady state
provides some information; specifically, Lemma 4 above showed that
1740
sign{det(OoZ(2 . . . . . 2))
I-I
(I-b)}=(-1)".
b~S(B)
If the sign of det(O0Z ) is ( - 1 ) n+l, then P u must be negative; this shows (ii).
Conversely, if the steady state is not unique, then by Poincar4-Hopf theorem
there must be some steady state at which
sign{det(OoZ(2 . . . . .
2))
1-[
(I-b)}=(-1)
n+'
b~-S(B)
But the sign of (OoZ) at that steady state must be ( - 1 ) n, since otherwise
Poincar6-Hopf theorem applied to the field x~--~Z(x, 2) would contradict
(UBE). This, again, shows (i).
Hence, non-informative sunspot may well exist. It should be stressed,
however, that those which are detected by Poincar6-Hopf theorem are linked
with non-uniqueness, either of the stationary state [case (i)] or of the backward
equilibrium [case (ii)], (since the condition given in the latter case contradicts
(UBE)).
As a last application of differential topology to the sunspot literature, one
can mention the investigation, in Chiappori and Ouesnerie (1989b), of the links
between sunspots and cycles in the one-dimensional version of the general
framework. The paper generalizes the results by Azariadis and Guesnerie
mentioned above. In particular, it shows that, under general regularity conditions, whenever a 2-cycle exists in the economy, then there also (generically)
exist SSE of any order k in the neighborhood of the cycle. Also, using standard
transversality theorem, the paper shows that there are many more SSE of
order k + 1 than SSE of order k (SSE of cardinal k + 1 are generically of order
k + 1). Moreover, some SSE can be chosen to be arbitrarily close to k-cycles,
in the following sense: for any T and any e, there exists a SSE such that the
probability of observing, over T periods, a deviation from a purely cyclical
behavior is less than e.
We have thus seen that the "Poincar6-Hopf approach" characterizes a set of
matrices that can be associated with SSE; the characterization has to do with
the location of the real eigenvalues of the matrix (with respect to those of B).
Note that, in our setting with a unique steady state, the approach can never
detect SSE when the Markov matrix is identity. It follows that if the Poincar4Hopf technique does detect any SSE at all, then the Jacobian determinant
^k
Z~xZM(X,...
, 2) must be zero for some M E ~ (since it is continuous in M,
and changes sign over the compact, connected set d~k). In other words, the
success of the Poincar6-Hopf approach (in our setting) is linked with the
existence of a singularity (and actually a bifurcation) of the vector field Z^ k M at
1741
( . . . . . ). Though the Poincar6-Hopf technology detects global SSE (i.e.

SSE that are "far from" the stationary equilibrium), it can only do that in
models where local SSE exists as well, and the detected SSE are necessarily
"connected" with local SSE.
Lastly, it must be emphasized that the converse of the previous statement is
not true. Local sunspot equilibria may exist, still fail to be detected by the
Poincar6-Hopf approach. Technically, the index at ( . . . . , ) may be equal to
the index of the field even though ( , . . . , )
is not the unique zero. In
particular, sunspot equilibria are only detected here for real crossing (a real
eigenvalue of M must cross the inverse of a real eigenvalue of B). Nothing can
be said, from this approach, on complex crossing, since the sign of the Jacobian
determinant does not change, though, as we have seen before, (local) SSE
exist in this case as well.
6.2. Bifurcation theory

Bifurcation theory has been used in the previous section to demonstrate
Woodford's conjecture. We shall now present a second application, due to
Grandmont (1989). It is important to understand the differences between the
two approaches. In Section 5, the bifurcation occurred in the space of Markov
matrices. Specifically, the idea was to consider the economy (as defined by the
exess demands under uncertainty, ~k) as given, and to vary the Markov matrix
describing the extrinsic process within ~ for some integer k. In particular, we
~k
were thus concerned with the zeros of the vector field ZM,
when the parameter
M changes. In what follows, we shall consider a family of economiesspecifically, of excess demands under certainty- indexed by some parameter,
and study the bifurcation between a steady state and a periodic equilibrium
when the parameter is varied. Hence, the bifurcation occurs in the space of
economies. Such a bifurcation generates deterministic cycles for the economy;
we shall then show the existence of SSE in a neighborhood of such cycles.
Specifically, let us consider, within the one-dimensional framework (X C E),
a family of economies indexed by a real parameter A ~ ( - ~ , ~7) for some
(small) ~7> 0. Assume that for any A, the equation Z~(xo, x) = 0 can be written
x o = XA(x), where XA is a C 3 smooth mapping such that XA(0)= 0, X ' ( 0 ) > 1,
and the equation X~(x) = rx has at most one non-zero solution for any positive
r, exactly one solution ~ for r = 1. These assumptions are identical to those in
Section 3.2; again, they can be derived, in the O L G framework, from utility
maximization of a representative consumer with separable preferences. In what
follows, we assume X'~(x) < 1 for all h . 35
3Sin particular, uniqueness of the stationary equilibrium A implies that X'~(~) <~1.
1742
It has been shown in previous sections that the existence of sunspot

equilibria around the steady state should depend on the sign of 1 + X'A(~)Accordingly, we consider a family (X~) such that Xx is differentiable wrt A, with
X~(o) = - 1
and
~A (X'~(A))(O)<O"
Then the map ga undergoes a Flip bifurcation at A = O. The Schwarzian

derivative of XA is defined as
SxAx)-
3 ( x:(x)
2
whenever g'~(x) # O; we restrict ourselves to the (generic) case where SXo(o) #

O. The qualitative structure of the set of equilibria only depends on the sign of
Sx0(o). Specifically:
Proposition 6 [Grandmont (1989)].
For ~ small enough:

(1) I f SXo(Xo) < 0 (supercritical Flip bifurcation), then (i) if A <~O, there is no
S S E within a "small enough" neighborhood of x, (ii) ira > O, there is a unique
deterministic cycle o f period 2, with support {xla, x2a}, in a small enough
neighborhood of xA. Moreover, there are infinitely many SSE within such a
neighborhood, and the union of their supports is the whole interval (1~, 2A)(2) I f SXo(o) > 0 (subcritical Flip bifurcation), then ( i ) / f A < 0, there is, for
some (small) real u > 0 , a unique cycle of period 2 (with support {xlx, x2~})
within u o f the stationary state. Moreover, there are infinitely many finite SSE
within (~ - v, A + v), the union of their supports includes (1~, 2~). Also, if
(x 1, . . . , Xr) is such a support, then x I < 1A < x2~ < Xr" (ii) I f A >! 0, there is no
cycle close to the stationary state; however, there are infinitely many local SSE in
any neighborhood of ~ .
This result can be better understood considering the following diagrams.

Assume, first, that SXo(o)<0 (Figure 32.5). Then for A ~<0, the only (deterministic or stochastic) equilibrium is the stationary equilibrium ~ within a
small enough neighborhood of ~. At A = 0, the system bifurcates and a
deterministic 2-cycle appears (in addition to ~). SSE appear as well; their
support, however, must be within the convex hull of the support of the cycle.
The properties are quite different if Sgo(Xo)> 0. Then (Figure 32.6) SSE
exist in the vicinity of the stationary state before and after the bifurcation takes
-g
1743
__-
Figure 32.5
place. After the bifurcation, local SSE exist in every neighborhood of ~. But
this is not true before the bifurcation. In the latter case, the support of any SSE
must be "spread enough" to include the support of the 2-cycle within its
convex hull. Lastly, it is important to note that this characterization does not
depend on the particular model (i.e. function gx) under consideration. Although, this approach does not characterize the set of random processes for
which SSE may appear it gives a very detailed description of the location of the
support of possible SSE.
Figure 32.6
1744
7. Extensions
7.1. Intrinsic versus extrinsic uncertainty
Sunspot equilibria provide examples of self-fulfilling prophecies that are triggered by purely extrinsic signals. In this section, we shall argue that any
intrinsic signal can also trigger beliefs that have extrinsic-like effects. Then,
even in economies where extrinsic uncertainty is ignored, sunspot equilibria
have a multiplicity counterpart. The argument below relies on Woodford
(1986b), Manuelli and Peck (1988), Chiappori and Guesnerie (1989a) and
Spear (1989).
A continuity argument
Consider a simple stationary monetary economy, for example, the basic

one-dimensional OLG model discussed at the outset of Section 3.2; in this
economy, money supply is held constant at M = 109 French Francs (FF).
Assume that this economy has, in addition to its stationary (constant) equilibrium (corresponding to a stationary price fi), a stationary sunspot equilibrium;
i.e. there is a natural event a t which can take, say, two values, a and a (red
and white). Here, a t is purely extrinsic, and follows some given, timeindependent Markov chain. In the sunspot equilibrium, price is p*~ or p.2,
according to the occurrence of a m(red) or a 2 (white).
We shall now modify the previous story, and replace the extrinsic uncertainty
by some intrinsic randomness. Specifically, let us forget about the process (a,).
Instead, we introduce some "trembling hand" phenomena in this economy, by
assuming that the machine producing money is not fully reliable. It n e v e r
produces exactly 109FF; rather, at each period, it produces either 109FF plus
one centime, or 109FF minus one centime. Moreover, over- and underproduction are correlated in exactly the same way (i.e. with the same Markov
matrix) as red and white were.
In this new, "trembling hand" economy, what are the self-fulfilling theories?
There are at least two of them. The first is obtained from a "slight" departure
from the stationary (constant) equilibrium of the initial model. If the quantity
of money were held constant at M , then the stationary equilibrium would be
associated with a constant price ft. Now, if the quantity of money is "slightly
random" in the previous sense, there will be two equilibrium prices, fil =/~ +
and f i 2 = fi + ,, according to whether the machine over- or under-produces.
Intuitively, both and ' are "very small"; i.e. the new equilibrium is "close
to" the stationary equilibrium.
-
1745
But clearly this is not the only self-fulfilling theory. Indeed, the same
continuity intuition as above suggests the existence of a second, very different
equilibrium, in which over-production generates a price p l = p.1 + e", whereas
under-production generates a price p 2 = p . 2 + ~,,, (again, a" and E'" are
"small"; the "slight" randomness of the money stock only "slightly" perturbs
the initial sunspot equilibrium).
Let us compare the two theories just described. First, it must be stressed that
both relate prices to fundamentals of the economy (here, quantity of money) in
a purely deterministic way. In particular, no extrinsic signal of any kind
intervenes in either the first or the second theory. Second, the predictions
differ dramatically. Along the first theory, the imperfectness of the moneymachine has only negligible consequences on prices; in the second case,
however, it deeply modifies the equilibrium. The interpretation is clear. In the
first theory, money only influences equilibrium as a "fundamental" of the
economy. If, for instance, the system is homogenous, then only nominal prices,
and not real values, would change. In any case, since variations of M are
"small" so is the effect on the economy.
On the contrary, money supply in the second theory simultaneously fulfills
two roles: its "fundamental" role in the economic system, but also a beliefgenerating role. That is, over- (or under-) production acts as a signal, which
drives agents' expectations towards a neighborhood of p,1 (or p , 2 ) . Hence,
this extreme example shows how a minor alteration of policy variables can
generate major economic changes. Typically, agents may overreact to the new
policy, overreaction being explained by "sunspot-type" beliefs though, strictly
speaking, there are no "sunspots" in this economy.
Woodford (1986b), who considering (in a setting more complex than the
present o n e - see Section 7.3) how local SSE were deformed when small
intrinsic uncertainty was introduced, is an early example of formalization of the
continuity argument. Remaining in the framework of the present survey, let us
introduce some additional, intrinsic randomness; excess demand will thus
become
v,; t+l)
where (Y~) is an exogenous, intrinsic random process, and /x,+~ is now the
(conditional) joint distribution of (xt+l, Y,+ i). When (Y,) is held constant, this
model is equivalent to the previous one; assume that the latter has a stationary
steady state ~, as well as a stationary sunspot equilibrium of finite order,
x = (x 1, . . . , x~), governed by some Markov matrix M. It can be expected that,
under extended regularity assumptions, whenever (Y~) follows a Markov chain
with transition matrix M and "small enough" support, then the stochastic
1746
dynamics defined by
2(x,, Y,;/x,+,) = 0
(7.1)
has (at least) two stationary solutions. In one of them, the support of the
(stationary) process followed by (xt) belongs to a neighborhood of , whereas
it is included in a neighborhood of x in the other case. This second solution is
thus "sunspot connected", in the sense evoked before [a precise statement of
this fact when x, is one-dimensional can be found in Chiappori and Guesnerie
(1989a)1.
In a similar vein, Manuelli and Peck (1988) construct a sequence of
one-dimensional overlapping generations economies indexed by some integer j;
in each of them, initial endowments depend on some given random process, in
an economy-specific manner. The sequence is such that this intrinsic randomness "shrinks", the effect of the process becoming negligible as j tends to
infinity. They then show the existence of a corresponding sequence of rational
expectation equilibria (REE) with the following property: at the limit, uncertainty becomes purely extrinsic and the sequence of (REE) tends to a sunspot
equilibrium. Furthermore, though for j large enough, the share of intrinsic
uncertainty is negligible, still the qualitative properties of the fluctuations as
well as their order of magnitude remain comparable for all economies of the
sequence.
Intrinsic versus extrinsic: additional considerations

In the previous examples, uncertainty is intrinsic but exogenous, i.e. it has its
source in the randomness of some exogenously given fundamental. However,
endogenous variables may as well generate "sunspot like" fluctuations. Spear
(1989) gives the following example, showing that the distinction intrinsic/
extrinsic may be more ambiguous than is generally assumed. Consider, again,
the one-dimensional overlapping generation model with backward-bending
offer curve, and duplicate it; there are thus two identical islands. Let (e,) be an
extrinsic random process; we can then construct a sunspot equilibrium in each
island, in which price today, Pt (resp. qt for the second island) depends on price
yesterday, and on the sunspot
Pt =f(Pt-1, et)
and
q t = f ( q , - l , et).
(7.2)
Note that both islands consider the same extrinsic signal et; this, actually, is
the crucial ingredient of the result. Now, the previous relations can be locally
inverted:
1747
Et = tP(P,-a, Pt) = ~( qt-~, qt) .

Cross-replacing in (7.2), we obtain
Pt--- f(P,-~, q~(qt-,, qt)) = F(p,_~, q , - l , qt)
and similarly
q, = F( qt-1, Pt-1, P t ) "
Spear shows the existence of an invariant measure over (Pt, qt). Now, in the
"global" economy consisting of the reunion of the islands, we can forget about
the original process (Et). In some sense, each island's decision acts as a signal
for the others; note that this signal is intrinsic. Furthermore, by defining the
exchange rate to be e t ~ - p t / q t for all t, one can allow agents to trade across
islands; no trade will occur at equilibrium, hence the latter will not be
modified. Clearly, this trick can be extended when islands are different (though
they must still have SSE based upon the same extrinsic process).
In the framework where the heteroclinic solutions of Section 5.2 have been
considered, a variant with non-neutral money (government expenditures are
bounded) has been introduced, so that money is a truly intrinsic variable
[Chiappori and Guesnerie (1989a)]. Two classes of rational expectations
equilibria are exhibited. In one class, equilibria are "sunspot connected", in
the sense that they can be obtained by continuous deformation (in the space of
economies) from a "pure" sunspot equilibrium. In the other class, equilibria
are "non-sunspot connected"; they are related by continuous deformation to a
stationary constant equilibrium of the limit case (the latter having no intrinsic
randomness). An interesting point is that the qualitative features of REE in
both classes are essentially identical. Namely, in both classes all endogenous
variables follow a non-stationary, recurrent random process, the support of
which belongs to a heteroclinic orbit of a dynamical system. This result
indicates that, whenever uncertainty becomes intrinsic, it may be impossible to
distinguish between "sunspot" and "non-sunspot" kinds of behavior, since
both will share the same stochastic properties (here, they follow the same
process with stationary transition probabilities but no invariant measure). This
is an example of a system exhibiting a minimal degree of complexity, where the
selection of equilibria based upon such criteria as stationarity of the process,
minimum variances, or some imprecise notion of "simplicity" or "realism" will
be inoperative.
1748
7.2. Learning
The emphasis of the present survey is on existence questions. Until now, we

only have attempted to understand how large was the set of sunspot equilibria,
as defined in Section 3. But the beliefs which sustain a particular equilibrium
may be unequally likely to emerge. The study of existence should then be
complemented by studies intending to understand how economic agents may
learn a given equilibrium. This is a vast program that is far from being
completed. In particular, real learning activity is likely to combine "eductive"
learning, which relies on mental activities of economic agents intending to
understand the working of the system,36 and "evolutive" learning, which
assumes mechanical revisions of expectations which are generally ad hoc [the
words "eductive" and "evolutive" are taken in the sense of Binmore (1987)].
The remarks made in this section only concern "evolutive" learning. They
also restrict attention on systems in which the basic equation
Z(Pt,/x(Pt+l)) = 0
(7.3)
can be inverted as
pt = q~(/z(pt+l) ) .
(7.4)
~
def
when /x is a Dirac measure & ~o((Pt+l)) = ~(Pt+l) so that equation (5.4)

restricted to deterministic expectations becomes
p, = e(p,+l)
(7.5)
A number of existing studies on learning within this framework have

concerned pure periodic equilibria. They are however relevant for our purpose, since periodic equilibria can be viewed as degenerate sunspot equilibria
and we will review them briefly.
The line of research initiated by Grandmont (1985a) and further developed
by Grandmont and Laroque (1986, 1987) considers learning processes of the
following type:
e
Pt+l = W ( P , - I , ' "
, Pt-r),
(7.6)
i.e. expectations for tomorrow are deterministic and depend upon past realizations up to T periods in the past.
36See footnote 1.
1749
The learning rule under consideration can lead to a periodic equilibrium only
if it predicts the continuation of the periodic equilibrium once it has occurred
in the last periods.
Formally W detects period k if for every k periodic sequence (p~},
W(P,-1,...,
Pt-T) = Pt+l-k"
Naturally, a steady state will be "detected" by the learning function F if

F ( p , p, p . . . . ) = p. Also if F detects period k, k ~>2, it detects period k',
where k' divide k and it "detects" the steady state (which is like detecting
period 1).
Assume now that the system has a deterministic steady state fi such that
= ~(/~).
Under some technical conditions concerning the derivatives at the steady
states, Grandmont and Laroque (1986) have shown that if the dynamics
generated by the learning rule W is locally stable (i.e. if it converges to a
periodic equilibrium of period k, k i> 1, when starting from a neighborhood of
it) and if the learning rule detects cycles of order 2k, then the perfect foresight
dynamics is not converging (Theorem 1).
In other words, in the context of the theorem a necessary condition for the
local stability of the learning procedure is that the periodic equilibrium is
determinate.
This result confirms in a setting of some generality an elementary intuition
on learning convergence. Take a one-dimensional system in which the steady
state is indeterminate. Then in the perfect foresight dynamics, Pt+ 1 is closer to
,6 than Pt is, but this means that a discrepancy between the expectation for
tomorrow and the steady state value is "amplified" in the price today, and this
clearly suggests that the learning rule will be unstable.
Grandmont and Laroque (1987) consider a more complex model with
predetermined variables. Again, they identify circumstances under which
stability of a stationary state in the learning dynamics implies its instability in
the perfect foresight dynamics. They obtain more precise results when the
perfect foresight dynamics is of dimension two (with one predetermined
variable).
Guesnerie and Woodford (1989) have considered adaptive learning rules
acting in the one-dimensional version of the model. Adaptive learning rules
"detecting period k" have the following form:
p~,+, = ap,+m_ ~ + (1 - a)p~+,_ k .
(7.7)
Price expectations as formulated k periods before, are revised and the
1750
revision is proportional to the discrepancy between realizations and expectations. Although these learning rules are clearly more specific than the general
learning rules of Grandmont and Laroque, they have not the finite memory
property and then are not special cases of the preceding ones.
Taking advantage of this more specific structure, Guesnerie and Woodford
(1989) have established necessary and sufficient conditions for local stability of
the learning procedure. These necessary and sufficient conditions indicate how
learning stability varies with a. With respect to previous findings, the following
points can be stressed:
A necessary condition for local stability of the adaptive learning rule
concerns the sign of the Poincar6-Hopf index of the k period cycle defined
along the lines of Section 6.1 (but for a cycle matrix as sunspot matrix). It
follows that if the Poincar6-Hopf method detects cycles, then the steady
state is not locally stable for the learning procedure with k period adaptive
learning rule.
A sufficient condition, Va, for the local stability of the learning rule is that
the periodic orbit is determinate, i.e. that there does not exist perfect
foresight sequences converging to it.
Woodford (1990) considers the simple O L G model of Section 1.3. Agents
use adaptive learning rules which provide, at each period, estimates of the
agent's optimal labor supply. The estimate is revised according to a "stochastic
approximation" algorithm which takes into account the new information on
past returns available at each period. This algorithm is not directly comparable
to previous algorithms (the revision of forecast associated with the revision of
action that it induces is not made explicit) but allows the application of results
due to Ljung, relating the convergence of the learning procedure with the
convergence of a well chosen associated system of ordinary differential equations. Let us summarize the main results obtained in this study.
If the possibility of correlation between an exogenous sunspot phenomenon
and the rates of return on labor were not envisaged- a case in which the
learning procedure would clearly be unable to discover sunspots- then the
learning dynamics would converge with probability one to the deterministic
(monetary) steady state. However, when the potential influence of sunspot
variable is not a priori ruled out then the learning dynamics may well converge
(locally or globally) to one of the sunspot equilibria. For example, when
sunspot equilibria of order 2 are detected by the Poincar6-Hopf method, the
learning dynamics converges with probability one to sunspot beliefs. In any
case, at least one sunspot equilibrium of order 2 (if any) is locally stable. Also,
the learning dynamics associated with sunspot beliefs of order k (k > 2) cannot
converge to an indeterminate monetary steady state.
Naturally, the above results are subject to different interpretations [see for
1751
example Evans (1989) for an argument on to the "fragility of sunspots"37].

However the previous results, whether they consider cycles of sunspot, clearly
give credit to the idea that the equilibrium selected by reasonable learning
rules is not necessarily- even in the simple model under consideration- the
steady state equilibrium.
7.3. Models with memory

A more comprehensive framework than the one that has been considered so
far would allow excess demand to depend also on history; for instance, in the
simplest case, on the value of state variables last period. Formally, the
stochastic dynamics is then characterized by some equation of the form
(7.8)
2(x,_~, xt, gt+l) = O.

Similarly, the deterministic dynamics becomes
(7.9)
Z ( x , _ l , x,, x,+~) = O,
and a steady state 2 is now defined by Z(2, 2, 2) = 0.38

Clearly, this formalization encompasses a wider range of economic models
than the one we have considered so far. For example, the general n-dimensional version of the overlapping generations model (with non-separable preferences) belongs to this class. The price to pay for this increase in coverage,
however, is a clear drop in the stock of existing results. The only clear-cut
conclusion that has been established so far is a generalization of Woodford's
conjecture. This is essentially an existence result that emphasizes the links
between existence of local sunspot equilibria, on the one hand, and indeter37Evans uses a criterion of independent interest called E-stability (weak or strong). With this
criterion, it may well be the case that all equilibria, and not only sunspot equilibria, are fragile.
Recent literature on learning, in settings similar to the present one, include Laffond and Lesourne
(1990), Evans and Honkapohja (1990).
38The regularity assumption (R) has to be adapted to the new framework. Basically, the
following assumptions would be needed (with straightforward notations). (i) Matrix O jZ(Y) is
invertible; hence, we can define B ' = - ( O _ l Z ) - l ( O o Z) and B"=-(O_IZ)-I(o1Z). (ii) Matrix
B =
is diagonalizable, and has no eigenvalue of modulus one; hence, there exists some
0)
matrix P such that B = P-1DP, where D =

D" ; D ' and D" are diagonal, and the s diagonal
elements of D ' (resp. the 2n - s diagonal elements of D") are of modulus greater than one (resp.
/ Poo Pol
smaller than one). (iii) When P is written under the form P = ~Plo
P l l ) ' where Poo and Pol (resp.
P~o and P ~ ) are s x n (resp. (n - s) n) matrices, then submatrix Pll is of full rank.
1752
minacy of the deterministic dynamics around the steady state, on the other
hand.
T h e main specificity of the m e m o r y case is the role played by initial
conditions. Assume the dynamics begins at date 0; then (7.8) and (7.9) include
a term x_l that is e x o g e n o u s l y g i v e n (and reflects the influence of past history
of the system39)~ This fact has the following consequence. The tangent
deterministic dynamics are characterized by
\'~t+l/
X t
'
where matrix B has been defined in footnote 28. As previously, perfect

foresight paths ( x t ) will converge to the steady state if and only if the vector
( xtxt / always belongs to the stable subspace generated by the eigenvectors of
B associated with eigenvalues outside the unit disk (or, in the non-linear case,
to the corresponding stable manifold). The problem, however, is that this
condition must be fulfilled at date 0 as well. This raises the question whether
x 1
onecanfind,
foranygivenx
l, a n x o s u c h t h a t t h e v e c t o r ( x o ) b e l o n g s t o t h e
stable subspace. The answer obviously depends on the dimension s of the

subspace. Specifically, under regularity conditions (see footnote 38), three
cases must be distinguished:
(i) s < n: then for almost all x l, n o such x 0 can be found;
(ii) s = n: for any X_x, there exist exactly o n e such x0;
(iii) s > n: for any x_l, there exists a c o n t i n u u m of such x 0.
Since non-linear dynamics are locally governed by the tangent linear system,
these conclusions are relevent to the determinacy properties of a steady state in
the non-linear system [for related studies, see K e h o e and Levine (1985)]; also,
as previously, they have a counterpart for the linear version of (7.8) 4o
[Blanchard and Kahn (1980)]. Specifically, in case (i), for almost all x_ 1 there
exist no perfect foresight path converging to the steady state, and the stochastic
linear system has no non-explosive solution. In case (ii), the deterministic
model (resp. the linear stochastic model) has a unique converging (resp.
non-explosive) solution. Lastly, in case (iii), the steady state is indeterminate
for the deterministic dynamics, and the stochastic linear model has a continuum of sunspot solutions.
39A standard interpretation is that, prior to t = 0, the economy was following a process of the
same kind (possibly with a different mapping Z). Then a permanent shock occurred, generating a
new excess demand, and, as a consequence, a new dynamical system.
4Then Z becomes Z(xt_l, xt,/xt+l) = Ax,_ 1 + A'x, + Sx A"xlz,+l dx (for notational convenience,
we take =0). Here, B' = - A - I A ' and B"= - A - 1 A ".
1753
The general case

Just as in the initial framework, the conclusions obtained above can be
extended to the local analysis of the general, non-linear dynamics around a
steady state. A result of this kind has been formally established by Woodford
(1986b). 41
Specifically, the basic ingredients of the result (which have already been
described in Section 3) are the following. Consider a random process (ut), and
define u ~= (u~, u,_ 1. . . . ); i.e. u ~is the (infinite) history of the process at date t.
The process is stationary, in the sense that the set of possible histories is
endowed with an invariant measure. Moreover, the stochastic excess demand
must have general differentiability (specifically, it must have Frechet derivatives in all its arguments) and measurability properties. Lastly, the deterministic excess demand Z is required to fulfill a regularity condition that is
essentially similar to that of the linear case (see footnote 38). Now, a sunspot
equilibrium is defined as a mapping from the set of possible histories of the
process to the set of state variables; i.e. let us put x, = ~(u') for all t (we shall
say that the corresponding SE is based upon the process (u,)). Note that,
whatever the (non-Dirac) probability distribution of the process, the set of
histories is infinite; hence, we do not exclude (and, in fact, we essentially
consider) sunspots with infinite support. Also, the autocorrelation structure of
the (xt) process may be quite complex (it depends on the structure of (u~) and
on the mapping q~).
The idea, at this point, is to consider the sunspot e~luation Z ( . ) = 0 as an
equation in q~, and to investigate whether the solution defined by q~(u~) =
for all u t is locally unique. The technique that has been described in the
alternative proof of Theorem 3 (see Section 4.2) applies to this more general
setting as well.
The following result obtains generically.
Theorem 5 [Woodford (1986b)]. For any given, stationary random process
(ut), stationary sunspot equilibria based upon (ut) exist in any neighborhood of
the steady state if and only if the following equivalent conditions are fulfilled:
(i) the steady state is indeterminate for the deterministic dynamics
(ii) matrix B has at least n + 1 eigenvalues outside the unit disk.
Examples of models that do exhibit indeterminacy of perfect foresight
equilibria and then can be shown (using Theorem 5) to have local SSE include
the O L G (or O L G like) models with capital accumulation of Farmer (1986),
Reichlin (1986) and Woodford (1986a).
41In Woodford's f r a m e w o r k , excess d e m a n d at date t also d e p e n d s on the expectations
formulated at date t - 1 upon state variable at date t.
1754
A complete discussion of models with memory is out of the scope of the

present survey. We should however mention that the invariant compact
argument of Section 3 should have a counterpart in this setting as well.
Statements using the invariance ideas can be found in Woodford (1986a), Spear
(1988) and Spear, Srivastava and Woodford (1990). In fact, the n-dimensional
O L G model with non-separable utilities of Spear, Srivastava and Woodford
(1990) considers small intrinsic uncertainty, but their argument can be viewed
(at least for the present purpose) as a combination of an invariant compact
argument and a continuity argument of the kind evoked in Subsection 7.1.
Also, some extension of the connection between sunspots and cycles may be
conjectured in this new setting [for study of cycles, see Farmer (1986) and
Reichlin (1986)]. However the nature of the counterpart, for models with
memory or predetermined variables, of the methods and results presented in
Sections 5, 6 and 7.2 is a question largely open to future research.
Appendix: Some examples of the general model

A number of specifications of the abstract model under consideration have
been studied in the economic literature. We now attempt to give an overview
of the existing models that fit the framework as well as of the economic
questions that have motivated these models [(see also Chiappori and Guesnerie
(1988), Guesnerie (1989a)].
Example 1.
Many versions of the popular overlapping generations models

(OLG) that have been studied after Samuelson (1958) and Gale (1973) do fit
the framework. In fact the study of the O L G model played a leading role in the
development of the sunspot literature. We have presented the simplest case
(one-dimensional, no government expenditure, representative consumer with
separable preferences) in the introductory example of Section 1.3. In this
framework, excess demand was
M Y(\ p cP'+ l )/
Z(Pc, Pc+l) = p--~-
(A.1)
Perfect foresight equilibria must verify

Vt,
- - M - Y ( Pt / = 0 .
Pc
\Pt+l /
(A.2)
The state variable can equivalently be taken to be the price, as above, or the
labor supply Yt; since equilibrium implies y, = M/p,+l , (A.2) can be written
1755
The exact form of the deterministic dynamics depends on function Y. Two

cases are presented in Figures 32.7 and 32.8; for the sake of convenience, we
have taken M = 1, Y(0) = 0, Y(x) > 0 if x > 0 and limx__,~ Y(x) = y~. In
Figure 32.7, Y is monotonic, while it is backward bending (for large values of
Pt/P,+I) in Figure 32.8.
If we assume Y(1) > 0 ("Samuelson case"), a stationary equilibrium obtains
for ~ = Y(1),/~ = M/Y(1). A second, degenerate stationary equilibrium may
obtain for infinite prices and zero production (autarky); note that the former
Pareto dominates the latter. Also, in this simple setting, the Pareto efficient
steady state is indeterminate if and only if the slope of the tangent at/~ is less
than one in absolute value; this can only occur if the curve is "enough
backward bending", as in Figure 32.8 (or, analytically, if the elasticity of labor
supply at the steady state is smaller than - 1 / 2 ) .
Yt+l
y
Figure 32.7
yt
1756
Yt+l
Yt
Figure 32.8
Example 2. This basic model can be complexified in a number of ways.
(a) The model is easilyffnodified by introducing heterogenous agents within
each generation; Z and Z then incorporate aggregate rather than individual
labor supplies. Also the introduction of government expenditures leads to a
richer setting. When the real expenditures g are financed from money creation,
the basic feasibility constraint becomes ct+ 1 Yt+l -- g (instead of ct+ 1 = Y t + l )
and the model has two steady states (cf. Figure 32.9), one at a low activity level
(the inflationary steady state) and the other with a high activity level [cf.
Sargent (1986)]. But government expenditures can also be financed through a
mix of fiscal (lump sum taxes) and monetary policies. The basic equation is
more complex [see for example Grandmont (1986)] but still fit our framework
[see Chiappori and Guesnerie (1989a)].
(b) Woodford (1986) has convincingly argued that the behavior of infinitely
lived agents subject to a cash in advance constraint, and constrained on
borrowing mimics the behavior of two period lived agents: if their utility
function is Et= 1 y t - l [ U ( c , ) - V ( y t ) ] and if they are constrained by Pt+lCt+l =
M~+ 1 and M~+1 = M t - P t C t - Yt, it can be easily shown that an equilibrium is a
stochastic process for the state variable that satisfies
=
v(yt) = 7E,(u(y,+O)
f u(x) = x U ' ( x ) ,
xV'(x).
where Iv(x) =
(A.4)
Ch. 32: Sunspot equilibria in sequentialmarket models
1757
Yt +1
yt
Figure 32.9
This obtains as a particular case of the abstract formulation with
Z(y,,
tZt+l)=yt
u-l[') / f
u(y) dl~t+l(y)].
(A.5)
Note however that in this interpretation of the basic equation, the period
length is not half life but a much shorter period, namely the average time
between the moment where the wages are paid and the moment the consumption goods are bought.
In fact, more complex models incorporating cash in advance constraints are
likely to retain some of the characteristics of the simple OLG model. For
example, Lucas and Stokey (1987) have studied an economy in which the
cash-in-advance constraint only applies to some commodities ("cash" goods as
opposed to "credit" goods). In spite of the presence of interest bearing assets,
the model has a reduced form which fits the one-dimensional version of our
abstract model [see Woodford (1988c) for a study of sunspot equilibria with
such a reduced form]. Similarly, models in which agents use money, for
precautionary motives, because they will be constrained on future borrowings
are in many cases very similar to the OLG model (see Bew[ey (1980) and
subsequent literature).
1758
Monetary models of different inspiration (for example the models of Sidrauski-Broek variety studied by Matsuyama) may have reduced form which fit
the one-dimensional restriction of the present formulation [see Matsuyama
(1989a) for the derivation of such a reduced form and the study of sunspot
equilibria and dynamical properties of these models].
Also, Aiyagari (1986) emphasizes a stock exchange interpretation of the
basic equation in the O L G model that provides a pedagogical illustration of the
results of Azariadis (1981b) and Azariadis and Guesnerie (1982).
Example 3.
The n-commodity version of the OLG model with separable

utility which has been extensively studied in the literature [see Balasko and
Shell (1981)] also fits the present formulation. The same would be true of the
n-commodity, separable version of most of the models sketched above. Also
models of international finance, which describe the interactions of interest rates
and exchange rates across countries, generally assume that (the vector of)
present rates depend upon (the vector of) expected rates as in our model [for
an example of such a model in a complete general equilibrium framework see
Manuelli and Peck (1986)]. The recent model of Kyotaki and Wright (1990), in
which different goods can serve as monies (both as a means of exchange and as
reserve of value) is another example fitting our formulation.
Example 4.
A last family of models fitting the one-dimensional version of our

framework explore the consequences of the relaxation of some standard first
best hypothesis [as in Woodford's model (1986a)]. A selection of other
examples in this vein, all leading to one-dimensional difference equations of
the form (2.4), include the multiplier-accelerator model of business cycle of
Woodford (1988b), (capital today depends on the expectation of capital
tomorrow which determines aggregate demand), and the growth model of
Hammour (1988) with capital externalities.
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Chapter 33
UTILITY THEORY
WITH UNCERTAINTY
EDI KARNI a and DAVID SCHMEIDLER b*
~Johns Hopkins University and

bTel Aviv University and Ohio State University
Contents
Part 1: Introduction
1. Decision making under risk and under uncertainty
1.1.
1.2.
1.3.
The problem defined

The analytical framework
The main results
Part 2: Utility theory with risk

2. Expected utility theory
2.1.
2.2.
2.3.
2.4.
2.5.
2.6.
2.7.
3.
4.
Preliminaries
Archimedean axiom
Independence axiom
Theorem (yon Neumann-Morgenstern)
Remarks
Integral representation
Bibliographical notes
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1767
1768
1768
1768
1769
1769
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1770
1770
1771
Non-expected utility theories
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3.1,
3.2.
3.3.
3.4.
3.5.
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1772
1773
1777
1781
Motivation
Functional representation of preference relations on lotteries
Utility theories with the betweenness property
Expected utility with rank-dependent probabilities
Local expected utility analysis
Dynamic consistency
4.1.
4.2.
4.3.
The problem defined

Atemporal sequential choice
Temporal sequential choice
1786
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1787
1790
*We benefited from comments of participants in BoWo'89. We also benefited from comments on
an earlier draft by Larry Epstein, Itzhak Gilboa, Karl Vind and Peter Wakker. Support from
Deutsche Forschungsgemeinschaft, Gottfried-Wilhelm-Leibniz-F6rderpreis is gratefully acknowledged.

P a r t 3: U t i l i t y t h e o r y with u n c e r t a i n t y
5. E x p e c t e d utility t h e o r y with s u b j e c t i v e p r o b a b i l i t i e s
5.1. Preliminaries
5.2, Savage's axioms
5.3. Theorem (Savage)
5.4. The Anscombe-Aumann approach
5.5. Topologically connected space of consequences
5.6. State dependent preferences
6. E x p e c t e d utility with n o n - a d d i t i v e s u b j e c t i v e p r o b a b i l i t i e s
6.1. Motivation
6.2. Expected utility with non-additive probabilities
6.3. Uncertainty aversion and the maximin criterion
6.4. Purely subjective non-additive probabilities
6.5. Comonotonic independence and topologically connected space of
consequences
6.6. Reduction of uncertainty to risk
P a r t 4:
7. T h e
7.1.
7.2.
7.3.
7.4.
7.5.
A t t i t u d e s t o w a r d risk
t h e o r y o f risk a v e r s i o n
The need for measures
Preliminaries
The Arrow-Pratt theory of risk aversion
Aversion to one risk in the presence of others
Multivariate risk aversion and risk aversion with state-dependent
preferences
7.6. Risk aversion with non-linear preferences
References
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1800
1802
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1817
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Ch. 33: Utility Theory with Uncertainty
1765
To do justice to the subject of utility theory with uncertainty would require

an entire handbook. Because of the space limitations of the present survey we
confine the presentation to a few selected topics. Over the years several
excellent expositions of the theory of decision making under uncertaintyparticularly Savage (1954, Chapters 1-5), Luce and Raiffa (1957, Chapter 2),
Fishburn (1970) and Dreze (1974, introductory remarks)- appeared.
More recent developments are discussed in Fishburn (1988), Wakker (1989a)
and Machina (1987). Arrow (1951) gives an interesting glimpse into the state
of the art in the early 1950s. Reading the recent surveys in conjunction with
Arrow's exposition highlights the dramatic transformation of the field in the
aftermath of Savage's fundamental work on expected utility theory. The
present survey provides an exposition of expected utility theory and the
theories that have emerged from departures from the sure-thing principle in
the theory of decision making under uncertainty and the independence axiom
in the theory of decision making under risk.
Part 1:
Introduction
I. Decision making under risk and under uncertainty
1.1. The problem defined

Utility theory with uncertainty describes a class of models designed to formalize the manner in which a decision maker chooses among alternative courses of
action when the consequences of each course of action are not known at the
time the choice is made. The distinguishing characteristic of the subject matter
is that each course of action results in one of several consequences.
1.2. The analytical framework

The problem is conveniently formalized with the use of the notions of
consequences, states of nature and acts. The first primitive of the theory is a
non-empty set of consequences, denoted by C. The empirical counterpart of a
consequence may be anything that has to do with the welfare of the decision
maker. The second primitive of the theory is a non-empty set of feasible acts,
denoted by A 0, whose elements are courses of action from which the decision
maker may choose. To every act in A 0 there corresponds a subset of consequences in C. A choice of an act results ultimately in a unique consequence
1766
E. Karni and D. Schmeidler
in the respective subset. H o w e v e r , which particular consequence will result is

not k n o w n (i.e. is uncertain) to the decision m a k e r prior to choosing his act.
A state o f nature is, by definition, a function that assigns to every feasible act
a consequence from the subset of consequences corresponding to this act. The
set of all states of nature (heretofore, states) is denoted by S. Clearly, in this
formulation knowledge of the state resolves the uncertainty. By definition acts
are functions from the set of states to the set of consequences. Thus, in
addition to feasible acts, the set of all acts, denoted by A, includes all
conceivable acts. In practice, the distinction between feasible and conceivable
acts is not always crucial, and in m a n y applications the sets S and C are taken
as primitive. Decision problems in which the set of states is a singleton, or in
which all acts are constant acts, and the set of consequences consists of
probability measures or lotteries on a set of outcomes are referred to as
decisions under risk; if the set of acts includes non-constant acts they are
decisions under uncertainty.
Given the primitives of the theory, a complete and transitive binary relation
on the set of consequences is a natural ingredient necessary to guide the
decision m a k e r ' s choices a m o n g acts. In the theory of choice under certainty
there is a one-to-one correspondence between acts and consequences. Therefore, a complete and transitive binary relation on the set of consequences is
necessary and sufficient to guide the decision m a k e r ' s choice a m o n g acts. In the
case of decision making under uncertainty, it is assumed that the choices are
governed by a binary relation on acts. This preference relation presumably
involves an evaluation of the consequences corresponding to each act and an
assessment of the likely realization of these consequences.
1.2.1. Definition. A preference relation is a binary relation, _~, on A that is (i)
complete, i.e. for all a, b E A either a -~ b or b ~- a, and (ii) transitive, i.e. for
all a, b, c, in A, a >- b and b -~ c imply a -~ c.
For a, b E A , t h e a s y m m e t r i c part of a preference relation, _>, is defined by
a > b if and only if a -> b and not b -> a; the symmetric part, - , is defined by
a -~ b and b ~- a. For a and b in A, a _> b has the interpretation that a is weakly
preferred (i.e. preferred or indifferent) to b, a - b means that a is indifferent
to b, and a > b means that a is strictly preferred over b.
Implicit in the preference relation on acts is a preference relation on the
underlying set of consequences. The latter is induced by the f o r m e r through
the restriction of the preference relation on acts to constant acts, namely, acts
that assign the same consequence to each state.
1.2.2. Definition. A real-valued function V on A represents ~- if for all a,
b E A, a -~ b if and only if V(a) >- V(b).
1767
As we have defined it, decision making under risk is a special case of the
theory of decision making under uncertainty. However, if we regard the set of
outcomes as a primitive and the lotteries as acts, then the theory of decision
making under risk is analogous to the theory of decision making under
uncertainty.
1.3. The main results
The modern theory of utility with uncertainty stems from two main results: the
von Neumann and Morgenstern (1944) expected utility theory with risk and
Savage's (1954) expected utility theory with uncertainty.
The essence of the von Neumann-Morgenstern theory is a set of restrictions
imposed on the preference relations over lotteries that allows their representation by the mathematical expectation of a real function on the set of outcomes.
This function is known as the von Neumann-Morgenstern utility function. A
main aspect of the theory is the specific functional form of the representation,
namely, the linearity in the probabilities. This feature is a direct consequence
of the restriction of the preference relation known as the independence axiom
(for details, see Section 2.3).
Savage's theory of decision making under uncertainty imposes restrictions on
the preference relations on acts that permit the representation of each preference relation as the mathematical expectation of a real function on the set of
outcomes with respect to a unique probability measure on the set of states. As
in the von Neumann-Morgenstern theory, an essential aspect of Savage's
theory is the linearity of the preference functional. However, unlike the von
Neumann-Morgenstern theory, in Savage's theory the existence of the probabilities is established jointly with that of the utility function. The specific
restriction on the preference relations that is directly responsible for the
specific form of the representation functional is the sure thing principle (for
details, see Section 5.2.2).
Before we discuss the meaning of these results it is worth noting that the
development of the von Neumann-Morgenstern theory is motivated by the use
of mixed strategies in von Neumann's solution to two person zero-sum games.
The use of mixed strategies presented the players with the choice among
lotteries over the outcomes. In this context the probabilities are obtained as an
implication of the use of mixed strategies. The interest in this theory for the
analysis of decision making in general, however, is largely due to Savage's
theory, which shows that problems of decision making under uncertainty are
reducible to, and may be formulated as, problems of decision making under
risk.
The common feature of the two theories described above is that in both the
representation functional is the sum of products of utilities and probabilities of
outcomes. The interest in the separation of utilities from probabilities stems
1768
from the presumption that the utilities are unalterable data of the decision
problem while the probabilities represent beliefs and vary with the information
available to the decision maker.
This view was challenged by Allais (1953). Subsequent experimental evidence suggesting that decision makers systematically violate the separability
assumptions revived interest in theories of decision making under risk that
depart from the independence axiom, and in theories of decision making under
uncertainty that depart from the sure thing principle.
In the present survey we review the theories of yon Neumann-Morgenstern
and Savage and trace the more recent developments along the lines described
above. Limitation of space prevents us from dealing with theoretical developments, also motivated in part by experimental evidence, that depart from the
transitivity or the completeness axiom. We have tried to present what seems to
us the central conceptual developments of the last decade, in each case
illustrating the main ideas with one or two concrete results.
The survey is organized as follows: in Sections 2, 3 and 4 we deal with the
representation of preferences under risk. In Sections 5 and 6 we deal with the
representation of preferences under uncertainty. In Section 7 we deal with the
issue of measurement of decision makers' attitudes towards risk.
Part 2: Utility theory with risk

2. Expected utility theory
2.1. Preliminaries
In the case of decisions under risk, i.e. when the set of states is a singleton, it is
analytically convenient to suppress the set of states by identifying the acts with
the corresponding lotteries and defining the preference relations directly on C.
In this case C is taken to be a convex subset of a linear space. A special case of
particular importance is when C is a probability space over an arbitrary
non-empty set of prizes or outcomes. Let X denote this set and let P be the set
of probability measures on an algebra on X, i.e. on a non-empty collection of
subsets of X that is closed under unions and complements. Let A(X) be the set
of all simple probability measures on the algebra of all subsets of X. (A
probability measure p is simple if, for some finite subset, E C X, p ( E ) -- 1). We
denote by 6x the element of P that assigns the unit mass to x E X . By
identifying C with P and defining the preference relation on P we implicitly
assume that all random variables taking values in X that have the same
probability distribution are indistinguishable insofar as the preference relations
are concerned. This assumption implies that the preference relations are
independent of the events of the sample space underlying the set of random
1769
variables in X, and that they are insensitive to changes in consequences over

events of probability measure zero.
Let p, q E P, since P is a convex subset of the linear space of measures on X,
the mixed lottery ap + ( 1 - a)q, is a lottery in P yielding the consequence
x E X with probability ap(x) + (1 - a)q(x). To assess the behavioral meaning
of the mixture operation, however, it is customary to interpret it as a
compound lottery. According to this interpretation, ap + (1 - a)q is regarded
as a two-stage lottery that selects the lotteries p and q with the respective
probabilities a and (1 - a ) in the first stage, and selects a consequence x in the
second stage by the lottery that was selected in the first stage. In this
interpretation, if the preference relations were defined on compound lotteries
in which the different stages were stochastically independent, they would not
distinguish between the one-stage lottery aflp + ( 1 - afl)q and the two-stage
lottery [3[ap + (1 - a)q] + (1 - / 3 ) q . The assumption that these two lotteries
are indifferent is known as the axiom of reduction of compound lotteries [see
Luce and Raiffa (1957)]. This axiom is implicit in our definition of preference
relations on P, or, more generally, on C.
2.2. Archimedean axiom

For all p, q, r E C, if p > q and q > r then there exist a , / 3 E (0, 1) such that
ap + (1 - a)r > q and q > tip + (1 - fl)r.
This is the weakest continuity assumption. It requires no topology on the set
C.
2.3. Independence axiom

For all p, q and r E C and all a E [0, 1], if p >- q, then ap + ( 1 - a)r>- aq +
(1 - a ) r .
The normative appeal of the axiom becomes clear if ap + ( 1 - a)q is

interpreted as a two-stage lottery. In this interpretation, a decision maker
facing a choice between the two mixed lotteries in the axiom figures that if the
event that has a probability of (1 - a) is realized, then he is awarded the same
prize (i.e. the lottery r) regardless of his choice. If the complementary event is
realized, since he prefers p over q, he is better off with the mixed lottery that
awards him p than the one that awards him q.
2.4. Theorem (yon Neumann-Morgenstern)

Let C be a convex subset of a linear space and >- a binary relation on C. The
following two conditions are equivalent:
1770
(i) -> is a preference relation (i.e. complete and transitive) satisfying the
Archimedean (2.2) and independence (2.3) axioms.
(ii) There exists a function U : C---~ such that U represents >_ on C, and U
is affine, i.e. U ( a p + (1 - a ) q ) = a U ( p ) + (1 - a ) U ( q ) .
Furthermore, (a) V : C---~ ~ is affine and represents ~_ on C if and only if
there are numbers [3 > O, and y such that for all p E C, V ( p ) = [3 U ( p ) + 7. (b)
I f C in the hypothesis is replaced by A ( X ) and, for all x E X, u(x) =- U(6x) then
(i) is equivalent to U ( p ) = Exe x u(x)p(x) for all p E A ( X ) , and u is unique up
to a positive affine transformation.
2.5. Remarks
Theorem 2.4 is the most common version of the von Neumann-Morgenstern
expected utility theorem. The function U in (ii) is usually referred to as the von
Neumann-Morgenstern Utility. Note, however, the von Neumann-Morgenstern (1944) expected utility theorem differs from this version in several
respects. First, instead of C, yon Neumann and Morgenstern speak of abstract
utilities that correspond in our model to the equivalence classes of the
preference relation. Second, they do not state the independence axiom explicitly. Variants of this axiom were formulated by Marschak (1950) and Samuelson
(1952) and shown by Malinvaud (1952) to be implicit in the von N e u m a n n Morgenstern theory. Third, instead of the operation of convex combination in
the linear space, von Neumann and Morgenstern introduce an abstract mixture
operation that satisfies almost all the conditions of mixture sets as presented in
Herstein and Milnor (1953).
A minor variant of Theorem 2.4 has been proved by Herstein and Milnor
(1953) for the more general framework in which the set of consequences is a
mixture set. In their version, the independence axiom (2.3) is replaced by the
weaker condition: if p, q E C and p -- q, then for any r E C, 0.5p + 0.5r
0.5q + 0.5r, and the Archimedean axiom is strengthened as follows.
2.5.1. Mixture continuity. For all p, q, r E C, the sets ( a E [0, l] [ a p + (1 a ) q ~-- r) and ( a E [0, 1] ] r ~- a p + (1 - a ) q ) are closed.
Theorem 2.4 as stated here (even for the more general case of mixture sets)
is stated in Fishburn (1970). However, the proof there is indirect and therefore
long. A shorter proof, based on the proof of the Herstein and Milnor (1953)
variant, can be easily be obtained.
2.6. Integral representation

The extension of the representation in the conclusion of Theorem 2.4 to
general probability measures requires additional assumptions to ensure the
integrability of the utility function. Here we shall consider the case where the
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choice set/5 is the set of countably additive probability measures on an algebra

of subsets of X.
L e t / 5 include all the degenerate lotteries 6x, x E X. Suppose that it is closed
under countable convex combinations (i.e. E~=1 oz~ptEP if for i =
1, 2 . . . . . Pi E/5, ai -->0 and E~=~ a t = 1) and under conditioning (i.e. PA E / 3 if
p a ( B ) = p ( A A B ) / p ( A ) for all B ~ ~f whenever p E P, A E ~f and p ( A ) > 0).
Assume that the algebra ~f contains all the singelton sets {x}, x E X and all the
sets {x E X I 6x > 3y} and {x ~ X[ 6y > 8x}. Finally, assume that the following
monotonicity condition holds.
2.6.1. If p ( A ) = 1 then: (a) 6x -> 6y for all x E A implies that p -> By, and (b)
6y >- 6x for all x C A implies that 6y -> p.
2.6.2. Theorem. Let /3 and g~ be as in (2.6). Suppose that the preference
relation >- on P satisfies the Archimedean (2.2) and independence (2.3) axioms.
Then there exists a bounded, real-valued function u on X such that for all p,
q E /3:
p >- q :~ f u(x) dp(x) >- f u(x) d q ( x )

x
Furthermore, u is unique up to positive affine transformations.

2.6.3. The proof of Theorem 2.6.2 is given in Fishburn (1970). Fishburn also
discusses alternative sufficient conditions. Note that the integrals in Theorem
2.6.2 are defined as follows: Sx u(x) dp(x) = sup{Sx u,(x) dp(x) I n = 1, 2 . . . . }
where for all n, un(x ) <- un+i(x); u,(x) is ~f-measurable, u(x) = sup{u,(x) I n =
1 , 2 , . . . } and u, converges to u uniformly. If ~f is a o--algebra and p is
~r-additive, the condition of uniform convergence is superfluous.
2.7. Bibliographical notes

Fishburn (1970, 1982a), provide detailed, self-contained expositions of expected utility theory under risk.
3. Non-expected utility theories
3.1. Mo~va~on
Experimental studies of decision making under risk reveal systematic violations
of the expected utility hypothesis in general and the independence axiom (2.3),
in particular [see Allais (1953), Kahneman and Tversky (1979), MacCrimmon
1772
and Larsson (1979)]. A review of the evidence is beyond the scope of the
present survey. [The interested reader is referred to Machina (1982a) and
Fishburn (1988, Chapter 3) for extensive and insightful reviews of the experimental evidence.] An example, however, will illustrate the nature of the
observed pattern of violations of the independence axiom and motivate the
quest for alternative theories.
Let [x, o~; 0, (1 - or)] denote the lottery that assigns the probability o~ to the
prize $x and the probability 1 - o~to 0, and consider the following two pairs of
lotteries:
qx = [1,000,000, 1.00; 0, 0.00]
versus
q2 = [5,000,000, 0.80; 0, 0.20]
and
q3 : [1,000,000, 0.05; 0, 0.95]
versus
q4 = [5,000,000, 0.04; 0, 0.96].
The great majority of subjects that were asked to indicate their preferences
between ql and q2 in the first pair and between q3 and q4 in the second chose ql
in the first pair and q4 in the second. This is a clear violation of the
independence axiom (2.3) known as the common ratio effect. To see this, note
that q3 : 0-05ql + 0.9560 and q4 = 0.05q2 + 0-9560- By revealed preferences
and the independence axiom, individuals who chose ql over q2 in the first pair,
should have chosen q3 over q4 in the second.
Prompted by this and other experimental results, several alternative theories
were proposed that depart from the independence axiom of expected utility
theory. In the sequel we survey some of these theories.
3.2. Functional representation of preference relations on lotteries

Let X be a separable metric space and denote by P ( X ) the space of probability
measures on (X, ~0) where ~0 is a Borel o--algebra on X. Let P ( X ) be
endowed with the topology of weak convergence, i.e. a sequence {Pn} C P ( X )
converges to p E P ( X )
in the topology of weak convergence if
f x f dPn --->~x f dp for all bounded continuous real functions f on X.
all pEP(X),
{qEP(X) [ p>_ q}
P ( X ) [ q -> p} are closed in the topology of weak convergence.
3.2.1. Continuity. For
and
{qE
3.2.2. Theorem. Let >- be a preference relation on P(X). If >- satisfies

continuity then there exists on P ( X ) a continuous real-valued function V that
represents >_ . Furthermore, V is unique up to continuous positive monotonic
transformations.
1773
3.2.3. Since P ( X ) is connected and, by Parthasarathy (1967, Theorem 6.2),

separable, the proof of Theorem 3.2.2 follows from Debreu (1954, Theorem
I). For a concise proof see Jaffray (1975).
3.2.4. Remark. If _> satisfies the independence axiom (2.3), then V in
Theorem 3.2.2 may be chosen affine [see Grandmont (1972, Theorem 2)].
Hence, by Huber (1981, Lemma 2.1), there exists a bounded continuous
function u : X--> E such that, for all p E P(X),
V(p) = f u dp.
In this case the integral representation is obtained without the conditions in
(2.6).
3.3. Utility theories with the betweenness property
3.3.1. The betweenness property characterizes a class of models of decision

making under risk whose distinguishing feature is that the preference ranking
of a probability mixture of any two risks is always in between the two risks.
Formally, a preference relation _> on P ( X ) satisfies betweenness if for all p,
q E P ( X ) , p > q implies p > a p + ( 1 - a ) q > q
for all a E ( 0 , 1 ) . Clearly,
betweenness is implied by independence. Furthermore, preference relations
satisfying betweenness are both quasi-concave and quasi-convex on P(X).
Thus, for every p, q E P(X), if p - q then, for all a E (0, 1), p ~ ap + (1 a ) q ~ q. Notice also that betweenness is equivalent to the condition of
mixture-monotonicity, i.e. for all p, q @ P ( X ) , if p > q then a p + (1 - a)q >
/3p + ( 1 - ~ ) q if 0-</3 < a _ < l .
3.3.2. Behavioral implications of betweenness. A well-known result in auction
theory [see Vickrey (1961)] is that an expected utility maximizing bidder
participating in ascending bid auctions with independent private values has a
dominant strategy. Furthermore, the dominant strategy is value revealing in
that it requires that the bidder stay in the auction as long as the price of the
object being auctioned is lower than his value, and quit as soon as the price
exceeds his value. When the object being auctioned is a risky prospect this
characterization of the equilibrium bidding behavior does not extend to general
non-expected utility preferences. The essential property underlying this result
is betweenness, which is a necessary and sufficient condition for the existence
of value-revealing dominant strategy in ascending bid auctions [see Karni and
Safra (1989a,b)].
E. Karni and D. Schrneidler
1774
3.3.3. Weighted utility theory. An example of a non-expected utility theory

with the betweenness property that generalizes expected utility theory is
weighted utility theory. We examine this theory in some detail.
3.3.4. W e a k substitution axiom. For all p, q ~ P(X), p - q
implies V[3 E
(0, 1) :13" ~ (0, 1) such that Vr E P ( X ) , [3p + (1 - [3)r ~ yq + (1 - y )r.
3.3.5. Remark. The independence axiom (2.3) requires that 3' = [3. By allowing y to be different from /3 weak substitution constitutes a weakening of
independence. The only restriction on 3' is that, y as a function of /3 is
independent of r. In conjunction with mixture continuity (2.5.1) weak substitution implies unique solvability, i.e. for every p, q and r in P ( X ) , if p > q > r
then there is a unique a E (0, 1) such that q ~ ap + (1 - a)r.
3.3.6. Theorem. Let >_ be a preference relation on P(X), then the following
conditions are equivalent:
(i) ~- satisfies mixture continuity (2.5.1) and weak substitution (3.3.4).
(ii) There exists on P ( X ) an extended real-valued function V representing ~_
and a non-negative real-valued linear function W such that
(1) for all p, q E P ( X ) and a E (0, 1)
V ( a p + (1 - a)q) :
aW(p)V(p) +
aW(p) +
(1 - a)W( q)V( q)
(1 - a ) W ( q )
(2) V may attain the value ~ or - ~ but not both,

(3) the product V W is real-valued vanishing only when V = O.
Furthermore, (a) if (V', W ' ) are real-valued functions on P ( X ) satisfying
(1)-(3), then there are constants a, b, c, d such that ad > bc, cV + d is
non-negative (non-positive), and
V' = (aV + b)/(cV + d ) ,

W' = W ( c V + d ) .
(b) If >- is defined on A(X), the set of all simple probability measures on X , and
for each x E X v(x) ==-V(6x) and w(x) ~ W(6x) then (i) is equivalent to (ii) where
V(p) :
v(x)w(x)p(x)
xcx w(x)p(x)
3.3.7. Theorem 3.3.6 and its proof are given in Chew (1985b). Condition (2)
excludes the possibility that there are p and q in P ( X ) such that V ( p ) =
- V ( q ) = ~. Condition (3) implies that the weight function W is non-vanishing
on P ( X ) . This condition implies that when V ( p ) and V(q) are not equal
1775
V(ap + (1 - a)q) is strictly monotonic in a. Since V represents -> it follows

that -> has the betweenness property. Finally, note that expected utility theory
is obtained as a special case of weighted utility theory, namely, the case in
which W is a constant function.
3.3.8. Integral representation of weighted utility theory for general probability

measures. As in the case of expected utility theory, the extension of weighted
utility theory to P(X) requires the imposition of additional conditions to assure
integrability. In particular, if mixture-continuity (2.5.1) is replaced by continuity (3.2.1), then A(X) may be replaced by P(X) and condition (i) in Theorem
3.3.6 is equivalent to the existence on X, of a real-valued continuous bounded
functions v and w, defined for all x E X by v(x) =- V(6x) and w(x) =- W(6~) such
that for all p, q ~ P(X),
P ~- q :>
f v(x)w(x) dp(x)
f v(x)w(x) dq(x)
.~ w(x) dp(x) >- f w(x) dq(x)
3.3.9. The proof follows from Huber (1981, Lemma 2.1), since both W and
V W are weakly continuous linear functionals on P(X).
3.3.10. Interpretation. Let _> be represented by the weighted utility functions
(v, w). Then for each simple probability measure p E A(X) we may define
Pw E A(X) as follows. For all x E X, pw(X) =p(x)w(x)[Ex~ x p(x)w(x)] ~.
Then, _> on simple probability measures is represented by the expected utility
functional U(.; w)=- Ex~ x Pw(X)V(X). Thus, one interpretation of weighted
utility theory is in terms of a transformation of the probabilities. In this case
the transformation of the probabilities is such that the ratio, pw(x)/p(x), of the
transformed probability to the actual probability is a function of the prize x.
For example, if w is low for prizes that are ranked high by the preference
relation and high for prizes that are ranked low, then the resulting distortion of
the probabilities implies overestimation of the probabilities of the less preferred prizes and underestimation of the probabilities of the preferred prizes.
The outcome is a functional representation that captures pessimistic attitudes
towards risk.
In the same vein, we may define a modified utility function, vw(.; p), where,
for all x E X, Vw(X; p) = w(x)v(x)[E~ x p(x)w(x)] -1. Then, -> has an expected
utility representation with the modified utility, which depends on the measure
p.
3.3.11. Consistency with the evidence. With an appropriate choice of the
weight function, weighted utility theory is consistent with the pattern of
behavior associated with the Allais paradox and some other violations of the
independence axiom [see Chew and MacCrimmon (1979)]. Furthermore,
1776
experimental observations reported in Cox, Robertson and Smith (1982)

indicate a tendency by subjects participating in descending bid auctions and
first price sealed bid auctions to bid higher prices on average for the same
object in the latter auction form. With independent private values the bidding
behavior in the two auction forms should lead to the same outcome if and only
if the bidders are expected utility maximizers. Weber (1982) shows that, with
appropriate weight function, weighted utility theory is consistent with this
evidence.
3.3.12. SSB theories. Let P be a non-empty convex set of probability measures defined on a Boolean algebra of subsets of X. ~b:P x P-->E is a
skew-symmetric bilinear (SSB) functional if for all p, q E/5, ~b(p, q ) =
- ~ ( q , p) and ~b in linear each argument. ~b represents >- on P if p->
q C ~ b ( p , q)>--O.
SSB representations are discussed in Kreweras (1961) and axiomatized in

Fishburn (1982b, 1983). Fishburn shows that if the underlying preference
relations satisfy transitivity then the weighted utility representation and other
representation functionals that satisfy betweenness are obtained as special
cases of the SSB representation.
3.3.13. Bibliographical notes. Chew and MacCrimmon (1979) were the first
to present an axiomatization of weighted utility theory for simple probability
measures on an arbitrary set of outcomes. For general probability measures on
intervals of the real line, Chew (1983) axiomatized a weighted utility functional
that generalizes the quasilinear mean. Nakamura (1984) obtained weighted
utility representations using alternative sets of axioms.
A generalization of weighted utility theory that involves a further weakening
of the independence axiom was developed independently by Fishburn (1983),
Chew (1985a) and Dekel (1986). Instead of weak substitution the essential
condition here is as follows.
3.3.13.1. Very w e a k substitution. For all p, q, r @ P(X), p - q implies the
existence of/3, y E (0, 1) such that tip + (1 - f l ) r - y q + (1 - y ) r .
Unlike weak substitution y may now depend on both/3 and r. Together with
mixture continuity (2.5.1) this axiom implies the existence of implicit weighted
utility representation of the preferences [for details and definitions, see Chew
(1989)]. In Dekel (1986), X is a compact metric space and the axioms do not
include very weak substitution explicitly.
In between weighted utility and implicit weighted utility there are additional
decision theories that have the betweenness property. A survey of axiomatic
utility theories with the betweenness property is provided in Chew (1989).
Fishburn (1988) includes an extensive discussion of SSB representation
theories with and without transitivity and is an excellent source of references.
1777
3.4. Expected utility with rank-dependent probabilities

3.4.1. Expected utility with rank-dependent probabilities (henceforth
E U R D P ) describes a class of models of decision making under risk in which
risks are represented by cumulative distribution functions and preference
relations on risks are represented by the mathematical expectation of a utility
function with respect to a transformation of the probabilities on the set of
outcomes. The distinguishing characteristic of these models is that the transformed probability of an outcome depends on the rank of that outcome in the
induced preference ordering on the set of outcomes. Formally, let J C R be an
arbitrary interval and denote by D j the space of cumulative distribution
functions on J. We denote by D~ the subset of D j that includes all the
distribution functions on J with finite range.
3.4.2. Definition.
Dj as follows:
An E U R D P functional, V : Dj ~ ~, is defined for all F @
V(F) = f u(x) dg(F(x))

J
where u : J---> E is monotonic increasing and continuous, and g : [0, 1]--~ [0, 1]
is continuous, strictly increasing and onto. If F E D~, x I < x 2 < < xn, and
that for all i = 2 . . . . . n, p ( x i ) ~ - F ( x i ) - F(x~_l) is the probability of x i and
p ( x l ) = F(Xl) is the probability of xl, then,
V ( F ) = ~'~ u(x~) g
i=1
p(xj)
-g
p(xj)
"=
3.4.3. Remarks. If g is the identity function, then the E U R D P functional is

reduced to the expected utility functional. In general, however, E U R D P
theories represent a departure from the independence axiom and, with an
appropriate choice of a probability transformation function, g, these theories
are consistent with the experimentally observed behavioral patterns that violate
the independence axiom. For instance, if g is convex and displays increasing
elasticity, then the corresponding E U R D P functional is consistent with the
common ratio effect (see Section 3.1). For the conditions required for V to be
consistent with other experimental evidence see Quiggin (1982), Segal (1987)
and Karni and Safra (1987).
The idea that decision makers facing choices among risky prospects transform the probabilities into decision weights and maximize the expectations of a
utility function on the set of outcomes with respect to these decision weights is
a natural extension of Bernoulli's hypothesis that decision makers use utility to
1778
transform monetary values when choosing among gambles. This notion appeared in Edwards (1962) and variations of the same idea appeared later in
Handa (1977), Karmarkar (1978) and Kahneman and Tversky (1979). These
studies deal with preferences over lotteries in A(X) that may be represented by
E~Ex to(p(x))u(x). In this representation the decision weight assigned to the
probability p(x), say, of the outcome x depends only on p(x). However, unless
the weight function is in identity, the induced preference relation fails to satisfy
first-order stochastic dominance defined below.
3.4.3.1. Definitions. Let _>1 be a partial order on D s defined for all F,
H E D j by F - > ~ H if and only if F(x)<-H(x) for all x E J . _>1 is called
first-order stochastic dominance. A preference relation, ->, on Dj satisfies
first-order stochastic dominance if, for all F, H E D j, F - > I H implies F_> H.
Strict first-order stochastic dominance, > ~, is defined from ~1 in the usual way.
Satisfying first-order stochastic dominance is regarded as a fundamental tenet
of rational behavior. To grasp the reason for the violation of this principle by
the aforementioned theories consider the following example. Let x and y be in
J and assume that x < y. Denote by w the weight function and suppose that
t o ( 1 ) = l and for some a E ( O , 1), w ( a ) + t o ( 1 - a ) < l .
Then, a6 x + ( 1 a)~y >1 ~x. Yet, if x and y are sufficiently close and u is continuous then
u(x) > to( a)u(x) + to(1 - a)u( y).
3.4.4. Anticipated utility theory. Quiggin (1982) was the first to axiomatize
an EURDP model which he called Anticipated Utility Theory. The key axiom
in Quiggin's formulation is the weak certainty equivalent substitution axiom.
To state this axiom formally we introduce the following definitions. Let
F E Dj, the certainty equivalent of F, C(F), is the number x E J defined by
6x -- F. Notice that if a preference relation is continuous and satisfies first-order
stochastic dominance, then J is sufficiently rich to include the certainty
equivalent of every F E Dj.
3.4.4.1. Weak certainty equivalent substitution axiom. A preference relaS
S
tion -> on D j satisfies weak certainty equivalent substitution if for F, H C Dj
such that F--- E~: 1 p(xi)6xl and H--- E~'=1 p(xi)6x~, [0.5~C(F) + 0.5~C(H)]
E p(ci)6ci, where c i -- C(0.56xl + 0.56x~).
The axiom of weak certainty equivalent substitution has the following
interpretation. There are two ways of reducing the compound lottery that
assigns equal probability to winning F and H resulting in equivalent simple
lotteries. The first requires that the second stage lotteries F and H be replaced
by their certainty equivalents, thus giving the simple lottery that assigns equal
1779
chance to getting C ( F ) and C ( H ) . The second involves changing the order of

i
n
summat
on to obtain
Ei_
l ai[0.5~ xi + 0.5Sx,],
where a i = P(Xi) = p(x~) and then
-i
replacing the second stage lotteries [0.58x, + 0.58x;] by their certainty equivalents, respectively. Clearly, the weak certainty equivalence substitution is
implied by the independence axiom (2.3). However, unlike in expected utility
theory, the reduced lotteries obtained in this way are not necessarily equivalent
2n
to the simple lottery Ei=
1 0.5p(yi)t~yi, where Yi = xi for i = 1 . . . . . n and Yi Xii
for i = n + l . . . . . 2n.
Quiggin's main result was to show that a preference relation on Dj satisfies
first-order stochastic dominance (3.4.3.1), weak certainty equivalent substitution (3.4.4.1) and a certain continuity requirement if and only if it has an
EURDP representation with g(1/2) = 1/2. Chew (1985a) shows that the latter
restriction is not necessary.
=
3.4.5. The dual theory. Yaari (1987a) developed an EURDP theory that,
loosely speaking, is an expected utility theory with the roles of payments and
probabilities reversed. In addition to trying to explain the violations of
expected utility theory, Yaari sought to separate the notion of decreasing
marginal utility of wealth from the notion of risk aversion. (Note that these
concepts are not completely divorced in EURDP theory. For a more detailed
discussion see Section 7.6.12.)
At the core of the dual theory is the dual independence axiom. To introduce
this axiom we need to define a new mixture operation. Informally speaking,
this operation mixes the payments in every event in the algebra over which the
space of measures is defined. Formally, let ] be a bounded interval in ~ and
denote by D~ the set of cumulative distribution functions on J. Let (T, 3-, ~) be
a probability space and let K be the set of all S-measurable real-valued
functions on T taking values in ]. The random variables Z, Y E K are said to
be c o m o n o t o n i c if, and only if, for every t and t' in T, ( Z ( t ) - Z ( t ' ) ) ( Y ( t ) Y ( t ' ) ) >-O. [The notion of comonotonicity was first introduced by Schmeidler
(1982). For further discussion see Section 6.2.] Let F z E D] be the cumulative
distribution function of the random variable Z. For any two comonotonic
random variables in K, say Z and Y, and a El0, 1] define the mixture
a F z O ( 1 - a ) F v to be the cumulative distribution function of the random
variable a Z + ( 1 - a ) Y . To illustrate the meaning of the mixture operation
consider a portfolio consisting of two assets in proportions a and ( 1 - a ) ,
respectively. Suppose that the risks corresponding to these assets are represented by the random variables Z and Y whose range is ]. Then, the risk
corresponding to the portfolio is represented by the random variable a Z +
( 1 - a ) Y , whose cumulative distribution function is denoted by o t F z O ( 1 -
1780
3.4.5.1. Dual independence. A preference relation _> satisfies dual independence if for all Fz, Fr, F w in D i such that Z, Y and W are pairwise
comonotonic and a E [0, 1], F z >- F r implies a Fz ~ (1 - a ) F w ~- a F r G ( 1 -
)Fw.
3.4.5.2. C o m o n o t o n i c i n d e p e n d e n c e . A preference relation _> on K satisfies
comonotonic independence if, for all Z, Y, W E K pairwise comonotonic,
Z-> Y implies a Z + (1 - a)W>_ a Y + (1 - a ) W for all a E [0, 1].
Yaari (1987a) shows that if we identify elements of K that have the same
distribution function then a preference relation on D i satisfies dual independence if and only if the corresponding preference relation on K satisfies
comonotonic independence. With this in mind note that when two random
variables are comonotonic, they may not be used as a hedge against each
other. Without this restriction, i.e. if Z_~ Y implies a Z + (1 - a)W>- a Y +
(1 - a ) W for all Z, Y and W in K and a E [0, 1], any two risky prospects are
ranked solely according to their expected monetary values. Thus, restricting
independence to random variables that are pairwise comonotonic permits the
extension of the set of preferences to include different attitudes toward risk.
3.4.5.3. Theorem. Let ~- be a preference relation on Dj. Then the following
two conditions are equivalent:
(i) _~ satisfies continuity (3.2.1), first-order stochastic dominance (3.4.3.1)
and dual independence (3.4.5.1)
(ii) There exists a continuous non-decreasing function f : [0, 1]--~ [0, 1] onto
such that for all G and H E D j,
G >- H => f f(1 - G(x)) dx >- f f(1 - H(x)) d x .

J
3.4.5.4. Theorem 3.4.5.3 and its proof are in Yaari (1987a). Integrating by
parts it is easy to see that G > _ H if and only if - f ~ x d f ( 1 - G ( x ) ) > - f j x df(1 - H(x)). Thus, the dual theory is an E U R D P model with a utility
function that is linear in the payments. [Note that g ( p ) = 1 - f ( 1 - p).]
3.4.5.5. B i b l i o g r a p h i c a l notes. In both expected utility theory and the dual
theory, preferences over risky prospects involving monetary payments are
represented by product measures defined on the epigraph of the cumulative
distribution functions in the payment probability plan. In both theories these
measures are factorizable into two marginal measures. In expected utility
theory, the measure along the probability axis is the Lebesgue measure, and in
the dual theory the measure along the payment axis is the Lebesgue measure.
1781
Building upon this idea, Segal (1989) developed an E U R D P theory in which

preferences are represented by a factorizable product measure and neither the
measure along the probability axis nor the one along the payment axis is
Lebesgue measure. Segal assumes that the preference ordering on Dj satisfy a
condition that he calls irrelevance. Let Z, Z', Y, Y' be random variables in J,
and denote by Fz, Fz,, F v and Fw, their respective cumulative distribution
functions. Let I be a finite union of segments. Then, if on I F z = F v and
F z, = Fy, and on the complement of I in J F z = F z, and Fy = Fy,, then Z is
(weakly) preferred over Y if and only if Z ' is (weakly) preferred over Y'. This
condition together with continuity (3.2.1) and first-order stochastic dominance
(3.4.3.1) are equivalent to the existence of a measure v on ] x [0, 1] such that,
for all F, G E Dj, F_> G if and only if v({epigraph of F } ) - v({epigraph of
G}). To obtain a factorialization of ~, into a product measure, Segal introduces
another assumption that, unfortunately, since it does not involve comparisons
of elements of D i, lacks clear behavioral interpretation.
Green and Jullien (1988) developed an alternative measure representation of
preferences on D i. Their result involves a condition called ordinal independence which differs from Se_gal's irrelevance only in that I must be an interval of
the form ] f'l ( - % 2] or J f-I [2, ~). The resulting measure representation has
the form, for all F E D j, V ( F ) = f j q ) ( Z F ( O l ) , Ol) d/x(o0, where ZF(OI ) inf{x E
] ] F(x) --> o~}, ~0 : ] x [0, 1]--~ N is continuous non-decreasing in x, q~(0, o~) = 0
and/x is a measure on [0, 1] that has a continuous distribution function.
An alternative and insightful axiomatization and discussion of Yaari's dual
theory is provided in Roell (1987). Using the fact that with the mixture
operation O, Dj is a mixture set [see Herstein and Milnor (1953)], Roell shows
that if a preference relation on this mixture set satisfies axioms analogous to
those of Herstein and Milnor, it has a dual theory representation.
Finally, Segal (1990) provides a different axiomatization of E U R D P theories
using preference relations on two-stage lotteries. Chew and Epstein (1989)
identify the separability assumptions underlying the different theories and
develop a generalized representation that include the betweenness theories and
the E U R D P theories as special cases. Gilboa (1988) and Jaffray (1988)
axiomatized a decision theory which generalizes both expected utility theory
and the maximin theory.
=
3.5. L o c a l expected utility analys&
3.5.1. Expected utility analysis is a set of results describing the behavioral

implications of the interplay between the shape of the yon NeumannMorgenstern utility function and the properties of the risks facing the decision
maker. These include the theory of risk aversion (see Section 7) and the theory
of stochastic dominance. Indeed, the widespread acceptance of expected utility
1782
is largely due to its clear behavioral implications for insurance, portfolio

selection and other risk sharing arrangements. Machina (1982a) discovered that
much of expected utility analysis is robust to the modifications of the preference functional required by the failure of the independence axiom to stand the
empirical test. In particular, if the preference functional is "smooth" in the
sense of having a local linear approximation, then locally (in the space of
distribution functions) it is an expected utility functional. Hence, in a local
sense it embodies expected utility analysis. Global implications analogous to
expected utility analysis may be obtained by the use of the Fundamental
Theorem of Calculus provided that the appropriate local properties hold
everywhere in the domain of the preference functional.
3.5.2. Frechet differentiable preferences. Let ] be a bounded interval in R,
and let Dj be endowed with the topology of weak convergence. Let _> be a
preference relation on D i satisfying continuity (3.2.1), then, by Theorem 3.2.2,
-> is representable o n Dj by a continuous, real-valued preference functional V.
Suppose that V is "smooth" in the sense of being Frechet differentiable. To see
the meaning of this assumption we introduce the following definitions and
notations.
3.5.2.1. Definitions. A real-valued functional T defined on a domain D of a
normed space X is Frechet differentiable at x @ D if for each h ~ X there exists
OT(x, h) E R that is linear and continuous with respect to h, and
T(x + h) - T(x) = OT(x, h) +
o(llhll),
where o(.) denotes a function which is zero at zero and o(t)/t--~O as t--~ 0. If T
is Frechet differentiable at x for all x E D then T is Frechet differentiable.
To apply this definition to the case at hand let ADj = { A ( F - H ) [ F ,
h E R } be normed by the L 1 norm I I A ( F - H ) I I = I A I L I F ( x ) H(x)[ dx. If V is Frechet differentiable then for each F E D i there exists a
continuous linear functional OV(F; .) on ADj which may be represented as
.fj U(x, F) d ( F - H)(x), where U(.; F) is absolutely continuous on ] [see
Machina (1982a)]. Hence, by definition,
HEDj,
V(F) - V(H) = f U(x; F)(dF(x) - dH(x)) +
o(llF- nil).
Consequently, a decision maker whose preferences are representable by a

Frechet differentiable preference functional ranks differential shifts from a
distribution F @Dj according to the expectation of the local utility function
U(x; F). Therefore, in this framework, expected utility analysis obtains locally.
1783
3.5.3. Global behavior analysis. To compare distributions that are far apart it
is necessary to define a differentiable path in Dj between the distributions and
then to integrate the derivative of the local expected utility along the path.
Formally, let {F(.; a ) ] a ~[0,1]} be a path in D i such that ]lF(.;c~)F(.; *)11 is differential in a at oz = a*, then, since the derivative of o(.) is zero
at zero, we have
d V(F(.;a))l~=,~ * : -~a
d
d----~
U(x; F(.; a*)) dF(x; a)l,:~,. .
Thus, by the Fundamental Theorem of Calculus, upon integrating along the

path we have
1
The sign of this expression represents the relative ranking of the distributions
F(.;1) and F(.;0), and it depends on the properties of the local utility
functions along the path that connects them. For instance, the local utility
function U(x; F) is monotonic increasing in x for all F ~ D j if and only if
V(F) -> V(F*) whenever F >1 F* [Machina (1982a), Theorem 1)]. In general,
all the results of expected utility analysis that depend on properties (e.g.
concavity) of the von Neumann-Morgenstern utility but not on the linearity of
the preference functional are preserved provided the same properties are
imposed on the local utility functions. Exceptions are comparative statics
results involving shifts in the distributions. For instance, if the von NeumannMorgenstern utility displays decreasing absolute risk aversion (see Section 7),
i.e. -u"(w)/u'(w) is decreasing in w, the willingness of a decision maker to
bear risks as his wealth changes is affected. This has important implications,
e.g. for the decision maker's optimal portfolio position. The same implications
do not necessarily obtain if each local utility function displays decreasing
absolute risk aversion, since the effects of an increase in the level of wealth,
say w, which is given with certainty, depends on how the measure of absolute
risk aversion of the local utility function, -U11(w; 6w)/U~(w; 8~), where U~
and UI~ denote the first and second partial derivatives of U with respect to its
first argument, varies with w. In addition to the effect of a change of w for a
given distribution 8w, which is captured by the property of decreasing risk
aversion of the local utility function U(.; 8w), it also depends on how this
measure is affected by variations in 6w itself. This effect has no counterpart in
expected utility analysis and must be treated separately. A detailed discussion
of comparative statics analysis based on local utility functions is provided in
Machina (1989a).
1784
3.5.4. Consistency with the evidence. For non-linear preference functionals to

be consistent with the reported violations of the independence axiom of
expected utility theory some additional structure is required. This structure
may be expressed in terms of properties of the local utility functions. Specifically, Machina (1982a) shows that the following characterization of the local
utility functions renders the preferences consistent with several types of
violations of the independence axiom,
3.5.4.1. Hypothesis.
For any x E J
and F,
HEDj,
if F>-lH
then
--Ull(x; F)/UI(x: F ) ~ --Ull(x; H)/Ul(x: H).

3.5.5. Uniqueness. Let V be a Frechet differentiable preference functional
representing the preference relation >- on D#, with the corresponding local
utility functions { U(. ; F) I F E D#}. For each F E D i define U*(.; F) = a(F) +
b(V(F))U(. ; F), where b(.) is a continuous, positive function on E, and a(.) is a
real function on D#. Then { U*(.; F) ] F E D j) is a set of local utility functions
corresponding to a Frechet differentiable preference functional V* that also
represents _>. In other words, a local utility function is unique up to affine
positive transformations with the restriction that the multiplicative constant be
the same for every equivalence class of _>. To verify these claims, let
~b(r) = y'~ b(z) dz, and define V*(F) = tp(V(F)). Since ~ is monotonic increasing, V* represents _>. By the chain rule we obtain U*(.; F) = b(V(F))U(.; F),
F E Dj. That adding a constant to the local utility function does not alter the
preferences over differential shifts of the probability distribution function
around F follows from the differentiability of V and the fact that fj ( d E ( x ) dH(x)) = 0 [for a more detailed discussion see Machina (1988)].
3.5.6. Remarks. Unlike the theories surveyed in Sections 3.3 and 3.4, in
which the representations were derived from the underlying structure of the
preference relation, Machina's approach invokes Theorem 3.2.2 and imposes
the main restriction, i.e. Frechet differentiability, directly on the representing
functional. The properties of the underlying preference relation that yield
Frechet differentiability have not been elucidated. Allen (1987) examines
conditions on preferences that permit their local representation by a utility
function that is linear in the probabilities. It is worth noting in this context that
EURDP functionals are not, in general, Frechet differentiable [see Chew,
Karni and Safra (1987)]. However, this in itself does not imply that the local
expected utility analysis is completely lost. Chew, Karni and Safra (1987) show
that important parts of this analysis are preserved if the preference functional
satisfies the weaker condition of Gateaux differentiability. Chew, Epstein and
Zilcha (1988) introduced an alternative definition of smoothness of preference
functionals on probability distributions with support in ~n and showed that if
1785
the representation functional is smooth then a whole class of results in

expected utility analysis obtains under non-expected utility theory.
3.5.7. Gateaux-differentiable preference functionals. The Gateaux differential
generalizes the notion of directional derivative in finite dimensional spaces.
Unlike Frechet differentials its definition does not require a norm on the
domain of the functional.
3.5.7.1. Definitions. Let V : D j - - > E , then for F, G E D~, V is Gateaux
differentiable at F in the direction ( G - F ) if d [ V ( ( 1 - a ) F + aG)Io+]/da
exists, and
d V((1 - a ) F + a G ) = f U(x; F) d(G(x) - F(x))
dol
'
J
where U(.; F):J--->R. V is said to be Gateaux differentiable at F if for all

G E D j, it is Gateaux differentiable in the direction ( G - F). It is Gateaux
differentiable if it is Gateaux differentiable at F for all F E Dj. U(.; F) is the
Gateaux derivative of V at F.
If the Gateaux derivative is taken to be the local utility function then much
of Machina's local utility analysis is extendable to Gateaux differentiable
functionals [see' Chew, Karni and Safra (1987) for a local utility analysis of
portfolio selection in the context of E U R D P theory].
3.5.7.2. Examples. If the choice set is D j, then for each F E Dj the local
utility function (Gateaux derivative) U(.; F) corresponding to weighted utility
theory is defined for all x E J by
U(x; F) =
w(x)[v(x) - V(F)]
yj w(z) dF(z)
Similarly, the local utility function at F E Dj of a general E U R D P functional is

given by
U(x; F) = f f'(F(z))
du(z),
xE J,
jx
where jx = ( _ ~ , x) fq J.
3.5.7.3. Remarks. The uniqueness properties of the local utility functions
obtained under Gateaux differentiability are the same as those obtained under
Frechet differentiability. It is important to note, however, that if the prefer-
1786
ence functional is not Frechet differentiable the local utility function, even if it
exists, does not necessarily capture the local properties of the preference
functional. The following example from Karni and Safra (1988) illustrates this
point. Let V be an E U R D P functional given by
V(F) = f x df(F(x)),
J
where J = [0, ~). Suppose that f is differentiable and on [0, 0], 1/2 < 0 < 1, f is
concave and f ( p ) > p. Then V displays aversion towards symmetric fair risks.
The local utility function, U(.; F), in this case is
X
t*
U(x; F) = I f'(F(z)) dz .
0
For F = 6y the local utility function is
U(x; ay)
~f'(O)x,
for x < y ,
[f'(O)y+f'(1)(x-y),
for x>-y.
Thus, if f ' ( 1 ) > f ' ( 0 ) then U(x; 6y) is convex at y. Hence, if it constitutes a
good approximation of V at 6y then V would display local risk proclivity toward
small symmetric fair risks around y. A contradiction. In fact, V is not Frechet
differentiable at 6y, and its attitudes toward risk is not captured by the local
utility function at this point.
4. Dynamic consistency
4.1. The problem defined

Most individual decisions are links in chains of decisions. Does the formulation
of the decision-making problem as isolated choices detached from past decisions then entail a loss of essential aspects of real life decision situations?
In many situations, decisions take the form of a contingent plan involving
sequential moves. When no unforeseen events interfere it is natural to expect
that the execution of the plan be dynamically consistent in the sense that the
continuation of the optimal plan formulated at the outset agrees with the
optimal continuation plan as of any subsequent stage. Does this restriction on
preferences imply the axioms of expected utility theory?
The answers to these questions depend to some extent on the context and, in
particular, on whether the time at which uncertainty is resolved plays an
Ch. 33: UtilityTheory with Uncertainty
1787
essential role in the process. We thus distinguish between atemporal and

temporal sequential decisions. An example of an atemporal sequential choice is
provided by ascending bid auctions in which a bidder faces a sequence of
decisions, namely, whether to bid a higher price when a given price is
announced. The time elapsed during the auction plays no essential role in the
analysis. An example of a temporal sequential choice problem is provided by
consumption plans over time. The execution of the plan involves actual
consumption over time, and there is no presumption that decision makers are
indifferent regarding the timing of the resolution of the uncertainty.
4.2. Atemporal sequential choice

4.2.1. Decision trees. The framework that we use to investigate dynamic
consistency is decision trees. Formally, a tree consists of a finite, non-empty set
of nodes, N, and a non-empty set, M, of ordered pairs of distinct nodes called
links, which satisfy the following condition. There exists a unique node to be
referred to as origin and for each node there is a unique sequence of nodes
starting from the origin and ending with that node such that any two consecutive nodes in the sequence constitute a link. The definition implies the
existence of nodes that are not the start of a link. These are called terminal
nodes and are denoted N T. The other nodes are the decision nodes and are
denoted by N D. For every decision node n denote by N(n) the set of nodes
belonging to links beginning with n. An act is a function that assigns to each
decision node n a probability distribution on N(n). To complete the description
of the decision tree we define a function that assigns an outcome in X to every
terminal node, v : N T--> X. This allows for the possibility of obtaining the same
outcome at two distinct terminal nodes. It is customary to distinguish between
decision nodes where the decision maker can determine any probability
distribution and decision nodes where the probability distribution is given
exogenously. (The latter are usually referred to as chance nodes.) In the
present context this distinction is not essential since we are interested in
preferences on acts. Note also that in this model a tree and an act correspond
to a unique, c o m p o u n d e d lottery, and for any compound lottery there exist
decision trees and acts that induce this lottery.
4.2.2. Compound lotteries. We denote by F(X) the set of all compound
lotteries on X. Formally, for integer k - > l , Ak(X)=Zl(Ak-I(X)) where
A(X) = X. Thus, F(X) = [.-J~-o Ak(X) Recall that for all compound lotteries
y, say y ~ Ak(X), the degenerate compound lottery 6y E Ak+~(X). On the
other hand we do not distinguish between y and 6y. As a result we have for all
k !
z
k, Ak(X)D [..)i~o A(X). Therefore we also introduce the notation Fk(X)=
{y ~ F(X) I Y E zlk(X) and y ~ A k - l ( X ) } . Hence F(X) is the disjoint union of
the sets F~(X), k = 0 , 1 , . . . .
1788
Given two compound lotteries y and z we introduce the notation z E y ,

which means that if the compound lottery y is played out there is a positive
probability that at some stage the compound lottery z will be obtained and
played out (if z ~E'X). Formally, we write z E y if there are k > l - 0 such that
y ~ F k ( X ) , z E F t ( X ) and for some j, 1 -< j -< k - l, there are Yi E F(X) where
O <-- i <- J , Y = Yi, Yo = z and for l <- i <--j, y i ( y i _ l ) > 0 or if z = y. Recall that
Y;(Y~-I) is the probability that the compound lottery Yi assigns to y~_ r If z E y,
we call z a sublottery of y.
4.2.3. Dynamic consistency, consequentialism and independence.
To formalize the notions of dynamic consistency we need as a primitive a preference

relation not just on lotteries but on sublotteries conditioned on the lotteries
they belong to as well. If z E y, we denote by (zly) the sublottery z given y.
Let ~ ( X ) = {(zly) ly ~ F(X) and z E y}. Our primitive is a preference relation on qt(X).
4.2.4. Definition. A preference relation _> on ~P(x) satisfies d y n a m i c consistency if for all quadruples of c o m p o u n d lotteries y , y ' , z , z ' : ( y l y ) > _
(y'ly')<=>(zly) >-(z'ly'), where z ~ y and y ' is obtained from y by replacing z
with z'.
This definition has the interpretation that if a decision maker prefers y over
y', then if he has to play z he will not exchange it for z'.
4.2.5. Definition. A preference relation -~ on ~ ( X ) satisfies consequentialism
if for
all quadruples
of compound
lotteries y, y', z, z': (zly) _~
( z ' t y ' ) C : > ( z l f ) >_ (z'l)7'), where z E y , z E)7, y ' is obtained from y by replacing z with z' and )7' is obtained from )7 by replacing z with z'.
Consequentialism was applied to decision theory by H a m m o n d (1988a,b) to
describe situations in which alternative courses of actions are judged solely by
their consequences.
4.2.6. Definition. A preference relation _> on qz(X) satisfies reduction o f
c o m p o u n d lotteries if for all y, y', z, z ' : ( z l y ) >- (z'ly')<::>(Zl~) >- (Y'l)7'),
where z E y, z ' E y ' , i E A(X) is the reduced form of z obtained by the
calculus of probabilities and )7 is the lottery obtained from y by replacing z with
Y. Similarly, i ' is the reduced form of z' and )7' is defined analogously to y'.
Given -> on ~P(X) the condition of reduction of compound lotteries implies
that _> is completely defined by its restriction to pairs of ( z t y ) , where
z ~ A(X). Consequentialism implies that it is independent of y. Hence, if ->
satisfies the two axioms, it induces a preference relation on A(x). The induced
preference relation determines >-.
1789
4.2.7. Theorem. If a preference relation >_ on ~V(X) satisfies reduction of

compounded lotteries (4.2.6) and consequentialism (4.2.5) then it satisfies
dynamic consistency (4.2.4) if and only if the induced preference relation on
A(X) satisfies the independence axiom (2.3).
4.2.8. Theorem 4.2.7 states the conditions under which no essential loss is
entailed by modeling decision behavior under risk as choice among one-stage
lotteries (as in Section 3). It also provides an alternative interpretation of the
independence axiom, i.e. dynamic consistency in atemporal sequential decisions under risk. Note that dynamic consistency implies that decision makers
are not engaged in self-deception in the sense of planning a course of action
while knowing in advance that they will not execute it when the time comes.
Finally, the independence axiom in conjunction with the continuity and the
condition of reduction of compound lotteries implies consequentialism and
dynamic consistency. For a proof of Theorem 4.2.7, see Karni and Schmeidler
(1990).
4.2.9. Bibliographical notes. The first to note the problem of dynamic inconsistency was Strotz (1956). He dealt with dynamic inconsistent consumption
plans under certainty, however. The relationships between dynamic consistency and expected utility maximizing behavior in the atemporal context was
treated in Hammond (1988a,b) who obtained a result analogous to Theorem
4.2.7 using choice functions rather than preferences. Weller (1978) assumes
that the preferences in each decision node are represented by an expected
utility functional and shows that dynamic consistency in trees is equivalent to
the conditions that the utility function in each decision node are equivalent and
the probabilities are updated according to Bayes' Rule. Karni and Safra
(1989a), using trees induced by ascending bid auctions with independent
private values as their universe of discourse, obtained a result analogous to
Theorem 4.2.7 where the dynamic consistency condition is defined in terms of
the bidding strategy.
One implication of Theorem 4.2.7 is that the application of non-expected
utility theories to sequential choices requires that reduction of compound
lotteries, consequentialism, or dynamic consistency must be relaxed. Machina
(1989b) argues that the non-separability inherent in non-expected utility theory
makes it natural to give up consequentialism and preserve the other two
conditions. Segal (1989b) argues in favor of abandoning the reduction of
compound lotteries to preserve consequentialism and dynamic consistency. He
assumes that the choice space includes the certainty equivalents and obtains
reduced-form lotteries from compound lotteries by replacing sublotteries with
their certainty equivalents thus folding the compound lotteries from the bottom
up. Karni and Safra (1989b) analyse ascending bid auctions with non-expected
utility preferences. Assuming reduction of compound lotteries and consequen-
1790
tialism they recognize the inevitability of dynamic inconsistencies. They impose

a condition called behavioral consistency which implies that, recognizing the
pitfall of dynamic inconsistency, decision makers eliminate dynamically inconsistent contingent plans from the choice set prior to deciding on the course to
be taken.
Finally, the relationships between dynamic inconsistency and the possibility
of inducing a decision maker to "make book against himself" are explored in
Yaari (1985) and Green (1987). The issue of the value of information, which is
closely related to dynamic consistency, is treated in Wakker (1988) and Schlee
(1990).
4.3. Temporal sequential choice

4.3.1. A two period consumption model. Consider a two period consumption
model. Let c,, t-- 1, 2, denote the level of consumption, and suppose that ct
takes its values in a bounded interval, J, in the non-negative real line. Denote
by M(J) the space of Borel probability measures on J, endowed with the
topology of weak convergence, and let D --- M ( J x M(J)) be the space of Borel
probability measures on J M(J) with the topology of weak convergence.
Elements of D have the interpretation of two stage consumption lotteries.
A decision maker is represented by two preference relations: a preference
relation on D that is representable by a utility function U l : D - + R, and a
preference relation on J M(J) represented by a real valued utility function
U 2. Assume that for each c E J , U2(c,.) is continuous on M(J). In this
formulation the second period preferences are independent of unrealized
alternatives, i.e. they satisfy consequentialism. Johnsen and Donaldson (1985)
show that, in the context of temporal sequential choice, consequentialism and
dynamic consistency do not imply expected utility maximizing behavior. In
fact, the nature of the representation depends on the decision maker's attitudes
toward the timing of the resolution of uncertainty.
4.3.2. Temporal dynamic consistency. The notion of dynamic consistency in
the present context is formalized in the following.
4.3.2.1. Definition. U ~, U 2 satisfy temporal dynamic cons&tency if for all

c E J, a E (0, 1) and m, m , m" E M ( ] ) ,
U2(c, m) >- U2(c, m') :> Ul(a6[c.m] + (1 -- a)6ic.m.])

-> U'(a6~c,mq + (1 -- ~)atc,m,,~),
where /~[c.ml denote the element of D that assigns the unit mass to (c, m).
1791
4.3.3. Attitudes toward the timing resolution of uncertainty. Individuals may

differ in terms of their attitudes toward the timing of resolution of uncertainty.
For instance, consider an individual about to leave for a week-long vacation for
which he paid in advance. Suppose that, before leaving he made an offer on a
house. His real estate agent will get the response of the seller before our
individual embarks on his trip. Would he prefer to know the outcome before
leaving, or would he rather wait and learn about it after the vacation? Both
attitudes seem plausible, and it is conceivable that he is indifferent between the
two possibilities. The main result here is that indifference toward the timing
resolution of uncertainty in conjunction with the other assumptions of the
model implies that the second period utility is linear in the probabilities. (It is
important to note that the uncertainty in this example is at the level of
consumption streams. If the uncertainty is at the level of income streams, early
resolution of the uncertainty may have the advantage of allowing better
planning.)
4.3.3.1. Definition. U 1 satisfies indifference towards the timing resolution of
uncertainty if for all a @ (0, 1), c E J and m, m' @ M(J),
U1(oea[,m] + (1 - oe)6[c.m,]) = ul(a[
....
+(l
oe)rn']) "
Note that the argument of U ~ on the left-hand side denotes the lottery
resulting from an early resolution and the argument of U 1 on the right-hand
side denotes the lottery corresponding to a late resolution.
4.3.4. Theorem. Let U l and U 2 satisfy temporal dynamic consistency
(4.3.2.1) and indifference toward the timing of the resolution of uncertainty
(4.3.3.1). Then for each c E J, U2(c; .) is an expected utility functional on
M(]).
4.3.5. Theorem 4.3.4 and its proof are in Chew and Epstein (1989). This
result may be extended to any finite number of periods.
4.3.6. Timing premium. A measure of the attitudes toward the timing of the
resolution of uncertainty is the timing premium defined by Chew and Epstein
as follows. For each a E (0, 1), and (c, m), (c, m ' ) @ , f M(J) such that
ul(t~[c,m]) ~ Ul(t~tc,m,]), let fl E (0, 1) be defined by
1
U~(a6Lc.ml + (1 - a)6[~,m,]) = U (6[~,~m+(,_e).,,l),

then the timing premium is given by
E, Karni and D. Schmeidler
1792
/3/(1
~'(a,m,m',c)=- al(1
-/3)
a)
Note that preference for early resolution of uncertainty implies a positive

timing premium, while a preference for late resolution implies negative timing
premium. If the preference for the timing of the resolution of uncertainty is
independent of the probability a (i.e. if for each c E ] and m, m' ~ M(]) such
1
t
that U~(6lc.ml)-> U (6It.re'l), r(a, m, m , c) exists and is independent of a E
(0, 1)) and U ~ and U 2 satisfy temporal dynamic consistency (4.3.2.1), then for
each c E J, U2(c, .) is a weighted utility functional on M(]) [see Chew and
Epstein (1989)]. Chew and Epstein also show that if the independence of the
timing premium is replaced by the weaker condition that a timing premium
exists then the U 2 in the conclusion of Theorem 4.3.4 is an implicit weighted
utility functional.
4.3.7. Bibliographical notes. Kreps and Porteus (1978) develop equivalent
analytical models of finite horizon dynamic choice theory and analyse the role
of alternative attitudes towards the timing at which uncertainty is resolved. An
extension of the framework of Kreps and Porteus (1978) to infinite horizon is
provided in Epstein and Zin (1989), who developed a class of recursive, but
not necessarily expected utility theory, over intertemporal consumption lotteries that permit the separation of the attitudes toward risk from the attitudes
toward intertemporal substitution.
The nature of preferences on income streams induced from preferences over
consumption streams was studied in Kreps and Porteus (1979). In general, the
induced preferences may not be represented by an expected utility functional
even if the underlying preferences over consumption streams obey the yon
Neumann-Morgenstern axioms. Machina (1984) demonstrates that the
methods of non-expected utility analysis are applicable in the analysis of
induced preferences over temporal risks.
Part 3: Utility theory with uncertainty

5. Expected utility theory with subjective probabilities
5.1. Preliminaries
Most economic problems involve decision making under uncertainty rather
than risk. The first, complete and still unsurpassed, axiomatization of decision
making under uncertainty is due to Savage (1954).
In Savage's theory the set of consequences, C, coincides with the set of
outcomes, X, and the set of acts, A, consists of all the functions from the set of
1793
states, S, to X. As mentioned in Section 1.2, a preference relation on A is a

primitive of the model.
To state Savage's main result we need the concept of an integral of
real-valued bounded function f on S with respect to a finitely additive probability measure ~r defined on the set of all subsets of S to be denoted ow. We
define:
M
5.1.1.
f ( s ) dTr(s)
= f ~({s ~ s I f(s) >-~)) d~

0
0
+ f [~r({s~glf(s)>-~))- alda
-M
The integrals on the right-hand side are R i e m a n n integrals and M is a bound

on the absolute value of f. The existence of the integral is guaranteed by the
monotonicity of the integrand.
Savage's t h e o r e m states the conditions that imply the existence of a unique
probability measure on ow and a von N e u m a n n - M o r g e n s t e r n utility function u
on X such that the functional a---~ ~s u(a(s)) d~-(s) represents -> on A.
The probability measure, 7r, obtained in Savage's t h e o r e m has convex range
everywhere (i.e. is non-atomic).
5.1.2. Definition. A probability measure ~- on owis said to have convex range
everywhere if for all a E [0, 1] and for all B, D E 5e, B C D there is an event
E E 5e, such that B C E C D and ~-(E) = a ~ r ( B ) + (1 - o0~r(D )
The existence of a probability ~- implies that if an act a @ A obtains finitely
m a n y values (henceforth simple acts), say x 1, x 2 . . . . . x , , then this act m a y be
viewed as a lottery in A(X) where for each i = 1 . . . . . n the probability of x i is
7r({sESla(s)=xi)
). In general, an act m a y be viewed as a probability
measure in P.
The fact that the measure ~- has a convex range everywhere guarantees that
every lottery in A(X) m a y be obtained as a distribution of a simple act. This
observation in conjunction with the conclusion of Savage's T h e o r e m 5.3
implies that choice between acts is equivalent to choice between lotteries on X
and that the preferences between lotteries may be represented by the yon
N e u m a n n - M o r g e n s t e r n utility. This constituted the basis for much of the
research of economic behavior in the presence of uncertainty (see, for example
Section 7). The applicability of this research hinges to a large extent on the
behavioral validity of Savage's axioms.
1794
5.2. Savage's axioms

5.2.1. Notations. Given an act a and an event F we denote by aIF the
restriction of a to F. Given a sequence of a c t s (ai)/k=l and a partition of S to
events (Fi)/k:l, (atIF~, a2[F2. . . . . ak[Fk) denotes the act a where a(s) = ai(s) iff
s E Fg. A special case of this notation is (ale, b[rc), where a, b are acts and F'
is the c o m p l e m e n t of F in S. A constant act a where a(s) = x for all s in S will
sometimes be denoted by x (when there is no danger of confusion). Thus
(ale, XIFc) denote the act that assigns the o u t c o m e a(s) for s in F and the
outcome x for s in F c. The set of constant acts is denoted by Ac.
T h e restriction to A c of the preference relation -> on A induces a preference
relation on X also denoted by _>. For x, y @ X when we write x > y we m e a n
that the outcome x is strictly preferred to the outcome y via the induced
relation or, equivalently, that the constant act x is preferred to the constant act
y. T h e interpretation of the notation a(s) > x is similar. But a > x only means
that the act a is preferred to the constant act x.
A f denotes acts that obtain finitely m a n y values. Thus, a E A r can be
represented by (Xi[Fi)i=l,
k
k a positive integer and (Fi)/k=l a partition of S.
For a, b ~ A and F C S we say a _> b given F (sometime denoted a -->Fb) if
for all c E A, (alF, ClFc) -> (bl~, ClFO. A subset F of S is said to be null if for all
a, b E A, a _> b given F, otherwise F is said to be non-null.
We now introduce Savage's postulates bearing in mind that his first postulate
is the existence of a preference relation _> on A. This assumption and, in
particular, its completeness part, like the assumption of existence of consumer
preferences in neoclassical economic theory, is very restrictive.
5.2.2. The sure thing principle. For all a, b, c, d E A and F C S, ( a [ F , CIFC)
(blF, dF c) iff (a[F , dlFc ) >--(blF , dlF, ).
T h e sure thing principle implies that for all F C S the relation "_> given F " is
a n o n - e m p t y preference relation. It is an independence axiom in that it implies
that the decision m a k e r ' s preferences between acts are independent of the
consequences in states to which the two acts assign the same consequences.
5.2.3. State independence. If F C S is non-null then, for all a ~ A and x,
y @ X, x -> y iff (XIF, a[rc ) -> (YIF, aide)
This axiom implies that the ranking of outcomes does not depend on the
state in which they occur.
5.2.4. Qualitative (or ordinal) probability. For all F, G C S and x, y, ~, 37 E X
with x > y and ] > 3 7 , (X[F , YIFc)>--(Xl~, ylcc) iff (XIF, 371FC)-->(X[c, 371C')'
5.2.4.1. A x i o m 5.2.4 implies the existence of a qualitative probability
relation on events in S. For F, G C S it is said that F is at least as probable as G

(in notation F_>*G) if for some (or all by 5.2.4.) x, y E X
(XlF, Yl~c) -~ (xlc, YIa0.
5.2.5. Non-degeneracy (of ->).
1795
with x > y ,
It is false that x -~ y for all (ordered) x, y E X.
5.2.6. Non-atomieity. For all a, b, c ~ A with a > c there is a finite partition

(F~)~_~ of S such that for all i, a > (CtF~, btFi) and (atFf, blF) > C.
The axiom of non-atomicity
set of states S is infinite. It
Moreover, it implies (together
topological space in the order
(together with non-degeneracy) implies that the

also plays the role of continuity assumption.
with the previous axioms) that A is a connected
topology.
5.2.7. Conditional monotonicity. For all a, b E A and F C S, a > b(s) given F

for all s ~ F implies a -> b given F, and similarly, b(s) > a given F for all s E F
implies b -> a given F.
5.3. Theorem (Savage)

Suppose that a preference relation >- on A is given. Then the following two
(i) The preference relation >- on A satisfies sure thing principle (5.2.2), state
independence (5.2.3), qualitative probability (5.2.4), non-degeneracy (5.2.5),
non-atomicity (5.2.6) and conditional monotonicity (5.2.7).
(ii) There exists a locally convex (5.1.2), unique probability ~ on subsets of S
and a bounded, unique up to a positive affine transformation utility u : X-->
such that a--* f s u(a(s)) d~r(s) represents >_ on A.
5.3.1. Remarks. Savage (1954) proved a somewhat weaker result, namely the
representation holds on the subset {a E A I u(a(.)) is bounded} of acts. Fishburn (1970) showed that condition (i) implies that the above subset of A
coincides with A.
The first part in Savage's proof was to show existence of (non-atomic)
probability ~r which represents the qualitative probability (5.2.4) on the subsets
of S. Next any a ~ A r is represented as an element of A ( X ) and it is shown that
an induced preference relation of A ( X ) is well defined and satisfies the axioms
of the yon Neumann-Morgenstern theorem. As a result, existence of a utility
u : X---> ~ is guaranteed.
5.3.1.1. The special case of Savage's Theorem 5.3.1 holds where A s
replaces A and axiom (5.2.7) is deleted.
5.3.2. Bibliographical notes. In spite of the central role of Savage's theory in
dealing with uncertainty in economics, its main impact is in statistics. There is a
1796
huge literature in statistics relating to Savage's Foundations. We only mention

Lindley (1980) here. Before the 1980s the economic literature offers relatively
little in the way of criticism and objection to Savage's expected utility theory.
Notable exceptions are Allais (1953) and Ellsberg (1961). Allais rejected the
von Neumann-Morgenstern expected utility theory, which is implied by Savage's theory, before Savage published his Foundations. Savage (1954, pp.
101-105) expressed the belief that expected utility theory may be successfully
defended against Allais' criticism. Ellsberg suggested a thought experiment the
results of which contradict Savage's approach (for more details see Section
6.1).
It is noteworthy that Savage (1954, Chapters 1-5) is still the best reference
to the statement, proof and interpretation, of Savage's theorem. In spite of the
theorem's importance it has never been extended and its proof has never been
shortened (however, see Remark 5.3.2). This is not the case for most of the
pathbreaking results proved in the 1940s and the early 1950s. For example, it
took the profession almost ten years to understand the yon NeumannMorgenstern expected utility result and to rewrite it in a way similar to
Theorem 2.4.
Finally, it should be mentioned here that the first attempt at axiomatization
of subjective probability in the modern sense is due to Ramsey (1931).
Savage's work also owes to ideas on subjective probabilities introduced by de
Finetti (1937).
5.4. The A n s c o m b e - A u m a n n
approach
5.4.1. Savage's work resolved the conceptual problem of the existence of

"purely" subjective probabilities. Probability appears only in the conclusion of
his theorem and not in the assumptions or in the description of the acts. This is
in contrast to the usual statistical models where the existence of a family of
probability laws is postulated. The main cost of Savage's approach in the
present context is the non-atomicity axiom (5.2.6) which implies that there are
infinitely many states of nature, each of them null.
Anscombe and Aumann (1963) have suggested a model of preference
relation over acts which allows for derivation of a unique subjective probability
over a finite set of states of nature. To do this they extended the set of acts by
enlarging the set of consequences to include all lotteries over a set of
outcomes. In our notations, A = {a: S---> A(X)}. Convex combinations in A are
defined pointwise, i.e. for all a, b E A and a E [0, 1], a a + (1 - a ) b = c, where
for all s E S, c(s) = a a ( s ) + (1 - ~ ) b ( s ) .
5.4.2. All the assumptions and the notations in Sections 5.1 and 5.2 apply
here with elements of A(X) replacing elements of X in (5.2.1), (5.2.3) and
(5.2.5).
1797
5.4.3. Since the set A defined here is a convex subset of a linear space, all the
definitions of Section 2 apply. Specifically, the von Neumann-Morgenstern
Theorem 2.4 applies to the set of acts with values in A(X).
5.4.4. Theorem. Suppose that a preference relation, >-, on the set o f finitely
valued acts, A f , is given. Then the following two conditions are equivalent:
(i) The preference relation >_ satisfies the Archimedean (2.2), independence
(2.3), state independence (5.2.3) and non-degeneracy (5.2.5) axioms (see
5.4.2).
(ii) There exists a unique probability 7r on the subsets o f S and a utility
u : X---~ ~, unique up to positive affine transformations, such that
a---~f s (Zx~ x a(s)(x)u(x)) d~r(s) represents >- on A s.
5.4.5. The proof of Theorem 5.4.4 involves three easy steps. The first is an
immediate application of the von Neumann-Morgenstern Theorem 2.4 and is
stated below because it may be of interest in itself.
5.4.6. Proposition. Suppose that a preference relation >_ on A =
{a : S----> A(X)} is given where S is finite. Then the following two conditions are
equivalent:
(i) _> satisfies the Archimedean (2.2) and independence (2.3) axioms.
(ii) There exists a so-called state-dependent utility Junction w : X x S--->
such that
a--~ ~ ~ a(s)(x)w(x, s) represents >- on A.

s~S xCX
Furthermore, ~ : X x S----~ is such that a--~ ZsE s ExExa(S)(X)W(X,S ) represents ~-- on A iff there are a > 0 and [3 : S---~ ~ such that for all s @ S: ~(., S) =
s) + [3(s).
5.4.7. The second step in the proof of Theorem 5.4.4 consists of showing that
state independence (5.2.3) together with the last part of (5.4.6) implies the
existence of u : X - - > E and ~-: 9-->[0,1] such that a-->E,E s ~r(s)
Z x e x a ( s ) ( x ) u ( x ) represents --> on A with S finite. Assuming Z,e s ~-(s)= 1
implies the uniqueness of 7r. The third step consists of a standard extension of
the result from the case where S is finite to A s.
5.4.8. Bibliographical notes. For the case in which S is finite the statement of
the A n s c o m b e - A u m a n n Theorem 5.4.4 is taken from Fishburn (1970). In the
original work Anscombe and Aumann (1963) distinguished between compound
lotteries and their reductions. Hence, the relation between their original
model, the model of von Neumann and Morgenstern and Savage's model is less
1798
transparent. Fishburn (1970) extended the theorem to an arbitrary set S. For

this purpose he added a restricted version of conditional monotonicity (5.2.7).
(Restricted to F = S). A n o t h e r extension of the theorem to an arbitrary set S
will follow from the theorem of Section 6.2. For this extension and in the
theorem of Section 6.2 itself, another version of monotonicity axiom is used.
For the case of finite S this version is implied by state independence of the
preference relation.
5.4.9. Monotonicity.
For all a, b in A, if for all s in S, a(s) >_ b(s) then a >_ b.
5.5. Topologically connected space of consequences

5.5.1. Given a preference relation over acts we have dealt with its representation by an expected utility functional. Such a representation, which is of the
form a---~Es~S Ir(s)u(a(s)), separates probabilities of states from utilities of
consequences. This separation is of interest because in many applications of
this model to economics we have a situation where the probabilities change
over time because of new information, whereas the basic preferences over
consequences, represented by the utility function, do not change. For example
consider the portfolio selection problem. A n investor may have a fixed attitude
J
toward risk over a long period of time (i.e. his von N e u m a n n - M o r g e n s t e r n
utility of m o n e y is unique up to positive linear transformations), whereas he
may change his preferences over the conceivable portfolios daily. New information changes his probability assessments.
Suppose a preference relation is given over acts A = {a : S---~ X} where both
sets, S and X are finite, and a ~ Zs~ s r(s)u(a(s)) represents this relation. Then
generically there is an open set of probabilities and utilities which represent
this relation. That is, if there is no indifference between distinct acts, i.e. all
inequality between expected utilities of distinct acts are strict, then small
changes in utilities and probabilities will not affect the (finitely many)
inequalities. In this situation Bayesian adjustment of probabilities may result in
different ranking of the act, depending on the particular representation chosen.
The two results which yield the desired representation, Savage (5.3) and
A n s c o m b e - A u m a n n (5.4.4), have their drawbacks. Those drawbacks can be
exemplified by the standard application of decisions under uncertainty to
general equilibrium analysis. We refer here to the A r r o w - D e b r e u extension of
the neoclassical consumption theory to contingent commodities. Let C denote
the consumption set of a neoclassical consumer, i.e. C is a convex subset of a
Euclidean space. Given a finite set S of states of nature, an act a : S---~ C is a
contingent consumption plan where a(s) is the (certain) commodities bundle
which will be consumed if state s E S occurs; A = {a:S---~ C} is the set of
contingen t commodities bundles.
1799
We are interested in representing consumers' preference relation over A by a

functional of the form a---~ ZseS 7r(s)u(a(s)) where 7r is a probability measure
on S and u(.) is a neoclassical utility on C.
Although the set C has an affine (or a linear) structure we are not interested
in preferences over A that can be represented by a linear utility. We would like
to include the cases where u is strictly quasi-concave. Wakker (1986) suggested
conditions on preferences which lead to a representation as above with a
unique prior and restricting the function u(.) only to be continuous. He
suggested the following.
5.5.2. Cardinal coordinate independence. Suppose that there are given acts a,
b, a' and b' in A, consequences x, y, x' and y' in C, and states s and t in S, s
non-null, such that a ( s ) = x , b ( s ) = y , a ' ( t ) = x and b ' ( t ) = y , a<_b,
(als,, X'ls) >- (blsc, y'ls), a'~- b ' Then (a'],c, x'l,) -> (b'l,c, Y'I,).
The condition says that if the consequences x and y are replaced in the acts a
and b (respectively), in state s, by the consequences x' and y' then the
preference a <- b is weakly reversed. Suppose now that a' ~- b', then replacing x
and y in a' and b' (respectively) by x' and y' in the state t will obviously
preserve the preference, i.e. (a'l,,, x'l,) >- (b'l,~, Y'I,).
5.5.3. Theorem. Suppose that a preference relation, >-, is given on the set
A = {a : S---~ C} where S isfinite, C is a connected topological space and at least
two states in S are non-null. Then the following two conditions are equivalent:
(i) a---~ Esc s ~r(s)u(a(s)) represents _> on A where ~- is a unique probability
on S and u is continuous and unique up to positive linear transformations.
(ii) For each a E A the sets { b E A l b > a }
and { b E A l a > b }
are open
in the product topology on A, and -~ satisfies cardinal coordinate independence.
5.5.4. Remark. Wakker (1986) showed that his cardinal coordinate independence implies the sure thing principle (5.2.2) for finite S (and when
existence of non-null states is guaranteed). Thus the following result is the
main step in the proof of the above theorem.
5.5.5. Theorem. Suppose that a preference relation, ~-, is given on the set
A = {a : S---~ C} where S is finite, C is a connected topological space and A has
the product topology, and at least three states in S are non-null. Then the
following two conditions are equivalent:
(i) a---~Es~ s w(a(s), s) where for all s E S, w(., s) is continuous and w
satisfies the uniqueness condition of Theorem 5.4.6.
(ii) For each a @ A the sets { b E A [ b > a }
and { b E A l a > b }
are open
and >- satisfies the sure thing principle (5.2.2).
1800
5.5.6. Bibliographical remark. T h e o r e m 5.5.5 is a version of Debreu's (1960)

separability result. H e assumed also topological separability of C. Kranz et al.
(1971) showed that (ii) implies the representation in (i) without separability
assumption. Wakker (1986) showed that also the continuity of w does not
require separability. T h e o r e m 5.5.5 and another result of D e b r e u for the case
that there are precisely two non-null states are based on the works of Blaschke
(1928) and Thomsen (1927). A most recent, and general result on additive
representation in the vein of T h e o r e m 5.5.5 is by Vind (1986).
T h e o r e m 5.5.3 is Wakker's (1984, 1986). H e extended his result to infinite
set of states S. In this case the cardinal coordinate independence condition has
to be restated [see Wakker (1986, 1989a)].
5.6. State dependent preferences

T h e r e are circumstances in which there is a natural definition of states and
consequences and the preferences over the consequences depend on the state
in which they occur. For example, it is conceivable that a person who on a
sunny day would prefer to watch a football game in an open stadium to staying
home and watching the game on television would reverse his preferences if it
rains. The orthodox approach, according to Savage, is to redefine the consequences and the states so as to maintain the state independence axiom.
However, this may result in description of consequences such as "watching a
football game in the stadium on a sunny day provided it rains." To suppose
that decision makers have preference relations on the redefined acts strains the
credulity.
5.6.1. Preliminaries. The representation of state-dependent preferences suggested here uses the framework of Anscomb and A u m a n n (1963). We start
with the natural set of acts A = {a : S - + A(X)} and a preference relation _> on
A that satisfies the Archimedean and independence axioms. Since the preferences over outcomes are state dependent, we may think of X x S as the set of
consequences and consider another preference relation, ~ , on zl(X x S) - t h e
set of prize-state l o t t e r i e s - that also satisfies the Archimedean and independence axioms. Next we define a consistency axiom relating the two preference
relations. To state this axiom we need some additional notation. We denote by
/3, ~ consequences in A(X x S). Such a/3 is said to be positive if for all s E S,
2x~ x/3(x, s) > 0. We define a function ~"from positive consequences in A(X x
S) to acts in A as follows: ~'(p) = a where a(s)(x) =/3(x, s)/ZycX/3(y, s).
Given a and b in A and s E S we say a equals b outside s if for all t E S, t # s,
and all x E X , a(x, t) = b(x, t). Likewise for/3 and q. Next we define the notion
of a null state. When the preference relation is state independent and its
non-symmetric part is non-empty, a state s E S is said to be null if any two acts
1801
that are equal outside s are indifferent. The indifference relation means that
the decision maker regards the realization of s as virtually impossible. When
the preference relation is state dependent, however, acts that are equal outside
a given state may be indifferent simply because all the consequences in the
given state are equally preferred. To conclude that a state is null we need
additional evidence to the effect that not all the consequences in s are equally
preferred. This evidence is provided by the preference relation ~ . Consequently, a state s ~ S is said to be obviously null if: (1) for all a and b in A such
that a(t) = b(t) for all t E S\{s}, a is indifferent to b and (2) there exist/~ and 0
in A ( X x S) such that/~ equals 0 outside s and/~ % q. If, on the other hand,
a > b for some a and b in A such that a(t) ~ b(t) for all t = s then s is said to be
obviously non-null. If all the consequences in a given state, say s, are equally
preferred there is no way of inferring the beliefs of the decision maker
regarding the likely realization of s from his choices among acts. In this case
the state s is neither obviously null nor obviously non-null. With this in mind
we state the following.
5.6.2. Strong consistency axiom. For all s E S and all positive ~ and d1 in
A ( X x S), if ~ equals gl outside s, and ~(p) > ~( gl), then [~ % el. Moreover, if s is
obviously non-null, then for all positive ~ and el in A(X x S) such that ~ equals
Cl outside s, ~ % gl implies ~(~) > ~( (1).
The strong consistency axiom requires that the decision maker is able to
predict his own decisions when facing choices between acts, given a hypothetical probability distribution on S.
5.6.3. Theorem. Let the preference relation >_ on A satisfy the Archimedean
and independence axioms, and suppose that > is non-empty. Let >_ be a
preference relation on A ( X x S) satisfying the Archimedean and independence
axioms. Suppose further that the two binary relations satisfy the strong consistency axiom (5.6.2). Then:
(a) There exists a real-valued function u on X x S and a (subjective) probability 7r on S such that, for all a and b in A,
a >- b iff ~
7r(s)u(x, s)[a(s)(x) - b(s)(x)] >- O,
sES xCX
and, for all ~, E1 in A(X x S),
P >- O iff
u(x, s)[p(x, s) - O(x,

sES xEX
s)].
1802
(b) The u in part (a) is unique up to a multiplication by a positive constant

and addition o f constants that may depend on the state.
(c) For s obviously null, ~r(s) = O, and if there exist a~ and b s in A such that a s
equals b s outside an obviously non-null state and a s > bs, then zr(s)> O.
Moreover, if for each s E S there exist fis and qs in A ( X S) such that Ps equals
qs outside s and l~s ~ dL , then the probability p o f part (a) is unique.
5.6.4. Remarks. The proof of Theorem 5.6.3 appears in Karni, Schmeidler
and Vind (1983). It applies Proposition 5.4.6 and the von Neumann-Morgenstern theorem. That paper also includes a stronger result based on a weaker
consistency requirement, namely, the preference relation on acts is in agreement with a hypothetical preference relation on a subset of A ( X x S) consisting
of all the prize-state lotteries that assign a given, fixed positive probability to
each state. The weaker formulation has the advantage of avoiding the need to
assume that the decision maker has preferences over prize-state lotteries with
different, and thus incompatible, probability distributions on S. The stronger
consistency requirement, on the other hand, prevents the possibility that two
distinct preference relations that incorporate two distinct posterior probability
beliefs give rise to distinct priors. A more detailed discussion of this point
appears in Karni, Schmeidler and Vind (1983).
5.6.5. Bibliographical notes. Alternative axiomatizations of expected utility
with state-dependent probabilities appear in Fishburn (1973), who assumes the
existence of preference relations on conditional acts, and Dreze (1959, 1987),
whose axiomatization is based on the methodological precept that only
information that may be extracted from decision makers by observing their
choice between pairs of acts may be used in the formulation of the axioms.
Wakker (1987) extended the results of this section to the framework of
Section 5.5.
6. Expected utility with non-additive subjective probabilities

6.1. Monva~on
Since most decision problems in economics involve uncertainty rather than

risk, it is desirable that theories of decision making under risk that are used in
economic analysis be obtained as an implication of theories of decision making
under uncertainty. The non-expected utility theories described in Section 3 are
no exception to this methodological precept. As these theories involve weakenings of the independence axiom, it is natural to seek the corresponding theories
1803
of decision making under uncertainty by weakening of the analogue axiom in

Savage's theory, namely, the sure thing principle.
A second reason for studying weakened versions of Savage's theory is
provided by a thought experiment due to Ellsberg (1961). In one version of
this experiment subjects are presented with an urn containing 90 balls. They
are told that 30 of these balls are red and that each of the remaining 60 balls is
either white or black. A bet on a color involves guessing the color of a ball to
be drawn at random. A correct guess entitles the subject to a prize of $100, an
incorrect guess yields $0. Subjects are asked to rank the three possible bets.
Ellsberg reports the finding that typically the bet on red was preferred over the
other two bets, and bet on white was equivalent to bet on black. Furthermore,
subjects are also reported to prefer a bet on either black or white to black or
red and to white or red, while being indifferent between the latter two bets.
These preferences are inconsistent with expected utility theory, and, in particular, with the existence of additive subjective probabilities. Because in Savage's
axiomatization the sure thing principle (5.2.2) is mainly responsible for the
additivity of the probabilities, it is natural to seek an explanation for Ellsberg's
findings by departing from this axiom.
The final point of motivation has to do with the notion of a prior probability.
In the neobayesian approach this notion pertains to the organization and the
representation of information available to a decision maker with regard to
those aspects of the decision problem that are subject to uncertainty. However,
according to this representation the probability assigned to an event does not
reflect the amount of information that underlies the assigned probability. For
instance, when the information pertaining to the likely realization of two
events is symmetric they are assigned equal probabilities. If the events are also
complementary the probabilities are 1/2, independently of the amount of
information.
There are two rules for assigning prior probabilities to events: (a) symmetric
information regarding the realization of events result in equal probabilities and
(b) if the sample space is partitioned to k symmetric (equiprobable) events then
the probability of each of these events is 1/k. If we accept the first rule but not
the second then it is possible to represent numerically the decision maker's
confidence in his probability assessment. For example, if there are two
equiprobable and complementary events and if each event is assigned the
probability 3/7, then 1 / 7 - - 1 - ( 3 / 7 3 / 7 ) may be taken to represent the
decision maker's confidence in his probability assessment. More generally,
allowing non-additive probabilities enables the representation of information
that additive probabilities cannot represent. Thus, the final reason for studying
decision theories under uncertainty that depart from the sure thing principle is
that doing so enables the representation of information by non-additive
probabilities.
1804
6.2. Expected utility with non-additive probability

In this section we use the n o t a t i o n and the definitions of Sections 5 . 1 - 5 . 4 , and
introduce additional definitions and a n e w p o s t u l a t e on p r e f e r e n c e s .
T w o acts a, b C A are said to be comonotonic if for no s,
t ~ S, a(s) ~ a(t) and b(t) > b(s).
6.2.1. Definition.
T h e m a i n innovation here, alluded to in the i n t r o d u c t o r y Section 6.1, is a

w e a k e n i n g of the i n d e p e n d e n c e axiom.
6.2.2. Comonotonic independence. A p r e f e r e n c e relation -> on A =
{a: S---~ C} (with C a c o n v e x set) satisfies for all a, b, c E A , a and c and b and
c pairwise c o m o n o t o n i c and for all ~z @ ]0, 1[: a > b ~ o m + (1 - a ) c > ab +
(1 - ~ ) c .
6.2.3. N o n - a d d i t i v e probability is, by definition, a set function 7r : 0---~ [0, 1]

such that 7r(~b) = 0, 7r(S) = 1, and E C F ~ 7r(E) -< 7r(F). B e f o r e stating the
m a i n result we point out that the definition of integral of a real valued b o u n d e d
function o n S in (5.1.1) holds even w h e n 7r is a non-additive probability. If
n
(Ei)i= ~ is a partition of S and f " S---~ E such t h a t f ( E i ) = a~ for i = 1 , . . . , n and
a I >- a 2 - > - - . -> a ,
and
a , + 1 = 0 then
f s f(s) O'T/'(S) = ~n/=l [(O~i -- O~i+l) X
gj)].
"1"1"(~i]=1
Suppose that a preference relation, ~-, on A / is given with

C = A(X). Then the following two conditions are equivalent:
(i) The preference relation ~- satisfies the Archimedean (2.2)i comonotonic
independence (6.2.2), monotonicity (5.4.9) and non-degeneracy (5.2.5) axioms.
(ii) There exist a unique non-additive probability ~r on the subsets of S and a
unique up to a positive linear transformation utility u : X---~ ~ such that
a---> -fs (ZxEx a(s)(x)u(x)) dqr(s) represents >_ on A k
6.2.4. T h e o r e m .
6.2.5. Extensions and corollaries

6.2.5.1. Definition. A n act a @ A is said to be b o u n d e d if for s o m e x,
y E C, x >- a(s) >- y for all s E S. We d e n o t e by A ( > ) the set of all b o u n d e d acts
in A.
6.2.5.2. Proposition.
Conditions (i) and (ii) of Theorem 6.2.4 are equivalent if Ay is replaced by A ( > ) in the statement of the theorem.
1805
The proof of the proposition is implied by the fact that the preference
relation -~ over A ( > ) that satisfies monotonicity is completely determined by
the preferences over Ay.
6.2.5.3. Corollaries. If in condition (i) of Theorem 6.2.4 the axiom of
comonotonic independence is replaced by the independence axiom (2.3) and in
(ii) additivity of ~r is assumed, then (i) and (ii) are still equivalent. The same
holds for Proposition 6.2.5.2. Finally, all the above results hold when all the
relevant functions are restricted to be measurable with respect to an algebra on S.
6.2.6. Bibliographical notes. The condition of comonotonic independence
and Theorem 6.2.4 were introduced in Schmeidler (1982). Proposition 6.2.5.2
first appeared in Schmeidler (1984a). Schmeidler (1989) includes both results.
Using Definition 5.5.1 for integrating bounded real valued functions with
respect to non-additive probability has been suggested by Choquet (1954).
Dellacherie (1970) has proved under unnecessary restrictions that the functional, f--~ j" f dTr, for f bounded and ~- non-additive probability is additive on
pairs of comonotonic functions ( f , g : S - - ~ E
comonotonic iff ( f ( s ) f(t))(g(s) - g(t))>-0 for all s, t ~ S.) The other direction, i.e. that a monotonic
functional on bounded functions which is additive on pairs of comonotonic
functions is a Choquet integral with respect co some non-additive probability,
has been proved by Schmeidler (1986). Anger (1977) proved that monotonic
and homogeneous of degree one functional is a Choquet integral if the
following weakening of comonotonic additivity is satisfied. The functional is
additive on all pairs of functions f, g such that 0 -< f(s), g(s) -< 1 and f(s) <
1 ~ g(s) = 0, for all s E S.
6.3. Uncertainty aversion and the maximin criterion

Suppose that a decision maker is indifferent between bets on two complementary events. A bet pays $100 if the decision maker wins it and $0
otherwise. The same decision maker prefers $40 for sure to either bet. This can
be explained by risk aversion. Suppose, however, that this decision maker
prefers a bet on " h e a d " in a flip of a fair coin over either of the other two bets.
Such a preference can be explained by uncertainty aversion. The preferences of
Ellsberg's example in Section 6.1 have this property. Given a preference
relation _> over A = {A: S--->A ( X ) ) we define:
6.3.1. Uncertainty aversion, a, b E A , a - b and a E (0, 1) imply a a + (1 a ) b >- b. (Strict uncertainty aversion requires adding a ~ b and a a + (1 -
a ) b > b.) The condition implies that substituting objective mixtures (in A(X))
for subjective mixtures can only increase the decision maker's welfare.
1806
6.3.2. Theorem. Suppose that the conditions of Theorem 6.2.4 as extended in

Proposition 6.2.5.2 (including (i) or (hence and) (ii)) are satisfied. Then the
following three conditions are equivalent:

(i) The preference relation ~- satisfies uncertainty aversion.
(ii) The non-additive probability ~r is convex, i.e. ~ ( E ) + 7r(F) <- 7r(E D
F) + 7r(E U F).
(iii) S f dTr = min{S f dp I P E core(Tr))} where core(Tr) is the set of additive
probability measures, p such that p ( E ) >- It(E) for all E C S.
T h e next condition is a weakening of c o m o n o t o n i c independence.
6.3.3. Certainty independence. For all a, b, c E A, where c ( s ) = y @ A(X),
for a l l s E S a n d a ~ ( 0 , 1 ) , i f a > b
then a a + ( 1 - a ) c > a b + ( l - a ) c .
6.3.4. Since c is a constant act, aa + (1 - a ) c is an act obtained from a by
" s m o o t h i n g " . The same kind of " s m o o t h i n g " operation applied to b results in
ab + (1 - ce)c. H e n c e , if a > b, the implication tea + (1 - a)c > ab + (1 - a)c
is quite plausible. This is not the case when the independence axiom is applied
to acts and c is an arbitrary act. The act aa + (1 - a)c m a y be m o r e complex
than the act a. It m a y have a higher variance than a. On the other hand
ab + ( 1 - a ) c
may still be s m o o t h e r than b. Thus the implication a >
b~aa+(1-a)c>ab+(1-a)c
m a y not be acceptable to the decision
maker.
The terms smoothing, complex and variance m a y be m o r e transparent if we
assume the existence of a (say affine) utility on A(X) and transform all acts into
" r a n d o m " utility variables.
The condition of comonotonic independence is formally and heuristically
between the condition of independence and that of certainty independence. If
a and c are comonotonic acts both are m o r e preferable on the same events [for
finite S one can order the states s~, s 2 . . . . , such that for all i, a(Sg)>-a(si+~)
and c(sg) >_ c(sg+~)]. H e n c e a a + (1 - a)c although not " s m o o t h e r " than a, is
of the same type as a. The same applies to b and c. As a conclusion, the
plausibility of the implication, a > b ~ a a + (1 - a ) c >- ab + (1 - a ) c with a
and c and b and c comonotonic, is m o r e compelling than without comonotonicity restriction, but is less compelling than when c is a constant act.
Suppose that a preference relation >- on A y C { a: S---~ A(X)}

is given, then the following two conditions are equivalent:
(i) :> satisfies certainty independence (6.3.3), monotonicity (5.4.9), uncertainty aversion (6.3.1) and the A r c h i m e d e a n axiom (2.2).
(ii) There exists a utility u : X--~ ~, unique up to positive linear transformations and a convex compact subset, say K, of additive probability measures
6.3.5. Theorem.
1807
on subsets of S (compact in the weak star topology) such that

a---~ rain{j" s u(a(s)) dp(s) I P E K} represents >- on A I.
Furthermore
(iii) The set K is unique iff >- is non-degenerate (5.2.5).
(iv) The equivalence between (i), (ii) and (iii) holds if A I is replaced by
A(>).
6.3.6. B i b l i o g r a p h i c a l n o t e s . The axiom of uncertainty aversion (6.3.1) and
Theorem 6.3.2 were introduced in Schmeidler (1984b, 1989). The axiom of
certainty independence (6.3.3) and Theorem 6.3.5 were introduced in Gilboa
and Schmeidler (1989). Wakker (1990) suggested the following condition on
_>: a > b, a E (0, 1) and b and c comonotonic imply a a + ( 1 - a ) c > a b +
(1 - a)c. Wakker's condition implies not only comonotonic independence, but
also uncertainty aversion, assuming monotonicity and the Archimedean axiom.
Moreover, these axioms in turn imply Wakker's condition. For additional
results see Chateauneuf (1987, 1988). Dow and Werlang (1987) presented an
application of non-additive expected utility with uncertainty aversion to explain
the decrease in the volume of trade on stock exchange in times of great
volatility in prices of stocks.
6.4. Purely subjective non-additive probabilities

6.4.1. A first natural challenge to the theory of expected utility with nonadditive probability as introduced in Section 6.2 is whether it can be restated in
Savage's framework. There, a preference relation _> on a set of acts A =
{a: S--->X} is given, where X is an abstract set without any structure except the
induced preference relation. The problem is to adjust Savage's postulates
presented in Section 5.2 so that if _> satisfies the adjusted postulates there exist
a unique non-additive probability measure r on subsets of S and a real valued
utility function, u, on X such that a--->fs u(a(s))d~(s) represents ->. Gilboa
(1985, 1987, 1989a,b) solved this problem and his results are presented in this
section.
In the sequel notations and definitions from Sections 5.1, 5.2, 5.3 and 6.2 are
used. The first step is to weaken the sure thing axiom (5.2.2) so that it would
apply to comonotonic acts only. In reality, however, the axiom below is not
comparable to the sure thing principle. It implies the qualitative probability
axiom (5.2.4).
6.4.2. For all a, b, c, d E A , allx, y, z, w E X , and all E, F C S s u c h t h a t
x > y , z > w , the acts (a[e,,xlE), (alEc , Y[E), (b[E~, z[E) and (blec, w[e ) are
pairwise comonotonic (6.2.1) and so are (C[Fc, XIF), (C[F,, Y[F), (d[F~, Z[F) and
1808
Then, (alec, xlE) ~ (blF~, XIF), (alec, YI~) ~ (Clec, YlF)

(ble~ , win ) ~ (d]F,, WlF) imply (clE~, ZlF ) >- (dlF~, ZlF ).
The next axiom weakens Savage's state independence axiom.
(dlr~, Wtr)
6.4.3.
For all E C S ,
x, y E X
and a E A ,
if x > y
and
then (ale,,X[e)>_
(al~c, ylD.
For uniqueness of 7r a double non-degeneracy is needed.
6.4.4.
For s o m e x , y, z i n X ,
x>y
andy>z.
The non-atomicity axiom of Savage (5.2.6), slightly altered, has to be

supplemented with an additional continuity axiom.
6.4.5. For all E C S, x, y E X and a; b E A, if (alec, xlE) > b, b > (ale,, Yle)
and (alEc, XlE ) and (ale~, yID are comonotonic then there is P C E such that
b -- (a]Ec, X]E\F, Y]F)"
6.4.6. For all a, E A , n E N, if for some E C S, x, y ~ A with x > y, (i) for all
s ~ S and n E N , a,(s)>-y and (ii) for all n E N , (a,]ec, X]e)--an+l, then
6.4.6.1. Recall that - * is defined in (5.2.4.1). This definition is induced by

(5.2.4) which is implied by (6.4.2) in the present model.
Finally the weakened version of conditional monotonicity (5.2.7) which
complies with comonotonicity is presented.
6.4.7. For all a, b E A and E C S such that for all s, t E E, r E S, f(s) > f(r)
and f ( r ) > f ( t ) imply r @ E , the following hold. If (alEc, a(s)le)>--b for all
s ~ E, then a -> b and if b >- (alec, a(S)IE) for all s E E, then b -> a.
6.4.8. Theorem. Suppose that a preference relation ~- on A = {a: S--> X } is
given. Then the following two conditions are equivalent:
(i) The preference relation satisfies axioms (6.4.1)-(6.4.7).
(ii) There exists a unique non-additive probability ~r on subsets of S and a
bounded, unique up to positive linear transformations, utility u : X--> ~ such
that a-+ f s u(a(s)) d~r(s) represents >- on A.
Furthermore, if A is replaced with A f in the statement of the theorem and the
axioms then (i) with (6.4.7) deleted is equivalent to (ii) with u not necessarily
bounded.
6.4.9. Remarks. The proof of Theorem 6.4.8 appears in Gilboa (1987). The
proof is difficult and complicated because of the non-additivity of the probabili-
1809
ty ~" to be constructed and because of lack of any mathematical structure on A

except the relation ->. Gilboa (1985) contains counterexamples to some
plausible or simplified variants of the axioms (6.4.2)-(6.4.7). It also contains
extensions of the t h e o r e m to quasi-continuity and continuity of zr. If zr is
additive, continuity means cr-additivity. These continuity results are comparable to A r r o w ' s presentation of Savage's theory [see A r r o w (1965, 1971)].
6.5. Comonotonic independence and topologically connected space o f

consequences
6.5.1. The alternative to Savage's model of purely subjective probability has
been presented in Section 5.5. W a k k e r (1986, 1989a,b) extended his model to
include non-additive probabilities. Indeed, T h e o r e m 5.5.3 holds if 1r is allowed
to be non-additive and the condition of cardinal coordinate independence is
relaxed by comonotonicity considerations. In order to state the new condition
first recall that we have a preference relation _> on A = {a: S---~ C} where S if
finite and C is a connected topological space.
6.5.2. Definition. Given four consequences x, y, z, w E C we write xy >c zw
if there is a state s and pairwise comonotonic acts (a[,c, x[,), ( b l , , Y[,),
(also, z[.,.) and (b],c, wls ) such that (al,,.,xl.J>-(b[.,, Y[s) and
(al~,, Z[s).
(bl,c,'wl,)>
6.5.3. Definition. Suppose that # S = n and s 1, s 2. . . . . s n is an ordering of S.

State s i is said to be non-null with respect to that ordering if there are two acts,
say a and b, that differ only for s i and a(sj_l) ~_ a(sj) and b(sj_l) >- b(sj) for
j=2,...,n,
anda>b.
6.5.4. Definition. Using the notations in Definition 6.5.2 we write xy >-c zw if
we have four c o m o n o t o n i c acts as above with a weaker implication: (a[s,,
xls) -> (blsc, Yl,) and (b[sc, w[,) -> (al~c, zls ). It is also assumed that s is non-null
with respect to some ordering consistent with comonotonicity of the four acts.
Finally we have:
6.5.5. Comonotonic cardinal coordinate independence. For any four consequences x, y, z and w it is not the case that x y > c z w and zw>-cxy.
6.5.6. Theorem. Suppose that a preference relation, >-, is given on the set
A = {a: S--* C} where S isfinite and C is a connected and separable topological
space. Suppose also that for some ordering of S there are at least two non-null
states with respect to that ordering. Then the following two conditions are
equivalent:
1810
(i) a--* f s u(a(s)) dlr(s) represents >- on A where rr is a unique non-additive

probability on S and u : C---->R is continuous and unique up to positive
transformations.
(ii) For e a c h a E A the sets { b @ A I b > a }
and { b E A I a > b }
areopenin
the product topology on A, and >- satisfies comonotonic cardinal coordinate
independence.
6.5.7. Remark.
S.
Wakker (1989b) recently extended T h e o r e m 6.5.6 to infinite
6.6. Reduction of uncertainty to risk

Of the three models of non-expected utility under risk presented in Sections
3.3, 3.4 and 3.5, the theory of expected utility with rank-dependent probabilities may be deduced from the theory of expected utility with non-additive
probability in a natural way. Suppose that a preference relation -> on A =
{a: S--~ C} satisfies the conditions of one of the main theorems of Section 6,
namely Theorems 6.2.4, 6.4.8 or 6.5.6. Then we have a non-additive subjective
probability ~- on subsets of S. The question is then whether there exists an
additive measure P on subsets of S and an increasing (or non-decreasing)
function f : [0, 1]--> [0, 1] onto, such that It(E) = f ( p ( E ) ) for all E C S. If the
answer is affirmative then any act a ~ A s can be represented as a lottery
p(a) E A(X). This representation is not one to one, however, if p ( a ) = p ( b )
then a is indifferent to b. If X C ~, f s u(a(s)) dlr = ~ u(x) df(F(x)), where F is
the distribution of p(a). This result may be extended to A or A ( > ) with ~r
convex-valued.
Suppose that ~r satisfies the following condition: for E, F, G C S, if E n G =
4~ = F n G then ~r(E) > 7r(F) implies ~-(E U G ) > ~-(F U G). Then the representation 7 r ( . ) = f ( p ( . ) ) holds with f increasing for infinite S if 1r is convexvalued. This result is part of Savage's proof of T h e o r e m 5.3. (Savage uses
qualitative probabilities instead of ~'.) The case of nondecreasing f is more
difficult. It requires an additional structural assumption [see Gilboa (1986) and
further discussion in Schmeidler (1989)]. At this time it is not clear how to
impose a natural condition directly on the preference relation _> on A that
would imply the condition on ~- of the previous paragraph without forcing
p = ~-. Hence, the validity of applying non-expected utility theory of Section 3
to the analysis of economic p h e n o m e n a involving decision making under
uncertainty is not clear. Further research is needed to close the gap between
theories on decision under risk and decision under uncertainty [see Machina
and Schmeidler (1990)].
1811
Part 4: Attitudes toward risk
7. The theory of risk aversion
7.1. The need for measures

A wide range of economic phenomena are considered responses to the nearly
universal desire to avoid bearing risk. The existence of insurance contracts and
the issuance of common stock are the most obvious examples. Other examples
include sharecropping agreements, futures trading in commodities and foreign
exchange, and long-term labor contracts. The main purpose of these arrangements is to permit a more desirable allocation of risks in the economy. The
analysis of these phenomena requires a definition of risk aversion and formal
measures of the intensity of risk aversion for different individuals, and the
attitudes toward risk of a given individual at different levels of wealth. The
original measures of risk aversion were developed independently by Pratt
(1964) and Arrow (1965). The Arrow-Pratt measures proved useful for the
analysis of decision problems involving univariate, state-independent utility
functions and single risks. Other problems require the strengthening of these
measures or the imposition of additional restrictions on the preferences whose
attitudes toward risk may be compared.
7.2. Preliminaries
Let ~ be the set of random variables in ~. Consider all the state-independent
reference relations on Y such that for each preference relation >- and every
Z E ~( there exists a certainty equivalent C u ( Z ) E ~, where u is a von
Neumann-Morgenstern utility function on ~ representing _> (i.e. the set of all
preference relations on Y such that for each Z ~ Y there exists C " ( Z ) E
satisfying E { u ( Z ) } = u(CU(Z)), where E is the expectation operator).
7.2.1. Definitions. A preference relation, >_, is said to display risk aversion if
for all Z E ~, E { u ( Z ) } < u(E(Z)); risk neutrality if E { u ( Z ) } = u(E(Z)); and
risk proclivity if E { u ( Z ) } > u(E(Z)).
7.2.2. Remark. By Jensen's inequality risk aversion, risk neutrality and risk
proclivity are equivalent, respectively, to concavity, linearity and convexity of
the von Neumann-Morgenstern utility function u. A utility function may be
concave over some interval and convex over another, thus displaying aversion
to some risks and inclinations toward others. One may, of course, define local
risk aversion at x C E by restricting the above definition to all Z with support in
1812
a neighborhood of x. Risk aversion is then equivalent to the requirement that

the preference relation displays local risk aversion at every x in ~.
7.3. The Arrow-Pratt theory of risk aversion

The study of the full range of the economic arrangements design to improve
the allocation of risk requires a measure of the intensity of risk aversion.
7.3.1. Definitions. Given a von N e u m a n n - M o r g e n s t e r n utility u, the risk
premium pU : ~f.__~R is defined by pU(Z) = E ( Z ) - C"(Z). A utility function u
is said to be more risk averse than another utility function v if for all Z E ~f,
p"(Z) >- p(Z). It is strictly more risk averse if, in addition, p"(Z) > p~(Z) for
some Z.
The risk premium function is the largest amount of money that a decision
maker whose preferences are represented by a utility function u is ready to pay
for the opportunity to exchange the risk Z for its mean value. By definition it is
positive if the decision maker is risk averse, negative if he is risk inclined and
zero if he is risk neutral. The use of the risk premium to measure the intensity
of risk aversion is suggested by the intuitive notion that, ceteris paribus, the
more risk averse a decision maker is the more he would be willing to pay to
avoid bearing any given risk. For local risks this criterion constitutes a
complete ordering of the preference relations. However, for global risks it
represents only a partial ordering.
A n o t h e r intuitive criterion for comparing attitudes toward risk stems from
the notion that any risk that is preferred by a more risk averse individual to a
certain outcome is also preferred by the less risk averse individual but not vice
versa. This idea, captured by the following definitions, is equivalent to risk
premium criterion (see T h e o r e m 7.3.3).
7.3.2. Definitions. Let Z and Y be in ~f and let F z and F v denote their
cumulative distribution functions, respectively. Z is said to represent a simple
mean utility preserving spread of Y from the point of view of u if E { u ( l ) } =
E { u ( Y ) } and there exist x * ~ E such that Fz(x )-> F r ( x ) for all x - < x * and
Fz(x ) --< F r ( x ) for all x > x*. A utility function u is more risk averse than
another utility function v if all simple mean utility preserving spreads from the
point of view of v are mean utility reducing spreads from the point of view of
U.
7.3.3. Theorem. Let u and v be two yon Neumann-Morgenstern utility

functions on ~, then the following conditions are equivalent in either the strong
or the weak forms:
1813
(i) p ' ( Z ) ( > ) -> p ( Z ) for all Z E ~ ;

(ii) for any Z, Y C ~ if Z is a mean utility preserving spread of Y from the
point of view of v then E { u ( Z ) } ( < ) < _ { E u ( Y ) } ;
(iii) there exists a monotonic increasing (strictly) concave transformation,
T : ~--> ~, such that u = T(v).
Furthermore, if u and v are twice differentiable, then the preceding conditions
are equivalent to
(iv) - u"(x) / u ' ( x ) ( > ) >- - v"(x) /v '(x) for all x E fl~.
7.3.4. Corollary. Let u be a twice differentiable von Neumann-Morgenstern
utility function on ~ then the following two conditions are equivalent in either
the strong or the weak form:
(i) - u"(x)/u'(x) is a (strictly) decreasing function of x;
(ii) for all non-degenerate Z and Y in ~ and a > O , if Z = a + Y then
p"(r)(>) -> F ( z ) .
7.3.5. The equivalence of conditions (i), (iii) and (iv), as well as the corollary
and their proof appear in Pratt (1964). The equivalence of condition (ii) and
(iv) and its proof appears in Diamond and Stiglitz (1974). The equivalence of
conditions (i) and (iii), however, is an immediate implication of a result of
Hardy, Littlewood and Polya (1934). Pratt was the first to introduce the notion
of risk premium and to discover the equivalence of (i) and (iv).
7.3.6. Remarks. The function - u " ( . ) / u ' ( . ) is known in the literature as the
Arrow-Pratt measure of absolute risk aversion. This measure was discovered
independently of Pratt by Arrow (1965), who used it to analyse an optimal
portfolio problem [see (7.3.7)]. For small actuarially fair risks, this measure is
twice the premium per unit of variance. Formally, let Z = + Y, where Y is a
random variable with zero mean and variance o-~. Then, for Y with support in
an e-neighborhood of , for e sufficiently small, p U(Z) is approximately equal
to [--u"(z) /u , (z)]O-y/2. A similar relation exists between proportional risks,
2Y, i.e. gains and losses that are expressed as a proportion of the decision
maker's mean wealth and the risk premium, j6u(.), expressed as a proportion of
the decision maker's mean wealth. For small risks, ~ " ( Z ) is approximately
equal to [-u"(Z)E/u'(Z)lo-ey/2. The expression - u " ( ~ ) ~ / u ' ( ) is the A r r o w Pratt measure of local relative risk aversion.
-
7.3.7. A portfolio problem. The ultimate justification for the introduction of

measures of risk aversion is their usefulness in the analysis of concrete
economic problems. To illustrate the usefulness of the A r r o w - P r a t t measures
of risk aversion, consider the problem of choosing an optimal portfolio when
there are two assets - a risk-free asset whose rate of return is zero, and a risky
1814
asset with a random rate of return R, E { R } > 0 . Given a von N e u m a n n Morgenstern utility function u, let a"(w, R) be the optimal investment in the
risky asset expressed as a proportion of the initial non-random wealth, w, of a
decision maker whose preferences over risky prospects are represented by the
expectation of u. Then, ceteris paribus, the more risk averse the decision
maker is (in the sense of Definition 7.3.1), the less risky is his optimal portfolio
position. Formally:
Let u and v be the yon Neumann-Morgenstern utility functions of two decision makers with the same initial wealth, w. Then the following
(i) p " ( Z ) >--p ( Z ) for all Z E ~Z
(ii) a " ( w , R ) < - - a ( w , R ) for all w E a
and R, where a h ( w , R ) =
arg max E { h ( w + a w R ) } , h = u, v.
7.3.8. Theorem.
7.3.9. This result is due to Arrow (1965) and Pratt (1964). Note that if Z is
non-degenerate, then a"(w, R) < aV(w, R) implies that u is strictly risk averse.
F u r t h e r m o r e , if u is twice differentiable then a"(w, R ) > 0. This follows from
the fact that for sufficiently small risks the attitudes toward risk of risk averse
individuals are approximately risk neutral.
7.4. Aversion to one risk in the presence of others

A crucial aspect of the portfolio problem in 7.3.7 is the availability of a
risk-free asset. If no such asset is available and there are instead two risky
assets, one of which is more risky than the other, then it is no longer the case
that a more risk averse individual in the sense of Definition 7.3.1 necessarily
takes a less risky portfolio position [for a counterexample see Ross (1981)].
The failure of the A r r o w - P r a t t measures to provide a natural characterization of the portfolio behavior in this case stems from the fact that these
measures are local, whereas attitudes toward risk that determine the portfolio
behavior in the absence of a risk-free asset necessarily depend on properties of
the utility function at points in its domain that are far apart. To illustrate the
point, suppose that the decision maker's initial wealth is the sum of two
r a n d o m variables, W, which takes the values w 0 and w 1 with probabilities a and
(1- a ) , respectively, and Z which takes the values z, and - z with equal
probabilities if w 0 is realized, and the value 0 otherwise. Assume that W
represents irreduceable risk and define the risk premium, p"(Z), to be the
largest sum of money that the individual with a utility function u is ready to pay
to avoid bearing the risk represented by Z. Then, p " ( Z ) is defined implicitly by
the equation
a u ( w o - p) + (1
-- o ~ ) u ( w 1 - / 9 )
1815
= o/[0.5u(w
0 -I- z ) nt- 0 . 5 u ( w
0 - z)]
--t- ( 1 - o d ) U ( W l )
For a small enough z, p " ( Z ) [ a u ' ( W o ) + ( 1 - a ) u ' ( w l ) ] is approximately the

expected utility loss associated with the payment of the risk premium and
-u"(Wo)Z2/2, the approximated expected utility loss associated with the risk Z.
By definition these two expressions must be equal to one another. The
definition of the Arrow-Pratt measure of absolute risk aversion is based on the
assumption that a riskless position is attainable and, therefore, for small risks
the utility loss associated with the payment of the risk premium is evaluated by
the marginal utility of the non-random wealth. The existence of an irreduceable element of risk and the fact that the risk premium is paid uniformly
requires that the risk premium be evaluated by the expected marginal utility of
wealth. This involves properties of the utility function that may not be captured
by the Arrow-Pratt measure because of its local nature. Indeed, it is easy to
verify that a utility function u may be more risk averse than another utility
function v in the sense of Definition 7.3.1 and yet have a lower risk premium,
p " ( Z ) . A stronger definition of risk aversion due to Ross (1981) has the
property that a more risk averse decision maker according to this definition
always takes a less risky portfolio position.
7.4.1. Definition. Let W and Z be bounded random variables in ~ and
suppose that for every realization w E Supp W, E { Z I w} = 0. For h = u, v let
ph(Z, W ) be defined by E { h ( W - p ) } = E { h ( W + Z)}. Then u is more risk
averse than v in the strong sense if p u(Z, W ) >_ p v(Z, W ) for all such W and Z.
7.4.2. Theorem. Let u and u be twice-differentiable, strictly concave, von
Neumann-Morgenstern utility functions on ~. Then the following three conditions are equivalent:
(i) u is more risk averse than v in the sense o f Definition 7.4.1;
(ii) there exists A > 0 such that for all x and y in ~, u"(x) /v"(x) ~ A >- u'( y) /
v'(y);
(iii) there exists A > 0 and G : R---~~, G'_<0, G"_<0, such that u = Av + G.
Furthermore, let Y = W + Z, where for every w E Supp W, E { Z I w} >- 0, and
a h ( w , Y) = argmax E{h((1 - a ) W + a Y ) } , h = u, v, then these conditions
imply au(W, Y)<_ a ( W , r ) .
7.4.3. Theorem 7.4.2 and its proof are due to Ross (1981). Ross also defines
the corresponding notion of decreasing risk aversion.
7.4.4. Remarks. Comparison of the attitudes toward risk of two utility
functions using the Ross measure requires that the functions being compared
1816
are both either concave or convex. In other words this measure does not apply
when one of the functions displays risk aversion and the other risk proclivity.
Moreover, unlike the A r r o w - P r a t t definition, according to which holding a less
risky portfolio position in the presence of a risk free-asset is equivalent to being
more risk averse, the notion of more risk averse defined by Ross is not implied
by the holding of a less risky portfolio position in the presence of other risks.
Machina and Neilson (1987) address these difficulties by strengthening the
definition of Ross. In particular, they require that a more risk averse decision
maker be ready to pay larger stochastic non-negative risk premium to avoid
bearing one risk in the presence of another. Formally, let ph be defined by the
equation E { h ( W - p ~ ' ) } = E{h(W + Z ) } , where ~ is a non-negative random
variable, and for every realization w of W, E { Z [ w } = 0 . Then one von
N e u m a n n - M o r g e n s t e r n utility function, say u, is more risk averse than
another, say v, if pU > pV. This definition is equivalent to each of the following
two conditions: - u " ( x ) / u ' ( y ) >- -v"(x)/v'(y) for all x and y in some compact
interval [0, M] C E and u(x) = hv(x) + G(x), for some A > 0 and non-increasing
and concave function G satisfying G"(x)u'(y) <- G'(y)u"(x) for all x and y in
[0, M]. If u and v are risk averse then u is more risk averse than v according to
the definition of Machina and Neilson if and only if au(W, Y)<_ av(W, Y),
where a, W and Y are as in T h e o r e m 7.4.2.
7.4.5. Bibliographical notes. Machina (1982b) strengthens the definition of

decreasing absolute risk aversion by requiring that the risk premium be a
non-increasing function of wealth whether the change of wealth is uniform
across states, as in the definition of A r r o w and Pratt, or not. (In the latter case
an increase in wealth is represented by a non-negative random variable.)
Machina shows that within the framework of expected utility theory this
restriction implies risk neutrality. Epstein (1985) strengthens Machina's definition and shows that mean-variance utility functions are implied.
For two risk averse utility functions and two stochastically independent risks,
Kihlstrom, R o m e r and Williams (198].) compare the certainty equivalent of
one risk in the presence of the other. They show that if either of the utility
functions displays decreasing absolute risk aversion then the certainty equivalent of the more risk averse decision maker will be smaller. Pratt (1988) shows
that a sufficient condition for the certainty equivalent of a given risk in the
presence of another to be smaller for a more risk averse individual (in the
sense of Definition 7.3.1) is that, for every realization of the random variable
representing the other risk, the conditional certainty equivalent of the given
risk be smaller and separated by a monotonic increasing function. Hart (1975)
points out difficulties in obtaining comparative statics results in portfolio theory
in the presence of several risky assets.
1817
Yaari (1969) developed measures of risk aversion in the context of the

state-preference approach, and applied his measures to portfolio analysis. [On
the latter point see also Mayshar (1975).]
Comparative attitudes toward risk involves two main issues: the first,
addressed in this section, deals with the comparison of attitudes of two decision
makers facing risk. The second issue has to do with stochastic orders and is
concerned with the question what class of decision makers consider one
prospect to be riskier than another. The second issue is not dealt with in the
present survey. The interested reader is referred to Rothschild and Stiglitz
(1970). A more detailed guide to the main results, starting with Hardy,
Littlewood and Polya (1934), is found in Schmeidler (1979). More recent
results appear in Landsberger and Meilijson (1990a-c).
7.5. Multivariate risk aversion and risk aversion with state-dependent
preferences
Decision problems involving multivariate risks or state-dependent utility functions are common. For example, a household's consumption-saving decisions in
the face of uncertain rates of return, or a farmer's choice of a crop in the
presence of uncertainty regarding the output and the future relative prices of
his crop and other goods are instances of decision making in the face of
multivariate risks. The choice of personal injury insurance or optimal flight
insurance coverage involves state-dependent preferences. The choice of a life
insurance plan involves multivariate state-dependent utility functions. The
essential difference between decision problems involving multivariate utility
functions and decision problems involving state-dependent utility functions is
that in the formulation of the latter there is an attribute of the ultimate
outcome, namely the state of nature, that is unalterable. In this sense, the state
of nature represents an uninsurable risk, and, as in the cases of univariate,
state-independent preferences, the presence of such risks necessitates modification of the measures of risk aversion.
7.5.1. Comparative multivariate risk aversion. Whereas in the case of univariate state-independent utility functions satisfying first-order stochastic dominance the induced ordinal preferences on the domain of the utility functions
are identical, in the cases of multivariate or state-dependent utility functions
they are not. Consequently, the comparison of attitudes toward multivariate
risks, or towards risks in which both the outcome and the state are arguments
in the decision maker's utility functions, is confounded by differences in the
ordinal preferences. To grasp the problem consider a v o n Neumann-Morgenstern utility function, u, defined on an n-dimensional commodity space, E~.
Let W be the set of random vectors in ~ such that E { u ( W ) } is finite for all
1818
W E off.. T h e certainty equivalent, C", is a correspondence defined on 74/"by the

equation u(C) = E { u ( W ) } . (For every W the value of the certainty equivalent
is an indifference set in Rn.) If v is another von N e u m a n n - M o r g e n s t e r n utility
function on R+, then a natural generalization of Definition 7.3.1 i s t o say that u
displays greater multivariate risk aversion than v if C"(W)>-C(W) for all
W ~ W, where Cu(W) >- C(W) means that for every (xl, x 2 , . . . , x , ) E
C " ( W ) there exists (x'~,x~ . . . . . x ' , ) E C V ( W ) such that xi>-xl, i=
1, 2 . . . . , n. However, unless u and v represent the same preference relation
they are non-comparable in the sense of this definition. Put differently, if u and
v represent distinctive ordinal preferences, then whether the certainty equivalence of u is larger or smaller than that v depends on the direction in which it is
measured. Since no natural direction in which to measure the certainty
equivalent exists, the notion that the more risk averse the individual the
smaller is his certainty equivalent for a given risk may be defined only for
utility functions that induce the same ordinal preferences. With this restriction
the problem is reduced to the univariate case, i.e. identifying each equivalent
class of the (common) preference relation with a point in ~ and then applying
the theory of univariate state-independent utility function. In particular, it is
easy to verify that u displays greater risk aversion than v if and only if u is a
concave transformation of v [see Kihlstrom and Mirman (1974)].
n
7.5.2. Autocomparability of multivariate risk aversion. The comparison of

attitudes toward multivariate risk of a given individual at different points in the
domain of the utility function requires a definition of the sense in which the
ordinal preferences at the two points are the same. This problem is treated in
Kihlstrom and Mirman (1981). According to their approach the degree of risk
aversion is the same at every point belonging to a given indifference set (i.e.
the degree of risk aversion is a function of the level of utility), and the
p r e f e r e n c e relations are autocomparable if they are homothetic. Using a result
of D e b r e u (1976) that every convex preference relation that is representable by
a concave utility function has a least concave representation, Kihlstrom and
Mirman show that if the preference relation is homothetic, then its least
concave utility representation is linear homogeneous. Let u* be a linear
homogeneous representation of a preference relation on ~n, if u is a concave
representation of the same preference relation then there exists h : ~---> ~ such
that u(x) = h(u*(x)), for all x ~ ~n. u is said to display decreasing (increasing,
constant) absolute risk aversion if h displays decreasing (increasing, constant)
absolute risk aversion in the sense of A r r o w and Pratt, i.e. if -h"(u*)/h'(u*) is
decreasing (increasing, constant) function of u*. The notion of decreasing
relative risk aversion may be defined analogously.
7.5.3. Comparative statics. Even under the restrictions that all the utility
functions being compared represent the same preference relations the corn-
1819
parative statics effects of multivariate risk aversion are complicated by the

multidimensionality of the utility function. To grasp the difficulty consider a
two-period consumption saving problem. Let Yl and Y2 denote the first and
second period incomes, respectively. Denote by a the level of saving and by 0
the random rate of return to saving. The decision problem is to choose a so as
to maximize E { u ( y 1 - a , y : + a(1 + 0))}. This problem is similar to the
portfolio problem described in Section 7.3.7. There is one important difference, however, that is the result of the multidimensionality of the utility
function. Whereas in the portfolio problem the two assets are perfect substitutes, in the consumption-saving problem the risky prospect - future consumpt i o n - i s not a perfect substitute for the risk-free prospect, namely, present
consumption. Consequently, a higher degree of risk aversion is neither a
necessary nor a sufficient condition for lower or higher saving. In fact, saving
increases (decreases) with an increase in risk aversion if there exists 0* such
that OulOa -->(-<)0 for 0 --< 0* and Ou/Oa --<(->)0 for 0 -> 0". The reason for the
aforementioned ambiguity has to do with the conflicting income and substitution effects. To see this define the certainty equivalent rate of return, 0", by the
equation u ( y I - a, Y2 + a(1 + 0")) = E { u ( y 1 - a, Y2 + a(1 + 0))}. If v represents the same ordinal preferences but is more risk averse than u, then ~v < ~,.
In other words, an increase in risk aversion is equivalent to a decline in the
certain rate of return and its effect on saving depends on the usual income and
substitution effects [see Diamond and Stiglitz (1974) and Kihlstrom and
Mirman (1974) for more details].
7.5.4. Matrix measures. Attempts to compare the attitudes toward risk of
multivariate utility functions representing distinctive ordinal preferences lead
to the development of matrix measures of risk aversion [see Duncan (1977),
Karni (1979)]. Consider, for instance, a decision maker facing an income and
relative price risk. Then, taking commodity n to be the numeraire, the decision
maker's preferences are represented by E { O ( y , p)}, where 0 denotes the
decision maker's indirect utility function, y denotes his income, and p is a
vector of relative prices. Let 01 and 0ij denote the partial derivative of ~Owith
respect to its first argument and the cross partial derivative with respect to its
ith and jth arguments, respectively. Define the matrix measure of absolute risk
aversion at a given (y, p) as M ~ ( y , p) = ] - ~ i j / ~ t l ( y , p)]. It can be shown [see
Karni (1979)] that if ~O* is another indirect utility function then, ceteris paribus,
q, is willing to pay larger premium (out of his expected income) to avoid any
given risk if and only if [M+_~ M~,.] is positive definite. This is also equivalent
to the condition that q,(ff* (t, p), p) is concave. However, this definition is
unsatisfactory in an important respect. It is natural to require that if ~Oand ~*
were to reach a risk sharing agreement that specifies payments from one to the
other contingent on the realization of y and p, then the less risk averse
individual should insure the more risk averse one. This, however, is not the
1820
case. The less risk averse decision maker does insure the more risk averse one
against income risk (i.e. he pays the more risk averse individual when the
income of the latter is low in return for being paid when the income of the
m o r e risks averse individual is high) but not necessarily against relative price
risks. T h e reason for this has to do with the difference in the ordinal
preferences. Relative price risks translates into income risks when they are
multiplied by optimal consumption bundles. Thus, if the optimal bundles are
different for two individuals then the same variations in relative prices translate
into different variations in income. In particular, it is possible that the more
risk averse individual consumes less of a commodity whose price fluctuates
randomly. Thus, the same random price variation represents a smaller risk for
him than it does for the less risk averse decision maker. Consequently, it may
be optimal for the more risk averse decision maker to insure the less risk
averse one against some risks.
7.5.5. Comparability of state-dependent preferences. Let S be an arbitrary set
of states of nature. Let ~ be the set of all real-valued functions on S. For a
given probability measure, p on S, and c E let B(p, c) = { W E ~ I E { W } =
c}. Let U be an expected utility functional representation of state-dependent
preferences. A reference point of V is a r a n d o m variable W * ( p , c) @ B(p, c)
such that U(W*(p, c)) >- U(W) for all W G B(p, c).
7.5.5.1. Definition. For any probability measure p on S and a statedependent expected utility functional U, let R S v ( p ) ~ { W * E ~ t W * is a
reference point of U in B(p, c) for some c -> 0}. RSv(p) is the reference set of
U given p.
For a risk averse individual, i.e. an individual whose utility of wealth is
concave in each state of nature, a reference point represents the most preferred
distribution of wealth across states among all such distributions that have the
same actuarial value. When the reference set represents an internal solution it
may be characterized as the set of gambles such that the marginal utility of
wealth is the same across states. In many situations the reference set is
independent of p. If the preferences are state independent then the reference
set is the certainty set, i.e. the set of constant functions on S.
7.5.5.2. Definition. Let U and V be two state-dependent utility functions.

Then U is said to be globally comparable to V if RS v C RS v.
Comparability is an asymmetric relation. This allows for the fact that the
utility of wealth may not be strictly concave in some states. If the two utility
functions are strictly concave in wealth in every state, then if one is comparable
1821
to the other they are mutually comparable. Note also that if the preference
relation is state independent then any two strictly risk averse utility functions
are mutually comparable. In other words, if the preferences being compared
are state independent the prerequisite for comparability of attitudes toward
risk is implicitly satisfied.
7.5.6. The measurement of risk aversion. For every probability measure p on
S and W E ~ 3 let c ( W ) = - E { W } , and define C " ( p , W ) implicitly by
E { U ( W * ( p , c - C U ) ) } = E { u ( W ) } , where the expectation is taken with respect to the measure p. We refer to W * ( p , c - C ~) as the reference equivalent
of W. The risk premium corresponding to W and p is defined as p " ( p , W ) --E { W * ( p , c(W)) - W * ( p , c ( W ) - C"(W))}. Thus, p " ( p , W) is the largest actuarial value a decision maker whose utility function is U is ready to forego for
the opportunity to exchange W for a point on his reference set. It is easy to
verify that if U is a state-independent utility function, then this definition is
equivalent to Definition 7.3.1.
7.5.6.1. Definition. Let U and V be mutually comparable, risk averse,
state-dependent utility functions. U is more risk averse than V if p"(p, W ) >pV(p, W ) for every probability measure p on S and every W E ~g.
7.5.7. Theorem. Let U and V be mutually comparable, r&k averse, statedependent, twice differentiable utility functions. Then the following conditions
are equivalent in either the strong or the weak form:
(i) -Uww(w, s)/Uw(w, s) ->[>1 -Vww(W, s)/V~(w, s) for all s @ S and w >O;
(ii) for every probability measure p on S there exists a monotonic increasing
[strictly] concave transformation Tp : ~----~~ defined by E { U ) = Tp[ E { V } ] and
T'p = T' for all p;
(iii) p " ( p , W) ---[>] pV(p, W) for every probability measure p on S and all
WE~.
7.5.8. Theorem 7.5.7 and its proof are in Karni (1985). Note that if U and V
are state-independent then the equivalence of (i), (iv) and (iii) of Theorem
7.3.3 is a corollary of Theorem 7.5.7.
7.5.9. Remarks. The comparison of attitudes toward risk of the same individual at different levels of wealth requires a definition of the sense in which
the reference sets at different points in the domain of the utility function are
the same. Autocomparability is possible if the reference set is a ray in the space
~3 [see Karni (1985)]. Formally, W * ( p , c) is linear homogenous in c.
If the insurance premium is a linear function of the actuarial value of an
1822
insurance policy and no co-insurance is allowed, then the optimal insurance

policy of a risk averse individual whose preferences are univariate stateindependent is characterized by full coverage over a minimum deductible [see
Arrow (1971)]. Furthermore, ceteris paribus, a more risk averse individual in
the sense of Definition 7.3.1 will choose a policy with a lower deductible.
When the preferences are state-dependent then the optimal policy is characterized by full coverage above minimum deductibles that may vary across states
[see Arrow (1974)]. In this case, using Definition 7.5.6.1 we obtain analogous
results, namely, that ceteris paribus, a more risk averse individual will choose
lower deductibles in each state [see Karni (1985)].
An expected utility maximizer who must choose among alternative investments while facing uncertain future income and relative prices behaves as if he
maximizes the expectation of an indirect utility function. Ultimately, of course,
he is facing a multivariate risk on the commodity space. But at the same time,
for a price taker, the relative prices may be taken to represent an unalterable
attribute of the outcome space, i.e. the space of all incomes and relative price
vectors. It seems, therefore, that the same problem may be formulated in
terms of state-dependent preferences. Indeed, under appropriate normalization
of the income and prices, the requirement that two indirect utility functions
have the same reference set is equivalent to the requirement that their
underlying preference ordering on the commodity space be the same [see Karni
(1985)].
7.5.10. Bibliographical notes. Stiglitz (1969) examined the restrictions imposed on the ordinal preferences on the commodity space implied by alternative assumptions on attitudes toward income risks and, conversely, the restriction on attitudes toward income risk implied by alternative assumptions on the
nature of the preference relation. Paroush (1975) discussed the definition of
multivariate risk premia. Hanoch (1977) studied the relationships between
relative risk aversion with respect to income and with respect to prices. Eisner
and Strotz (1961), Yaari (1965) and Arrow (1974) analysed insurance problems
involving state-dependent preferences. Karni and Zilcha (1985) analysed the
effect of risk aversion on the demand for life insurance. This analysis involves
multivariate, state-dependent utility functions.
7.6. Risk aversion with non-linear preferences

The attitudes toward risk represented by expected utility functionals are
captured by the concavity of the corresponding utility functions. Similarly, the
attitudes toward risk represented by "smooth" non-linear functionals are
captured by the concavity of the corresponding local utility functions. However, whereas when the preference functional is linear in the probabilities all
1823
the local functions are identical, in the non-linear case the local utility functions
are different. Thus, the extension of the expected utility theory of attitudes
toward risk to non-linear functionals requires that the local utility functions be
appropriately qualified.
7.6.1. Definition. A preference functional V on D~ is said to display risk
aversion (strict risk aversion) if for all F, G E D], V(F) >- V(G) (V(F) > V(G))
whenever F is a mean preserving_ spread of G, i.e. whenever .[jx ] F ( z ) G(z)[ dz - 0 for all x, where jx =- j O (-0% x], and fy ]F(z) - G(z)] dz = 0.
For a detailed discussion of the meaning of mean preserving spread see
Rothschild and Stiglitz (1970).
7.6.2. If V in Definition 7.6.1 is Frechet differentiable with local utility
functions U(.; F), F E D j, then risk aversion is equivalent to each of the
following conditions: (a) U(x; F) is concave in x for all F, and (b) for any F,
G E D j and a ~ (0, 1], if /~(G) denotes the mean of G then V ( ( 1 - a ) F +
a6~(c) ) - V ( ( 1 - a ) F + ozG) [see Machina (1982)].
7.6.3. F G Dj is a simple compensated spread of G from the point of view of
V if V(F) = V(G) and there exist x' E J such that F(x) >-- G(x) for all x < x' and
F(x) <- G(x) for all x -> x'.
7.6.4. Definition. A preference functional V is more averse than a preference
functional V* if for every F, G E D] such that F is a simple compensated
spread of G from the viewpoint of V*, V(F)<--V(G).
7.6.5. Comparative risk aversion of Frechet differentiable functionals. A
Frechet differentiable functional V displays risk aversion if and only if all the
local utility functions are concave [see Machina (1982a)]. Equivalent characterizations of the relation "more risk averse than" for Frechet differentiable
functionals are given in Theorem 7.6.6. These are analogous to the conditions
given in Theorem 7.3.3.
7.6.6. Theorem. Let V and V* be a pair of Frechet differentiable preference

functionals on Dy with local utility functions U and U*, respectively. Then the
following conditions are equivalent:
(i) for any F, G E D j and a E (0, 1], if c and c* are defined, respectively,
by
V((1 - o~)F + a G) -- V((1 - a ) F + a6c)
and
V*((1 - a ) F + a G) =
V * ( ( 1 - oz)F+ a~c.), then c<-c*;
(ii) for every F E Dy there exists a continuous, monotonic increasing and
concave transformation TF : ~--->~ such that U(.; F ) = TF(U*(.; F));
1824
(iii) V is more risk averse than V* in the sense of Definition 7.6.4.

Furthermore, if for all F E D j the local utility functions are twice differentiable then the following condition is equivalent to the preceding conditions,
(iv_.) for all F ~ D], -U~l(x; F ) / U I ( x ; F) >- - U ~ , ( x ; F ) / U ~ ( x ; F) for all
xEJ.
7.6.7. Theorem 7.6.6 and its proof appear in Machina (1982a). The function
c(G; F, a) defined in condition (i) is the conditional certainty equivalent of G
according to V. The conditioning of the certainty equivalent is a result of the
need to compare the certainty equivalents of a distribution G according to the
local utility functions, U(.; F) and U*(.; F), of another distribution F. In
expected utility theory, since all the local utility functions are identical, the
conditional and unconditional certainty equivalents are equal.
Note that the conclusion of Theorem 7.6.6 may be obtained under the
weaker condition of Gateaux differentiability [see Chew (1983) and Chew,
Karni and Safra (1987)].
7.6.8. Conditional asset demand. To illustrate the usefulness of these definitions and at the same time to highlight a difference between the theory of risk
aversion under expected utility and nonexpected utility, consider the portfolio
problem (7.3.7). The comparative statics result summarized in Theorem 7.3.8
invokes the fact that when a preference functional is linear and the utility
function u is strictly concave then E ( u ( w ( 1 + a Z ) ) } is strictly quasi-concave in
a. In other words, using the terminology of Tobin (1957/1958), a risk averse
expected utility maximizer is a diversifier. If the preference functional is
non-linear then risk aversion in the sense of Definition 7.6.1 does not imply
diversification [see Dekel (1989)].
7.6.9. Definition. Let F~ E Dj denote the cumulative distribution function of
(r + a ( Z - r)), then a preference functional V is said to display conditional
diversification if for all G E D j, [3 E (0, 1], V is strictly quasi-concave in a over
the set of distributions {(1 - f l ) G + flF~ [ [3 E ~}.
7.6.10. Theorem. Let V and V* be a pair o f Frechet differentiable preference
functionals on D j with local utility functions U and U*, respectively. Suppose
further that V and V* display conditional diversification and that U and U* are
differentiable. Then the following condition is equivalent to the conditions in
Theorem 7.6.6.
For any given G ~ D j, [3 E (0, 1], a constant positive r, and a non-negative
random variable Z such that E { Z } > r if a = arg max V((1 - [3) G + [3F~) and
ol* = arg max V*((1 - [3) G + [3F ~ ) , then ~ <- a * .
1825
7.6.11. Theorem 7.6.10 and its proof are in Machina (1982a). A definition of
(unconditional) diversification is given in Dekel (1989). Dekel shows that if V
displays risk aversion and is quasi-concave then it displays diversification and
that if V displays diversification then it is risk averse but not necessarily
quasi-concave.
7.6.12. Risk aversion in the theory of expected utility with rank dependent
probabilities. Let V be Gateaux differentiable EURDP-functional then
Chew, Karni and Safra (1987) show that: (a) V displays risk aversion (strict risk
aversion) if and only if both the utility function and the probability transformation functions are concave (strictly concave). (It is easy to verify that this is a
sufficient condition for the local utility function to be concave but it is not
necessary.) (b) If V displays risk aversion then it displays diversification, and if,
in addition, the corresponding utility function v is strictly concave then, for
every given/3 @ [0, 1], V is strictly concave on the set {(1 - f l ) G + flF~ t a E
~}. (c) Theorem 7.6.6 holds with a weakened hypothesis requiring that V and
V* be Gateaux differentiable and with condition (ii) replaced by the requirement that the probability transformation function, g, and the utility function, v,
corresponding to V be concave transformations of g* and v*, respectively,
where g is the probability transformation function and v is the utility function
corresponding to V*. (d) If, in addition, V and V* display risk aversion and v
and v* are concave then the equivalence in Theorem 7.6.10 holds. (e) If V* is
more risk averse than V then the unconditional demand for the risky asset
induced by V* is no larger than that of V. Formally, for any constant positive r,
and for any random variable Z with support in [ - 1 , ~) such that E { Z } > r, if
6 " = arg max~ V*((1 - a)r + a Z ) and d = arg max~ V((1 - a)r + a Z ) , then
Note that in E U R D P theory risk aversion implies that the preference
functional is quasi-convex on Dy. Thus, conclusion (b) above is an example
that diversification does not imply quasi-concavity of the preference functional
(see 7.6.11).
7.6.13. Risk aversion in the dual theory of choice under risk. In the dual
theory of choice under risk the linearity of the utility function implies that the
decision of how much to invest in a risk-free asset hinges on the expectation of
the random variable representing the return on the risky asset with respect to
its transformed distribution function. In this theory decision makers are
plungers (i.e. they invest their entire portfolio in either the risky asset or in the
risk-free asset depending on whether the aforementioned transformed expectation is positive or negative, respectively.) Since, the higher the transformation
function of the decumulative distribution function, the larger the transformed
1826
expectation of the corresponding r a n d o m variable, a necessary and sufficient

condition for one individual to invest at least as much as another in the risky
asset is that his probability transformation function is higher. But higher
probability transformation function does not imply higher risk aversion. Thus,
unlike the general E U R D P analysis, in the dual theory higher risk aversion is
not necessary for one individual to invest always a larger a m o u n t in the
risk-free asset.
Roell (1987) shows that risk aversion in the context of the dual theory is
consistent with the pattern of choice associated with the Allais paradox and
other observed violations of the independence axiom. H o w e v e r , Machina's
hypothesis II (see 3.5.4.1) in the context of this theory implies expected
m o n e t a r y value maximizing behavior.
7.6.14. Bibliographical notes. As in expected utility theory, the m e a s u r e m e n t

and implications of differential attitudes toward risk were extended to include:
(a) aversion to one risk in the presence of others when the representation
functional is Frechet differentiable [Machina and Neilson (1987)] and in the
dual theory [Roell (1987)], (b) multivariate risk aversion for Frechet differentiable functionals [Karni (1989)] and in the dual theory [Yaari (1987b)] and (c)
risk aversion with state-dependent preferences [Karni (1987)].
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Chapter 34
EQUILIBRIUM
DIMENSIONAL
THEORY IN INFINITE
SPACES*
A N D R E U MAS-COLELL ~ and WILLIAM R. ZAME b
aDepartment of Economics, Harvard University

bDepartment of Economics, Johns Hopkins University
Contents
1.
2.
3.
4.
5.
6.
Introduction
The essential mathematical structures
Basic assumptions
Preferences and continuity
Prices
The main difficulties
6.1.
7.
8.
9.
Compactness
6.2.
Supportability
6.3.
Joint continuity
The basic fixed point argument

Interior consumption and L~
Properness and general commodity spaces
9.1.
One consumer
9.2.
Several consumers
10. The order ideal L(w)

11. Separable utilities and the finance model
12. The lattice structure of the price space
13. Other approaches
14. Production
15. Final comments
References
1836
1838
1842
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1849
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1864
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1888
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*Support from the National Science Foundation and the Deutsche Forschungsgemeinschaft,
Gottfried-Wilhelm-Leibniz-F6rderpreis during BoWo'89 is gratefully acknowledged. Thanks are
also due to R.A. Dana, P.K. Monteiro and N. Yannelis for careful reading of the manuscript.

1836
A. Mas-ColeU and W.R. Zame
I. Introduction
In this chapter, we attempt to give a summary account of the extension of the

classical general equilibrium model to an infinite dimensional setting. Our
account centers on the existence of competitive equilibrium.
The finite dimensional theory was surveyed by Debreu (1982) in Volume II
of the Handbook of Mathematical Economics. Although some of the pioneering contributions to the infinite dimensional theory had already appeared at
that point [Debreu (1954b), Gabszewicz (1968a,b), Bewley (1972, 1973),
Prescott and Lucas (1972)], it has only been in the last ten years that the theory
has undergone explosive growth.
In the classical finite dimensional theory, the commodity space is the
canonical finite dimensional linear space R". By contrast, there is no canonical
infinite dimensional linear space. Different economic applications require
models involving different (non-isomorphic) infinite dimensional linear spaces.
Fortunately, the mathematical discipline of functional analysis has already been
well developed as a tool for the abstract study of linear spaces. In this survey,
we shall follow the methodology of functional analysis, and attack the existence
problem from the abstract point of view. The advantage of this method is that
it yields general results, capable of application in a wide variety of specific
models. But the abstract approach also has a cost. Much interesting economics
lies in the details of particular models. For example, in intertemporal models
the functional analytic treatment typically abstracts away the inner recursivehess of the models, which are themselves at the heart of a rich body of
economic theory [see Prescott and Mehra (1980)].
As an indication of the way in which different infinite dimensional spaces
arise naturally in economics, we briefly describe three modeling problems
which lead to quite different infinite dimensional commodity spaces.
(A) In intertemporal allocation problems, the natural commodity bundles
are consumption streams. If we consider consumption of a single physical
commodity, taking place at discrete intervals, over an infinite time horizon, the
appropriate consumption streams are sequences of real numbers. Since the
universe is finite, it is natural to consider only bounded sequences. We are led
naturally, therefore, to consider the space l~ of bounded sequences (of real
numbers). We interpret an element x E 1~ as a discrete consumption stream,
and x(t) as consumption in the t-th period. Alternatively, we may consider
consumption of a single physical commodity, taking place continuously through
time, at a bounded rate, in which case we are led to consider the spaces
L~([0, T]) or L~([0, oD]) of bounded measurable functions. Again, we interpret
an element x E L~([O, T]) (or x E L~([O, co])) as a consumption stream, but
Ch. 34: Equilibrium Theory in Infinite Dimensional Spaces
1837
now x(t) is viewed as an instantaneous rate of consumption. For further

discussion, see Bewley (1972, 1973). We might also consider consumption
streams which are required to depend continuously on time, as in Gabszewicz
(1968a,b) and Horsley and Wrobel (1988).
(B) In allocation problems under uncertainty, the natural commodity bundles are consumption patterns which depend on the state of the world. Such
consumption patterns are most naturally modeled as random variables (i.e.
measurable functions) on some probability space (S, ~, P0. If, as is the case in
many financial applications, we insist that consumption patterns have finite
means and variances, we are led to consider the space L2(S, Z, p.) of square
integrable functions on (S, ~,/.~). For an element x E L2(S, ~ , / , ) , we interpret
x(s) as consumption if state s occurs.
More generally, we can model intertemporal allocation problems under
uncertainty by equipping the o~-algebra X, with an increasing time filtration
{,~,}; Y,, is the set of events that are known at time t. In this case, commodity
bundles are naturally modeled as stochastic processes X, adapted to the
filtration {~,} (roughly speaking, this means that X t depends only on information available up to time t). For further discussion, see, for instance, Duffle
and Huang (1985) or Duffle (1988).
(C) In models of commodity differentiation, to allow for many different
commodity characteristics, we are led to take as commodity space the space
M(K) of (signed) Borel measures on a compact metric space K. We interpret K
as representing commodity characteristics, and a positive measure x on K as a
commodity bundle comprising various characteristics in various quantities.
That is, for each Borel set B of possible characteristics, x(B) represents the
number of units of those characteristics represented in the commodity bundle x
[see Mas-Colell (1975), Jones (1983a, 1984), Podczeck (1985), Ostroy and
Zame (1988)].
Following this Introduction, Section 2 summarizes the basic mathematical
structures. This section is technical and may simply be used as reference. Next
we concentrate on exchange economies and specify the basic assumptions
which are maintained throughout the rest of the paper (Section 3), discuss the
meaning of topological assumptions (Section 4), and introduce the fundamental concept of a price system (Section 5). We then isolate (Section 6) three
difficulties which lie at the heart of the existence problem in infinite dimensions. Section 7 contains the basic fixed point argument, which is then
applied in Sections 8 and 9 to a wide variety of infinite dimensional spaces.
Sections 10, 11, 12 discuss important extensions. Section 13 summarizes a
few alternative approaches to the existence problem. Section 14 incorporates
production, and finally, Section 15 presents some concluding comments.
Throughout we have tried to provide examples and counter-examples, as well
as theorems.
1838
A. Mas-Colell and W.R. Zame
As with any survey, this one reflects the points of v i e w - and even prej u d i c e s - of the authors. We are well aware that this is not the only survey
possible.
2. The essential mathematical structures

T h r o u g h o u t , we shall let L be a topological vector space; i.e. a (real) vector
space, equipped with a topology ~- having the property that the vector space
operations (vector addition and scalar multiplication) are (jointly) continuous.
We shall also assume that the topology r is H a u s d o r f f and locally convex; i.e.
that ~- has a neighborhood base at 0 consisting of convex sets. (Continuity of
scalar multiplication implies, in addition, that there is always a neighborhood
base at 0 consisting of convex and s y m m e t r i c sets; i.e. convex sets W such that
w= -w.)
By a linear functional on L, we m e a n a linear mapping from L to R. We
denote the value of the linear functional p at the vector x by p x.
T h e fundamental distinction between finite dimensional and infinite dimensional topological vector spaces is expressed in the existence and continuity of
linear functionals. If L is finite dimensional, every linear functional is continuous, and every disjoint pair of convex sets can be separated by a linear
functional; i.e. if A , B are disjoint convex sets then there is a (necessarily
continuous) non-zero linear functional p on L such that p x ~ p y for every
x E A, y E B (Minkowski's theorem). If L is infinite dimensional however, the
existence of a continuous linear functional separating disjoint convex sets A, B
is not guaranteed; indeed, there m a y even be no discontinuous linear functional separating A and B.
T h e most important facts a b o u t the existence of continuous linear functionals
on locally convex spaces are the H a h n - B a n a c h t h e o r e m and its corollaries, the
extension t h e o r e m and the separation t h e o r e m . The H a h n - B a n a c h t h e o r e m
can be formulated in a n u m b e r of ways. The following is the simplest.
H a h n - B a n a c h Theorem. L e t L be a real vector space, L o C L a subspace,
W C L a convex symmetric set containing 0 a n d p : L o--~ ~ a linear functional
such that IP" w[ < 1 f o r every w E W N L o. Then there is a linear functional
: L ~ R which extends p and has the p r o p e r t y that 1~. w I <<-1 f o r every w E W.
In particular, if L is a locally convex topological vector space, L 0 is a
subspace, and p : L0--~ R is a continuous linear functional, then there is a
continuous linear functional /~: L--~ ~ which extends p (this is the H a h n B a n a c h extension theorem).
In finite dimensional spaces, Minkowski's t h e o r e m guarantees that any two
1839
disjoint convex sets can be separated by a continuous linear functional. The

corresponding result is false in infinite dimensional spaces, unless one of the
convex sets has an interior point.
Separation Theorem.
Let L be a locally convex topological vector space and

let A , B be disjoint convex sets, one of which has an interior point. Then there is
a non-zero continuous linear functional p : L --> ~ such that p . x <~p . y for each
xEA, yUB.
In the particular case of most interest to us, the set A may consist of a single
point x, and B may be the set of consumptions preferred to x. If B has an
interior point, we can separate x from B, or equivalently, support B at x.
We d e n o t e the set of continuous linear functionals on L (the dual space) by
L*. The dual space is itself a vector space, and comes equipped with a number
of natural topologies. T o describe these topologies, it is convenient to abstract
a bit and consider an arbitrary pair ( L , L ' ) of vector spaces, together with a
bilinear mapping (x, p ) - - ~ p . x : ( L , L')---~R which is non-singular in the
sense that for each non-zero x E L there is a p ~ L ' such that p x ~ 0 and for
each non-zero q E L ' there is a y ~ L such that q y ~ 0. Any such pairing
gives rise to topologies on L and L', of which the most interesting are the weak
topologies and the Mackey topology. The weak topology o'(L, L ' ) on L is the
weakest topology for which the maps x---~p.x are continuous (for each
p E L ' ) . Similarly, the weak topology cr(L', L ) on L ' is the weakest topology
for which the maps p---~p.x are continuous (for each x ~ L ) . In terms of
convergence of nets: x~ ~ x in t h e topology o-(L, L ' ) exactly when p - x~
p . x for each p ~ L', and p~---~p in the topology o-(L', L ) exactly when
p~ y---~p y for each y E L. The Mackey topology r(L, L ' ) is the topology for
which convergence x , ~ x means that p . x ~ ~ p . x
uniformly for p in any
o-(L', L ) - c o m p a c t subset of L'. Similarly, the Mackey topology ~'(L', L ) is the
topology for which convergence p , ~ p means that p , y ~ p y uniformly for
y in any o-(L, L ' ) - c o m p a c t subset of L.
All these topologies are Hausdorff, locally convex vector space topologies.
Moreover, when equipped with either the weak or the Mackey topology, the
dual space of L is precisely L'. The fundamental fact about these topologies is
that (among Hausdorff, locally convex topologies) the weak topology is the
weakest with this property and the Mackey topology is the strongest (this is
Mackey's theorem).
In particular, if we begin with the topological vector space L, equipped with
the locally convex topology r, then we obtain the dual pair ( L , L * ) . By
Mackey's theorem, the topology ~- lies between the weak topology tr(L, L * )
and the Mackey topology r ( L , L*). In particular, every o-(L, L*)-closed set is
r-closed set, and every r-closed set is ~-(L, L*)-closed. For convex sets, we can
1840
say more: it follows from the H a h n - B a n a c h theorem that the topologies

~r(L, L * ) and r ( L , L * ) (and hence the intermediate topology r) have the same
closed convex sets. For further information a b o u t topological vector spaces and
duality, we refer to Schaefer (1971).
T h e crucial fact about the topology o-(L*, L ) , also called the weak star
topology, is that m a n y subsets of L* are compact; this is Alaoglu's theorem.
Alaoglu's Theorem,
Let L be a locally convex topological vector space and let

W be an open symmetric neighborhood o f O. Then the set { p E L*: IP" w[ ~< 1
for every w E W } is tr(L*, L)-compact.
In addition to the vector space structure, we shall wish to consider order
structures. By an ordered topological vector space L we m e a n a topological
vector space (assumed H a u s d o r f f and locally convex) together with a reflexive,
transitive, anti-symmetric relation ~ on L. We assume that the order relation
and the vector space structure are related in the following way: (a) if x ~< y and
aER +thenax<~ay,(b)
ifx~<yand0~<zthenx+z~<y+z.Wedefinethe
positive cone L + = {x: x / > 0 } ; note that L + is convex and is a proper cone, i.e.
if x E L + n ( - L + ) then x = 0. (Alternatively, given a proper convex cone
C C L, we obtain an ordering of L by defining x ~< y whenever y - x E C.) We
also assume that the ordering is continuous in the sense that the positive cone
L + is closed. Note that if L is an ordered topological vector space, then the
dual space L* is also ordered, with positive cone ( L * ) + = { p E L*: p . x >10
for every x E L + } . M o r e o v e r , the positive cone ( L * ) + is evidently o-(L*, L ) closed (and hence ~-(L*, L ) - c l o s e d ) .
For x, y @ L, define the order interval [x, y] = {z: y ~< z ~< y}. We say that a
subset A C L is solid if [x, y] C A w h e n e v e r x, y E A.
T h e subset A C L has a supremum (or least upper bound) if there is an
element sup A E L such that x~<sup A for every x E A and sup A ~<y for
every y E L which has the property that x ~< y for every x E A. Similarly, the
subset A C L has an infimum (or greatest lower bound) if there is an element
inf A E L such that x / > i n f A for every x E A and inf A 1>y for every y E L
which has the p r o p e r t y that x/> y for every x E A. We usually write x ^ y
rather than inf{x, y} and x v y rather than sup{x, y}. If every pair x, y of
elements of L has a s u p r e m u m x v y and an infimum x ^ y, we say that L is a
vector lattice (or Riesz space). We write x + = x v 0 and x - = ( - x ) v 0 for the
positive and negative parts of x; then x = x + - x-. We write ]x] = x + + x - for
the absolute value of x. The notion of a vector lattice is much stronger than that
of o r d e r e d vector space. For instance, if L is an n-dimensional ordered vector
space, with positive cone L +, then it is a vector lattice precisely when L + is
g e n e r a t e d (as a cone) by exactly n linearly independent vectors.
A linear functional f : L --~ R is order bounded if it maps order intervals in L
1841
to b o u n d e d subsets of 6. T h e collection of order b o u n d e d linear functionals on

L is the order dual L b. T h e order dual of a vector lattice is again a vector
lattice. For f, g E L b, the s u p r e m u m f v g and infimum f A g are the (order
bounded) linear functionals whose values at positive elements x E L + are given
by
f v g(x) = s u p { f ( y ) + g(z): 0 ~< y, 0 -<- z, y + z = x} ,

f A g(x) = i n f { f ( y ) + g(z): O~<y, O <
~ z, y + z = x} .
A fundamental
property.
fact about
vector lattices is the
Riesz decomposition
Riesz Decomposition Property. Let L be a vector lattice and let x~ . . . . .
x,, z
be positive elements of L such that z <~ E x i. T h e n there are positive elements
z ~ , . . . , z n of L such that z = E z i and z i<~xi for each i.
If the lattice operations (x, y)---> x A y and (x, y)---> x v y are (uniformly)
continuous, then L is a topological vector lattice. Continuity of the lattice
operations is equivalent to the topology ~- being locally solid; i.e. having a base
of neighborhoods of 0 consisting of (symmetric, convex) solid sets. If L is a
topological vector lattice, then every continuous linear functional on L is order
bounded, so the dual space L* is a subspace of the order dual L ~. Indeed,
L* is an order ideal in Lb; i.e. i f f ~ L*, g C L b and 0 ~ < g ~ < f t h e n g E L * . In
particular, L* is itself a vector lattice.
The most important class of topological vector lattices are the normed
lattices; i.e. topological vector lattices in which the topology is defined by a
norm I1 I1: L--"
We require that the norm satisfy: (a) II xll = I 111xll for
and x E L ;
(b) [Ix+yll<<-llxll + Ilyll; (c) Ilxll--0 exactly if x = 0 ; (d)
Ilxll ~< Ilyll whenever

If in addition, L is complete in the metric
induced by the n o r m , we say that L is a Banach lattice.
The most important examples of Banach lattices are the Lebesgue spaces.
Let (S2, ~ , / z ) be a o--finite measure space. For l ~ ~ for which the n o r m
]l/p
is finite. We write L~(J2, i f , / x ) for the space of (equivalence classes of)

b o u n d e d measurable functions f :/2--> ~, with the n o r m
1842
Ilfll
= inf{M: Ix{x: f(w) < M} = 0}.
The ordering on Lp(~Q, 0%,/.I,) is defined pointwise; i.e. f / > g if f(w) >! g(w)
almost everywhere. For l~<p <0% the dual of Lp(I2, 0%, Ix) is Lq(O, 0%, Ix),
where ( l / p ) + ( i / q ) = 1. The pairing is given by
f . g = f f(w)g(~o) dix .
The dual of L=(O, 0%, IX) is the space ba(~2, 0%, IX) of bounded, finitely additive
set functions on 0% which vanish on sets of Ix-measure 0. This is much larger
than L~(O, 0%, IX), which may be identified as the subspace of ba(O, 0%, IX)
consisting of countably additive set functions.
If follows from Alaoglu's theorem that, for 1<q~<o% subsets A C
Lq(,.O, 0%, IX) that are norm bounded and closed with respect to the weak star
topology o'(Lq, Lp) are also compact with respect to this topology. In particular, order intervals are weak star compact. Since L~ (~2, 0%, IX) is not the dual of
L=(O, 0%, IX), Alaoglu's theorem does not guarantee o'(L1, L~) compactness
(i.e. weak compactness) of order intervals. However, compactness of order
intervals in Ll(~2, 0%, IX) is a well-known fact [see Schaefer (1974)].
For more information about topological vector lattices and Banach lattices,
we refer to Schaefer (1974), Aliprantis and Burkinshaw (1978, 1985), and
Aliprantis, Brown and Burkinshaw (1989b).
Linear space structures were introduced in economics by Debreu (1954b);
vector lattices were introduced by Aliprantis and Brown (1983).
3. Basic assumptions
From now until Section 14, when we introduce production, we shall restrict our
attention to the pure exchange case. It is convenient to collect here the basic
assumptions that will be maintained throughout. These assumptions are a
minimal collection; we usually need to require more. In Section 15 we discuss
briefly some of the ways in which the present assumptions may be relaxed.
The commodity space L is a (Hausdorff) locally convex, topological vector
space. We denote the topology by r. The commodity space is endowed with an
order structure I> for which the positive orthant L = {x: x ~>0} is a nondegenerate (i.e. L + # {0}), closed, convex cone.
There are N consumers. Each consumer i is described by a consumption set
X i C L +, a preference relation >~i on X i, and an endowment vector ooi ~ L +. It is
assumed that, for each i:
1843
(a) X i is closed, convex, and satisfies the free-disposal property X i + L + C
x/;
(b) the preference relation ~>i is a complete pre-order which is z - c o n t i n u o u s
(i.e. ~>~ is a closed subset of X i X i ) , c o n v e x (i.e. each of the sets {y: y ~>ix}
is convex), and m o n o t o n e (i.e. x + v ~>ix for every x E Xi and v ~ L + ) . We
shall also assume strict m o n o t o n i c i t y in the (relatively weak) sense that there is
some v o E L + such that x + a v o >~ x for every x E X~ and a > O.
(c) ,o;
x;.
4. Preferences and continuity

If the commodity space L is finite dimensional, it admits a unique locally
convex vector space topology. If L is infinite dimensional however, it will
always admit many such topologies. Some of these topologies will be comparable (i.e. some will be finer and some will be coarser), and some may not be. It
should be stressed that the choice of topology on L can only be dictated by
economic, rather than mathematical, considerations.
In essence, a topology on L is a notion of "closeness" between vectors in L.
For economic purposes, it seems natural to treat elements x, y E L as close if
they are regarded as such by agents in the economy (consumers and
producers). This suggests that the relevant restrictions on a topology on L are
that the given consumption sets (and production sets) be closed and that the
given preferences be continuous. H o w e v e r , we shall actually adopt a weaker
restriction; we say that the topology o- is c o m p a t i b l e if consumption sets are
closed and preferences are upper semi-continuous (i.e. for each consumer i,
the preferred sets { y: y ~ i x } are o--closed). When we consider production, we
shall also require that production sets be closed.
It might appear that allowing for upper semi-continuity of preferences,
rather than requiring full continuity, is nitpicking. In fact this is not so, indeed
the distinction is quite important. The reason for this is that, in locally convex
spaces, it is "easier" for a convex set to be closed than it is for a non-convex
set. For instance, if C C L is convex and closed in the locally convex topology
~-, it is automatically closed in the weak topology o~ associated with ~-. (This is a
consequence of the Separation T h e o r e m ; see Section 2.) Thus, if ~ is a
r-continuous, convex preference relation, then all preferred sets { y: y ~ x} are
T-closed and convex, hence o--closed. In particular, the weak topology associated with any compatible topology is itself a compatible topology. As we shall
see, this fact plays an important role in many places. In particular, it makes it
possible to begin with a topology in which preferences are continuous, but
carry out the technical work in a w e a k e r - but still c o m p a t i b l e - topology.
Because infinite dimensional spaces admit many topologies, many economic
1844
restrictions on preferences can be expressed in a natural way in terms of

topological hypotheses. Some examples may serve to illustrate this; the first
two are from Bewley (1972).
Example 4.1. Let L = l=. As in the Introduction, we interpret sequences
x E l= as (discrete) consumption streams (of a single physical good) over an
infinite time horizon. Consider a consumer whose consumption set is the
positive cone and whose preference relation is ~>. Norm continuity of
imposes no restrictions on the time preferences of this consumer. In particular,
norm continuity is consistent with preferences which give the same utility to a
single unit of consumption, independent of the date. On the other hand, upper
semi-continuity of ~ with respect to the weak topology o-(l~, l 1) imposes a kind
of upper impatience (upper myopia). To be specific, suppose that x > y; for
each n, let z n E l= be the consumption stream which is 0 in the first n periods
and 1 thereafter. Then y + z~---~ y in the weak topology o-(I~, 11), so upper
semi-continuity implies that x > y + z ~ for sufficiently large n. Informally, gains
in the distant future are negligible. Similarly, lower semi-continuity of ~ in the
weak topology o-(l~, 11) corresponds to lower impatience (lower myopia):
losses in the distant future are negligible. The typical impatient (myopic) utility
function is of course U(x) = Z 6"u(x(n)), for some single period utility function
u and discount factor 6 < 1. It is important to note, however, that impatience
(myopia) is not tied to separability: there are many impatient (myopic)
preferences that are not separable. For an extensive analysis of impatience
(myopia) and its implications, see Brown and Lewis (1981), Araujo (1985),
Raut (1986), and Sawyer (1987).
Example 4.2. Let L = Loo(S, X, IX), where (S, , IX) is a probability space; to
distinguish this case from the preceding, we assume that (S, X, IX) is not purely
atomic. We interpret S as the set of states of the world, and elements
x E L~(S, 2~, IX) as random, state dependent consumption patterns. As in the
preceding example, norm continuity of a preference relation ~ on the positive
cone Loo(S, ~, IX)+ has no strong economic implications. However, upper
semi-continuity in the weak topology cr(L~, LI) (or, equivalently if ~ is
convex, in the Mackey topology ~'(L~o,L1) ) has a natural and important
interpretation. To be specific, suppose that x > y; let {E n} be a sequence of
measurable sets such that IX(En)--~O, and let z n be the characteristic function
of E'. Then y + z~--~y in the weak topology o-(Loo, LI) (and in the Mackey
topology z(L~, LI)), so upper semi-continuity implies that x > y + z ~ for
sufficiently large n. Informally, gains in events of low probability are negligible.
This example also provides a convenient place to illustrate our point about
the distinction between continuity and upper semi-continuity of preferences.
1845
The most important preferences are given by von Neumann-Morgenstern

utility functions:
u(x) = S u(x(t)) d/.~(t)

for v :[0, o0)--->(-~,~) a concave function. As Bewley (1972) shows, such
utility functions are concave and continuous in the Mackey topology (and are
therefore upper semi-continuous in the weak topology), but they are continuous in the weak topology only if the underlying felicity function 0 is linear.
(Keep in mind that we have assumed the probability space (S, 2f,/x) is not
purely atomic.) It is instructive to see why this is so for the typical case
S = [0, 1], ,Y = Borel sets, /z = Lebesgue measure (the general case is quite
similar). Since 0 is concave and not linear, we can find positive numbers a </3
such that
o(( +/3))
o( ) + lo(/3).
For each n, let r ~ : [0, 1]---> ( - ~ , oo) be the nth Rademacher function,
=~+1
ifm/2n<~t<(m+ l)/2n, meven,
rn(t)
-1
ifm/2n<~t<(m+l)/2n, modd.
This construction guarantees that, for each n, {t: r"(t)= +1} and {t: rn(t)=
- 1 ) have measure , and that q . rn-+O for each q E LI(S, 2, ~) (i.e. the
sequence {r "} of Rademacher functions converges weakly to 0). Hence, if we
set
x"(t) = ( 1 - r"(t))a + (1 + rn(t))/3 ,

we obtain a sequence {x n } of positive functions in L~(S, ,Y,/x) such that, for
each n, (t: xn(t) = ~ } and {t: xn(t) =/3} have measure , and {x n} converges
weakly to the constant function l ( a +/3). It follows that
f
u(x ~) = J v(x~(t)) d/~(t)

=
+
u((
that is u is not weakly lower semi-continuous.
1846
A. Mas-ColeUand W.R. Zame
Example 4.3. Set L = M(K), the space of (signed) Borel measures on a

compact metric space K. As in the Introduction, we interpret K as representing
commodity characteristics, and a positive measure x E M ( K ) + as a commodity
bundle comprising various characteristics in various quantities. Preferences that
are continuous with respect to the weak topology o-(M(K), C(K)) find commodity bundles comprised of approximately equal quantities of nearby characteristics to be near perfect substitutes. In particular, given positive measures x,
y we may choose sequences xn---~ x, yn---~ y (weakly) such that each x n, yn has
finite support. Then x > y if and only if x ~ > y" for all sufficiently large n [for
applications to models of commodity differentiation, see Mas-Colell (1975),
Jones (1983a, 1984), Podczeck (1987), Ostroy and Zame (1988)].
It should not be imagined, however, that all economic restrictions on
preferences can be expressed as continuity requirements on preferences. The
following example, which we shall encounter repeatedly in several guises, may
serve to illustrate the point.
Example 4.4. Set L = M([0, 1]). Following Huang and Kreps (1987), we
interpret the interval [0, 1] as time, and a positive measure x E M([0, 1]) + as
total consumption of a single physical commodity, so that x([a, b]) is consumption in the time interval [a, b], etc. Motivated by the idea that consumptions at
nearby times should be uniformly good substitutes, Huang and Kreps are led to
focus on the weak topology o-(M([0, 1]), Lip([0, 1])) arising from the pairing of
M([0, 1]) with the space Lip([0, 1]) of Lipschitz functions [see also Jones
(1983a, 1984)]. The weak topology ~r(M([0, 1]), Lip([0, 1])) is weaker than the
weak topology o-(M([0, 1]), C([0, 1])), so in principle, continuity with respect
to the former topology is a stronger requirement than continuity with respect
to the latter. However, we are really interested only in preference relations
defined on the positive cone M([0, 1]) , and it may be shown that, on the
positive cone, these two topologies coincide.
The point is simply that continuity properties of preferences may not allow
us to discriminate finely enough between economic restrictions on preferences.
As we shall see later, we may need to appeal to other considerations, such as
restrictions on marginal rates of substitution.
As will become clear in subsequent sections, we place a great deal of
emphasis on weak topologies, because the existence of a compatible weak
topology is crucial in establishing the existence of an equilibrium.
A final observation: in what follows, we shall typically assume that preferences can be represented by utility functions. Given our monotonicity conditions, this involves no loss of generality [see Fishburn (1983), Mas-Colell
(1986a), Shafer (1984), Monteiro (1987), Richard and Zame (1986)]. Similarly, there is no loss of generality in assuming that utility functions are also
continuous.
1847
5. Prices
Unless we specify to the contrary, by a price (or price system), we shall always
mean a linear functional p : L--~ ~ which is continuous with respect to the
given topology T on L. This definition demands some comment.
First, we require that p be linear. Since this is a familiar requirement, and its
interpretation in the infinite dimensional setting is no different from its
interpretation in the finite dimensional setting, we shall not elaborate on it.
Second, we require that p be defined and finite for each x E L ; i.e. that
every (conceivable) commodity bundle be priced. This is certainly a desirable
property, but it is also a strong one. This is especially true in the infinite
dimensional setting because it is frequently the case that not all commodity
bundles are "present in the market". A simple example may serve to illustrate
the point. As we shall see in Section 10, this example is entirely representative
(at least for exchange economies) of the situation in commodity spaces for
which the positive cone has an empty interior.
Example 5.1. Take L = L 2 ( [ 0 , 1]), with consumption sets X i = L +. Let the
aggregate endowment to be the constant function with value 1. If to has a finite
price and prices are positive, then every commodity bundle x ~ L 2 ( [ 0 , 1]) with
0 ~< x ~< to also has a finite price. Hence every commodity bundle y having the
property that y = Ax for some x C L, 0 ~< x ~< to and A E ~, also has a finite
price. However, since to is identically 1, this set of commodities is precisely
L~([0, 1]), which is of course a p r o p e r subset of L2([0, 1]). In particular, if
p ~ L1([0 , 1]) + D L2([0 , 1]) = L*, then p assigns a finite price to every element
of L=([0, 1]) (and hence to every commodity bundle "present in the m a r k e t " ) ,
but if p Eft'L2([0, 1]), then p does not assign a finite price to all elements of
L2([0, 1]) (so some conceivable commodity bundles are left unpriced).
Finally, we require that p be continuous. In part this is merely a mathematical and methodological desideratum. In some settings, continuity of prices will
be a weak requirement, or will follow automatically. For instance, our monotonicity assumptions entail that equilibrium prices are positive, and in many
commodity spaces (Banach lattices, in particular), positive linear functionals
are automatically continuous.
In general however, continuity of prices reflects the choice of topology, and
as we have already discussed, the choice of topology has economic meaning.
To put it another way, continuity of equilibrium prices with respect to a weak
topology yields more economic information than continuity of prices with
respect to a strong topology. Ideally, we should ask that prices be continuous
with respect to the weakest topology with respect to which preferences are
continuous; call it o-. If consumption sets have non-empty interior with respect
to the topology cr (in particular, since we require X i -~- L + C X i , if the positive
1848
cone L + has a non-empty interior with respect to o-), this is an unambiguous

requirement and is automatically satisfied. (The half space defined by a
supporting price must contain a preferred set, and hence a set which is open
with respect to or; this is enough to guarantee that p is continuous.) Unfortunately, consumption sets will generally have empty interior with respect to o-,
and as the following example shows, it will not always be possible to find
supporting prices that are continuous with respect to o-.
Example 5.2. As in Examples 4.3 and 4.4, we consider the commodity space
L - - M ( [ 0 , 1]), paired with L ' = C([0, 1]). Define the linear utility function
u : L+---~ E by
U(X) = f t 1/2 dx(t) .
This utility function is continuous with respect to the weak topology or(L, L').
If the endowment w is the Lebesgue measure, then the unique supporting price
at o~ is the function p ~ C([O, 1]) = L' defined by p(t) = t 1/2, and p is continuous with respect to the topology o-(L, L').
On the other hand, we may also consider the pairing of L = M([O, 1]) with
L " = Lip([O, 1]). The utility function u is also continuous with respect to the
even weaker topology o-(L, L"), because the topologies o-(L, L") and o-(L, L ' )
coincide on L +. However, the unique supporting price p is not continuous with
respect to the topology or(L, L"), because it is not a Lipschitz function.
The end products of any equilibrium theory are equilibrium allocations and
equilibrium prices. We require equilibrium prices to be continuous, but this
requirement has a number of possible expressions:
(i) there is at least one equilibrium allocation supported by a continuous
price (but there might also be equilibrium allocations supportable only by
discontinuous prices);
(ii) every equilibrium allocation can be supported by a continuous price
(but some equilibrium allocations might also be supportable by continuous
prices);
(iii) every equilibrium price is continuous.
Of these, (i) seems a bit too weak, since there might be no natural way to
decide which equilibrium allocation is the "correct" one. (This situation does
not seem to have arisen in applications, but it has not been thoroughly
studied.) On the other hand, (iii), while perhaps the most desirable, seems to
be too much to ask for in general. In some settings, it will be possible to make
"trivial" alterations in an equilibrium price which render it discontinuous and
yet leave its equilibrium nature unchanged. For most purposes, (ii) is satisfac-
1849
tory, since it says that the set of equilibrium allocations is not affected by the
methodological requirement of continuity. For related discussion, see Bewley
(1972), Yannelis and Zame (1986), Podczeck (1987), Ostroy and Zame (1988)
and Gilles and LeRoy (1987).
6. The main difficulties
In this section, we discuss some of the main difficulties that arise in infinite
dimensional equilibrium theory. We do not suggest that they are the only
difficulties, but they are central ones. Moreover, none of these difficulties are
present in the finite dimensional setting, so they illuminate the differences
between the finite dimensional and infinite dimensional theories. The three
difficulties we isolate are:
(1) attainable sets may not be compact;
(2) preferred sets may not be supportable by prices;
(3) wealth may not be jointly continuous as a function of quantities and
prices.
6.1. Compactness
The first difficulty is that some of the sets which are bounded in finite
dimensions may not be bounded in the infinite dimensional setting. Indeed,
this is typically the case for budget sets. For instance if the commodity space is
L = L=([O, 1]), the consumption set X i = L=([O, 1]) +, the endowment (JOi
L=([O, 1]) + is non-vanishing, and the price p ELI([O, 1]) + is not O, then the
budget set {x@L=([O, 1])+: p ' x < - p ' o ~ i } is never bounded. It turns out,
however, that this unboundedness of budget sets, while a serious obstacle for
demand theory, is not a serious obstacle for the existence of equilibrium, and
can be sidestepped by a suitable truncation argument.
Of more concern is the fact that the attainable set
Z = { ( x t , . . . , XN) E LN: xi E Xi, ~, Xi <~O)}
need not be bounded in the appropriate sense. (That it is always closed follows
from the closedness of the consumption sets X~ and the positive cone L +, and
the continuity of addition.) An example will illustrate the point.
Example 6.1. Let L = Ct([0, 1]), the space of continuously differentiable
functions on [0, 1], with the norm
IlXlll = suplx(t)l + suplx'(t)l
1850
and pointwise ordering. With two consumers, having consumption sets X~ =

X z = L and endowments ~o~ = to2 = 1, the attainable set is
Z = {(x 1,x2): x 1 >tO, x 2 >~0, x I + x z <~2} .
Since arbitrarily small functions may have arbitrarily large derivatives, Z is
evidently u n b o u n d e d (in the norm I[" [[1).
A sufficient condition for norm boundedness of Z is that the norm and order
structures of the commodity space make it into a Banach lattice. Then of
course, Z will be norm bounded since, by construction, it is order bounded.
However, even when the attainable set is bounded, it need not be compact.
(Keep in mind that the H e i n e - B o r e l theorem is not generally valid in infinite
dimensional spaces: closed and bounded sets need not be compact.) For
instance, if L = L=([0, 1]), X 1 = X2 = L + and tol = 0)2 ~ 1 , then of course the
attainable set is
Z = { ( X l , X2): X 1 ~ 0, X 2 ~ 0, X 1 X 2 ~ 2 )
which is norm bounded but not norm compact.

Roughly speaking, the attainable set Z will be compact in the topology of L
only in two circumstances: if consumption sets are "thin enough" that order
bounded sets are compact, or if order b o u n d e d sets themselves are "thin
enough" to be compact. Two examples may serve to illustrate.
Example 6.2.
(a) If L = C([0, 1]), then closed, norm bounded, equicontinuous subsets of L are norm compact (Ascoli's theorem). Hence, if norm
bounded subsets of each consumption set X~ are equicontinuous, then the
attainable set Z will be also norm compact [see Horsley and Wrobel (1988)].
Note, however, that norm bounded subsets of consumption sets cannot be
equicontinuous if consumption sets contain the positive cone C([0, 1]) , so this
assumption is incompatible with our basic assumptions. However, if each
consumption set is of the form X i = A'i L +, where -~'i has the property that
norm bounded subsets are equicontinuous, we shall still be able to push the
analysis forward.
(b) If L = lp, for 1 <~p < ~, then order intervals [0, to] are norm compact,
whence the attainable set Z is also norm compact.
As we shall see, however, economic considerations lead us to consumption
sets which may coincide with the positive cone, and to commodity spaces in
which order intervals are not compact in the given topology of L. Hence we
cannot expect the attainable set to be compact in the given topology of L.
Fortunately, it is usually not necessary that the attainable set Z be compact in
Ch. 34: Equilibrium Theory in Infinite DimensionalSpaces
1851
the given topology of L ; all that is necessary is that the attainable set be
compact in some (weaker) compatible topology. Some examples follow.
Example 6.3. (a) If L is a reflexive Banach lattice (e.g. L = Lp(S, 2f, tx) for
l<p<~),
then all norm closed, bounded, convex sets are compact in the
weak topology o'(L, L*) (Alaoglu's theorem; see Section 2). As noted in
Section 4, preferences that are convex and norm continuous are automatically
upper semi-continuous in the weak topology o-(L, L*), so we obtain compactness of the attainable set in a compatible topology for free.
(b) If L = L 1(S, ~ , / x ) , which is not a reflexive space, then norm closed,
bounded, convex sets need not be compact in the weak topology o-(L, L*)
(indeed the unit ball is not weakly compact). Nevertheless, order intervals are
weakly compact (i.e. LI(S, ~, tz) has order continuous norm, see Section 2), so
we again obtain compactness of the attainable set in a compatible topology for
free.
(c) If L is the dual of a Banach lattice L . (e.g. L = L=(S, ~, ix), which is
the dual of the Banach lattice L . = LI(S , )f, Ix), or L = M(K), which is the
dual of the Banach lattice L . = C(K)), then convex, norm bounded sets that
are closed in the weak star topology o'(L, L . ) are also weak star compact
(Alaoglu's theorem again). Hence the attainable set will be weak star compact
provided only that consumption sets are weak star closed; this will be so if
consumption sets coincide with the positive cone. As discussed in Section 5, the
weak star topology o-(L, L . ) will be compatible whenever the Mackey topology z(L, L .) is compatible.
(d) More generally, let L be the dual of the Banach lattice L . , and let L '
be a separating subspace of L* (e.g. L = M([0, 1]), L . = C([0, 1]), L ' =
Lip([0, 1])). Then the topology tr(L, L') is Hausdorff and is weaker than the
weak star topology o-(L, L . ) , so these two topologies coincide on weak star
compact sets. (The identity mapping of a weak star compact set K into itself is
o-(L, L . ) to o-(L, L ' ) continuous. Continuous mappings preserve compactness, and compact subsets of Hausdorff spaces are closed. Hence the identity
mapping sends closed sets to closed sets, whence its inverse is continuous also,
so the topologies on K coincide.) Hence the attainable set will be tr(L, L')
compact provided that consumption sets are ~r(L, L') closed.
Compactness of the attainable set with respect to a compatible topology has
many useful cor:~equences. The one which we use most often is closedness of
the utility possibility set.
To be precise, choose utility functions u i : X i - - - ~ representing the given
preferences (as we remarked at the end of Section 4, our monotonicity
assumptions guarantee that this is always possible). Write u = ( U l , . . . , UN).
The utility possibility set is
1852
v = u(Z)
- (RN) +
uN(xN)) ~ ~N: ( x , , . . . ,
= {(u,(xl),...,
x~) ~ Z } - (RN) + .
N o t e that monotonicity of preferences implies that U is bounded above by

( u l ( o g ) , . . . , uN(og)). It is easily seen that the compactness of Z and the u p p e r
semi-continuity of each u i together imply that U is closed. (If {u(x")} is a
sequence in U converging to v E R E, compactness of Z implies the existence of
a subnet of the sequence { x n } , convergent to some x E Z. U p p e r semicontinuity of each u i implies that v <~ u ( y ) , so v ~ u ( X )
(~N)+ = U.) Without
these two hypotheses, the utility possibility set U may not be closed; indeed,
Pareto o p t i m a need not exist at all.
-
Example 6.4.
Let L = I~, X 1 = X 2 = l~+ , o91 = o92 = (1, 1 . . . . ), and define utili-
ty functions by
/~/I(X1) : Z 2 txl(t) ,
u2(x2) = lim inf x2(t ) .
These utility functions are n o r m continuous, but u 2 is not o-(1o~,11) u p p e r
semi-continuous; the set of allocations is tr(l~, 11) compact but not n o r m
compact. The utility possibility set is
U = {(a 1, a2) E ~ 2 al < 2 and a 2 ~< 2, or a 1 ~< 2 and a 2 ~ 0} ,
which is evidently not closed [see A r a u j o (1985)].
6.2. Supportability
If L is finite dimensional, C C L is a convex subset, and x E L \ C , then

Minkowski's t h e o r e m guarantees that we can find a non-zero linear functional
p separating x from C (i.e. p x ~<p . z for every z E C). Taking C to be the set
of consumption bundles strictly preferred to x, we conclude as usual that
(convex) preferred sets can be price supported. But if L is infinite dimensional,
the existence of separating functionals and supporting prices is not guaranteed.
Example 6.5.
Let L
Z v t ( x ( t ) ) , where
12, and define a utility function u : l 2--> R by
u(x)=

"2ix(t)
1853
if x(t) <~2 -2` ,
v,(x(t)) :
2-'[x(t) + 1 - 2 -2']
if x(t) > 2 -2` .
It is easily checked that u is norm continuous (indeed, even weakly

continuous), concave and monotone. But if to E 12 is defined by to(t)= 2 -4',
then the preferred set to to cannot be supported by a non-zero price. (The only
candidates are multiples of the sequence {2'}, which do not define linear
functionals on 12, even discontinuous ones.)
Note that the utility function u is defined on the positive cone 12, but cannot
be extended (as a continuous, concave function) to all of l 2.
In the infinite dimensional setting, the Separation Theorem guarantees that
it will be possible to separate a convex set C from a point x ~" C, provided that
the interior of C is not empty (see Section 2). Hence, if consumption sets have
non-empty interior, then the continuity and convexity of preferences will
guarantee that preferred sets (which in this case will also have non-empty
interior) can be price supported. From the point of view of supporting
preferred sets, therefore, the best-behaved commodity spaces are those for
which the positive cone has non-empty interior. Of the spaces discussed to this
point, only C ( K ) and L~ have this property (and in a certain sense, these are
the "universal" spaces with this property; see Section 10). In other spaces,
there is no alternative but to make assumptions on preferences that guarantee
supportability of preferred sets.
6.3. Joint continuity
The wealth map (x, p) ~ p - x arises in many arguments in equilibrium theory.
In the finite dimensional setting, this map is jointly continuous, and this
continuity plays an important role (in fixed point arguments for instance). In
the infinite dimensional setting, there are many possible topologies on the
commodity space L and its dual L*, and hence many possible senses in which
we could ask for the wealth map to be jointly continuous. In order that the set
of allocations be compact, we are led to consider a weak topology on the
commodity space L ; in order that the set of supporting prices be compact, we
will similarly be led to consider a weak topology on the price space L*.
Unfortunately, such a pair of choices usually leads to failure of joint continuity
of the wealth map.
Example 6.6. Let L
= Z 2 ( [ 0 , 1]), so L*
be the nth Rademacher function,
= L2([0
1]). As in Example 4.2, let r"
1854
+1
f
r'(t) =
L- 1
if m / n <~t < (m + 1)/n, m e v e n ,

if m / n <<-t < (m + 1)/n, m o d d ,
and set x ' = p ' = l + r " .

Then x'-->l in the weak topology o-(L,L*) and
p"---> 1 in the weak star topology o'(L*, L ) , but p ' . x ' = 2 for each n.
Roughly speaking, in order to be sure that the wealth map (x, p)--->p . x is
jointly continuous with respect to topologies T, ~-* on L, L*, we need to know
that ~-is at least as strong as the Mackey topology z(L, L*) or that z* is at least
as strong as the Mackey topology ~-(L*, L). Since neither the set of allocations
nor the set of supporting prices will generally be Mackey compact, this presents
a potentially serious problem. As we shall see in Section 7, however, we can
usually circumvent these difficulties, because we need information about
behavior of the wealth map only along very special sequences (or nets) of
consumptions and prices.
7. The basic fixed point argument

We have identified three difficulties arising in infinite dimensional spaces:
supportability, compactness and joint continuity. In succeeding sections, we
nail have a great deal to say about the first two of these. In this section we
show that joint continuity questions arise only at particular combinations of
allocations and prices, and that, as a consequence, it turns out that the joint
continuity difficulties can simply be finessed (given appropriate solutions to the
supportability and compactness problems).
There are many possible approaches to the infinite dimensional existence
proof; some of them are discussed in Section 13. The approach we take in this
section, and that we use as our main organizational principle, is based on the
Second Fundamental Theorem of welfare economics. The strategy is to look in
the Pareto frontier of the set of attainable utilities; this is an approach
pioneered by Negishi (1960) and Arrow and Hahn (1971) in the finite
dimensional case, and used by Bewley (1969), Magill (1981) and Mas-Colell
(1986a) in the infinite dimensional setting. We adopt this approach here simply
because it most easily allows us to make our points about the main difficulties.
As in Section 6, we write o~ = E ~0i for the aggregate endowment, and denote
by
Z =[X=(X1,.
. . ,XN) E X 1 x
' ' ' X XN: Z Xi ~O)} ,
the attainable set (assuming free disposal) of the economy; elements of Z are
1855
allocations. The utility possibility set of the economy is

U = { v e ~ N ; V < U(X) = (UI(X1) . . . .
= u(Z)
- (~N)+
, UN(XN)), some x
E Z} ;
elements of U are utility vectors. Without loss of generality, we normalize each

ui so that ui(o~i)= O.
The utility vector u ~ U is a weak optimum if there is no u' @ U such that
u~ > u i for each i; it is an optimum if there is no u' E U such that u 1/> u i for
each i, with strict inequality for at least one i. An allocation x is a weak
optimum (respectively, optimum) if the corresponding utility vector u(x)=
( U l ( X l ) , . . . , uu(xN) ) is a weak optimum (respectively, optimum).
A pair (x, p ) E X L * is a quasi-equilibrium if p . o ) # 0, and for each i,
p . Xti >~ p " o) i whenever ui(xl) > ui(xi). We focus throughout on quasi-equilibrium rather than on equilibrium only because the conditions which guarantee
that the two notions coincide are entirely parallel to the well-understood, finite
dimensional case [see McKenzie (1959), Arrow and H a h n (1974)]. We should
also note that, under our maintained hypotheses on preferences, every equilibrium is a quasi-equilibrium.
The First Fundamental T h e o r e m of welfare economics is valid in our setting;
every equilibrium allocation is an optimum. Indeed, suppose that (x, p) is an
equilibrium and that x' is an allocation with the property that ui(x'i) >! ug(x~)
for each i, with strict inequality for at least one i. Then p x~/> p Xg for each i,
with strict inequality for at least one i. Hence p Z x~ > p o2. Monotonicity of
preferences guarantees that p is positive, so this inequality contradicts feasibility of the allocation x'. It should be noted that this argument depends only on
the equilibrium nature of the price p and on its linearity on the set of attainable
consumption bundles; the argument does not depend on the continuity of p or
its finiteness on all of L.
What about the Second Fundamental T h e o r e m of welfare economics? Let us
say that the price vector p E L* supports the utility vector u E U if p o) 0
and p . (E x~ - o2)/> 0 whenever ui(xl) >>-ui for all i. Similarly, p supports the
allocation x @ X if it supports the corresponding utility vector u(x). Note that
monotonicity of preferences guarantees that supporting prices are positive. If p
supports x then p . (E x ~ - E xi)>-0 whenever ui(x'i)>1 ui(xl) for each i, so
p .x~>~p .x~ for each i. Let P(u) be the set of prices supporting the utility
vector u; note that P(u) is a convex set.
The Second Fundamental T h e o r e m asserts that every weak optimum can be
supported by some price, or equivalently, that for every weak optimum u, the
set P(u) is not empty. As we have discussed in the previous section, this is in
general not true in the infinite dimensional setting. We will have a great deal to
say about this problem in succeeding sections, but for the m o m e n t our focus is
1856
elsewhere, so we shall simply assume that P(u) is not empty for each weak
optimum u. In fact we shall need to assume more, namely that the supporting
prices can be chosen in some o-(L*, L ) - c o m p a c t set.
The above takes care of the supportability problem. To deal with the
compactness problem we shall simply assume that the utility possibility set U is
closed. (Recall that monotonicity of preferences implies that U is always
bounded above by (Ul(W) . . . . , UN(W). )
As we have discussed in the previous section, U will be closed if the
attainable set Z is compact in a compatible topology. However, two points
about compatible topologies should be kept in mind. First, the use of compatible topologies is purely a technical device to establish the compactness of U
(in particular, we never alter our assumption that utility functions be continuous in the topology ~-). Second, the requirement that U be closed is strictly
weaker than the requirement that Z be compact in some compatible topology;
this extra sharpness may be of value in some economic applications. For
instance, U will be closed whenever there are subsets k i C Xi, compact in a
compatible topology, with the property that u ( X ) = u(X). This is exactly the
circumstance alluded to in the final remark of Example 6.2(a). For another
example where the utility possibility set is closed even though the set of
allocations is not compact, see Cheng (1988).
With the supportability and compactness issues taken care of, the existence
of a quasi-equilibrium is guaranteed.
Theorem 7.1. A s s u m e , in addition to the basic assumptions, that:
(i) U is closed;
(ii) there is a convex, o'(L*, L )-compact set K C L* such that p . o~ 0 f o r
all p E K, and every weak optimum can be supported by some p E K.
Then the economy has a quasi-equilibrium.
Let A be the N - 1 simplex. For any s ~ A, denote by v(s) the point in
U fq(~N)+ which is furthest from 0 on the ray from 0 through s. It is
immediate that s ~ v(s) is an upper semi-continuous function (see figure 34.1).
For s E A, write Q(s) = P(v(s)) n K, and choose an allocation x(s) @ X such
that u(x(s))>i v(s) and Z xi(s ) = o~. Our assumptions imply that Q(s) is nonempty, convex and o-(L*, L ) compact.
We define a correspondence F : A----~-~ EN by
Proof.
F(s) = {(s 1 + q ' ( x l ( s ) - wl), . . . , s N + q ' ( X N ( S ) - Wu)): q E Q(s)}.
Since Q(s) is non-empty, convex and compact, it follows that F has non-empty,
convex, compact values. We claim that F is in fact an upper hemi-continuous
correspondence.
1857
u2
I/1
Figure 34.1
To see this, consider sequences {sn}, {t"} where s"--~s in A and t" E F(s")
for each n. Choose q " E O(sn), so that qn. (Xi(S n) __ OJi)= t; for each n, i.
Passing to a subnet if necessary, we m a y assume that q" ~ q for some q E K.
Set t i = q . ( X i ( S ) - - tOi)"~ we will show that t = ( t l , . . . , tu) E F(s) and that
t"--~ t; this will yield the u p p e r semi-continuity of F. We assert first that
q E Q(s). I n d e e d , suppose that ui(zi) > vi(s ) for each i. U p p e r semi-continuity
of v implies that u i ( z i ) > vi(s" ) for large n, so qn. E (Z i --tO~)>10 and hence
q . E (z i - toi)>~O. Monotonicity of preferences now implies that q - Z ( z ~ toi) i> 0 whenever ui(zi) >! vi(s ) for each i, which is to say q @ Q(s), as asserted.
Now suppose that z i E X i and ui(zi) > vi(s ). Again, ui(zi) > vi(s n) for large n,
so we obtain
o ~ q n ' ( z ~ -- ,o,) + ~ q n ' ( x j ( s ) -- , 0 )

= qn" (Z i -- OOi) -- q"" (Xi(S") -- Wj)
= q" "(Z i -- X i ( S " ) ) .
1858
Monotonicity of preferences implies that
0 ~< lim inf q". (Xi(S) -- x ( s n ) ) .
Since q"---> q, we conclude that q xi(s) <- lim sup q" x~(s"). On the other
hand, E xi(s" ) = E Xg(S) = o~, so that
q . o~ ~>lim sup ~ q" . xi(s" ) = lim sup
q n . 09 =
q " o~ .
Hence, q " . xi(s")---> q .xi(s ) for each i. We conclude that t E F(s) and t'---> t,
and hence that F is upper semi-continuous.
Finally, note that if s i = O for some i, then vi(s)=O. Hence q . [ w i +
Ej~. i xj(s) - oJ] >I 0, which yields q- [w~ - x~(s)] ~>0. We conclude that t i ~<0,
whence s i = O, t~ E F(s). Hence it follows from a standard application of
Kakutani's fixed point theorem that F has a fixed point ~. Taking p E Q(g) and
writing x = x(g), we see that (x, p) is a quasi-equilibrium.
Note that the failure of joint continuity does not present a problem in the
above p r o o f because we need only consider very special sequences of consumptions and prices. To make the same point in a slightly different way, consider a
sequence { p ' } of price vectors and a sequence {x n} of consumption profiles
(so that x" @ X 1 X N for each n). Assume that p"---~ p in the topology
o-(L*, L ) and that x"---~x in the topology o-(L, L*). In general, there is no
reason to suppose that pn. x" --> p x. H o w e v e r , the argument we have given
[which goes back to Bewley (1968)] shows that this will be the case provided
that: (1) E x7 = w, and (2) pn supports x n. To put it another way, restricted to
the domain of price/consumption pairs satisfying (1) and (2), the map
(x, p)--->p.x is jointly continuous. (The argument used in the proof above is
actually a bit more subtle, since convergence of utilities substitutes for convergence of allocations, but the essence is the same.)
We conclude this section with a remark. The attentive reader will have noted
that the above proof makes no use whatever of any continuity hypotheses on
preferences, although upper semi-continuity is implicit in the assumption that
the utility possibility set U is closed. A t first sight this may seem surprising
since it is well k n o w n - even in the finite dimensional s e t t i n g - that upper
semi-continuity of preferences does not suffice for the existence of equilibrium.
R e m e m b e r , however, that we have only established the existence of a quasiequilibrium. It is in showing that a quasi-equilibrium is indeed an equilibrium
that full continuity of utility functions will be required. Suppose for instance
that (x, p) is a quasi-equilibrium and that for every i there is a z i ~ Xi with
p z~ ui(xi) and p - y , . = p . o h. If u~ is
Ch. 34: Equilibrium Theory in InfiniteDimensionalSpaces
1859
continuous (indeed, if it is continuous on the segment [zi, Yi]), then u(y~) >
ui(x~) for some y~ E X j with p - y~ < p . w~. But this contradicts the quasiequilibrium nature of (x, p). Therefore x~ is in fact preference maximizing on
the budget set of consumer i, and so (x, p) is an equilibrium.
8. Interior consumption and L~

Of the three main difficulties we have identified in infinite dimensional
equilibrium theory, the previous section has shown how to address one, the
joint continuity difficulty, given solutions to the other two, and it is to these
that our attention now turns.
As we have discussed earlier, supportability of optima is not a problem in
commodity spaces for which the positive orthant has non-empty interior, and
closedness of the utility possibility set is not a problem in commodity spaces for
which order intervals are weakly compact. Unfortunately, there are no infinite
dimensional spaces which enjoy both of these properties. In this section, we
shall consider commodity spaces for which the positive orthant has non-empty
interior. This makes the supportability problem easy to handle; to obtain
closedness of the utility possibility set we shall have to impose additional
assumptions. In the following section, we treat general commodity spaces,
where, for the supportability of optima we will also need additional assumptions.
We therefore assume for the remainder of this section that the commodity
space L is a topological vector space for which the interior int L + of the
positive cone L + is non-empty. Typical examples of such spaces are C([0, 1])
with the uniform norm and the positive cone C([0, 1]) + = {x: x(t)>~O all t},
and L=(S, E, tx) (for (S, Z , / x ) a o--finite measure space), with the essential
supremum norm and positive cone L=(S, Z , / x ) + = {x: x(t) >!0 almost all t}.
The first thing to observe is that if o~ E int L +, then K = { p E L*: p/> 0 and
p ~0 = 1} is o-(L*, L)-compact. Indeed, let W be an open, symmetric neighborhood of 0 such that w + W C L +. If p ~ K then the restriction of p to ~o + W
is positive, so the restriction of p to W is bounded below by - 1 ; since W is
symmetric, it follows that the restriction of p to W lies between - 1 and + 1,
and Alaoglu's theorem (see Section 2) then implies that K is compact.
If (adopting the terminology and notation of the previous section), u ~ R N is
a weakly optimal utility vector, set
V = { ~ zi: ui(zi)~ui for each i } - { w ) .

It is evident that 0 ~ int V (otherwise, u could not be weakly optimal) and
1860
A. Mas-Colelland W.R. Zame
int V # 0 (int L 0 and preferences are monotone, so that V D L ). Hence

we may apply the Separation Theorem (see Section 2) to find a continuous
linear functional p 0 such that p v 1> 0 for each v E V. We have p >~0 and
p . ~o > 0 (since o~ E int V). We may therefore assume that p . w = 1, and hence
p ~ K. Moreover, if u = u(x) for the allocation x, then for each consumer i, p
supports the preferred set {z F ui(z~) >~ui} at x i. In particular, we conclude
that the Second Fundamental Theorem of welfare economics holds in this
setting [a fact first established by Debreu (1954b) in his pioneering study of
equilibrium in infinite dimensional spaces]. Combining all of this with Theorem
7.1, we obtain the following result.
Theorem 8.1. Assume, in addition to the basic assumptions, that ~o E int L +.
Then every weak optimum can be supported by a price vector. If, in addition,
the utility possibility set U is closed, then a quasi-equilibrium exists.
Versions of this result have been established by E1-Barkuki (1977), Bojan
(1974), Magill (1981), Yannelis and Prabhakar (1983), Horsley and Wrobel
(1988); the result is already in Bewley (1972) for the case L = L=.
As we have discussed, closedness of the utility possibility set U is not
automatic, and will typically require strong, but economically meaningful,
restrictions.
If L = C ( K ) then its dual is L* = M ( K ) , so that prices are countably additive
measures on K; the value of the bundle x at prices p is p - x = f x(t) dp(t),
which has a natural and obvious interpretation. Unfortunately, in this case it
seems quite difficult to identify natural conditions guaranteeing that the utility
possibility set U is closed. (If K is an infinite, compact metric space, for
example, there will be no natural topology in which the set of allocations is
compact.) Perhaps the most promising methodology is the one described in
Section 6: search for norm compact sets Xi C Xi such that
If L = L=(S, ~, k~), then as discussed in Section 6, we can identify natural

conditions which imply that the utility possibility set U is closed. For instance,
this will be the case if consumption sets are closed and preferences are upper
semi-continuous with respect to the Mackey topology r(L=, L1) (equivalently,
with respect to the weak star topology o-(L~, L 1)). The first of these conditions
will certainly be met if consumption sets are Mackey closed (hence weak star
closed), and the second will be met if preferences are (upper) impatient. Under
these conditions, Theorem 8.1 yields an equilibrium price in the dual space
L=(S, Y,, ~)*. But what, in concrete terms, is the dual space L=(S, .,~, t~)*?
1861
Unfortunately, the answer is that the dual space is unmanageably large. To be

precise, Lo~(S, ~ , / z ) * may be identified with the space ba(S, 2 , / ~ ) of bounded,
finitely additive set functions on ,~ which vanish on sets o f / z measure 0. A m o n g
the finitely additive set functions in ba(S, ,Y,/~) are the countably additive
ones; i.e. the countably additive measures on ( S , ~ ) that are absolutely
continuous with respect to IZ. In view of the R a d o n - N i k o d y m theorem, these
countably additive set functions may be identified with functions in
LI(S, ~, tz), with the pairing p - x = J" p(s)x(s) dtz(s) (see Section 2). Such
prices have very natural economic interpretations. For instance, if we interpret
elements of S as representing states of the world, so that a function in
L=(S, ~, IX) represents a bundle of contingent commodities, then a function in
LI(S, ~, IX) represents commodity/state prices. However, prices in ba(S, ,~, tz)
that do not belong to LI(S, ~, I~) seem to have no natural economic interpretation. (It seems that they have no concrete mathematical interpretation, either;
indeed, their very existence depends on the Axiom of Choice.)
As the following examples shows, the possibility that equilibrium prices
might not be in L a is quite real.
Example 8.1. Let L = l~, the space of bounded sequences. (We identify l~
with the space of b o u n d e d measurable functions on the positive integers, with
counting measure.) Consider a one consumer economy with co = (1, 1 . . . . ),
X = l~+ and the utility function u : l~+ --~ R defined by u(x) = lim inf x(t). It is
easily seen that u is concave and norm continuous, so there is a price p E 1"
such that p x ~>p ~o > 0 whenever u(x) >i u(w) = 1, but no such p can belong
to l 1. (To see this, define, for each k, an element x k ~ l~ by xk(t) = 0 for t < k
and x k ( t ) = 2 for t>~k. Then u(xk)=2>u(w), but if p E l I then p.xk--->O,
while p w > 0.)
The supporting price in Example 8.1 has the property that all its mass is
"concentrated at infinity." (Economically, this is not surprising, since utility
depends only on what happens at infinity.) Results of Yosida-Hewitt [see the
discussion in Bewley (1972)] show that this is quite typical of finitely additive
measures. T o be more precise, let (S, ~,/.Q be a o--finite measure space, and
let p E ba(S, Y,, tz) be a positive finitely additive measure. Then p can be
written uniquely as a sum p = Pc + Pl, where Pc is a positive, countably additive
measure and Pr is a positive, finitely additive measure with the property that
there is no positive, countably additive measure q such that p~ i> q/> 0; we
refer to Pc as the countably additive part and to py as the purely finitely additive
part. Purely finitely additive measures are supported on arbitrarily small sets,
in the sense that, for every purely finitely additive measure Pi E ba(S, ,~,/z),
there is a descending sequence {E"} of measurable subsets of J2 such that
/z(E")---~O and pr(J2\E")=0 for each n.
1862
A. Mas-Colell and W.R. Zarne
Our discussion in Section 5 suggests that we should not expect that prices be
more continuous than preferences. T h e r e f o r e , we should not hope to find
supporting prices in L~ unless preferences are continuous in the stronger
topology that forces continuous prices to be in L~; i.e. the Mackey topology.
T h e following example from Sawyer (1987) shows that Mackey upper semicontinuity will not suffice.
Example 8.2. Again, this is a one-consumer example. Let L = I=, X = 1+.
Define the endowment 0) by oJ(1) = 2, 0)(t) = 1 + 10 -t for t > 1; and define the
utility function u by u(x)= i n f x ( t ) + q . x , where q E 11 is given by q ( 1 ) = 2,
q(t) = 10 -t for t > 1. The utility function u is concave, strictly monotone, norm
continuous and Mackey (hence weak star) upper semi-continuous. T h e r e is a
price p E l* that supports the preferred set at 0), but no such price can belong
to l 1. (If p E l 1, a simple argument shows that p = a q
for some a > 0 .
However, if we define x E l = by x ( 1 ) = 1.8, x ( t ) = 1.4 for t > l , we see that
u(x) > u(0)) and q- (x - 0)) < 0, a contradiction.)
H o w e v e r , even Mackey continuity of preferences will not suffice to yield
prices in L~ if consumption sets do not coincide with the positive orthant, as
the following example of Back (1988) shows.
Example 8.3. Let L = 1o~.The economy has two consumers, with consumption
sets X 1 = l+~, X2 = {x E l+~:x(O) + x(t) ~> 4 for t > 0}. Utility functions ul, u2
are defined by Ul(X) = Z 3-'x(t), u2(x ) = x(0) + 2 Zt> 0 3 - % ( 0 . Finally, endowments ~ol, w2 are given by wl(t ) = 0)2(t) = 2, for t ~> 0. Note that preferences are
linear and weak star continuous, and that the endowments belong to the
(norm) interior of l +. However, we claim that this economy has no quasiequilibrium supported by a price p E l 1.
Observe first that the initial endowment (0)~, oJ2) is an optimum. (To see
this, note that if X 2 were all of l~+ , (0)1, w2) would not be an optimum, but any
improvement would involve transferring some amount of commodity t = 0 from
the second consumer to the first consumer. The actual definition of X 2 makes
this impossible,) Hence if p E l T is a quasi-equilibrium price, utility maximization by the first consumer would entail that p ( t ) = a 3 - ' for some a > 0 .
However, no such price system can support the preferred set of the second
consumer at 0)2. Indeed, define x 2 E X 2 b y x 2 ( 0 ) = (.01(0) - E', x2(t ) = 0)z(t) + e
for t > 0 . Then Uz(X2) = Uz(0)z) and p . x 2 = P ' 0 ) z - ~ a e 0 sufficiently small, /,/2(X2 @ 60)) > U2(0)2) and p . (x 2 + 60)) < p . to2, as desired. We conclude that there is no quasi-equilibrium price p E l~.
The budget set )(2, while "untraditional", is economically meaningful. If we
interpret t = 0 as representing consumption today and t > 0 as representing
consumption in various possible states of the world tomorrow, the constraints
1863
defining X z may be read as stating that subsistence requires a total of 4 units of

consumption over the two dates.
As these three examples suggest, to obtain equilibrium prices in L~ we shall
have to require that preferences be Mackey continuous and that consumption
sets coincide with the positive orthant. Bewley (1972) showed that these
conditions are indeed sufficient.
Theorem 8.2. Assume, in addition to the basic assumptions, that:
(i) X i = L~(S, ~, ix) + for each i;
(ii) each ~i is Mackey continuous;
(iii) each ~i is strictly monotone, in the sense that if x i E L=(S, ,~, ix) + and
v E i n t L=(S, E, Ix) + then x i + v >ix;
(iv) to E int L~(S, ~, IX)+.
Then the economy has a quasi-equilibrium, and every quasi-equilibrium price

belongs to LI ( S, 2f, Ix).
Proof. Since consumption sets are closed and preferences are upper semicontinuous in the Mackey, and hence weak star, topology, our earlier discussion shows that the utility possibility set U is closed. The existence of a
quasi-equilibrium now follows from T h e o r e m 8.1.
Let (x, p) be a quasi-equilibrium. It follows easily from strict monotonicity
that E x i = to. (This is the only place where strict monotonicity is used.) By the
Yosida-Hewitt theorem quoted earlier, we may decompose p = Pc + Pl into a
countably additive and a purely finitely additive part. We wish to show that
py = 0. Because to is strictly positive, it suffices to show that pf to = 0. Suppose
to the contrary that PI" to > 0. Then Z Pc" xi = Pc " to 0 so that p c ' X j + e P ' t o O and p f ( O \ E " ) = 0 for each n. Define y" by y"(t) = 0 for
t E E " and y " ( t ) = x j ( t ) for t ~ E ' . For each n, y " E X j (recall that X j =
L=(S, ~Y, IX)+). Because y"---~ xj in measure, and hence in the Mackey topology
(see Section 2), lower semi-continuity of preferences implies that y" + eto >j x i
for n sufficiently large. However, since p f ( O \ E " ) = 0 for each n, we have
PI" Y" = 0 for each n, so p (y" + eto) < p . toi, which is a contradiction. We
conclude that pf = 0, and hence that p E L I(S, E, IX), as desired.
Note that strict monotonicity is used in the above argument only to
guarantee that E x i = to; without strict monotonicity, we cannot rule out
quasi-equilibria for which E x i < to, and such quasi-equilibria may be supported
by prices p ~ L ~ ( S , ~, IX). In that case, however, it is possible to show that the
countably additive part Pc also supports the same quasi-equilibrium allocation
1864
[Bewley (1972)]. In our setting, we note that our proof technique always yields
quasi-equilibrium allocations such that E xj = w, so our quasi-equilibrium
prices are necessarily in LI(S, ~, I-~).
The proof of Theorem 8.2 also helps to understand the hypotheses that
consumption sets be the positive orthant and that preferences be Mackey
continuous. These hypotheses are used precisely to ensure that if y, z E X i with
Y >i z, {E n} is a descending sequence of measurable sets such that/x(E")---~ 0,
and we define y" by putting y"(t) = 0 for t E E n and yn(t) = y(t) for t ~ E ~, then
we obtain a sequence {y"} of vectors that, first, belong to the consumption set
Xi, and, second, have the property that y" >i z for sufficiently large n. Any
hypotheses that yield this conclusion can fulfill the same function [see Prescott
and Lucas (1972)].
9. Properness and general commodity spaces

We turn now to general commodity spaces, for which the positive cone L + may
have empty interior. As we have indicated, the central problem in such spaces
is supportability of optima, and this section will be devoted largely to this
problem. It is important to keep in mind that the list of commodity spaces for
which the positive orthant has empty interior includes many of the most
important commodity spaces, including the Lp spaces (and more generally, the
reflexive Banach lattices). Recall that those are well behaved from the point of
view of compactness of the attainable set.
We treat first the one consumer case. Afterward, we address the general
situation, where optimal allocations involve real trade between consumers.
9.1. One consumer

Supporting prices are differentials, or more generally, subdifferentials, of
utility functions. They are measures of marginal rates of substitution. When
consumption sets have non-empty interior (and preferences are continuous),
such supporting prices are guaranteed to exist (and to be continuous). When
consumption sets have empty interior, however, marginal rates of substitution
may be unbounded in such a way as to preclude the existence of supporting
prices (see Examples 5.1 and 6.5). It seems natural therefore to require of
well-behaved preferences that they admit supporting prices. This leads to the
notion of properness, which was introduced by Mas-Colell (1986a). Antecedents to this notion appear in the economics literature in the notes of Debreu
and Hildenbrand (1970) [see Bewley (1972) for a discussion], and the papers of
Chichilnisky and Kalman (1980), Jones (1984) and Ostroy (1984).
1865
We say that the preference relation ~>, defined on the consumption set X, is
p r o p e r at x with respect to the vector v, if there is an open cone Fx at 0,
containing v, such that x - Fx does not intersect the preferred set {x' ~ X: x '
x}; i.e. if x ' ~ x then x - x ' ~ ' F x (see Figure 34.2). The interpretation we have
in mind is that the commodity bundle v is desirable, in the sense that loss of an
amount a v (with ot > 0) cannot be compensated for by an additional amount
otz of any commodity bundle z, if z is sufficiently small. We say that >~ is
uniformly proper with respect to v on the subset Y C X if it is proper at every
y E Y, and we can choose the properness cone independently of y.
When preferences are convex, properness of ~ at x with respect to v is
equivalent to the existence of a price p ~ L* which supports the preferred set
{x' E X: x ' ~ x} at x and has the additional property that p - v > 0. Indeed, if
such a p exists, we can simply take Fx = {z: p - z > 0 } .
Conversely, if ~ is
proper at x with respect to v, then { x ' E X: x ' ~ x} and x - F x are disjoint
convex sets, and the latter has non-empty interior, so the Separation T h e o r e m
(see Section 2) provides a continuous linear functional p E L* that separates
them; i.e. p - z <~p- x' for each z @ (x - Fx) and x ' ~ x. Because Fx is an open
cone at 0, containing v, it follows that p z < 0 for each z @ Fx, and hence that
p v > 0 and p x' ~>p x for x ' ~ x , as asserted. (For non-convex preferences,
: x'>_x~
.t,'/
"..-'/
//
/
//
/~ "F
t /
,~
t'
/
/
/
F i g u r e 34.2
1866
A, Mas-Colell and W.R. Zame
properness may still be interpreted in terms of marginal rates of substitution,

but is more general than linear supportability.) Properness is thus a requirement which is no stronger than necessary for our purpose. Uniform properness, however, is a more serious restriction than properness, and will fail for
some important preference relations; see Sections 10 and 11.
A related notion was introduced by Yannelis and Zame (1986) in the context
of u n o r d e r e d preferences (see also Sections 13 and 15). We say >~ is F-proper
(F for forward) at x E X with respect to v if there is an open cone Fx (at 0) such
that v E F x and (x + F x ) M X C { x ' E X : x ' ~ x } ;
i.e. if z E F x and x + z E X
then x + z ~> x (see Figure 34.3). We say that ~ is uniformly F-proper on
Y C X with respect to v if it is F-proper at each point y E Y and the properness
cone may be chosen independently of y.
In general, properness and F-properness are incomparable conditions, but it
is easy to see that uniform properness on X (with respect to v) is equivalent to
uniform F-properness on X (with respect to v).
It seems natural to surmise that properness is related to extendibility of
preferences, and Richard and Zame (1987) have shown that this is indeed the
case. T o be precise, take X = L +. Uniform properness of ~ on X implies the
existence of a convex cone /~ containing L + and having non-empty interior,
and a convex preference relation ~ on L that extends ~ . In general, the
extended preference relation ~- may be chosen to be either upper or lower
{,.,x
,,
////
///
Figure34.3
~'x~ / / / /
1867
semi-continuous; if order intervals are weakly compact, it may be chosen to be

both upper and lower semi-continuous (i.e. to be continuous). Conversely, the
restriction to the positive cone of a continuous, convex preference relation
defined on a convex c o n e / ~ containing L + and having non-empty interior (for
instance, the entire space L ) , is uniformly proper on order bounded sets. In
particular, this provides a simple way to construct uniformly proper preferences.
It is easy to see that the preferences described in Example 6.5 are not proper
(at to). The preferences described in Example 5.2 are p r o p e r (at to) in the
topopology o-(M([0, 1]), C([0, 1])), but not in the topology o-(M([0, 1]),
Lip([0, 1])). This should serve as a reminder that the notion of properness
depends on the topology of the space (through the requirement that the cone
Fx be open).
9.2. Several c o n s u m e r s
It would be most convenient if properness, which is equivalent to supportability of individual preferred sets, were sufficient to guarantee supportability of
weak optima. Unfortunately, this is not so, as the examples below demonstrate; this first is from Richard and Z a m e (1986) and the second from Jones
(1987).
+
Example 9.1. Let L = l 2, X 1 = X 2 = 1z . As in Example 6.5, define u : l 2 --~

by u ( x ) = Z v , ( x ( t ) ) , where
if x ( t ) < ~ 2 2,,
"2'x(t)
o,(x(t))
2 t[x(t) + 1 - 2
2,]
ifx(t)>2
2,.
This utility function has no supporting price at the vector to E 12 defined by

to(t) = 2-4'; the only candidate is the unbounded sequence {2'). Now let ql, q2
be non-collinear, strictly positive linear functionals on 12, and define utility
functions u~, u 2 by
ui(xi) = m i n { u ( x i ) , qi " xi + ui())
--
qi" w } .
These utility functions u i are continuous, concave and strictly monotone. Let
endowments be w1 = w2 = w. It may be seen that consumer i's preferred set to
w i is
{x i E l ; : u ( x i ) >! u(toi)} N { x i E l ; : qi" xi >>-u(toi))
1868
so that (to~, oJ2) is an optimal allocation. On the other hand, the only prices
supporting these preferred sets are (up to positive multiples) on the line
segment joining qi to the unbounded sequence {2t}; the only such price that
belongs t o / 2 is qi itself. Since ql, q2 were chosen non-collinear, this means that
no common supporting price exists.
These preferences are evidently proper at the endowments (since supporting
prices exist), but they fail to be F-proper at the endowments, or to be
uniformly proper on the attainable portion of the consumption sets.
Example 9.2. Set L = L = ( [ 0 , 1 ] ) , equipped with the weak topology
tr(L=([0, 1]), C1([0, 1])) from the pairing of L=([0, 1]) with C~([0, 1]), so that
the price space is L* = C~([0, 1]). Set X 1 = X 2 = L +, w1 = w2 -= 1. Define utility
functions u~, u 2 by
u,(xl) = f txl(t ) dt ,
u2(x2) = J (1 - t)x2(t ) dt.
These utility functions are continuous and uniformly proper (since they are
linear). However, the optimum xl = characteristic function of [0, 1/2], x 2 =
1 - xa is not supportable by any continuous price. The reason is not difficult to
see: the only candidates for a supporting price are positive multiples of the
function
p(t)= l-t
for0~<t~<l/2,
p(t)=t
for 1 / 2 ~ < t ~ < l .
This price does not belong to C1([0, 1]), and so is not continuous in the weak
topology o-(L~([0, 1]), C1([0, 1])).
Note that the lattice operations are not continuous in the topology
tr(L~([0, 1]), C1([0, 1])); equivalently, this topology is not locally solid (use the
Rademacher functions discussed in Example 4.2).
We also refer to Example 8.3, which may easily be modified to apply to any
of the lp spaces, 1 < p < 0% in order to show that even with linear preferences,
when consumption sets differ from the positive orthant, optima may not be
supportable by prices [see Back (1988)].
As the examples indicate, we need to assume uniform properness, not just
properness; we need to assume that the commodity space is a topological
1869
vector lattice, not just a v e c t o r lattice; and we m u s t assume that c o n s u m p t i o n

sets coincide with the positive orthant. With all these restrictions, h o w e v e r ,
supportability of o p t i m a is g u a r a n t e e d . T h e following results are due to
Mas-Cotell (1986a).
T h e o r e m 9.1. A s s u m e , in a d d i t i o n to the basic a s s u m p t i o n s , that:
(i) L is a t o p o l o g i c a l v e c t o r lattice;
(ii) X~ = L + f o r each i;
(iii) p r e f e r e n c e s are u n i f o r m l y p r o p e r o n the o r d e r interval [0, to] with respect
too).
T h e n there is a tr( L *, L ) c o m p a c t , c o n v e x set K C ( L * ) + s u c h that p . to = 1 f o r
every p E K , a n d e v e r y w e a k o p t i m u m can be s u p p o r t e d b y s o m e p E K .
Proof. Let u be a w e a k l y optimal utility vector. M o n o t o n i c i t y and the

restriction Xi = L + g u a r a n t e e that there is a weakly o p t i m a l allocation x such
that E x~ = to and u i = u i ( x i ) for each i. F o r each i, let Fg be a p r o p e r n e s s cone
for >~ and F = n F/. Set
V={~(zi-x~):ui(zi)>~u~(x~)
for each i } .
It is evident that V is c o n v e x ; we assert that V n ( - F ) = ~.

T o see this, let W C L be a n e i g h b o r h o o d of 0 such that to + W generates F.
B e c a u s e the t o p o l o g y is locally c o n v e x and locally solid, there is no loss o f
generality in assuming that W is convex, s y m m e t r i c and solid. If z - to @ V n
( - F ) then there are zi>~O such that z = E zz, ui(zi)>~ u i ( x i ) for each i and
z-(1-a)toC~W
for s o m e a > 0 .
O f course, ( 1 - a ) t o - z < ~ t o .
Hence
[(1 - a)to - z] + ~< to and so
z = (1 - a)to - to + to - [(1 - a)to - z] + + [(1 - a)to - z l / > - a t o + [ ( 1 - a)to - z ] - .
It follows that [(1 - a ) w - z ] - ~< z + ~to.
o f vector lattices (see Section 2) allows
0 <~ s i <- z i - ato for each i and [(1 - a)to
We n o w set v i = z i + oew - s i >-0. N o t e
T h e Riesz D e c o m p o s i t i o n P r o p e r t y
us to find vectors s~ C L such that
- z ] - = E s i.
that [(1 - oz)to - z] E oeW and
O<~s i<~ [ ( 1 - a ) t o - z ] - ~ I ( 1 - a ) t o - z I
so that s i E a W . P r o p e r n e s s at v / t h e r e f o r e implies that u i ( v i ) > u~(z~) for each

i. O n the o t h e r h a n d ,
1870

E vi = z + a w - [ ( 1 - a ) w -
z]-
<- z + a w - [ ( 1 - a ) w - z ] - + [ ( 1 - a ) w - z] +
= z + o~o)+ [(1 - oz)w - z]

~(.0,
which contradicts the optimality of the allocation x. We conclude that V N

( - F ) = It, as asserted. We can now apply the Separation T h e o r e m to find a
continuous linear functional p separating V from - F ; as in the proof of
T h e o r e m 8.1, p is the desired supporting price.
From the above and T h e o r e m 7.1 we immediately obtain the following
theorem.
(i) L is a topological vector lattice;
(ii) X i = L f o r each i;
(iii) preferences are u n i f o r m l y p r o p e r on the order interval [0, w] with respect
too);
(iv) the utility possibility set U is closed.

Then a quasi-equilibrium exists.
As we have noted several times, if L is a reflexive Banach lattice (e.g.
L = Lp, 1 < p < ~ ) or a Banach lattice with order continuous norm (e.g.
L = L1) , then it is automatically the case that the weak topology is compatible
and the set of allocations is weakly compact, so closedness of the utility
possibility set is also automatic.
Since the Mackey topology on L= is locally solid, T h e o r e m 9.1 might be
viewed as a generalization of T h e o r e m 8.2, but it should be noted that Mackey
lower semi-continuity is a weaker condition than Mackey uniform properness
(for example, the former is compatible with infinite marginal utility at zero
consumption, while the latter is not).
We should also point out that, even in the finite dimensional case, properness-like assumptions are not dispensable if we insist (as seems most reasonable) on finding a quasi-equilibrium price p with p . ~o > 0 [Mas-Colell (1985),
Yannelis and Z a m e (1986)].
While we have established the existence of quasi-equilibria supported by
continuous prices, we have left open the possibility of quasi-equilibria supported by discontinuous prices; see the discussion in Section 10.
A r e we at the end of the road? Not quite. Aside from the unfortunate
restriction that consumption sets coincide with the positive orthant (see Section
1871
15 for further discussion), two of our assumptions will not be satisfied in some
economically interesting settings. The first is uniform properness, which rules
out infinite marginal utility for zero consumption and is thus incompatible with
some models used in finance. The other is local solidness of the topology,
which rules out commodity spaces such as L = M(K), with the weak topology
o(M(K), C(K)), and is thus incompatible with some models of commodity
differentiation.
In the next three sections, we see that, in many cases of interest, these
assumptions can be relaxed. In Section 10 we show that, even without uniform
properness, it is still possible to find price systems which are not defined for all
consumption bundles. (Properness will then suffice to guarantee that such price
systems can be extended continuously to all commodity bundles.) In Section 11
we apply these ideas to a financial model. Finally, Section 12 shows how the
assumption of a locally solid topology may be eliminated.
10. The order ideal L(to)

As we noted in Section 5, requiring that prices be defined and finite on all of L
amounts to requiring that every conceivable commodity bundle be assigned a
finite price. In this section, we explore the consequences of relaxing this
requirement. As we shall see, this leads naturally to a weaker notion of
equilibrium, whose existence can be established even if preferences are not
proper. When preferences are proper, this weaker equilibrium notion yields an
equilibrium in the usual sense.
Informally, we shall insist that endowments (and hence all feasible bundles)
be assigned a finite price, but we allow for the possibility that commodity
bundles " n o t present in the m a r k e t " are left unpriced. Such a possibility was
first considered by Peleg and Yaari (1970) in the context of intertemporal
equilibrium theory.
In what follows, we assume that L is a topological vector lattice with
topology ~-, that consumption sets X i = L + for each i, and that the attainable
set Z is compact in some compatible topology o-, or simply that the utility
possibility set U is closed.
The key notion is the order ideal generated by the aggregate endowment w:
L(w) = { x E L: Ix I ~< hw for some h > O } .

If L = L~(S, ~, Ix) and to is bounded away from O, then L(w) = L. In general
however, L(w) is much smaller than L. For instance, if L = L 1(S, 2;,/x), then
L(w) consists of functions x for which the ratio ]x(t)/w(t)] is bounded. If
L = M(K), then L(w) consists of measures x that are absolutely continuous
1872
with respect to to and have bounded R a d o n - N i k o d y m derivatives (see also

Example 5.1).
Note that, in an exchange economy, L(to) contains all the feasible consumption bundles so that [as pointed out by Brown (1983)], we can determine all
Pareto optimal and core allocations by considering the restriction of the
economy to L(to). (That is, we consider the economy with consumption sets
Xg(to) = X i n L(to), preferences obtained by restricting to L(to), and the same
endowments). This suggests that we look for quasi-equilibria of the restriction
of the economy to L(to), and then consider the relationship between such
quasi-equilibria and quasi-equilibria of the original economy. This strategy has
been employed by Zame (1987), Aliprantis, Brown and Burkinshaw (1987b),
Araujo and Monteiro (1989a) and Duffle and Zame (1989).
The search for quasi-equilibria in L(to) is much easier than in L because
L(to) carries a lattice norm (i.e. a norm with respect to which the lattice
operations are uniformly continuous) with respect to which the positive cone
has a non-empty interior. This norm is defined by setting for x E L(to)
Ilxll
= inf{A > 0: Ixl ~< Ato}.
It is easy to check that I1" I1~ is a lattice norm on L(to) and that the I1" I1~
topology is stronger than the topology z (because z is locally solid). Moreover,
to is in the I1 I1o interior of the positive cone L(to) + = L(to) N L +. Thus, L(to)
is much like L~. Indeed, in many cases of interest, L(to) is actually isomorphic
to L~(S, ~, Ix) for some measure space (S, ~Y, Ix) [see Zame (1986)]. For our
present purposes, we need only observe that the restriction of the economy to
L(to) enjoys all the properties required in Theorem 8.1. Hence, the restriction
of the economy to L(to) has a quasi-equilibrium (x, p), where p is a positive,
I1"
continuous linear functional on L(to), E Xg = ~o and p - to # 0.
It should be emphasized that (x, p) is not a quasi-equilibrium in the usual
sense, since we have not priced all commodity bundles in L. Moreover, at this
point we can draw no conclusions about continuity of the price p (with respect
to the topology z) or its extendibility to all of L. On the other hand, to this
point we have made no assumptions about preferences other than convexity
and continuity with respect to z.
To study the continuity of p (with respect to z) and its extendibility to all of
L, we make use of the notion of F-properness discussed in Section 9. Recall
that F-properness of >~i at xi with respect to the vector to (and the topology ~-)
means that there is a z-neighborhood Wg of 0 such that every point of the
forward cone F = {x i + hto - hz: h > 0 , z E W~) which also belongs to L + is
preferred to xg. As we have already noted, properness and F-properness are
closely related; in particular, uniform properness and uniform F-properness are
equivalent. Moreover, it is easily seen that F-properness of ~>i at xi implies
properness at xg of the restriction of ~>g to L(oJ).
1873
We assert that if each preference relation ~i is F-proper at x i (with respect to

to), then the price p is continuous with respect to the original topology ~-. (Note
that our assumption is only on the behavior of the preference relations at a
single point.) To see this, set W = NW,.; without loss of generality, we may
assume that W is solid and symmetric (i.e. W = - W ) and that p . to = 1. To
show that p is continuous, it suffices to show that it is bounded on some
neighborhood of O. Since W is symmetric, it suffices to establish this for y ~>O.
We claim that in fact p . y ~< N for each y E W t3 L(to) +, whence ]p- Yl ~<2N
for each y @ W N L(to). Since y E L(to), there is a A > 0 such that 0 ~ y
Ato; set z = ( 1 / A ) y < ~ t o . Because Z x i = t o , we conclude that E ( x i +
( 1 / A ) t o ) - z 1> 0. We now apply the Riesz Decomposition Property of vector
lattices (see Section 2) to find z ~ , . . . , ZNE L(to) + such that E z~= z and
xg + (1/A)to - z~ 1>0 for each i. Since z~ ~< z and z E (1/A)W, solidity of W
implies that z i E ( 1 / A ) W for each i. F-properness implies that x i +
( 1 / A ) t o - z s > f s x i , and the quasi-equilibrium conditions then imply that
p - (xi + (1/A)to - zi) >~p. x~ for each i. Summing over all consumers, rearranging terms, and keeping in mind that p / > 0, we conclude that
N12~ = p . (NllOto >! ~ p . (1/,t) to
i>
p - (11a)y
so that p . y <~N, as asserted. We conclude that p is continuous. [This

argument is from Yannelis and Zame (1986).]
If L(w) is dense in L (i.e. if to is in the quasi-interior of L + ) , then the price p
has a unique continuous (with respect to ~-) extension/~ to all of L. It is easily
checked that (x,/7) is a quasi-equilibrium for the original economy. (If L ( w ) is
not dense in L, the price p may have many continuous extensions to L, and it
might happen that none of them is a quasi-equilibrium price. However, if each
of the preference relations ~>i is uniformly proper, it may be shown that there
is some continuous extension /7 of p to L such that (x,/7) is a quasiequilibrium.)
Summarizing, we obtain the following result ]which is a variant of results
obtained by Zame (1987), Aliprantis, Brown and Burkinshaw (1987b), Araujo
and Monteiro (1989a) and Duffle and Zame (1989)].
Theorem 10.1. Assume, in addition to the basic assumptions, that:

(i) X i = L + for each i;
(ii) the attainable set Z is compact in some compatible topology (or simply
that the utility possibility set U is closed).
Then:
(a) the restriction of the economy to the order ideal L(to) has a quasiequilibrium (x, p), such that the price p is continuous in the ll " IIo~ norm on
L(to);
1874
(b) if each preference relation > i is F-proper at x i then p is continuous in the

topology of L;
(c) if, in addition, either L ( w ) is dense in L (i.e. to is in the quasi-interior of
L +), or every > i is uniformly proper, then p extends to a continuous price fi on
all o f L, and (x, ~) is a quasi-equilibrium for the original economy.
Three final comments are in order here. First, note that the result above
yields a quasi-equilibrium price/), provided only that preferences are F-proper
at a single particular allocation - a quasi-equilibrium allocation for the restriction of the economy to the order ideal L(oJ). This will certainly be the case if
preferences are F-proper at every individually rational, Pareto optimal allocation. Second, the hypothesis that to be in the quasi-interior of L + is quite weak
in many circumstances. For example, if L = L p (l~<p <co) with the norm
topology, or L= with the Mackey topology, this restriction means only that to is
non-vanishing except on a set of measure 0. However, if L = M ( K ) with the
norm topology, this restriction is unpleasantly strong, since M ( K ) + has no
quasi-interior points unless K is countable. Third, we should not forget that we
are restricting ourselves to exchange economies. The discussion we have given
here depends crucially on the fact that the feasible set is a subset of an
appropriate order interval. This is in the nature of things for an exchange
economy, but quite problematical in the more general production context.
Nevertheless, by appealing to truncation arguments, the order ideal approach
remains a powerful technique even in the production context [see Zame
(1987)].
II. Separable utilities and the finance model
As we have discussed in the Introduction, in finance models it is common to

take the commodity space to be L2(S , ~, /.t) (for (S, ~,,/~) a probability space)
and consumption sets to be the positive cone L2(S , ~,/1.)+. Since the positive
cone has an empty interior, Theorem 8.1 does not apply. Moreover, much of
finance theory assumes instantaneous utility functions with infinite marginal
utility for consumption at zero, a requirement incompatible with uniform
properness, so Theorem 9.1 also does not apply. In what follows, we show how
the special structure of the finance model may be combined with Theorem 10.1
to sidestep these difficulties. As we shall see, the idea is to exploit separability
of utility functions and the nature of optimum allocations. Our discussion
follows Araujo and Monteiro (1989a) and Duffle and Zame (1989).
Let (S, ~ , / ~ ) be a probability space. We take as commodity space L =
Lp(S, 2, p~) (with the norm topology and pointwise ordering) and as price
space the dual L* = Lq(S, ,~,/~), where 1 ~ p <oo and ( l / p ) + ( l / q ) = 1 (in
1875
the finance setting, p = q = 2). We assume that individual utility functions

u~: L+---> R + are norm continuous, strictly monotone, concave and additively
separable. That is, there are concave, continuous, strictly m o n o t o n e functions
v i : [0, ~) S---> E such that
1
Ui(X) : f Di(X(S), S) O / . Z ( S )
for each x ~ L +. We shall also assume that each v i ( . , s) is continuously
differentiable on (0, ~) for each s; we write v~(., s) for its derivative (and
v~(0, s) for the right-hand derivative at 0).
+
For each i, define Q i : L p x S--->ff~ + by Q i ( z , s ) = v i ( z ( s ) , s ). Araujo and

Monteiro (1989a) show that properness of u i at z is equivalent to F-properness
of u i at z, which in turn is equivalent to the assertion that the function Q i ( z , )
belongs to Lq. In this case, Q i ( z , ) is a supporting linear functional at z. If z is
strictly positive then Q~(z, ) is (up to scalar multiples) the unique supporting
linear functional at z. F r o m this it follows, incidentally, that u~ cannot be
uniformly proper if v~(0, s) = ~ for each s.
On the other hand, T h e o r e m 10.1 assures us that an equilibrium will exist
provided that to is strictly positive (and hence belongs to the quasi-interior of
L p ) and that for every weak optimum x which is individually rational (i.e.
ui(x~) >1 ui(o~i) for each i), each u i is F-proper (equivalently in this setting,
proper) at x i. In fact, it suffices to have properness for a single allocation z.
A r a u j o and Monteiro (1989a) establish the following theorem for the case
z~ = wi; Duffle and Z a m e (1989) use (in essence) the case z i = oo/N.
Theorem 11.1. I f ~o(s) > 0 f o r almost all s ~ S, and there is any allocation
z >1 0 with Z z i = 0 ) , and such that u i is p r o p e r at zi f o r each i, then the e c o n o m y
has a quasi-equilibrium.
Proof. Let x be any individually rational weak optimum; we wish to show that
each v i is proper at x r T o this end, we use optimality to choose weights a/,
0 < a i < 1, such that the weighted sum E aivi(Yi(S), s) is maximized (over all
allocations y) by taking y = x. It follows that for almost all s ~ S, if xi(s) > 0
then
aiQi(xi, s) >1 a j Q J ( x j , s)
for every j .
For each k, set S~ = {s: x k ( s ) > Zk(S)}. If S ~ S k, then for every i we have
aiQi(xi, s) <~ ak Qk(Xk, S) <~ a~ Q~(zk, S)
and if x E S \ U S ~ , then for every i we have
A . Mas-Colell and W . R . Z a m e
1876
aiQi(xi, s) = aiQi(zi, s) .
Since a / < 1 for each i, we conclude that
i
c~iQ (xi, s) <~max Q~(z~, s) .

Because Qk(zk, ) belongs to Lq for each k and ai > 0 for each i, we conclude
that Q (x i, ) belongs to Lq for each i. Hence u i is proper at x i for each i, as
desired.
Therefore, for every individually rational, weak optimum x, each u i is
proper, and hence F-proper, at xi. The existence of a quasi-equilibrium now
follows from Theorem 10.1.
Although we have derived Theorem 11.1 via Theorem 10.1, it could also be
derived directly from Theorem 7.1. To accomplish this, note that, in the
argument we have given, strict monotonicity of preferences guarantees that the
weights ai are uniformly bounded away from 0. Therefore, we can support
individually rational weakly optimal allocations by prices lying in a compact
set.
For more on existence issues in the finance model, see Karatzas, Lakner,
Lehoczky and Shreve (1990), Dana and Pontier (1989) and Dana (1990).
12. The lattice structure of the price space
In the preceding sections, we have seen that the order structure of the
commodity space plays a key role when consumption sets have empty interior.
Indeed, many of the arguments we have given to this point depend heavily on
the assumptions that the commodity space is a lattice and that the lattice
operations are (uniformly) continuous, or equivalently, that the topology is
locally solid. As Example 9.2 shows, these assumptions are not entirely
dispensable. Unfortunately, they rule out some economically important examples, including the commodity space M ( K ) equipped with the weak topology
o-(M(K), C ( K ) ) , and the commodity space M([0, 1]) equipped with the weak
topology o-(M([0, 1]), Lip([0, 1])). As we have discussed (see the Introduction
and Examples 4.3 and 4.4), these commodity and price spaces have been used
in models of product differentiation and intertemporal consumption. In this
section we show how the assumptions on the commodity space can be
weakened to incorporate examples such as these. Our discussion follows
Mas-Colell and Richard (1991).
In what follows, we consider a commodity space L which is (Hausdorff)
locally convex topological vector space with topology % and which is ordered
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by a closed, convex, non-degenerate, positive cone L +. We also assume that L

is a vector lattice with respect to this order, but we do n o t assume that the
lattice operations are continuous (in particular, we d o not assume that r is
locally solid). Instead, we assume only that the dual space L* is a sublattice of
the order dual (i.e. that for p, q in L * , the supremum p v q and infimum p ^ q
are also in L*). If L is a topological vector lattice, the lattice structure of L*
obtains automatically, but, as may be seen from the examples cited above, the
lattice assumption on L* is strictly weaker than the assumption that L is a
topological vector lattice.
Note that the commodity/price duality of Example 9.2 (L = M([0, 1]) with
the topology o-(M([0, 1]), C~([0, 1])), L* = C1([0, 1])) does not satisfy these
assumptions; with the natural order, the commodity space is a vector lattice
and the positive cone is closed, but the dual space is not a lattice. As the reader
may see, it is precisely this failure of the dual to be a lattice (i.e. the failure of
the supremum of two differentiable functions to be differentiable) that lies at
the heart of Example 9.2. And it is precisely this failure to be a lattice that
distinguishes between price spaces such as C ( K ) and Lip([0, 1]) on the one
hand and C1([0, 1]) on the other.
The argument for the existence of equilibrium in this setting, like the
argument given in Section 9, breaks into two parts. The first part establishes
the existence of a compact set of supporting prices.
Theorem 12.1. A s s u m e , in addition to the basic a s s u m p t i o n s , that:
(i) L is a vector lattice and L * is a sublattice o f the order dual;
(ii) f o r each i, X i = L +;
(iii) f o r each i, ~ i is u n i f o r m l y p r o p e r on the order interval [0, ~o].
T h e n there is a w e a k star c o m p a c t , c o n v e x set K C ( L * +) u such that E Pi " w = 1
f o r every ( P l , - , PN) E K , a n d every w e a k o p t i m u m is s u p p o r t e d by a price
o f the f o r m P l v . . . v PN f o r s o m e ( p l , , PN) E K.
The crucial difference between Theorems 12.1 and 9.1 is that here the
supporting price is constructed in an explicit way (which makes quite clear the
role played by the lattice structure of the price space). The explicit construction
of the supporting price makes it possible to treat the set of supporting prices in
a "disaggregated" fashion, and it is this avoidance of aggregation which allows
us to dispense with local solidness of the topology ~- in L.
Proofl Let x = ( X 1 . . . . .
XN) be a weak optimum (we assume E x i = oo), and
for each i, set W,- = {z E L+: z > i x i } , and V/= W/+ F, where F i s the properness cone. Write V = { ( v t , . . . , VN) E L U: v i E V/}. Uniform properness implies that V A Z = 0. Since V contains an open set, the separation theorem
provides a linear functional (Pl . . . . , PN) E L *N separating V from Z. There is
1878
no loss of generality in normalizing so that E Pi" to = 1. To see that p~ v , v

PN is a supporting price, we show first that ( P l V " V PN)" Xi = Pi" Xi for each
i. N o t e that the definition of supremum for linear functionals (see Section 2)
yields
E
(Pl
V''"
pN)'Xi
= (Pl V''"
=(Pl
PN)" E Xi
V "'" VpN)'tO
-~E pi'xi
(the last equality following because ( P l , . , PN) separates V from Z). On the
other hand, (p~ v . . . V p U ) ' X i > ~ p i ' x i for each i. Combining these gives
( P l v v p u ) v xi = Pi" xi for each i, as desired. Observe now that if z i >ix~
then p i . z~/> pg- x~ (this again follows from the separating property). T h e r e f o r e
( P l v "'" V p N ) ' Z i > ~ P i " z i ~ P i ' X i > ~ ( p l
V''"
VpN)'X i .
Finally, we may take

K = {(Pa . . . . .
PN): ~ Pi" OJ = 1 and Pi" Y >10 for each i
and each y ~ F } ,
so the proof is complete.
As in Section 9, we obtain the existence of quasi-equilibrium.

(i) L is a vector lattice a n d L * is a sublattice o f the order dual;
(ii) f o r each i, X i = L +;
(iii) f o r each i, ~ i is uniformly p r o p e r on the order interval [0, to];
(iv) the utility possibility set U is compact.
Then the e c o n o m y has a quasi-equilibrium.
The proof of T h e o r e m 12.2 follows the same outline as the proof of T h e o r e m

9.2, but it is more subtle, because the price set here is disaggregated. (Since
the lattice operations in L are not assumed to be continuous, we cannot
conclude that the aggregated price set { P l v v PN: ( P l , , PN) ~ K } is
compact.) In essence, what is required is to reprove T h e o r e m 7.1 with a
1879
disaggregated price set. Establishing the required upper hemi-continuity and

convexity properties is delicate, and we refer to Mas-Colell and Richard (1991)
for details.
13. Other approaches

To this point, we have focused on the approach to the existence of equilibrium
via the Negishi method. There are at least three other approaches to the
existence of competitive equilibrium that have been used in the infinite
dimensional setting: finite approximations, core equivalence and excess demand. We cannot do justice here to the virtues of each of these methods;
instead, we give a detailed sketch of the method of finite approximations, and
content ourselves with merely indicating the way in which the other methods
proceed. As we have noted previously, our main purpose for following the
Negishi approach is that we are able to exhibit the main difficulties in a clear
way. Of course, since these difficulties are central to the existence problem,
they arise, in one way or another, in all proofs. We shall try to make this
apparent in our discussions.
The idea underlying the method of finite approximations is to approximate
the given economy (with an infinite dimensional commodity space) by a family
of economies with finite dimensional commodity spaces. Familiar results then
guarantee that each of these economies has an equilibrium. One then proves
that an equilibrium for the original economy can be obtained as a limit of
equilibria for the finite dimensional economies. To illustrate the details, we
sketch a proof of T h e o r e m 8.1 via finite approximations. With only one fairly
small variation, the argument is Bewley's (1972) [see also Mertens (1970)].
Theorem 13.1. Assume, in addition to the basic assumptions, that tO @ int L +,

and that the utility possibility set U is closed. Then a quasi-equilibrium exists.
Proof. Let 0% be the family of finite dimensional subspaces of L which contain
the initial endowments tog. Note that ~ is directed by set inclusion. For each
F E o%, let ~ e be the economy obtained by restricting all the data to the
subspace F; i.e. consumption sets in ~ e are X i n F, etc. The usual finite
dimensional existence results guarantee that the economy ~ e has a quasiequilibrium (XF, pF).
There is no loss in normalizing so that pF. tO ----1. Since tO ~ int L +, there is a
symmetric neighborhood W of 0 such that t O + W C L +, whence t O + ( w n
F ) C F n L +. Monotonicity implies t h a t pF is positive on F n L +, so pF. Z >!
- 1 for z E W n F. Symmetry of W now yields - 1 ~ p F . Z ~ +1 for z E W N F.
We can then apply the H a h n - B a n a c h extension theorem (see Section 2) to find
1880
an extension/~ of pF to all of L such that/~Fo W = 1 and - 1 ~ / ~ F Z ~ +1 for

all z E W.
Alaoglu's theorem (see Section 2) guarantees that the set of linear functionals
zl={q@L*:q-o~=l
and-l~<q.z~<+l
for a l l z E W }
is o-(L*, L ) - c o m p a c t , so, passing to a subnet if necessary, we may find a linear

functional p E L *
such that p . w = l ,
-l~<p-z~<+l
for all z E W and
^F
p y ~ p y for all y ~ L. The assumption that the utility possibility set is
closed implies that there is an allocation x such that bli(Xi) ~ lim sup ui(x F) for
each i. We shall show that (x, p) is a quasi-equilibrium.
We first establish the following claim: If ui(y~) > ui(x~) then p - y~/> p . oJ~. If
not, then there is a finite dimensional subspace F 0 E o% such that, whenever
>
F D bo, we have ui(Yi)
ui(x Fi ) and p . Yi < P" ti; there is no loss in assuming
that F 0 contains y~. Since 13F--->p and/3 F is an extension of p F we may also
choose F 0 so that pF. Y~ < pF. Wi whenever F 29 F 0. However, this contradicts
the fact that (x v, pF) is a quasi-equilibrium, and this contradiction establishes
the claim.
Finally, to show that (x, p) is a quasi-equilibrium, we must only verify that
p xi ~ p o)i for some i, then, since
Z x~ = Z w~, it follows that p xj < p % for some j. Monotonicity then yields a
contradiction to the above claim, so the proof is complete.
As we have noted many times, closedness of the utility possibility set follows
from the existence of a compatible topology in which the set of allocations is
compact. For instance, if the commodity space is L = L~(S, ~, p~), closedness
of the utility possibility set follows if preferences are Mackey (and hence weak
star) upper semi-continuous and the consumption sets are Mackey (hence weak
star) closed. These are precisely the assumptions of Bewley's (1972, T h e o r e m
1).
The arguments used above are readily adapted to the case of unordered
preferences [see Khan (1984)]. We should also note that, although monotonicity of preferences, the assumption that X i + L + C Xi, and the order
structure of the commodity space L, all play a role in this argument, they are
in fact superfluous; Zame (1987) shows how to eliminate them entirely.
It is instructive to compare the way in which the main difficulties we have
isolated (supportability, compactness, joint continuity) are addressed in the
argument sketched above and in the Negishi approach. As in the Negishi
approach, compactness is assumed in the form of the assumption that the
utility possibility set is closed. (This substitutes for the assumption of a
compatible topology in which the set of allocations is compact.) As in the
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Negishi approach, joint continuity is finessed by arguments that amount to

proving the joint continuity of the wealth map (x, p ) ~ p x only along special
nets of consumptions and prices. Finally, supportability is guaranteed by the
assumption that the positive cone L has a non-empty interior, but here this
assumption is used indirectly. On the one hand, it guarantees that the
quasi-equilibrium prices pF for the finite dimensional approximating economies
lie in a o-(L*, L)~compact subset; on the other hand, it guarantees that the
limit of a subnet is not the zero price.
If L has an empty interior, neither of these conclusions is necessarily valid.
In general, it may not be possible to choose the finite dimensional equilibrium
prices to lie in a o-(L*, L)-compact set, or to be sure that the limit price is not
identically zero. Here properness comes to the rescue. Yannelis and Z a m e
(1986) show how to use uniform F-properness (which is equivalent to uniform
properness) to obtain bounds on the finite dimensional equilibrium prices.
These bounds guarantee that the finite dimensional equilibrium prices (suitably
normalized) lie in a o-(L*, L)-compact subset, and hence have a convergent
subnet, and that the limit of this subnet is not the zero price. The argument is
rather complicated, however, because the use of F-properness to obtain
bounds on the finite dimensional equilibrium prices depends on being able to
choose the finite dimensional subspaces F C L to actually be sublattices. A
more efficient route to the result is to use the arguments of the proof of
Theorem 13.1 to establish the existence of equilibrium in the order ideal L(to),
and then use F-properness to conclude that the equilibrium price on L(to)
extends to an equilibrium price on all of L (see Section 10).
The method of core equivalence is based on the Debreu-Scarf theorem,
which, in the finite dimensional setting, asserts the coincidence of the set of
equilibrium allocations of an economy with the intersection of the cores of all
replications. Since an algorithm of Scarf provides a direct proof of the
non-emptiness of the core of a finite dimensional economy, the Debreu-Scarf
theorem also provides a proof of the existence of competitive equilibrium in
the finite dimensional setting. Aliprantis, Brown, and Burkinshaw (1987b,
1989b), following a precedent of Peleg and Yaari (1970), have used this
method to establish the existence of equilibria in the infinite dimensional
setting. First of all, they show that if there is a compatible topology in which
the set of allocations is compact, then the economy has a non-empty and
compact core. (This can be obtained via finite approximations or directly
through Scarf's theorem.) It follows that the intersection of the cores of all
replications (which Aliprantis, Brown and Burkinshaw call the set of Edgeworth equilibria) is non-empty. That every equilibrium allocation is an
Edgeworth equilibrium is a simple extension of the first welfare theorem. The
converse is true whenever the positive cone of the commodity space has a
non-empty interior. In particular, an Edgeworth equilibrium can always be
1882
A . Mas-Colell and W . R . Z a m e
supported as a price equilibrium on the order ideal L(w). An appeal to

uniform properness then guarantees that the equilibrium price on L(w) can be
extended to all of L so as to be an equilibrium price for the original economy.
The excess demand approach has been used in the infinite dimensional
context by a number of authors, including Aliprantis and Brown (1983), Bojan
(1974), E1-Barkuki (1977), Yannelis (1985), Florenzano (1983) and van Zandt
(1989). As in the finite dimensional setting, it depends on the use of some form
of the Kakutani fixed point theorem or its variant, the Gale-Debreu-Nikaido
lemma. Assuming compactness of the set of allocations (or closedness of the
set of utility possibilities), the crucial issue is obtaining a compact price
simplex. If the positive cone of the commodity space has non-empty interior
(and preferences are monotone), the set A identified in the proof of Theorem
13.1 is a suitable compact price simplex. If the positive cone has empty
interior, however, it will in general not be possible to find a compact price
simplex which does not include the zero price. Again, uniform properness
comes to the rescue, since it guarantees that the only prices we need consider
are those in the simplex
{qEL*:q.v=l
and-l~<q-z~<+lfor
allzEV}
where v is a properness vector (common to all consumers) and V is the

neighborhood of 0 whose existence is assumed in the definition of uniform
properness. The joint continuity problem can be finessed as in the proof of
Theorem 13.1. (A minor complication is that, for a given price p, endowment
wi and utility function ui, an optimal consumption choice need not exist. Hence
one cannot work directly with the excess demand mapping; a truncated version
must be used.)
Finally, we should refer to Ionescu-Tulcea (1986, 1988b) for the infinite
dimensional version of the approach to the existence of equilibrium via
generalized games. (The technical issues are similar to those arising in the
excess demand approach, although the disaggregated nature of the generalized
games approach may be a potential advantage.)
14. Production
In this section, we review the extension of the previous results to a production

context. This extension is less straightforward than in the finite dimensional
setting. Over and above the familiar difficulties (compactness of the set of
feasible allocations, supportability of o p t i m a , . . . ) there are new ones specific
to production. In retrospect this should not be surprising, since many of the
1883
previous results depended on order restrictions on consumption sets (for

instance X; = L +), which have no obvious analog for production sets. We will
concentrate on these additional difficulties, but we omit the proofs, referring
the reader to the original papers - or challenging h i m / h e r to adapt the proofs
for the exchange case!
Before proceeding further, let us agree on the data of a production
economy. On the consumption side, we simply adopt the notation and assumptions introduced in Section 3 and maintained throughout. We describe the
production side by a finite number M of firms, each of which is characterized
by a production set Yj. In the recursive treatment of production theory, it is
customary to assume a countable number of firms, one for each date [see
Malinvaud (1953). This difference is important for the study of production
efficiency in the intertemporal context, but not for the study of equilibrium.
We shall always assume that production sets are closed and convex, contain 0,
and have the property that y - L + C Yj whenever y E Yj (that is, we assume
free disposal in production). Profits of the firms are distributed to consumers
according to firm shares (Oq), where E Oij = 1 for each j.
By an allocation we mean an (N + M)-tuple (x, y) where x~ E X~ for each i,
Yi E Yj for each j and
N
Ex,=E to,+E y,.

i=l
i=1
j-1
As usual, a quasi-equilibrium is an (N + M + 1)-tuple (x, y, p) where (x, y) is

an allocation and p is a continuous linear functional on L such that p to > 0
and:
(1) p - yj = m a x { p . v: v E Yj} for each j;
(2) p - x/~<p- toi + E 0~j(p yj) for each i;
(3) if ui(v)> ui(xi) then p . v >~p . toi + X Oij(p. yj).
The boundedness assumptions that are typically used in the finite dimensional setting to obtain compactness of the set of attainable allocations are far from
sufficient in the general infinite dimensional setting. On the other hand, the
order boundedness properties that are so useful in the exchange case are far
from automatically satisfied in the general production context. Thus, we shall
need to make compactness assumptions on the attainable set directly. The
hypotheses should not be difficult to verify in each particular application.
As might be expected from our discussions of the exchange case, the
supportability problem disappears when the positive cone L , and hence the
production sets Yj, have a non-empty interior. With the appropriate compactness assumptions, this leads quickly to the following theorem, due essentially
to Bewley (1972).
1884
Theorem 14.1. A s s u m e that the maintained hypotheses on the consumption

side and the above assumptions on the production side are valid. I f
(i) o9 E int L +,
(ii) there is a compatible topology in which the set of attainable allocations is
compact,
then the economy has a quasi-equilibrium.
As in the exchange case, this result is not completely satisfactory. If the
commodity space is L=, we only obtain a quasi-equilibrium price in the dual
space L * = ba, the space of finitely additive measures. We would like instead
to obtain a quasi-equilibrium price which is a countably additive measure, i.e.
an element of L 1. In the exchange case, we can do so ( T h e o r e m 8.2) if
X i = L~+ for each i, o9 E int L~+, and preferences are strictly m o n o t o n e and
continuous in the Mackey topology ~-(L=, L1). In the production case, it is
natural to require in addition that production sets be Mackey closed and that
the set of attainable allocations be weak star compact. But, as the following
example shows, more will be required.
Example 14.1. Take L = 1=. There is one consumer, with consumption set
X = l~+, endowment o9 = (1, 1 , . . . ) , and utility function u ( x ) = Z 4-nx(n).
T h e r e is one firm, whose production set is
Y={y:y+(1)~<liminfy
(n)}.
Let (x, y, p) be a quasi-equilibrium, and suppose that p E 11. For each n/> 2,
write z n for the sequence whose first n terms are 0, and whose remaining terms
are 1. Profit maximization guarantees that p ( 1 ) ~ 2. On the
other hand, utility maximization guarantees that p ( 1 ) > 0. Hence p . znTgo.
But this contradicts the supposition that p E l l .
With the interpretation of elements of l= as commodity streams over an
infinite time horizon, the above example is familiar from growth theory. In
economic terms, the difficulty is that outputs come before inputs. To treat such
difficulties, Prescott and Lucas (1972) suggested the following assumption.
Possibility of Truncation.
If ( y ( 1 ) , . . . ,
y(n),...)E Y, then ( y ( 1 ) , . . . ,
y(n), 0, 0 . . . . ) E Y for each n.

Using this assumption (for the commodity space L = l~), Prescott and Lucas
(1972) obtain the existence of supporting prices in 11. In order to obtain prices
in L 1 (for the commodity space L = L=), Bewley (1972) uses the YosidaHewitt decomposition of linear functionals p E ba + into a countably additive
part Pc and a finitely additive part Pr (see Section 8) to formulate the following
assumption, which is a generalization of the Possibility of Truncation.
1885
Exclusion Assumption. For each production set Y C L~ = L~(12, ~ , / x ) and

each p ~ ba +, there is a sequence {F.} of measurable sets such that pc(F.)--> O,
p r ( O \ F . ) = 0 for all n and ( y l O \ F n ) E Y for each y E Y and all n.
Together with the assumptions of Theorem 8.2 and the assumption that
production admits constant returns to scale, the exclusion assumption is just
what is required to yield quasi-equilibria with prices in LI. In fact, it guarantees that all quasi-equilibria can be supported by prices in L~.
Theorem 14.2. Let L = L~. Assume the maintained hypotheses and:
(i) for each i, X i = L+~;
(ii) preferences are strictly monotone and Mackey continuous;
(iii) for each j, Yi is a Mackey closed, convex cone at 0 and satisfies the
exclusion assumption;
(iv) to E i n t L~+;
(v) the set of attainable allocations is o-(L=, L~)-compact.
Then the economy has a quasi-equilibrium. Moreover, if (x, y, p) is any
quasi-equilibrium with p E ba +, then (x, y, Pc) is also a quasi-equilibrium
(where Pc is the countably additive part of p).
For commodity spaces in which the positive cone has empty interior, failure
of supportability may entail that quasi-equilibria need not exist, as the following example shows.
Example 14.2. The commodity space is L = 1~. There is a single consumer,
with consumption set X = l~, endowment o)1 = (4 n) and utility function
u(x) = E x(n). There is one firm, whose production set Y is the closed convex
cone (at the origin) generated by the negative cone ( - 1 1 ) and the set of all
vectors of the form - 6 k +26k+1, for every k which is not a power of 2.
Interpreting a sequence in l 1 as a commodity stream over an infinite time
horizon, this means that the production technology can produce, from one unit
of input in a given period, two units of output in the next period (except for
initial periods which are powers of two.) It is easily checked that the consumption side of this economy satisfies our maintained hypotheses and that the set
of allocations is norm compact. However, this economy has no quasiequilibrium.
To see that this is so, suppose to the contrary that (x, y, p) were a
quasi-equilibrium, where p @ l~ = l~ is a bounded sequence. Profit maximization by the firm implies that the functional p is positive, and that p(k)>2p(k + 1) for each k which is not a power of 2. On the other hand, because
there is no production in any period which is a power of 2, the consumer's final
allocation x is certainly strictly positive in such periods. Utility maximization by
the consumer therefore implies that, in particular p(2 m) = p(2") > 0 for each m
1886
and n. Since the sequence p is unbounded, these conditions can only be

compatible if p(k)---0 for each k, a contradiction.
A little reflection reveals the problem here: one unit of input, if used late
enough, may be used to produce an arbitrarily large quantity of output (many
periods later). In particular, the rates of technological transformation are
unbounded. This difficulty can be treated by making assumptions which,
directly or indirectly, bound (marginal) rates of technological transformation.
Two assumptions of this kind have been used in the literature. Mas-Colell
(1986b) and Richard (1989), assume that production sets satisfy a condition
which is the analog, on the production side of the economy, of uniform
properness on the consumption side of the economy. This condition indirectly
bounds marginal rates of technological transformation, in much the same way
that properness in consumption bounds marginal rates of substitution. Zame
(1986) gives a condition which explicitly bounds marginal rates of technological
transformation. Although they are different, both assumptions make essential
use of the lattice structure of the commodity space. Since properness in
production is easier to describe, we begin there (although Zame's approach
was historically first and served as inspiration). We follow Richard (1989),
which generalizes and simplifies Mas-Colell (1986b).
Let L be a topological vector lattice, Y a production set (in particular, Y is a
closed, convex set containing the negative cone), and o) a positive element of
L. (In practice, we shall want to take for o) the aggregate endowment). We say
that Y is o)-uniformly proper if there is a neighborhood W of 0 in L such that,
for each y E Y , ( y - V ) N { x E L : x + < - y + } C Y ,
where V is the cone V =
{A~o + Aw: w E W, ~ > 0 } . Note that if o) E i n t L + (which of course requires
that int L + ~ 0), this condition is automatically satisfied, since we may take for
W the translate to the origin of any open neighborhood of ~o contained in L +.
(In particular, this covers the case where L is finite dimensional and all goods
are represented initially.) Informally, o~-uniform properness is the assumption
that w can substitute for any other input in the production of any given output,
and that the rate of substitution is uniformly bounded.
To describe the approach in Zame (1986), we assume that the commodity
space L is a normed lattice. For the production set Y, we say that the marginal
rate of technological transformation is bounded if there is a constant C such
that, if y = y + - y - is in Y and 0 ~< z - ~ y - , then there is a z + such that
0 ~ z + ~ y + , z + - z - is in Y and Ily - z+ll ~ Clly- - z-II. Informally, this is
a condition on the marginal rates of transformation of inputs to outputs.
In finite dimensional spaces, o~-uniform properness is always satisfied if
o) >>0, but marginal rates of technological transformation may be unbounded
near zero production.
Perhaps these conditions may be most easily understood in the context of a
technology which produces a single output good according to some (smooth)
1887
production function f : ( - L +) ~ R. In that case, the marginal rate of technological transformation is bounded precisely when the directional derivatives
Dz f(Y) of the production function f are (uniformly) bounded (for all inputs y
and positive directions z ~<y). By contrast, production is to-uniformly proper
exactly if the ratios Dzf(y)/Do, f ( y ) are uniformly bounded (for all inputs y
and positive directions z ~<y). Thus, if D~ f ( y ) is uniformly bounded away
from 0, then to-uniform properness implies a bounded marginal rate of
technological transformation. However, if D~ f ( y ) is not uniformly bounded
away from 0, the two conditions are incomparable. The following example
makes the same point.
Example 14.3.
Y~ =
y:
Let L = l~; consider two production sets
n~__2y+
(n)~<y(1
)}
Y z = { y : ~ y-(n)<~ ~ y+(n)for each k } .

n=k
n=k
As before, we interpret an element of 11 as a stream of a single commodity over

an infinite time horizon. The production set Y~ corresponds to a storage
technology in which any quantity of the commodity may be stored at date 1,
for release at any future time(s); no new input to storage is possible. The
production set Y2 corresponds to a storage technology in which any quantity of
the commodity may be stored at any date, for release at any future date(s), and
new inputs to storage are possible at any time. (But release before storage is
impossible.) If we take any to @ l~ with t o ( l ) > 0 , then Y1 is to-uniformly
proper, but Yz is not. On the other hand, for both Y1 and I12, the marginal
rates of technological transformation are bounded (by 1).
Either to-uniform properness of production sets or bounded marginal rates
of technological transformation are sufficient to guarantee that quasi-equilibria
exist. Theorem 14.3 is from Richard (1989) and Theorem 14.4 is from Zame
(1986). Zame (1986) also gives a result which is valid without the assumption
of constant returns to scale in production. However, as McKenzie (1959) has
shown, the assumption of constant returns to scale involves essentially no loss
of generality.
Theorem 14.3. Let L be a topological vector lattice. Assume the maintained
hypotheses on the consumption side and:
(i) for each i, X i = L "
(ii) preferences are to-uniformly proper;
(iii) each production set Yj is w-uniformly proper;
(iv) the set of attainable allocations is compact in some compatible topology.
1888
A. Mas-Colell and W.R. Zarne
Theorem 14.4. Let L be a normed lattice. A s s u m e the maintained hypotheses

on the consumption side and:
(i) f o r each i, X i = L +;
(ii) preferences are o~-uniformly proper;
(iii) each production set Yj is a closed convex cone at 0 and its marginal rate
o f technological transformation is bounded;
(iv) the set o f attainable allocations is compact in some compatible topology.
15. Final comments
Lack of space has prevented us from discussing many other topics. Here we
mention a few that seem important and promising for further research.
(A) With the exception of Theorems 7.1 and 8.1, we have not considered
general consumption sets with empty interior. Although little has been done in
this area, a tentative conclusion is that general consumption sets are similar to
general production sets, and that methods analogous to those used in the
production case may be relevant. Some special results and a striking counterexample have been given by Back (1988); see Example 8.3 and the remarks
following Example 9.2. The free disposal assumption on consumption sets (i.e.
X i + L C X i ) is also restrictive in some contexts (such as finance models with
incomplete markets). See Boyd and McKenzie (1990) for more on consumption sets.
(B) An important line of research in classical general equilibrium theory has
been the relationship of the core to the set of competitive allocations. In the
infinite dimensional setting, Aliprantis, Brown and Burkinshaw have developed an extensive body of work centered around the infinite-dimensional
version of the Debreu-Scarf core convergence theorem. We have briefly
touched on this work in Section 13; for further details, we refer the reader to
the original papers and especially to a recent monograph [Aliprantis, Brown
and Burkinshaw (1989b)]. Nothing seems to have been done to date on more
general core convergence results (i.e. without the assumption of replication).
There is also an extensive literature on infinite dimensional versions of
Aumann's core equivalence theorem for non-atomic economies, including
Gabszewicz (1968a,b), Mertens (1970), Bewley (1973), Mas-Colell (1975),
Jones (1984), Ostroy (1984), Gretsky and Ostroy (1986b), Zame (1986),
Podczeck (1985), Rustichini and Yannelis (1987) and Ostroy and Zame (1988).
The existence of equilibrium is a particularly thorny issue; see in particular the
counter-examples in Zame (1986).
(C) Determinacy (local uniqueness) of equilibrium is largely unexplored in
the infinite dimensional setting. Some early ,work was carried out by Chichilnisky and Kalman (1980) in the context of resource allocation problems and by
1889
Araujo and Scheinkman (1977) in the context of capital theory. Kehoe,

Levine, Mas-Colell and Zame (1989) have followed an approach that takes
excess demand functions as primitives; their work uses the theory of Fredholm
operators and Smale's infinite dimensional version of Sard's theorem. Approaches that take preferences and endowments as primitives seem to encounter many difficulties (in addition to the usual difficulties of doing calculus in
infinite dimensional spaces). The natural domain of prices is the positive
orthant (L*) of the dual space, but this set usually has empty interior, which
is very inconvenient for doing calculus. Moreover, excess demand functions are
typically not defined [Araujo (1987), Hildenbrand (1989)] and are not generally smooth even when they are defined. Indeed, Araujo (1987) argues that
excess demand functions can be smooth only if the commodity space is a
Hilbert space.
It might appear that the Negishi approach would avoid most of these
difficulties by allowing us to work with the utility map on a finite dimensional
space. This approach has indeed been applied in a special case by Kehoe,
Levine and Romer (1989a,c), but carrying it through in reasonable generality
has met with a serious technical difficulty: establishing the smoothness of the
utility mapping.
(D) One limitation of the Negishi approach that we have adopted is that it is
very dependent on utility functions, and therefore on the completeness and
transitivity of preferences. To treat unordered preferences, the approach via
finite dimensional approximations is superior (see Section 13). Existence
results with unordered preferences have been obtained by Khan (1984),
Toussaint (1985) and Yannelis and Zame (1986).
The Negishi approach also depends on the Pareto optimality of equilibria,
and hence is not applicable to distorted or incomplete markets (where equilibria need not be Pareto optimal). Unfortunately, the approach via finite
dimensional approximations also does not appear to work when markets are
incomplete (even if the number of securities is finite). The difficulty (as a
careful reading of our discussion in Sections 8 and 13 will show) lies in finessing
the joint continuity of the wealth mapping.
Existence of equilibrium with incomplete markets and a countable number
of states (or commodities) has been obtained by Zame (1988), Green and
Spear (1988), Zevine (1989) and Hernandez (1988). The case of a continuum
of states (or commodities) is difficult and remains largely unresolved. For
related work, see Duffle, Geanakoplos, MacLennan and Mas-Colell (1988).
For tax-distorted markets, some results have been obtained by Kehoe, Levine
and Romer (1988) and Jones and Manuelli (1989).
(E) As our examples show, when the positive orthant has empty interior
and preferences are not proper, weak optima may not be supportable by
prices. A number of authors have studied the approximate supportability of
1890
A. Mas-ColeU and W.R. Zame
weak optima. The sharpest results are due to Aliprantis and Burkinshaw
(1988) and Becker, Bercovici and Foias (1990); see also the survey by Becker
(1991). For the existence of approximate equilibria we refer to Khan and
Vohra (1984) and Aliprantis and Burkinshaw (1988).
(F) Throughout, we have assumed that there are only a finite number of
types of consumers. Allowing for the possibility of infinitely many types raises
many new issues and goes well beyond the scope of this survey. For work on
overlapping generations models, see Chapter 6.
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Chapter 35
OVERLAPPING GENERATIONS
JOHN D. GEANAKOPLOS a and HERAKLIS M. POLEMARCHAKIS b'*
aCowles Foundation for Research in Economics, Yale University and bC. O.R.E., UniversitO
Catholique de Louvain
Contents
0. Introduction
1. T h e e c o n o m y
1.l. The temporal and demographic structure
2. The existence of competitive equilibria

2.1. Truncations
3. The optimality of equilibrium allocations

4. Aggregate revenue at equilibrium
5. Stationary economies and cycles
6. Indeterminacy
7. Implications for macroeconomics
References
1900
1903
1910
1915
1917
1926
1937
1940
1943
1946
1948
*We wish to thank J. Burke and J.-F. Mertens for very helpful conversations.
This work was carried out, in part, at the Department of Economics of the University of Bonn
during BoWo'88, '89 and '90; we wish to thank the Department for its hospitality and the Deutsche
Forschungsgemeinschaft, Gottfried-Wilhelm-Leibniz-F6rderpreis for financial support.

1900
J.D. Geanakoplos and H.M. Polemarchakis
O. Introduction
Competitive equilibria in economies of overlapping generations are different

from competitive equilibria in economies that extend over finitely many
periods, finite economies for short. These differences concern the properties of
competitive equilibria, such as existence, optimality and determinacy or local
uniqueness; and the phenomena compatible with competitive equilibria, such
as net aggregate debt or fiat money with a positive price.
Ever since the introduction of the model of overlapping generations by
Allais (1947) and Samuelson (1958), economic theorists have striven to isolate
the reasons for the differences between this model and the definitive model of
a finite economy elaborated by Arrow (1951), Debreu (1951, 1970) and Arrow
and Debreu (1954). This is also our focus.
In the original model of Allais and Samuelson, time evolves over discrete
periods. In each period, a new generation is born and lives for two or three
periods. Later extensions of the model permit generations to live longer and
even be immortal, include many commodities in each period and introduce
uncertainty; the latter is referred to as the stochastic overlapping generations
model.
All the variants of the model of overlapping generations allow for an infinity
of time periods and hence for infinitely many commodities. This infinity of time
periods and commodities is not a mathematical curiosity, but rather is central
to the economic significance of the model. Consider a pay-as-you-go system of
social security. Each period, the young generation makes payments that are
given directly to the old. The young cooperate in this enterprise because they
expect to receive payments when they grow old. Were it believed that there
would be no next generation, the system would surely break down immediately. In economic models in which the rationality of individuals is presumed to be
unlimited, the fact that no new generation would appear at some point in the
very distant future would also lead to the immediate break down of the social
security system. Individuals would reason that no payment would be made at
the period in which no young generation would appear, the generation just
before would refuse to make its payment, therefore the generation just before
that would also refuse, etc. For exactly the same reason, fiat money can have
positive value in an economy of overlapping generations, whereas in a finite
economy, as Hahn (1965) has pointed out, it must have zero value in the last
period and hence, by backward induction, it must have zero value in every
period.
In an economy of overlapping generations, the temporal and demographic
structure is explicit, which evidently enriches the study of problems such as the
transfer of value over time. It also allows the claim that the inability of
Ch. 35: Overlapping Generations
1901
individuals to trade directly with individuals whose consumption and endowment spans commence after they have perished is the distinguishing feature of
economies of overlapping generations. This, we argue, is not essential. It is
possible to make the demographic structure explicit in a finite economy as well
and to suppose that the consumption of any single individual extends over only
few periods. Yet, equilibria in this economy share the qualitative properties of
equilibria in abstract Arrow-Debreu economies provided the asset market is
complete. A complete asset market, which is essential in the construction of
Arrow and Debreu, implies that trades occur as if all individuals, irrespective
of the period of their biological birth, could participate in an initial exchange of
contracts for the dated and possibly contingent delivery of commodities or
revenue. Furthermore, there is no issue of bequest motives. This way of
modelling exchange at an Archimedean point, without reference either to the
biological lifespan of individuals or of the mediation of transactions, is evidently metaphorical. But the metaphor is no more strained for overlapping
generation than for Arrow-Debreu economies. We maintain the hypothesis of
a complete asset market and hence of a unique budget constraint throughout
this survey.
What distinguishes economies of overlapping generations is the countable
infinity of individuals and commodities. This has two consequences, one
straightforward, and the other depending on two further assumptions. First,
recall that in a finite economy, prices determine the value of arbitrary
commodity bundles; technically, they define a linear functional on the commodity space [Debreu (1954)]. In an economy of overlapping generations, the
finite valuation of arbitrary commodity bundles need not be possible. In
particular, even if individual consumption bundles have finite value, the
corresponding aggregate consumption bundle need not. Thus, Walras' law
need not hold for economies of overlapping generations. For a large class of
economies of overlapping generations, we can always find allocations in which
aggregate consumption equals aggregate supply for every commodity, and yet
at the same time every individual is spending less on his consumption than the
value of his endowment. Second, with countably infinite individuals and
commodities, competitive equilibria are limits of sequences of allocations for
finite economies. These allocations are competitive, except that some markets
are allowed not to clear. Since the periods at which markets fail to clear tend to
infinity, the model of overlapping generations has been interpreted as "lack of
market clearing at infinity" [Geanakoplos (1987)]. This approximation by finite
economies is possible because of two properties that further distinguish
economies of overlapping generations, the continuity of individual preference
relations or utility functions, which can be interpreted as impatience, and the
hypothesis that only a finite number of individuals desire and essentially own
any commodity.
The failure of finite valuation accounts for the features of competitive
1902
equilibria in economies of overlapping generations. Market clearing may

require that the value of the consumption bundle of an individual exceed the
value of his initial endowment. Prices may fail to convey the aggregate scarcity
of commodities and competitive equilibrium allocations may fail to be Pareto
optimal. When more than one commodity market fails to clear at infinity, as is
the case in economies with more than one commodity per period, more
degrees of freedom are operative at a competitive equilibrium than the one
required to account for the budget constraint and competitive equilibrium
allocations may be indeterminate. Net aggregate transfers revenue may be
compatible with a competitive equilibrium; and this is closely linked with the
possibility that fiat money which provides no utility or liquidity services
maintains a positive price at equilibrium.
The interpretation of economies of overlapping generations as a lack of
market clearing at infinity also explains the properties of equilibria in these
models, of which the auxiliary hypotheses of impatience and finite ownership
and desire for any commodity hold. Since dropping the requirement that all
markets clear only eases the existence problem, economies of overlapping
generations satisfying the auxiliary hypotheses and a further hypothesis on
individual endowments have equilibria. Moreover, there may be many dimensions of equilibria, since not all the markets clear. The dimension of potential
indeterminacy is related to the number of markets that do not clear, which in
turn depends on the number of commodities per period and the lifetime of the
agents. Furthermore, since markets do not necessarily clear, Pareto optimality
cannot be expected, unless the value of the commodities in the markets that do
not clear is essentially zero. For the same reason, fiat money may have positive
value in equilibrium.
It is very interesting that many of the properties of finite economies are
restored in infinite horizon economies if there is some finite set of individuals
whose aggregate endowment is a nonnegligible fraction of the aggregate
endowment of the whole economy. Since individuals are characterized by
impatience, market clearing requires that each agent have finite wealth. It
follows that when a finite number of agents control a nonnegligible fraction of
the resources of the whole economy, the aggregate endowment has finite value
and Walras' law is restored. Moreover, the value of the commodities in the
markets at infinity that do not clear is essentially zero. This argument rests
entirely on the endowment stream of the nonnegligible agents, and not at all
on whether they consume in every period, or "live" forever.
The infinite time horizon allows the demographic structure, the preferences
and endowments of individual consumers or the production possibilities of
firms to display simple recursive patterns, which also distinguishes economies
of overlapping generations. Competitive equilibria in which endogenous variables, prices and quantities, inherit these recursive patterns are referred to as
steady states. Alternatively, endogenous variables at competitive equilibria
1903
may display recursive patterns more complex than the simple pattern displayed
by the exogenous structure of the economy; such equilibria are referred to as
endogenous business cycles. Chaos is observed when endogenous variables
display no pattern whatsoever.
Production introduces no essential difference as long as the production spans
of firms are finite. We do not consider production economies in this survey.
The countably infinite index of commodities need not refer to calendar time.
Location or any other characteristic suffice to give rise to economies analytically equivalent to economies of overlapping generations.
Uncertainty alters the argument significantly if the asset market is incomplete. As in the case of a finite economy, a complete asset market reduces
analytically an economy under uncertainty to an economy under certainty
[Arrow (1953), Debreu (1959b)]. When the asset market is incomplete,
beyond the existence, optimality and determinacy of competitive equilibrium
allocations which are problematic, as they are in a finite economy [Cass (1985),
Hart (1975)], novel considerations arise; among them, whether endogenous
variables retain the stochastic properties of exogenous variables, such as serial
dependence or memory [Duffle, Geanakoplos, Mas-Colell and McLennan
(1989), Dutta and Polemarchakis (1990)].
1. The economy
We denote commodities by
/EL,
and individuals by
hEH.
Assumption 1. The set of commodities is non-empty and countable, L =
{ 1 , . . . } ; also, the set of individuals, H = { 1 , . . . ) .
Either the set of commodities or the set of individuals may be finite;
nevertheless, most interestingly, they are both countably infinite.
We denote commodity bundles by
x=(...,x, .... )EA,
where the commodity space, A, is the Euclidean space of dimension equal to
the cardinality of the set of commodities. The context should clarify whether x k
refers to the kth component of a commodity bundle or the kth term in a
sequence of commodity bundles (x n: n = 1 . . . . ).
1904
The non-negative orthant of the commodity space is A+ = {x E A : x ~ 0 } and

the projection on the lth coordinate is A~. The vector of units is 1, and 1 t is the
vector with a unit in the lth coordinate and zero otherwise.
An individual is characterized by a triple
(X h,u h,w h ) ,
forhEH,
of a consumption set, a utility function and an initial endowment.
Assumption 2. For h E It, the consumption set, X h C A, is convex, bounded

from below, for simplicity X h C A+, and allows for free disposal, X h + A+ C
X h. The
utility function,
u h :X h ~ R ,
is quasi-concave,
uh(x')>
uh(x) ~ uh(Ax ' + (1 -- A)x) > Uh(X), for 0 < A ~< 1, and weakly monotonically
increasing, x' >>x ~ uh(x ') > uh(x), for x', x E X h. The initial endowment, 0 <
w h ~ X h, is a positive consumption bundle such that (1 - eh)w h E X h, for some
0<eh<l.
The individual does not desire commodity l at x E X h if and only if
( x - x t l / ) E X h and uh(x) = Uh(X--X111); the individual does not desire the
commodity if and only if he does not desire the commodity anywhere in the
consumption set. The set of commodities desired by the individual, somewhere
in his consumption set, desired for short, is L h C L. The individual is endowed
h
with commodity l if and only if w / > 0.
In examples we suppose, for simplicity, that the consumption sets of
individuals coincide with the non-negative cone of the commodity space,
X h = A+, unless we explicitly state otherwise.
The weak monotonicity of the utility function complements the free disposal
assumption on the consumption sets.
T h e assumptions on individual characteristics are standard [Arrow and
D e b r e a u (1954); also Debreu (1959a), Arrow and Hahn (1971)], and require
no comment.
The only necessary novelty here is the choice of a topology for the
commodity space and the assumptions that in this topology individual consumption sets are closed and utility functions are continuous.
The commodity space is a topological vector space with the product topology. A base for the product topology consists of cylinder sets of the form
IIIELF 0 1 X [II~L/LF At, where 0 / C_A l are open and L F C L is finite. It is the
weakest topology for which the projection maps 7r~ : A---~ A t are continuous. By
the Tychonoff theorem, a product set C = IllE L C l is compact if the sets C 1C A /
are compact. A sequence (xn: n = 1 , . . . ) converges, l i m n ~ xn = x, if and only
if every component converges, lim,~= x/. . = x/, for l E L. A set, C, is compact
if and only if, for any sequence, (Xn:Xn E C, n = 1 , . . . ) , there exists a
convergent subsequence (X~k: k = 1 , . . . ) , and x E C such that limk~= Xnk = X.
1905
Assumption 3. For h E I-I, the consumption set, X h, is closed, and the utility
function, u h, is continuous in the product topology.
If a commodity bundle does not permit an individual to survive, x ~ X h, the
assumption that the consumption set is closed, and hence its complement is
open, implies that there exists a neighborhood, V(x), such that V(x)N X h --O.
Since V(x) is open in the product topology, there exists a finite set L r C L and
e > 0 such that x ' ~ X h, where Ix', - xt[ < e, for / @ LF, no matter what the
value of x'~, for l~.L F. Sufficiently distant modifications, even if unbounded,
do not suffice to permit survival. Similarly, if a commodity bundle, x', yields
higher utility than another, x, uh(x ') > uh(x), continuity of the utility function
implies that there exists a neighborhood, V(x'), such that uh(x ") > uh(x), for
x " E V(x). Since V(x') is open in the product topology, there exists a finite set
L e C L and e > 0 such that the commodity bundle x " E V(x'), if [x'~ - x'/[< e for
IELF, no matter what the value of x'~, for I~F~LF, and hence uh(x")> uh(x).
Sufficiently distant modifications, even if unbounded, do not reverse the order
of preference.
In the above comparison, we could take L F = {l E L: l ~< {, for some [}, the
set of all commodities with index less than some /. Thus, continuity in the
product topology implies that, in a sense, individuals "agree" that commodities
with a lower index, l, are more important than commodities with a higher
index. As we point out later, when the index of commodities involves calendar
time that extends infinitely into the future but not the past, the assumption of
continuity in the product topology suggests that individuals are "impatient".
There is no presumption of uniform impatience, however; it may well be the
case that individual h desires only commodity l = h, for h = 1 , . . . . As we see
later, the failure of uniform impatience is related to the possible inefficiency of
competitive equilibria.
The study of economies with infinitely many commodities, typically a
continuum, and finitely many individuals has often restricted attention to
bounded commodity bundles, x E As = {x E A: [Ix][~ < ~}, where Ilxll =
sup{Ix,l: l ~ L}, and has imposed continuity of individual utility functions in
the Mackey topology [Bewley (1972)]. The Mackey topology is the strongest
topology under which the topological dual of the commodity space is the space
of summable prices, and is evidently weaker than the topology defined by the
supremum norm, I1 II . The Mackey topology is stronger than the weak
topology, the weakest topology in which all linear functionals are continuous.
The weak topology is stronger than the product topology. The sequence of
bounded commodity bundles (xn: n = 1 , . . . ) , where xn. , = 1, for l ~< n and
xn. t = n, for l > n, for n = 1 , . . . , converges to the commodity bundle = 1 in
the product topology but not in the weak topology and hence not in the
Mackey topology. Thus, our assumption of continuity in the product topology
is strong. On the other hand, a sequence of bounded commodity bundles
1906
converges in the weak topology if and only if it converges in the Mackey

topology; that is, these topologies induce the same concept of convergence of
sequences on bounded commodity bundles [Hildenbrand (1990)]. Moreover,
the convergence of a uniformly bounded sequence of commodity bundles is the
same in the Mackey and the product topologies.
Since the commodity space endowed with the product topology is separable
and the individual consumption sets are convex and hence connected, the
existence of a continuous utility function is no stronger than the assumption
that the underlying preference relation be complete and continuous [Debreu
(1954b)]. It is straightforward to handle incomplete preference relations [Wilson (1981), Burke (1988)].
Assumption 4. The aggregate endowment of each commodity is finite and
strictly positive,
0<wt=
E w ht < w ,
hEH
for/EL,
and thus
O~wEA.
Since, for any commodity, 1, and any 1 > e > 0, there exists a finite set of
individuals, who jointly are endowed with ( 1 - e ) w t, each commodity is
essentially owned by finitely many individuals.
The aggregate endowment need not be uniformly bounded. By rescaling the
units of measurement of different commodities we could always suppose this to
be the case. Continuity in the product topology is not affected by such
rescaling. For the purposes of equilibrium theory, we need not contemplate
individual consumptions that exceed the aggregate endowment, though this
may be contrary to the spirit of a competitive equilibrium, since individuals
might, indeed, contemplate unbounded consumption bundles. Pursuing this
direction, nevertheless, we could suppose that w E A ~ + = { x E A s : x >! 0}, and
also xhc_Xzw = { x E A + : IIxll <2w}, for h E H . Continuity with respect to
the product topology in Xzw, which as we have noted is equivalent to Mackey
continuity, is weaker than the assumption of continuity in the product topology
in A; from the economic point of view, it amounts, roughly, to the assumption
that the impatience of individuals exceeds the growth rate of the aggregate
endowment. Our stronger assumption has the advantage of keeping separate
the restrictions on preferences and the restrictions on endowments. The
weaker assumption would mix the two by imposing continuity of the utility
function on a domain that is dependent on the aggregate endowment through
the rescaling of the units of measurement of commodities.
1907
Ch. 35: O v e r l a p p i n g G e n e r a t i o n s
The set of individuals who desire commodity l is

DI= {hEH: IELh},
for/EL.
Assumption 5. For l E L, Dt is finite, at most finitely many individuals desire

each commodity.
An allocation is an array of individual consumption bundles,
It
x = { x h@X h : h @ H } .
An allocation is feasible if and only if EhE H Xh = W. Since the individual
consumption sets allow for free disposal, while utility functions are weakly
monotonic, there is no loss of generality in stating the feasibility condition with
equality.
Lemma 1. Let {D; : D; C H, l E L} be a collection of finite sets o f individua&.
Suppose (w,,: w,,/>0, n = 1 . . . . ) is a convergent sequence o f commodity bunh
r
dies, w = lim,__,~ w , , and let (x~n: Eh~ n x~ = w,, x,,, = 0 i f h y ~ D , , I E L , n =
1 , . . . ) be an associated sequence o f allocations. There exists a convergent
subsequence, (x,,H: k = 1, . .), with x n = llmk_~
"
n a feasible allocation,
X,k
~hElt X
= W.
Proof. Let ~ C A be such that w , ~ < ~ , f o r n = l , . . . .

Let X ~ = { x ~ X h:x~<
}, for h E H, be the set of consumption bundles for individual h bounded
above by ~. Since individual consumption sets are closed and bounded below,
the set X~ is closed and bounded. Since the set IIte L [0, wt] is compact, X~ is a
compact subset of X h. It follows that the set X~ = IIhE N X~ is compact. Hence,
a convergent subsequence exists, (x,~: k = 1 , . . . ) , with x u = l i m k ~ x~k. Since
individual consumption sets are closed, x N is an allocation. It remains to show
that x u is feasible or, equivalently, that Ehc n x h = w. But this is evident, since
EhElt X h = EhcD) X~ = Eh@D} l i m k ~ x2k = l i m k ~ EhE1) } xn~.t
h = wl, f o r l E L . The
transposition of the summation and the limit is possible since D~ is a finite set.
[]
If, for each commodity, individual consumption bundles are not restricted to
vanish for all but finitely many individuals, the argument fails. If the feasibility
constraint is imposed as an inequality, this does not occur, but the same point
arises in the argument for the existence of competitive equilibria [Burke
(1988)].
Associated with a feasible allocation there is an allocation of utilities,
un(x n) = (uh(xh): h E H) .
1908
Definition 1.
An allocation, x a, Pareto dominates another, x ,n, if and only if
uh(x'h)~uh(xh),
for h E H ,
with some strict inequality. An allocation is Pareto optimal if and only if it is

feasible and no feasible allocation Pareto dominates it.
We denote commodity prices by
p = (..., p,,...)EP,
an element of the positive price domain, P = A+/{0}. Again, the context

should clarify whether Pk refers to the kth component of a price vector or to
the kth term in a sequence of prices ( p , : n = 1,...).
At commodity prices p, the value of a consumption bundle, x, is
p x = Z plXl ,
IEL
which may be infinite. Note that prices do not define a linear functional on the
commodity space. They do define a linear functional o n A F = { x E A: x / ----0, if
I ~ L v for a finite set L v C L ) . Moreover, any non-trivial, weakly monotonically increasing linear functional of A F is described by a p E P.
At commodities prices p, the individual optimization problem is
maxuh(x) s.t. px<~pw h , f o r h E I t .

Definition 2. A competitive equilibrium is a pair of prices and a feasible
allocation, (p*, x'U), such that, the commodity bundle x *h solves the individual optimization problem at p*,
uh(x)>uh(x *h) ~
p * x > p * w h,
f o r x E X h,
and
p * x *h = p * w h ,
forhEI-l.
It follows from the weak monotonicity of individual utility functions that at a

competitive equilibrium
p*wh < ~ ,
for h E I t .
Note that competitive equilibrium defines a single budget constraint for each
individual. Thus, implicitly, the asset market is complete. Each individual
chooses a consumption bundle that he pays for at once. We can thus imagine
that trade occurs ex ante, under a veil of ignorance, before any uncertainty is
1909
resolved. Many applications of the model of overlapping generations study

economies in which the special demographic structure suggests multiple budget
constraints. The resulting competitive equilibria under multiple budget constraints sometimes can be reduced to the equilibria described above, but often
they cannot be. We have chosen not to survey the vast literature on competitive equilibria with multiple effective budget constraints in economies of
overlapping generations.
Definition 3. An economy is individually finite if and only if, for h E It, the
set of commodities desired by the individual, L h, is finite.
A uniform bound on the number of commodities desired by each individual
is not important. Each commodity can be replaced by a finite, yet unbounded
over the set of commodities, number of perfect substitutes, thus destroying the
uniform upper bound yet yielding an essentially equivalent economy, in
particular preserving continuity in the product topology.
This concludes the description of an abstract exchange economy,
E = ( L , H , (X h, u t', wh): h @H}.
Note that we have incorporated the hypotheses that there is a countable
infinity of commodities and a countable infinity of individuals, each commodity
is desired and is essentially owned by finitely many individuals and that the
utility functions of individuals display impatience. It remains to represent the
recursive possibilities inherent in economies of overlapping generations.
Definition 4. An abstract exchange economy, E = {L, H, (X ~, u h, wh): h ~ H},
reduces to another, E' = {L', H', (X h', u h', wh'): h' E I-I'},
E---> E t ,
if and only if there exists a bijective map, g : H---~H', and a linear, continuous,
weakly monotonically increasing, surjective map, ~o:A---~A', such that, for
h ~I-I, X g~h) = ~ ( x h ) , W g(h)= ~o(wh), and btg ( h ) = u h ~ -1
Economies are equivalent,
E--E' ,
if and only if there exist bijective, equivalence maps, f : L ~ L' and g : It---~ It',
between the sets of commodities and individuals, respectively, in the two
economies such that for h E H , Xg~h)=~0(Xh), wgCh)=q~(Wh) and u g~h)=
1910
uho@ -1, where ~ : A - - ~ A '

l' ~ L'.
is defined componentwise by q~r(x)= x i - , t r ), for
Evidently, if the economies E and E' are equivalent under the equivalence
maps f : L---~L' and g: H---~H, (p*, x *H) is a competitive equilibrium for the
economy E if and only if (p'*, x '*n) is a competitive equilibrium for the
*
economy E ,' where P'l* = PI-'tr),
for 1' E L', and Xtl,*g(h) = x s* h-,(r), for l ~ L
and h E H.
If an economy, E, is obtained from an economy, E', by replacing a
commodity by a finite number of perfect substitutes, the economy E reduces to
the economy E'.
Economies are equivalent if they differ only in the indexation of commodities and individuals.
Evidently, the identity maps f = i L and g = i n establish the equivalence of an
abstract exchange economy of overlapping generations, E, with itself. But
there may be other such equivalence maps.
Definition 5. The group, G, of symmetrics of an abstract exchange economy,
E, is the group of equivalence maps of E, where ( f l , g l ) o ( f 2 , g2) =
(fl f2, gl g2) defines the composition, and the identity maps (iL, in) define
the unit element.
It is often of great interest whether or not there exist competitive equilibrium
allocations, or other special allocations, x n, that are invariant under all
symmetries, that is, for every symmetry, ( f , g ) ~ G, x g(h) = ~o(xh), for h E ti.
Another class of interesting allocations are those that are invariant to a
subgroup, G t C~G, of symmetries of E. When the temporal structure of the
economy is explicit, symmetries can be interpreted as time invariance.
For a positive integer, n, G n is the nth power of the group G, a subgroup.
Definition 6. An allocation for the exchange economy E is a cycle of order n if
and only if it is invariate under the subgroup G " C G of the group of
symmetrics of E, but is not invariant under any subgroup G m, for m < n.
1.1. The temporal and demographic structure
Economies of overlapping generations received their name from the special

pattern of preferences and endowments that Allais and Samuelson used in their
first examples in which individuals lived for two or three overlapping periods
consuming and exchanging only in their lifetimes. We present now an explicit
demographic and temporal structure underlying the abstract economy that we
1911
introduced above. This formulation includes as special cases the first examples
as well as the so-called stochastic overlapping generations models as long as the
set of histories of realizations of uncertainty up to any date is at most
countable. The essential reason why all these models can be understood simply
as instances of an abstract exchange economy is that in all of them individuals
optimize under a single budget constraint.
We denote time periods by
t E T t j = {t . . . . . [}.
Thus, time extends infinitely into the future but not into the past if T_,.z= T ~ ,
and it extends infinitely into the future as well as into the past if T_,.i = T ~ .
Time is finite if both t and i are finite; they may coincide.
Under uncertainty, we denote date-events by
(s, t) ~ s ,
where S = U,~T, 7S, is a non-empty, countable set, and
S,=(1,...,S,}x{t},
fortET_,z.
If (s, t) E S,, we interpret s as an event at t or a history of realizations of

uncertainty up to t. For t ~< t < [, there is associated with every date-event
(s, t + 1) E S,+~ a unique date-event 6(s, t + 1) = (s', t) E S,, its immediate
predecessor. Thus (S, ~O) is a tree. A date-event (s', t') precedes a date-event
(s, t) if and only if (s', t') = 6"(s, t), for some 1 ~< n < ~; this we denote by
(s', t ' ) < (s, t). For a date-event (s, t ) E S , the branch that contains (s, t) is
S(s., ) = {(s', t') E S : (s', t') = (s, t) or (s', t') < (s, t) or (s, t) < (s', t')}.
A temporal structure is thus a triple
(Tt,i, S, ~0).
In the special case of certainty, the temporal structure is simply I"_,.,.
When time extends infinitely into the future but not into the past under
uncertainty, one of countably many states of nature 0t E 6),, for t E T~=, may
be realized each period; in particular, a date-event is (s, t ) = ( 0 1 , . . . , 0,, t ) E
S, =IIi,= 1 ~9,, {t). When time extends infinitely into the past as well as into
the future, it is important to preserve the countability of the set of events at
any finite time. This can only be maintained if there is no uncertainty before
some finite time. For simplicity, we require that one of countably many states
of nature, 0_~ @ O ~ , is realized at "t = -o0" with no further uncertainty until
t = 0, while one of countably many states of nature, 0, E O,, may be realized
each period t I> 1; in particular, a date-event is (s, t ) = (0 ~, t), for t < 1, or
( 0 ~ , 0 , , . . . , 0,, t), for t ~> 1.
1912
Definition 7.
A n exchange e c o n o m y of overlapping generations is a triple,
(E, (T_,,t, S, q,), (o-L, o-n) ) ,

of an abstract exchange economy, E, a temporal structure, (T,,~, S, 0), and a
pair (o"L, o-n), where o-L : L---~ S is a function, while o-n : It--~ S is a correspondence such that (i) for (s, t ) E o n ( h ) , either w~ > 0 or l E L h for some I E
o-~l(s, t), (ii) if w hl > 0 or I E L h and o-L(/)~E'o-n(h), (s', t ' ) < ~rL(l ) for some
(s', t ' ) E o n ( h ) , and (iii) for (s', t ' ) E S , there exists (s, t ) E S such that
(s', t ' ) < (s, t) and o-~l(s, t ) 0 .
F r o m (iii), time extends infinitely into the future. C o m m o d i t y l is available at
O'L(/). Individual h, conditional on (s, t), is " b o r n " at t ( h ; (s, t)) = sup{t' E
h
T_,~ : if t " < t' and O'L(/) ---- (S", t") E S(s,t), w I = 0 a n d lJ~'Lh}; individual h is
born at t ( h ) = s u p { t E T _ , ~ : i f t ' < t and O'L(l)=(s,t ), w ht = 0 and / ~ ' L h } =
inf{t'ET,_,~:t'=t(h;(s,t))
for some ( s , t ) E S } . From (i) and (ii),
t(h;(s,t))=inf{t'CTz~:(s',t')Eo'n(h)nS(,.,)}
and
t ( h ) = inf{t' E T_, ~ :
(s, t') @ on(h)}. From (iii), further, individuals do not cease to be born. The
periods of consumption or e n d o w m e n t of the individual indeed begin at t(h) or
t(h; (s, t)), conditional on (s, t), and not earlier. The individual, conditional on
(s, t), " d i e s " at {(h; (s, t)) = inf{t' E T_~ :if t " > t' and o-l~(l) = (s", t") @ S(s,,),
w ht = 0 and / ~ ' L h } ; the individual dies at i ( h ) = i n f { t ' ~ T t = : i f
t ' > t and
trL(l)=(s,t'), w h = 0 and l~Lh}=sup{t'ET,_~:t'=t(h;(s,t)),
for some
(s, t) ~ s~,,,)}.
The date of birth of an individual m a y not be finite, t(h) = - m . A n individual
m a y be " i m m o r t a l " , i-(h) = ~.
As a special case, we obtain a model in which the life spans of individuals are
stochastic [Yaari (1985)]. The state of nature at t, 0,, may determine the
individuals who are born as well as the individuals who die at t. In this case, the
n u m b e r of individuals alive at any date-event m a y be non-stochastic, while an
individual may be alive at any date following his birth and is thus immortal.
We refer to o-n as the demographic structure. Note that, since o-n is a
correspondence and not necessarily a function, we may not need to consider
individuals as distinct according to the date-event at their birth.
U n d e r certainty, we write (~'L, ~-n) for (O'L, crri).
A change of notation is convenient when the temporal structure is explicit.
We denote commodities available at (s, t) by
(l, (s, t) ~ Lo.,) = { 1 , . . . , L(~..,)} x {(s, t)} ,
for (s, t) ~ S ,
the set of commodities at t is L, = U (,.,)Es, L(,,,), and the set of commodities is

L = U , e L , L,.
1913
A commodity bundle is
x = (...,x(~.t),...) E A,
where A = Hcs,,)~s A(~,t) and x(,,,) = ( . . . , x(l,(~,,)) . . . . ) ~ A(~,,) is a commodity
bundle at (s, t); also, A, = II(s,t)Es, A(s,,), and x t E A, is a commodity bundle at t.
Individuals who are born at t, and thus form a generation, we denote by
(h,t)@Ht={1,...,Ht)x{t},
for t E T ,
and the set of all individuals is H = U tot H,.

The periods of consumption of an individual are T (h't) = {tCh't),..., { (h'} C
T_~.~, such that t ' ~ ' T (h'') ~ L t, N L (h'= O, and his consumption span is 1 <~
A(h,,) <<{(h,,) _ t(h.,) + 1. The periods of endowment of an individual are
(h t)
(h t) -- ( h t)
,
(h t)
(h t)
T w" = { t ~ " . . . . ,tw" }_CT,.~, such that t ~"T~" ~ w , , " = 0 , and his endowment span is 1 <~A~ ''') ~ {~ 't) - t~ '') + 1. Thus, t = min{t (h'0, t~'t)}. The
periods of consumption and endowment of an individual need not coincide. In
particular, the endowment span of an individual may be infinite even though
his consumption span is finite.
As a special case we obtain individually finite economies in which the
consumption, and possibly the endowment span as well, of each individual is
finite, which have been traditionally referred to as economies of overlapping
generations.
Exchange economies of overlapping generations are equivalent,
(E, (T_t,~-,S, ~/), (o-L, on) ) -- (E', (T_t,,,-,, St, ~'), (O'L, O'H))
if and only if the abstract economies, E and E', are equivalent, E ~ E'.
Definition 8. The temporal structure is simple if and only if time extends
infinitely into the future but not into the past, under certainty. The simple
temporal structure is thus T~,:~.
Lemma 2. Every exchange economy of overlapping generations is equivalent
to an economy with a simple temporal structure.
Proof. Let (E, (T~j, S, ~0), (O'L, On) ) be an exchange economy of overlapping
generations. Let T I ~ be the simple temporal structure. Consider the map
re:L--~T1 ~ defined by % ( l ) = t , if t>~l, and Z L ( l ) = l - - t , if t~<0, where
(t, s) -- O-L(/). Consider the map ~'n : It----~T 1,~ defined by ~-n(h) = t, if (t, s) E
oN(h ) and t ~> 1, ~-n(h)= 1 - t-(h), if ((h)~<0, (s, t ) E on(h ) and t<~0, and
"rn(h ) = 1 if ((h)/> 1, (s, t) E crn(h) and t ~< 0. Evidently, (E, T1 ~, (~'L, ~'u)) is an
exchange economy of overlapping generations.
[]
This equivalence reduces economies in which time extends infinitely into the
1914
future as well as into the past, under certainty as well as under uncertainty, to
economies under certainty in which time extends infinitely into the future but
not into the past.
W h e n time extends infinitely into the future but not into the past, continuity
of the utility function in the product topology can be interpreted as impatience.
The impatience implied by continuity in the product topology is stronger than
that implied by continuity in the weak and hence the Mackey or norm
topologies. Nevertheless, any continuous, intertemporally separable utility
function U (h't)~-- ~,t,cT(h,t)Ul h't) that are well defined everywhere on the consumption set with X (h't) = IICETIh.,~X},h'') and ul,h'') :xlh")---~R a continuous
function, for t ' E T(h't) I does satisfy continuity in the product topology. An
important example is the function u (h't)= ~t,ET~h.t) /3t'o(h't), where L,, = [, for
t' ~ T (h't), t3(h't) : L - ~ R is a continuous, bounded function, and 0 </3 < 1.
In examples, we suppose, without loss of generality, that the temporal
structure is simple, unless we explicitly mention otherwise.
Example 1. Economic activity extends infinitely into the past as well as into
the future under certainty. One commodity is available each period, L, =
{(1, t)}, and one individual is born, I-I, = {(1, t)}. The economy is equivalent
to an e c o n o m y in which time extends infinitely into the future but not into the
past, T _ , , , , = T I ~ , two commodities are available each period, L',,=
{(1, t ) , ( 2 , t)}, and two individuals are born each period, I-I~, =
{(1, t'), (2, t')}. It suffices to identify periods t = t'/> 1 and t = 1 - t' ~< 0 with
period t ' ~> 1, individual (1, t) with individual (1, t'), for t = t ' ~> 1, and individual (1, t) with individual (2, t') for t = 1 - t' ~< 0, and similarly commodity
(1, t) with commodity (1, t'), for t = t ' ~> 1, and commodity (1, t) with commodity (2, t'), for t = 1 - t' ~< 0.
Definition 9. The demographic structure is simple if and only if the temporal
structure is simple and, in addition, the consumption span of each individual is
two. This does not restrict the endowment spans of individuals.
Every exchange economy of

overlapping generations that is individually finite is equivalent to an economy
with a simple demographic structure.
L e m m a 3 [Balakso, Cass and Shell (1980)].
Proof. The argument is constructive. Let E be an abstract economy that is

individually finite.
Let L 0 be any finite set of commodities, and let L t = {1} U L 0 and ill =
{1} U { h E l t : L t N L h ~t or w th > 0 ,
for I E L ~ } .
Define inductively
L t = {t} Uhcu,_l Lh/Ut,<_t_lLt,, and II t = {t} U {h E l l : L t A L h ~ or w h > 0 ,
for I E L , } / U , , ~ t ~H~,. Evidently, {Lt: t @ T l ~ ) is a partition of the set of
commodities, L, and {Ht: t@ T ~ } is a partition of the set of individuals, II.
1915
Consider the economy (E, T~.~, (rL, rn)), where the maps % : L---> T~ = and
zn : H---> T 1,= are defined, respectively, by %(1) = t such that l E L, and rri(h) =
t such that h E H,. By construction, L (h't) C L, U L,+~ and thus, without loss of
g e n e r a l i t y , T (h't) = {t, t + 1} o r A (h't) = 2.
[]
Example 2. Economic activity extends infinitely into the future but not into
the past, under certainty. One commodity is available each period, L, =
{(1, t)} and one individual is born, H, = {(1, t)}. The life span of an individual
is three, T (n'') = {t, t + 1, t + 2}. The economy is equivalent to an economy in
which time extends infinitely into the future but not into the past, T' = {1 . . . . },
two commodities are available each period, L',,--{(1, t'), (2, t')}, and two
individuals are born, H;, = {(1, t'), (2, t')}. It suffices to identify period t with
period t' = [t/2], commodity (1, t) with commodity (1, t'), for t' = [t/2], if t is
odd and (2, t') if t is even, and similarly individual (1, t) with individual (1, t')
for t' = [t/2] if t is odd and (2, t') if t is even, where [k] is the smallest integer
greater than or equal to k.
2. The existence of competitive equilibria

We consider first examples that isolate the reasons for the failure of existence
of competitive equilibria. In some sense, assumptions 1-5 are necessary in
order to ensure the existence of competitive equilibria, but they are not
sufficient. Even after introducing assumptions 6 and 7, we only guarantee the
existence of "compensated equilibria". The existence of competitive equilibria
requires yet another condition.
Competitive equilibria may fail to exist when consumption bundles are
uniformly bounded, but not continuous in the product topology, if the aggregate initial endowment is not bounded.
Example 3 [Wilson (1981)]. One commodity is available each period,
(1, t) = t, and one individual is born, (1, t) = t. The utility function of individual t is u ' = x , + a x , + 1 with a < 1, and his initial endowment is w ' =
( . . . , 0, w'~ = 2', w'~+l = 2 t+l, 0 , . . . ) . In addition, a second individual is born in
the first period, (2, 1) = 0. The utility function of individual 0 is u = E~_ 1 /3'x~,
with i < 13 < 1, and his initial endowment is w~:= (w~ = 2, w~ = 0 . . . . ). Observe
that the utility function of individual 0 is indeed Mackey continuous on A~ ~.
However, the aggregate initial endowment is w = (4, 8, 1 6 , . . . ) and hence not
bounded, w ~ A ~ . + . In order to show that no competitive equilibria exist, we
argue by contradiction. Suppose p* are competitive equilibrium prices. Note
first that Pt+~* ~ p*', otherwise, from the optimization of individual t it follows
*t
that at the associated allocation xt+ ~ = 0 and hence, from the budget constraint, Pt, x,* t ~ p, * 2 t - -~-pt+~z
*
~t+l
1
* , that x,* t > 2t+l =
which implies, If
" Pt+
* 1 > ~p,
1916
w,, a contradiction. But P*I ~< l p , implies, since / 3 > 1, that there is no
solution to the optimization problem of individual 0.
Competitive equilibria may fail to exist if infinitely many individuals desire
some commodity.
Example 4 [Burke (1988)]. One commodity, (1, t) = t, is available in periods
following the first, t = 2 . . . . . while two commodities, (1, 1) = 0 and (2, 1) = 1,
are available in the first period. In the first period, a countable infinity of
individuals, ( h , 1 ) = h for h ~ H ~ = { 1 , . . . } , are born and they are the only
individuals in the economy. Individual h has utility function u h = x o + Xh, and
his initial endowment is w h = (0 . . . . ,0, w~_l = 1, whh _ 1, 0 , . . . ) . Note that all
individuals desire commodity 0. In order to show that no competitive equilibria
exist, we argue by contradiction. Suppose (p*, x * n ) is a competitive equilibrium. Evidently, p* >>0. Utility maximization implies that x *h = 0, for t 0, h,
,h
,h
and the market clearing conditions reduce t o Eh= 1 x o = 1, while x h =
Wh
h + Wh
h+ ~ = 2, for h = 1 , . . . . From the budget constraint of individual h it
follows then that p * w ~ = p ~ + P ~ - I > ~ 2 P ~ or ~ P h "-=Ph-~ ~< " ~ P 0 . Indeed, . - . = P h = P h - ~ . . . . .
P o , for l f p h < P h - 1 for some h , Ph < P 0 , X0 =
0, and then, from the linearity of the utility function of individual h and again
from his budget constraint, P h = P h - 1 , a contradiction. But the constancy of
prices leads to a contradiction since it implies from the individual budget
constraints and market clearing that Xo, h = O, for h = 1 , . . . .
With a particular commodity desired by infinitely many individuals, the limit
of competitive equilibrium allocations for the finite economies obtained by
restricting attention to individuals h ~< n and commodities h ~< n may not be a
competitive equilibrium for the full economy. For a particular commodity, the
aggregate feasibility constraint may be satisfied with equality all along t h e
sequence of competitive equilibrium allocations for the truncated economies
but not at the limit, even though the price of the commodity remains positive.
The limit operation need not commute with aggregation across individuals
when the latter involves an infinite sum and thus the set of feasible allocations
is not compact; equivalently, the infinite sum of upper-semi-continuous correspondences, the individual excess demands, need not be upper-semicontinuous.
Indeed, Assumption 5 requires that at most finitely many individuals desire
each commodity.
Definition 10.
An abstract, exchange economy is irreducible if and only if, at

any feasible allocation, x ~, and for any non-trivial partition, {H l, H2}, of the
set of individuals, there exists an individual, h 2 E H 2, such that
Uh2(Xh2+ Wh)Uh2Xh2
hEH
1917
This does not allow for a reallocation of commodities and thus strengthens the
analogous condition for finite economies [Nikaido (1956), McKenzie (1959);
also, D e b r e u (1962), A r r o w and H a h n (1971)].
Assumption 6.
The abstract exchange economy is irreducible.
If the economy is not irreducible, competitive equilibra may not exist; this is
the case in a finite economy as well.
Example 5 [Arrow (1951)]. Consider an abstract finite exchange economy.
T h e r e are two commodities, l = 1, 2, and two individuals, h = 1, 2. Individual
h = 1 has utility function u I = x~ and initial endowment w ~ = (1, 1). Individual
2 has utility function u 2 = x 2 and endowment w 2 = (0, 1). Evidently, the
economy is not irreducible. For the partition I-I'= {2} and t t 2 = {1}, no
individual in H 2 benefits by receiving the aggregate endowment of individuals
in I-I ~. In order to show that competitive equilibria do not exist we argue by
contradiction. Suppose p* = ( p ~ , P 2 ) are competitive equilibrium prices. If
P2 > 0 , commodity 2 is in excess supply since individual 1 supplies the
commodity inelastically while individual 2 is not endowed with commodity 1 to
offer in exchange. If P2 = 0, there is no solution to the optimization problem of
individual 2.
2.1. Truncations
Let
E = { L , H , (X h, u h, wh): h EH}
be an abstract exchange economy.
The argument for the existence of competitive equilibria proceeds by
considering a sequence of finite or "truncated" economies that tend to the
"full" economy, at the limit.
Consider a finite set of commodities, L n C L, and a finite set of individuals,
H n CH.
Consider the commodity space A n, Euclidean space of dimension L n, the

cardinality of L n and commodity bundles x n ~ An; for a commodity bundle
x E A, x n = projA,,X; A n+ = { x n ~ A n : x n />0}.
For a commodity bundle x n ~ A n and for an individual h E H , we write
n,h E A for the commodity bundle defined by x^n,h
t , for l E L n, and 27 "h ~ - W Ih,
for l ~ / L n. For prices pn E pn = A~ / {O}, we w r i t e / ~ ~ P for the prices defined
by/~7, for I E L n, a n d / ) 7 =O, for I~Z'L n. For commodity bundles x E A and
x'EA,
we write ( X ^ n X ' ) E A
for the commodity bundle defined by
(x ^n X')l = Xt, for l E L n, and (x ^n X')t = X't, for l ~ ' L n. The vector of units in
1918
A ~ is 1~. T h e context should m a k e clear w h e t h e r x k refers to a c o n s u m p t i o n

b u n d l e for the kth individual in the full e c o n o m y or to a c o m m o d i t y bundle in
the k t h truncation.
A finite e c o n o m y
E" = {L", H ", (X "'h, U. ",h w~,h) : h @ H " }

is o b t a i n e d by considering c o m m o d i t i e s in L ~ and individuals in I-V and
restricting the characteristics of individuals to A n C A. T h e c o n s u m p t i o n set of
an individual is X ~'h = {x~: ~ , h E x h } , his utility i.u n .c u o.n . . .I S . /,/. ' . : A ' h " - ~ ] t { ,
defined b y un'h(x~) = Uh,(X^n "h \), and his initial e n d o w m e n t is w n ' h. A n allocation
n ,It n
is an a r r a y x "'n" = {x ~,h E x " ' h : h E I-I" }. A n allocation, x
, of c o m m o d i t i e s
in the t r u n c a t e d e c o n o m y is u n a m b i g u o u s l y associated with an allocation g , , n
in the full e c o n o m y , w h e r e . ~ n , h _ W h, for h ~/I-I n. T h e desirability of c o m m o d i t i e s , P a r e t o d o m i n a n c e , irreducibility and c o m p e t i t i v e equilibrium are
defined by analogy to the definitions in the full e c o n o m y or, equivalently, in a
s t a n d a r d finite e c o n o m y .
A n increasing s e q u e n c e of sets of c o m m o d i t i e s , (L ~ : L " C L "+~, n = 1 . . . . ),
c o n v e r g e s to the set of c o m m o d i t i e s , L, if and only if 1,3 ~= ~ L n = L; similarly,
an increasing s e q u e n c e of sets of individuals, ( H " : H " C _ H "+~, n = l , . . . ) ,
c o n v e r g e s to the set of individuals, H, if and only if I,_J~_1 H " = H. T h e
s e q u e n c e of finite t r u n c a t e d e c o n o m i e s , (E": n = 1 , . . . ) , associated with conv e r g e n t increasing sequences of finite sets of individuals and c o m m o d i t i e s we
say c o n v e r g e s to the e c o n o m y E.
T h e e c o n o m y E is sequentially irreducible if and only if it is the limit of a
s e q u e n c e of finite irreducible e c o n o m i e s .
P e r h a p s surprisingly, an e c o n o m y m a y be sequentially irreducible even
t h o u g h it fails to be irreducible and c o m p e t i t i v e equilibria fail to exist.
E x a m p l e 6. T w o c o m m o d i t i e s are available each period, (/, t), for l = 1, 2. A n
individual, (2, 1) = 2, has utility function u: = x~2A) and initial e n d o w m e n t
w z = (w~ = ( 1 , 0 ) , . . . ,
w~ = ( , 0 ) , . . . ) . In addition, each period, an individual
is b o r n , (1, t), and has utility function
U (l't)
fX(l.t)+X(2.t+l)--l,
2x<2,,+ 1) + 2x~1., ) - 2
~
IX(2, ,+1)
for0 ~~<X ( 2 , t + l ) ' X ( 1 , t ) ~< 1 and x(2., + l ) ~- X(l,t) ~<1

fr 0-<
~ x (2,t+
for x ( 2 . t +
1)
~<2, 0-<
~ x ( 1 , t ) -<
~ 1 and 1 ~<x
~
(2,
t+l)
-{-X(l,t)
>~2 or X(l,t) /> 1
1) ~
and initial e n d o w m e n t w ' = (. . . 0 , ' w , ~ l ' = (0, 2 ) , 0 , .. .). O b s e r v e that individual (1, t) desires c o m m o d i t y (1, t) only as lo_ng as x~2 ,+1)~<2. C o n s i d e r
first the t r u n c a t e d e c o n o m y El, associated with L t = LJt= 1 L, and lndwlduals
1919
H i = U ~=1 H,. In order to show that it is irreducible, suppose irreducibility fails

for some non-trivial partition {ITIi'1, I7I~'2}. It follows from the preferences and
endowments of individuals that if (1, t)EI~I 7"1 also (1, t - 1 ) E I~Ir'l and thus
(1, 1) ~ I~I~'k Suppose 2 E I~I7'2. Then (1, 1) E I~I''2 and hence I~I7'2 = H, a contradiction. Conversely, suppose 2 ~ H z'~. Thus, since at a feasible allocation for
the truncated economy individual (1, [) indeed desires commodity (1, [) with
which individual 2 is endowed, (1, [)~I~I ~'~ and hence I7ti ' t = H 7, which is a
contradiction. Competitive equilibria prices for the truncated economy are
p*~ = ( p ~ = (0,1), P2*r = (0,1), . . . , P?-I
*' = (0, 1), P7*z = (4, 1)) and the associated allocation is described by x *i'2 = ,[X I,~.2 = ( 0 , 2 ) , 0 , ..), x *7"~'t) -:
( ' ' ' 0 , ' *0i ' (,1 "~) =,( 0+, 2 )1,
. "),. for
.
.t = l , .
, t - - - l , and x * i ' ( l , i ) = ( . . . , 0 ,
x~ ~'(l'i) = (,0)). Alternatively consider the full economy, E, and the feasible
allocation ~f* = limi~ = 2 *'t. At this allocation, commodities (1, t), with which
individual 2 is endowed, are not desired by any other individual, and hence the
utility of no individual in I~I2 = ( ( 1 , 1) . . . . } would increase if he were to receive
the aggregate endowment of individuals in 171l = {2}. It follows that the full
economy, E, is not irreducible. In order to show that indeed no competitive
equilibria exist for the full economy we argue by contradiction. Suppose p* are
competitive equilibrium prices. From the strict monotonicity of the utility
functions of individuals 2 and (1, t) in commodities (2, 1) and (2, t + 1),
respectively P(2.,) > 0; since (2, 1) is not desired by any individual other than 2,
and since this individual is endowed only with commodity (1, t), equilibrium
requires that P ( t . , ) > 0 for some t. But this is a contradiction since commodity
(2, t) is desired only by individual (1, t - 1 ) and hence at the associated
. *O,t)
competitive equilibrium allocation ~(z.t+~)=2,
which in turn implies that
commodity (1, t) is not desired by any individual. Observe that as the point of
truncation tends to infinity, the competitive equilibrium prices tend to
lim~/~.i=p.
= (p~ = (0, 1) . . . . , p * = (0, 1 ) , . . . ) at which the revenue of
individual 2 vanishes.
Competitive equilibria may fail
consumption set; in particular if
consumption bundle up to time
individual after time t, fails to be
to exist due to the structure of an individual

a commodity bundle that coincides with a
t and with the initial endowment of the
in the consumption set.
7 [Burke (1988)]. One commodity is available each period, (1, t) =

t. In the first period, two individuals are born, ( i , 1) = i and (2, 1) = j, and they
are the only individuals in the economy. Individuals i has consumption set
X i = {x: x~>0 and x t + 2 t - 3 ( x 2 - 1)~>0 for t = 3 , . . . } , his utility function is
i
u = X l , and his initial endowment is w i = ( . . . , 2 , . . . ) . Note that a consumption bundle such as x = (1, , ,1, 2, 4, 8 , . . . ) does not yield a consumption
bundle if x, is replaced by w,, for t large. Individual ] has a consumption set
X ~= {x: x i> 0}, utility function u j = x~ + E~=2 4 -('+l) min{x,, 5} and initial
Example
1920
endowment w j = ( . . . . 2 . . . . ). In order to show that no competitive equilibria

exist we argue by contradiction. Suppose (p*, x *H) be a competitive equilibrium. By the strict monotonicity of the utility function of individual j, p * > 0.
Market clearing, the boundedness from below of X ~, the requirement that
x * ' E X i and in particular the structure of X i imply x2* i /> 1. It follows that
, i __
*i
x - (x I , 1 , 0 , . . . ) while x *j = (4 - x~,i , 3, 4 , . . . ) . Utility maximization by individual j then implies that p * = \r/ 1-1* , 1-*
. . t~ut
. . . this I S a
/ 2 , " " " , ' ~,.,)-2(t-2) P2* ,. .).
contradiction since at prices p* individual i does not maximize utility subject to
the budget constraint at x ' i ; the alternative bundle x' = x(~ ~+p2/2p~* *,
0 , . . . , 2 ' - 3 . . . . ) is a preferred point in the consumption set and it is affordable, p * x ' : p ? x l ' + P2 + 2,53 (2' 3)(2-2(t 2))p; = plxtiq_ Y]',~-2 (.t-I
) P2* =
P~x~ i + P 2 = P *x*i.
Definition 11. Autarky is everywhere eventually individually feasible, if and
only if, for h E H, for any increasing, convergent sequence of finite sets of
commodities, (L": n = 1 , . . . ) and for any consumption bundle x h E X h there
exists r~ such that 2 "'h E X h, for n = I/ . . . . .
This restricts the structure of individual consumption sets; yet, it is weaker
than the assumption that X h = A + [Wilson (1981), Burke (1988)] and is
necessarily satisfied in individually finite economies.
7. In the abstract exchange economy, autarky is everywhere
individually feasible.
Assumption
Competitive equilibria may fail to exist in the presence of individuals whose

consumption-endowment spans are infinite yet their initial endowment is an
eventually negligible proportion of the aggregate endowment.
8 [Wilson (1981)]. One commodity is available each period,
(1, t) = t. In the first period, two individuals are born; the first, (1, 1) = 1, has a
consumption span of two, while the second, (2, 1) = i, has an infinite consumption span. In periods following the first, one individual is born, (1, t ) = t,
whose consumption span is two. The utility function of an individual with a
two-period consumption span is u ' = x, + 3xt+l, and this initial endowment is
w' = ( . . . , 0, w', = 1, wi+ I = 1, 0 . . . . ). The utility function of the individual with
infinite consumption is u i = xl, and his initial endowment is w i = ( . . . , wI =
()' . . . . ). Note that the endowment of individual i is eventually a negligible
proportion of the aggregate endowment; that individual i derives utility from
consumption only in the first period simplifies the argument but is not essential.
In order to show that no competitive equilibria exist, we argue by contradiction. Let p* be competitive equilibrium prices. Since every commodity enters
the utility function of at least one individual strictly monotonically, p* > 0. Let
T~.~ = { t > 1: p*+~ < 3 p * } C T . Observe first that T*1,c is an infinite set; otherExample
Ch. 35: OverlappingGenerations
1921
wise, p*w i = ~ , which is incompatible with equilibrium, in particular with

*
X*t t = 0 and hence
market clearing in the first period. Further, for t E TI~,
t
x *'-1= w',-l+ w,+
w i, > 2 ; from the budget constraint of individual ( t - l )
*
*
*t-1
*
then, 2p, < p, x,
--P*-I + P* and hence P*-x > P*- Since TL~ is an infinite
set, P I > P E > " ' > P * - I > P * > " ' .
It follows that p*w'=r,~=1_ 2-tp, 1 >
+ x~ ~, while
0
for t > l .
In the same economy, it is remarkable that by permitting some individuals to
overspend their budget, without requiring any individuals to spend less than
their budget, market clearing can be restored. Moreover, the income transfer
can be restricted to individuals with infinite endowment spans. The argument is
constructive. L e t f i * = ( . . . . . .fi~
,
.), wherefi~ = 1 and P,+l-* = ( 1 +''-t'-lZ) P.t,*
for t = 2 , . . . . Consider the allocation , n = {,~, , , : t = 1 , . . . } where *' =
--St
(3,0,...),
while * ' = ( . . . . O , x , + 1 = 2 + 2 - u + l ) , O , . . . ) .
Since fi*w'<fi~
w h i l e p- * x , i _- ( ~3 ) P-,l , a net transfer of revenue r*' = fi*x *i > ( 1)fi~ > 0 implements (fi*, , n ) as a competitive equilibrium with a positive net transfer of
revenue or a compensated equilibrium.
Definition 12. A compensated equilibrium is a pair, (fi*, , n ) , of prices and
a feasible allocation such that
u h ( x ) > u h ( *h) ~
f i * X > f i * *h,
forx~X h
and
fi**h ~ fi*wh
forhEH
with equality whenever an individual is endowed with finitely many components.

From the weak monotonicity of the individual utility functions, it follows
that at a competitive equilibrium
fi*wh
~p*.~*h
< ~ ,
f o r h E H .
A compensated equilibrium is a competitive equilibrium if and only if
fi,,h =fi,W h
for h E It
From the weak monotonicity of the utility functions, it follows that at a

compensated equilibrium
Uh(X)>~uh( *h) ~ fi*X>~fi* *h,
forxEX h,hElt.
1922
Theorem 1 [Wilson (1981), Burke (1988); also, Balasko, Cass and Shell
(1980), O k u n o and Zilcha (1982)]. In an abstract exchange economy, under
Assumptions 1-7, compensated equilibria exist.
We consider a convergent sequence of prices and a convergent sequence of
feasible allocations for the full economy obtained from the competitive equilibria for a sequence of finite modified truncated economies.
Lemma 4.
If ( p , ~ P : n = l , . . . )
and (x,,~A+:n=l,...) are convergent
sequences of prices and consumption bundles.

(lirn Pn)(!irn x n) ~< lim i n f ( p ~ x , ) .
Proof. Let p = l i m o _ ~ p~ and x = l i m , ~ = x,. For any k, it follows from
positivity that ( p , AkO)(x,,^kO)<~p~x~. Letting n---~o% we obtain that
( P ^ k 0)(X ^ k 0) ~< lira i n f ~ ( p n x n ) . Since px = l i m k ~ ( p ^ k 0)(X ^ k 0), px <lim inf~_~(p~x,).
[]
It is worth remarking that the reverse inequality in L e m m a 4 need not hold.
Take P n = X n = l n , n = l , . . . ;
evidently, l i m n ~ = p n = l i m ~ x , = 0 .
Then
( l i m , ~ p,)(lim,__,~ x~) = 0 < 1 = lim i n f , ~ p , x , .
A difficulty in proving the existence of compensated equilibria arises from
the possible failure of the economy to be sequentially irreducible. In order to
obtain competitive equilibria for a convergent sequence of finite truncated
economies, it is necessary to perturb the structure of each economy with the
perturbation vanishing at the limit. If the perturbation involves only the
e n d o w m e n t of each individual, it may not be limited to finitely many commodities. It is then necessary, and rather involved, to show that at the limit the
value of the perturbation vanishes [Burke (1988)]. In our argument we perturb
the utility functions as well as the initial endowments. The perturbation of the
utility functions allow us to perturb the endowment of each individual in only
one commodity and simplifies the limiting argument. The perturbation of the
initial endowments allow us to perturb the marginal utility of each individual in
only one commodity, different for each individual, thus preserving the property, essential for the limiting argument, that finitely many individuals desire
each commodity.
Proof of Theorem 1.
Consider the convergent increasing sequence of sets of

commodities, (Ln: L n C L n+l, n = 1 . . . . ), where L n = {1 . . . . , n}, and the convergent increasing sequence of finite sets of individuals, ( H n : H n C H n+~,
n = l . . . . ), where H n = { 1 . . . . . n } C H .
Recall that A n is the Euclidean space of dimension L", and, for x E A,
x n=projAn x while, for x n @ A n and h ~ H , 2 n'h is the vector defined by
x~n,h
t = x nl, for I E L n, and 27 'h = W lh, for l ~ ' L " . Prices are pn E pn = A~/{O}
1923
and/9" is defined by/97 = P t , for l ~ L n and t97 = 0 , for l~E'L~. The vector of
units in A n is 1".
For n = 1 , . . . the modified truncated economy E " is obtained by first
perturbing the utility functions and the initial endowments of individuals in the
full economy, and then truncating, according to
=
and
w,,,.h =
-x h
n
wh + 1 ih+l
)n
forhEtI',
for h E H " / { n }
while
w ..... =
wn + _1 i l
The truncated, perturbed utility function of individual h, u '''h, is strictly

increasing in commodity h, since the utility function, u h, is weakly monotonic;
also, u '"J' is quasi-concave. The modified, truncated initial endowment of
individual h < n, w '"'h, is positive in commodity h + 1, and of individual h = n
in commodity 1.
The set, D;", of individuals who desire commodity l in the modified
truncated economy is contained in I) t U {l}L a finite set independent of n. The
aggregate endowment is (Ehen, ' w h + ( 1 / n ) l ) " >> 0.
Let (p*", x *"'n') be a competitive equilibrium for the modified truncated
economy E'". That a competitive equilibrium exists follows by the standard
argument for finite economies, since the economy is irreducible [McKenzie
(1959), D e b r e u (1962), Arrow and Hahn (1971)]. Furthermore, the income of
each individual at a competitive equilibrium is positive, p * " w '~'h > 0 and
p , n >>0. Without loss of generality we suppose that p*"w ' " ' 1 = 1. Also, since
individuals do not displayh satiation while consumption sets allow for free
disposal we have that x~ n" = 0 for hJE'D t U {/}.
Let w " = w + ( l / n ) ( 1 A , 0 ) E A. Note that, for h E H , l i m n ~ ff,,,,h = w h
and also l i m n ~ w '" = w.
Let ~,n,n be the allocation for the full economy associated with the equilib,nh
h
rium allocation for the modified truncated economy, defined by ~ ' = w , for
h ~ ' H " . Observe that by construction EhEri 2 * ' ' h = w " . By passing to a
subsequence, by L e m m a 1 we obtain that
2 *H= lim ~,.,n

n----> oc
is a feasible allocation.
1924
1.
Claim
For h E H, there exist finite, positive scalars, 0 < c A <~ (h < o% such
that
0 < c h ~< lim inf p*nw~'h <~lim sup p * ~ w '~'h <~ ~h < oo.
--
n---~ ~
n._~cc
We argue by contradiction. Let H ~ = {h ~ H: lim s u p ~ p * ~ w '~'h = ~} and

let H 2 = {h E H: lim s u p ~ p * ~ w '~'h < ~}. Suppose H ~ ~ 0; since 1 E H 2, the
partition {H ~, H 2} is non-trivial. By the irreducibility of the full economy, there
exists an individual, h~ ~ H 1, such that uh~(~7*h~ + Eh~l~ wh) > Uh~(~f*h~). By
continuity, there exists r~ such that uh~(~ *h~ + Ehcn2 ( w h/x~ 0)) > uhl(5*h~). By
the convergence of the competitive equilibrium allocations for the modified
truncated economies, the finiteness of the aggregate endowment, w t < ~, for
1 = 1 . . . . , r~, the continuity of the utility functions in the product topology and
the structure of the consumption sets, there exist scalars, 0 < e < l and
0 ~ ~ ~
1, n: ~ n- and a finite set H F2 C H 2 , such that u t n 'h I ( 6 x .'~n 'h 1 + ( 1 - 6 )
( 1 - e ) w t n ' h I _[_ Xhsn~(w h ^ a 0 ) , ) ~ u r n 'h I (x * n "h I ), for n = n ,--. . . .
From mdividual optimization in the truncated economies, p*" ~hclt~(W h A ~ 0 ) n >
~n
tn h 1
(1 - ~ ) e p
w ' , for n = n , . . . . But this is a contradiction, since the left side
is b o u n d e d as n--->~, while the right side is not. It follows that H ~ = 0 or
equivalently, p * " w '~'h <~ ?h < ~.
TO argue the lower bound, let H ~= {h E H: l i m i n f ~ p*nwn'h > 0 } and
H 2 = {h E H: liminf~_~ p * ~ w ~'h = 0 } . Proceed exactly as above, getting an
inequality in which the higher side goes to zero and the lower stays bounded
away from zero, a contradiction.
For l @ L, take h E H with w~ > 0, this is possible by assumption 4. By claim
-h
h
1, there exists rit such that 0 <<-P't" <~ c / w t , for n = r~z. . . . . Thus, by passing to
a subsequence, we obtain/~* E A+ w i t h / ~ = lim~__,~ P"*~
t , for I E L .
Claim
2.
ForhEH,
O< fi*W h < ~ .

In particular
/5* > 0
a n d hence fi* are prices f o r the full e c o n o m y , fi* @ P.
By L e m m a 4, f i * w h <~lim inf,__,~(fi*"ff '''h) ~< (h < ~; half the claim follows

at once. T o argue the other half, let H e = {h @ H:/5*w h = 0}; note that for any
ff and any h E H e, l i m , ~ p*n(wh A,~ 0) = 0. Let H 1 = {h @ H: f i * w h > 0}. For
h C H 1, lim inf,__,= p * ~ w '~'h > 0. If H 2 ~ 0 and H t 0, we get a contradiction as
in the proof of Claim 1. If H 1 = 0 and H 2 = H, note that, by weak monotonicity, ul(2 .1 + E~en2 w h) = u l ( y *l + w) > u~(2"1). Again by proceeding as in the
p r o o f of Claim 1 we get a contradiction.
Claim 3.
1925
ForhEH,
T o see this note again that, by L e m m a 4, f i , ~ , h < lim inf~_.~ /),,,~,n.h =

lim i n f ~
lira i n f , ~ p * ~ w '~'h ~ ~h < ~.
p*nx*n'h
Claim 4.
Forh~H,
We argue by contradiction Suppose that for some individual f i . y . h <
fi*W h < ~ . By weak monotonicity, there is r~ such that uh(y h + (1 A~ 0 ) ) >

uh(y*h). By quasi-concavity, for 1 > e > 0 , uh(x,) > uh(y*h), where x, =
~?.h + e(1 A,~ 0). But for small e, fi*x, < f i * w h. Since the two series converge,
the tails of both infinite sums in the last inequality must be negligible. Hence,
there is n such that ~*(X~A nw h)<fi*"w h, for n = n , . . . .
But
uh(x~ A~W h ) > u h ( *h + ( 1 / n ) l )
for n large. Finally, for large n,
p *"(x ~ A ~ Wh)" 
ForhEH,
uh(; *~) ~
p*x>~
*~ .
We argue by contradiction. Suppose that for some individual, h, and for

some x E X h, uh(x) > uh( y*h), while fi,h <~fi , ,h. Since fi , ,h /> f i , Wh > 0, it
follows from the structure of the consumption set that there exists x ' =
6x + (1 - 6)(1 - e)w h E X h such that uh(x ') > Uh(y*h), while fi*x' < fi,,h.
But from continuity, convergence and the structure of the consumption sets,
there exists r~ such that this contradicts the optimization of the individual in the
truncated economies for n = r ~ , . . . .
In order to complete the argument that (fi*, , n ) is a compensated equilibrium, it remains to show t h a t / ~ , , h = I~,W h if Wh vanished in all but finitely
,n
rn h
,n
n h
.
tn h
n h
many components. But hmn~=(p w ' - p
w ' ) = 0 , since w ' and w "
differ only in the component lh+~, for n1>h + 2 . Thus, fi,:f,h <~
l i m n ~ p*nx*"'h = lim,,__,~ p*nw'n'h = limn~= p*nw"'h = p * w h, where the first
equality follows from the budget constraint in the truncated economies, while
the last equality follows from the convergence, by construction, of the modified
endowments to w h and by the fact that the latter vanishes in all but finitely
many components.
Thus (fi*, . n ) is a compensated equilibrium.
[]
Corollary 1. In an abstract exchange economy, under Assumptions 1-7, if

every individual is endowed with at most finitely many commodities, competitive
equilibria exist.
1926
J.D. Geanakoplos and H . M . Polemarchakis
Definition 13. A finite set of non-negligible individuals exists everywhere, if

and only if for any feasible allocation, x n, there exists a finite set of individuals,
H F C H, a commodity bundle that vanishes in all but finitely many components,
w v, a scalar k > 0 and an allocation x 'n such that
x,h= k ~
h~H
wh + wF
h@HF
and
uh(x 'h)>luh(xh) , f o r h ~ H .
The definition, evidently, generalizes the condition that a finite set of
individuals own a non-negligible fraction of the aggregate endowment of all
but finitely many commodities [Wilson (1981); also Burke (1988)]. It allows
the sets of individuals, HF, and the commodity bundle w F to vary with the
allocation x n. More importantly, it is based on a utility comparison and not on
a commodity by commodity comparison and thus it is invariant to inessential
changes in the indexation of commodities.
Theorem 2. In an abstract exchange economy, if a finite set of non-negligible
individuals exists everywhere, under Assumptions 1 and 2, in particular if
individual utility functions are weakly monotonically increasing, every compensated equilibrium, ( fi*, 2*n), is a competitive equilibrium,
fi*2*h = lJ*W h,
for h E H ,
and the value of the aggregate endowment is finite,

ff*W~.
In particular, under Assumptions 1-7, if a finite set of non-negligible

individuals exists everywhere, competitive equilibria exist.
Proof. Consider a compensated equilibrium, (fi*,2*n). Let the set of individuals HF, the commodity bundle WF, the scalar k and the allocation x 'n be
as in the definition of a finite set of non-negligible individuals.
It follows from the definition of a compensated e~uilibrium that, since
individual utility functions are weakly monotonic, fi*2 ~</~*x' , and hence
~*W~*(WF+
k ZhsnFW h )<C<
Since 1 5 * 2 h ~ p-* w h while 2h~nX-h =W,
15"2 h = lS*w h, for h ~ H
[]
3. The optimality of equilibrium allocations
We first consider examples that illustrate the failure of Pareto optimality of
competitive equilibrium allocations.
1927
Competitive equilibrium allocations may fail to be Pareto optimal if the

value of the aggregate endowment at the equilibrium prices is infinite.
Example 9. One commodity is available each period, (1, t ) = t and one
individual is born, (1, t ) = t. The utility function of an individual is u'=
t
lnx,+llnx,+l,
and his initial endowment is w t = ( . . . , O , w , t 5 ~ w,+
1=
1, 0 , . . . ) . In addition , an individual is born in period 1, (2, 1) = 0, with utility
function u = x l and initial endowment w = ( w > 0 , 0 . . . . ). Prices p * =
5
*
(1 . . . . . P,*I = ~P,
, . . . ) are competitive equilibrium prices and the associated
allocation coincides with the initial endowment. The feasible allocation x ' "
" t = 2 , 0 , ..) and x ' = ( x ] = w , +0
described by x ' t = ( . . , 0 , x ' / = 4 , xt+
1, 0 . . . . ) Pareto dominates the initial endowment.
Alternatively, suppose that individual 0 has utility function u = l n x 1 +
E~_~_ ()' I ln(max{8, x,}) and initial endowment w = ( . . . , w , = ~ 5 ~ /!~,
1,...).
Prices p* again suppose the initial endowment as a competitive equilibrium
allocation which is suboptimal.
Observe that in both cases the value of the aggregate endowment at the
equilibrium prices fails to be finite. This is of interest in the second case in
particular, since there is an individual, 0, whose consumption span as well as
his endowment span are infinite Nevertheless, the individual fails to be
non-negligible and thus fails to impose a finite value on the aggregate endowment.
Competitive equilibrium allocations may fail to be Pareto optimal, even if
the value of the aggregate endowment at the equilibrium prices is finite, though
individual utility functions fail to be weakly monotonic even if they are locally
nonsatiated, for x E X h and V(x) a neighbourhood of x, there exists x' E V(x)
such that uh(x ') > uh(x).
E x a m p l e 10.
Consider an abstract exchange economy with commodities L - {1 . . . . } and individuals H = {1, 2}. Individual 1 has utility function u 1 = x 1 and
initial endowment w I = ( 1 , 0 , . . . ) .
Individual 2 has utility function u 2 =
inf{xt: l E L } and initial endowment w 2 = ( . . . , w~ = 2 - t , . . . ) ; evidently, the
utility function of individual 2 is not weakly monotonic, if A x =
( . . . , A x / , . . . ) >> 0, but limt~= Ax t = 0 and x' = x + Ax, U2(X ') = ua(x) = 0 even
though x' >> x. Prices p* = ( 1 , . . . ) are autarky competitive equilibrium prices,
1
the associated allocation coincides with the initial endowment. At p*, w
evidently solves the optimization problem of individual 1 and so does w 2 for
individual 2 since no consumption bundle, whose value does not exceed
p*w 2 = 1 at p*, yields greater utility to the individual Note also that p*(w I +
w 2) < ~. On the other hand, the allocation described by x ' l = ( 3 , 0 . . . . ) and
x ' 2 = (0, . . . . . x'/ = 2 - l , . . . ) Pareto dominates the initial endowment allocation
1928
In a finite economy, local non-satiation implies that at any prices, p, for any
consumption bundle, x E X h, and any x > 0, there exists a consumption bundle
x' E X h such that p(x' - x) < e and uh(x ') > uh(x), at least when continuity of
the utility functions fails. This is not the case in an economy with a countable
infinity of commodities. Note that the continuity of the utility functions, which
also fails in the above example, is not employed in the argument for the Pareto
optimality of competitive allocations in a finite economy.
Theorem 3. In an abstract exchange economy, under Assumptions 1 and 2, in
particular if the individual utility function is weakly monotonically increasing, a
competitive equilibrium allocation, x* n is Pareto optimal if at p*, the associated
competitive equilibrium prices,
p*w < oo .
The p r o o f is essentially as in the case of a finite economy.
Proof. In order to show that the allocation x *n is Pareto optimal, we argue by
contradiction. Suppose the allocation x 'n is feasible and dominates the competitive allocation x *n.
Note first that
uh(x'h)>Iuh(x *h) ~ p*x 'h>~p*w h,
forhEll.
This follows from the weak monotonicity of the utility function. If p*x'h<
p*w h, the commodity bundle Ax h defined by Ax'/h= (p*w h --p*x'h)(21pt)-l,
for l E L is strictly positive, Ax 'h >>0, and hence uh(x'h+ AX 'h) > uh(x'h)>~
uh(x*h), while p*(x 'h + A x 'h) <~p*w h, which contradicts the optimization of
individual h at prices p*.
Also,
uh(x'h)>uh(x *h) ~ p * x ' h > p * w h,
forhEH.
This follows immediately from the optimization of individual h at prices p*.

Since the allocation x 'n dominates the competitive allocation x *n, by definition uh(x'h)>~ uh(x*h), for h E t t, with some strict inequality. Since p*w =
ZhE n p*wh< co, it follows that EhE n p*x'h> Zh~ n p*w h. But this contradicts
the feasibility condition Eh~ u x 'h = Eh~ n Wh, since p* > 0.
[]
In an abstract exchange economy in which a finite set of nonnegligible individuals exists everywhere, under Assumptions 1 and 2, in particular if the individual utility functions are weakly monotonically increasing, a
competitive equilibrium allocation, x *n, is Pareto optimal.
Corollary 2.
1929
Proof. It suffices to observe that at the associated competitive equilibrium

prices, p*, the value of the aggregate endowment is finite, p*w < o~.
This accounts for the Pareto optimality of competitive allocations in
economies with "land", interpreted as a commodity bundle that renders its
owners always non-negligible. Evidently, whether the consumptions span of
the owners is infinite or not is of no consequence.
The interest of Corollary 2 lies most importantly in that it gives conditions
for the Pareto optimality of competitive equilibrium allocations that refer only
to the exogenous structure of the economy, the utility functions and initial
endowments of individuals, and not to the competitive equilibrium prices
themselves. It is thus the analogue of the first welfare theorem for finite
economies [Arrow (1951), Debreu (1951)].
The optimality of competitive equilibrium allocations is complemented by
the characterization of conditions under which a Pareto optimal allocation is
indeed a competitive equilibrium allocation for some redistribution of initial
endowments.
Let ri be a feasible Pareto optimal allocation: if the abstract

exchange economy with initial endowments w h= h for h E It, satisfies Assumptions 1-7, there exists prices p* such that (p*, n) is a competitive
equilibrium.
Theorem 4.
Even if an abstract exchange economy satisfies Assumptions 1-7, the

economy obtained by substituting for the initial endowment of each individual
by his consumption bundle at a Pareto optimal allocation need not satisfy the
same assumptions. In particular, irreducibility may fail and competitive equilibria may fail to exist. This is the case in a finite economy as well. Thus,
Theorem 4 is the analogue of the second welfare theorem for finite economies
[Arrow (1951), Debreu (1951)].
Proof. Since the economy with initial endowment allocation a satisfies
Assumptions 1-7, it follows from Theorem 1 that a compensated equilibrium,
(p*, x'U), exists.
From the definition of a compensated equilibrium, it follows that uh(x *h) >~
uh(h), for h C tt. Since, by hypothesis, the allocation ri is Pareto optimal,
uh(x *h) = uh(h). But then, (p*, a ) satisfies the definition of a compensated
equilibrium and a fortiori of a competitive equilibrium.
[]
It remains to characterize conditions under which competitive equilibrium
allocations without a finite non-negligible set of individuals are Pareto optimal.
We restrict our attention to economics with a simple demographic structure;
from Lemma 2, this is without loss of generality for economics that are
individually finite.
1930
Theorem 5 [Brown and Geanakoplos (1982)] In an exchange economy of

overlapping generations with a simple demographic structure, under Assumptions 1 and 2, in particular if the individual utility functions are weakly
montonically increasing, the allocation at a competitive equilibrium ( p*, x* n) is
Pareto optimal if
hm
lnf
p t* w tt = 0
t-->~
where w I
--E(ht)eH,
W}h't).
Without loss of generality, suppose H 1 ~ ft. For t-~ T 1~, let A x ' E A'
and consider the optimization problem
Proof.
max i _- - / 3. 1 . , I . (1,1)
. , (1,1) s.t.
1
-[- p 2 . ~ 2
u(h")(x (h'')) >/u(h")(x *(h'')) ,
X'lh
for (h, t) ~ H, and t = 1 . . . . , { - 1,
w, ,
(h.I)EH~
xlh+,~)+
(h,t)EH t
(h,,+l)
Xt+ 1
Wt+ I ,
for t = 1,
{-- 2
(h,t + l )CH t
.H
. ( h , i - l ) <~
(h , t - 1 ) ~ H t _ 1
x.(hs-1)
+ A xf
(h ,t.- 1 ) ~ Ht ... 1
Let q~Z(Ax') be the value of the objective function at a solution From the
weak monotonicity of the individual utility function, it follows that q~r(0)=
p..(1,1)
.
.(1,1)
1~1
+/a2. 2
, while ~'(Ax~)<~i(O)+p*~Ax '.
Suppose a feasible allocation, x 'n, Pareto dominates the competitive allocation, x ' n ; without loss of generality, u(l'l)(x '(1'1)) > u(l'~)(x*(l'l)) and hence
p~ x ,(1.1)
1
+ p 1 X , 2 ( 1 , I ) . Since the allocation is feasible, it satisfies the constraints of
the above optimization problem for A x ' = w ~ __ E(hf_l) x ~ ( h , ? - I ) , for {ET1 ~.
But this is a contradiction since q ~ t ( A x ' ) > pl . ,I( 1 , 1 ) p 2+* x , 2 ( 1 , 1 )
>q~7(0), independently of /-@T 1 ~, while ~Z(Ax i) - ~ ( 0 ) ~ p 7 (w i E(h,i_l) x *(h''-l))
p~ w~t and, by hypothesis, lim i n f ~ p~* w~t = O.
[]
If lim i n f , ~ p* wtt> 0, the competitive equilibrium allocation may still be
Pareto optimal Nevertheless, there exists an alternative exchange economy of
overlapping generations with a simple demographic structure which differs
from the original economy only in the utility functions and for which (p*, x *n)
is a competitive equilibrium while the allocation x *n fails to be Pareto optimal
In particular, the economy in which the utility function of individual (h, t) is
U(h,t)
= p~x
t q- Pt+lXt+l
1931
Competitive equilibrium allocations may fail to be Pareto optimal in

economies in which the marginal rate of substitution of commodities, the slope
of a supporting hyperplane to the indifference curve of an individual at the
equilibrium consumption bundle is invariant to small changes in the relative
consumption of the individual in the two periods in his consumption span.
Example 11. One commodity is available each period, (1, t ) = t, and one
individual is born, (1, t ) - - t . The utility function of the individual is u t =
t
xt + xt+ 1, and his initial endowment is w ~-- ( . . . , 0, w~' = 1, wt+ 1 = 1, 0, . . . ) . In
addition, an individual (2, 1 ) = 0 is born in the first period, whose utility
function is u = x~, and his initial endowment is w = (w = 1 , 0 , . . . ) . The
initial endowment is indeed a competitive equilibrium allocation supported by
prices p* = ( . . . . 1 . . . . ). The allocation x 'n described by x'l = 1 + e and x ' / =
tt
t+l
1-e .....
e',xt+ l = l + e + . . . + e ' + e
, for t - - l , . . , is well defined for
e < and Pareto dominates the initial endowment.
Let (p*, x *n) be a competitive equilibrium. Consider the individual expenditure minimization problems
p*,+,
min z~+ t
--
~ -
I1Pt+l [I
(Xt+l--Xff+(tl +1) )
s.t.
>i
llP ' ll
( x , - x *("'')) = z,
x ~ X (h''),
for (h, t) @ It ,
. *(h,t) "Jl- z~+l, O , .. . ) .

where x = ( . . . . O, x *(h'O + z~, ~t+l
The per capita endowment of a commodity is
H~W(t")'
for(l,t) EL.
From the solution of the individual expenditure minimization problem, we

obtain the expenditure function f(h.t), for (h, t) E H. If, for some z,, a solution
to the minimization problem yields f(h't)(Zt)= ~.
The function f(h.t) is, up to price normalization, the expenditure in the
second period of consumption required for the individual to attain the level of
utility associated with this consumption at the competitive equilibrium if the
expenditure at the first period of his life is exogenously modified. In the special
case of one commodity per period, the expenditure function coincides with the
indifference curve through the equilibrium consumption of the individual,
whenever the utility function is monotonically increasing in xt+ 1.
1932
Definition 13a. The competitive equilibrium, ( p * , x * n ) , in an exchange

economy of overlapping generations with a simple demographic structure
satisfies the non-vanishing_Gaussian curvature condition if and only if there
e x i s t s t E T ~ ~ and scalars fit > 0 and d t > 0 foi" t = t . . . . such that
(i) for t = t , . . . ,
Ht>O ,
(ii) for (h, t ) E H, and t = t . . . . ,
Ilp,*ll>o,
IIp ll
I]--~,*+il[ z, +/3,z~,
f,(z,) =
_( IIp*+,ll
IIp2
II
for Ilz, H~< d , ,
2/3,d,)z, -/3,d~
( llP*,I~---/+
IIp*tl 2/3,d,)z, -
for z , > dr
'
'
f o r z , < - d, ,
fl, d~,
(iii) for some t~ > 0 and t = [ , . . . , g(ll p_;*+,II/11p*+l II)

(iv) for some d > O and t = [ , . . . , d,/> d.
Pt >>-fi, and
In order to interpret the non-vanishing Gaussian curvature condition, consider the special case of one commodity per period, in which function, f(h.,),
coincides with the indifference curve through the equilibrium consumption
point. The function coincides with f(h.,) at z* = 0 or equivalently, at the
equilibrium consumption point and does not lie anywhere below it. The curve f,
is linear quadratic with strictly positive Gaussian curvature at z* = 0. If the
indifference curve is smooth, which, nevertheless, we do not require, and f(h.,)
and f, are tangent at z,* = 0, the requirement that f(h.,)>~f, amounts to the
Gaussian curvature of the indifference curve not vanishing at z* = 0.
Theorem 5a [Cass (1972); also Benveniste and Gale (1975), Balasko and Shell
(1981a)]. Consider an exchange economy of overlapping generations with a
simple demographic structure such that the per capita endowment of each
commodity is bounded,
1
H~t w(,.,) < -~ k ,
for (l, t) E L and some k > O.
Under Assumptions 1 and 2, a competitive equilibrium (p*, x *n) in which the

non-vanishing Gaussian curvature condition is satisfied, the allocations x *n is
Pareto optimal if
T
lim ~
m ~
1933
Ch. 35: O v e r l a p p i n g G e n e r a t i o n s
The uniform bound on the per capita endowment of all commodities is

normalized by the cardinality of the set of commodities available in each
period. This is necessary for the restriction to be meaningful; otherwise it is
possible to replace each commodity by a possibly large, yet finite, number of
perfect substitutes in order to satisfy any positive upper-bound on the per
capita endowment of each commodity. The non-vanishing Gaussian curvature
condition fails in Example 11.
If population grows at a constant rate, #I-I t = (1 + n)', while the real rate of
interest is constant, [IP* II = (1 + r*)II Pt*l II, the divergence condition takes the
familiar form
r*~n.
If population grows at a constant rate, and the rate of interest is constant yet
time extends infinitely into the future as well as into the past, the divergence
condition takes the form [Samuelson (1958)]
r*~F/
This follows simply by applying the construction of L e m m a 2 which establishes

the equivalence between economies that extend infinitely into the future as
well as into the past with economies in which time extends infinitely only into
the future.
The Euclidean norm is the divergence condition can be replaced by any
norm.
Proof. Let (p*, x *n) be a competitive equilibrium that satisfies the curvature
condition. In order to show that with the per capita endowment of commodities uniformly bounded, the allocation x *u is Pareto optimal if
l i m , ~ Etr_[ 1/H, II
II =
w e a r g u e by contradiction.
Suppose the allocation x 'n is feasible and dominates the equilibrium allocation x* u.
Let t = min{t I> i- u~h")(X '(h't)) > u(h't)(x*Ih")), for some (h, t) E tilt}. Without
loss of generality, t = t = 1.
Since p* are competitive equilibrium prices, r,(h,1)cU~ t'2* /~2,(h.1) -- x2(h.1)) ~ 0.
This is the case since, from the feasibility of the allocation x',
E(h,~)En, (X](h'x) -- X~ (h'x)) = 0, while, from the optimization of individuals H x,
,it(h,1)
Z(h,X)~HlPl(x](h'X)--xl(h'X))~-E(h,X)EUlIIZl.X2
--x2(h'X))>0 since the individual utility functions are weakly monotonic. It follows that, for t = 2 . . . . .
~ ( h . t ) c n , P t * "[.Xtt(hd)--x~(h't))<O,
while
. ,(h,t)~
~ , ( h . t ) ~ n t l J, t + l [ A[ . t (+h dx) _ A.t+
x J>0.
t(h.t)
,
Let
Z't(h")=(p*/llp*lll)(X',(h")--X*(h") ) and z,+ 1 =(p,+l/llp,+l[I)x
,
(h t)
,t
I.Xt+l"
,(h.,)_X,+l,(h.,)~), Lor~-- ( h , t ) EI-I. Let zt=(1/Ht) Z(ha)~nz , " and z,+~ =
t(h,t)
*
( l / H , ) E(h,,)~n, z,+x From the monotonicity of the function f , it follows that
1934
f~* ( z " ) I> 0. From the uniform upper bound on the per capita endowment of all
commodities and the definition of z't' it follows that IIz'/II <-k. From the
quasi-concavity of individual utility functions and consumption sets, we may
suppose that IIz','ll ~ d ~ d,. Thus,
IIp* IIz;' IIp*+l tlz;~-i - fit I]P*+I II (z;') 2 ~
Setting
obtain
et =
-H, zt+
1''
" 1 > 0, observing that

z,+
o,
for t = 1. . . . .
..
,,+ll
Islt+lZt+
H,
( Ht ]2
-][P*+,]] H---~+
1 e,+]]P*+2lle,+,-f,+lHP*+2]l\H,+l/
and substituting, we
2>~O'
et
for t = 1 . . . . .
Rearranging terms, multiplying both sides of the inequality by Hi+l, for
t = l . . . . , and taking reciprocals, we obtain
1
I 1P,+,iiH,+l~.,
"
(Ht) 2
]Ip,*+,IIH,~, + f,+,llp,*2ll ~
1(
e~
].p,*_.+,HH,s,
(Hi)2 s~
Ilp,*+iilH, e, Ilp*+,lIH, e,+t3,+,llp,*+=ll H---~+
"
n
1-
IIp,*+iil-,~,
t~'+lllP'+211~
,
. . .+ .- . . ,
IIp,+,IIH,~,
e,
(i-/,)2
/3,+,HN,+2[I ~
f'+' IIT,*+I
IIp,*;, II/4,~,
IIP*+III H,+I
for
t =
1,....
Observe now that the expression
lip,*;2Jl
/3,+, Up,*l ]]
Hp,*+zll H,
1 + f,+~ I]P,*+~l[
H,---~,~'
e,
1935
is monotonically increasing in
fi,+, II p,*+211
IIp,*+,l[
and monotonically decreasing in
H,
Ht+l e t , for t = 1 , . . . .
By assumption,
II p,*+.ll
' IIp,*+lll
-
Ot
~Pt+l
while ~
et
mt
H,+,
tt+l
Z;tl = --Zt+l ~ k ,
for t = 1 . . . . .
Substituting, we obtain
1
* H
IIp,+.ll
]]Pt*lllHtet
/)t+l
[]Pt*;111 Ht+I 1 + ~6t+ik '
for t =
1, . . . .
Summing over t = 1 , . . . , and cancelling terms, since t~,+~/> t~ > 0,

T
E
1
~-.
1
l+tSk
,=~ [[P*+IIIH,+,
Ilp~'llH, e,
It follows that
T
lim ~]
~oo,
,=, H, IIp*, II
But this is a contradiction and hence the competitive allocation is Pareto
optimal.
[]
Definition 13h. The competitive equilibrium (p*, x *n) in an economy with a
simple demographic structure satisfies the bounded curvature condition if and
only if there exists t-E T and sets of individuals K t = {(h, t ) l , . . . , (h, t)K,} C_Ht,
commodity bundles Ax,, and scalars/3, ~>0 and _dt > 0, for t = {, . . . . such that
(i) for t= i , . . . , p* Ax,>O, K,> I ,
(ii) for (h, t ) E K, and t = t-,.., the consumption bundles x '(h't) defined by
0,
x;W ~-- x.,<,,,> + IlpT, IIz;,
Pt* AXr
for t' # t, t + 1Kc '
Ax,,
'
for Nz,rll ~<d ' ~ 1

-
andt'=t,t+ 1
'
J.D.
1936
Geanakoplos
and
H.M.
Polemarchakis
where by convention K~_~ = 0 , satisfy u(h")(X'(h"))> u(h")(X *(h''l) SO long as

t
*
2
z , < 0 a n d z ' t + l >~-(p*~/llp,+lll)zt + [3,zt
(iii) for some p > 0 and t= {, . . . . fl,(l[p~+lll/tlp*ll) = p, < ~ , and
(iv) for some _d>O and t = [ , . . . , d,/>_d.
In the special case of one commodity per period, the bounded curvature
condition requires that, locally at z* = 0 , the indifference curve not be
anywhere below a quadratic function with finite Gaussian curvature with which
it coincides at z, = 0. In particular, this excludes the case in which, for
t = t-+ 1 . . . . , the utility functions of individuals are not strictly monotonically
increasing in xt+ ~.
Consider an exchange economy of overlapping generations with a simple demographic structure, under Assumptions 1 and 2. The allocation at a competitive equilibrium,
( p * , x ' n ) , satisfying the bounded curvature condition, is not Pareto optimal if
Theorem 5b [Cass (1972), Benveniste and Gale (1975)].
lim ~
T_~= =Z g, llPTI t < ~ "

Proof. The argument is constructive. Suppose, without loss of generality that
/-= 1 and let
T
lim ~
--S<OO.
Consider the allocation x 'u defined as follows. For (h, t ) ~ ' K , , X t ( h ' t ) : X * ( h ' t ) .
tt
II

t
For (h, t) G K , if suffices to specify z, and z,+~. Requiring tha_t -K,z,+ 1 =
tt+l
tt
K,+lZ,+
~ , if
suffices to specify e~ = Z,+l, for t = {, .. and also z ' / = 0.
Let z ' / = 0 and choose e i > 0 . Observe that u(h'i)(x'(h'i))> u~h'~)(X*~h'i)) for
(h, t-) E Kz. Define inductively e,+ 1 by
1
IlP*+IHe'+~K'+' I]P*+lllerKt
Pt+ I
HP'*lltK'+1 1 + p,+,- ( K~'+I) e, '
for t = 1, . . . .
Note that e,+, is well defined since Ilp*+xll > 0 and K,+, i> 1. To complete the
argument, it remains to show that e t < _d, for t = 1 . . . . . since then by construction, u*(h'O(X '(h't)) >I u*(h")(X *h't)) for (h, t ) ~ K,. Summing over t = 1 , . . . , T
and cancelling terms we obtain
1
iip~lle~.gy > lip2 ii elK,
so.
1937
Since limr_,~ IIP~ II KT : 0 , et < _d, for t = 1 , . . . , if initially e, is chosen sufficiently small.
[]
The optimality properties of competitive allocations may extend beyond
Pareto optimality.
A coalition K C H blocks an allocation, x n, in an abstract exchange economy
if and only if there exists an allocation for K, x 'K = {x 'h E xh: h E K}, which is
feasible for K, EhC K x 'h = Zh~ K w h, and Pareto dominates x n for K, uh(x 'h) >I
uh(x h), for h E K, with some strict inequality. An allocation, x n, is in the core
of an abstract exchange economy if and only if it is feasible and it is not
blocked by any coalition. Evidently, a feasible allocation that is not Pareto
optimal cannot be in the core, since it is blocked by the coalition K = H.
In finite economies, under weak monotonicity, competitive equilibrium
allocations are in the core. Under stronger, convexity assumptions, the set of
core and competitive equilibrium allocations coincide in particular for large
economies obtained by replicating a given economy. Evidently, replication
does not augment the number of commodities in the economy, which is finite
[Debreu and Scarf (1963)].
It is a straightforward extension of Corollary 1 that, in an abstract exchange
economy in which a finite set of non-negligible individuals exists everywhere,
competitive equilibrium allocations are in the core. This follows from the finite
value of the aggregate endowment and hence of the endowment of any
coalition.
By a similar argument, a coalition of finitely many individuals can never
block a competitive equilibrium allocation.
In the absence of a finite set of non-negligible individuals, even if the
demographic structure is simple, the non-vanishing Gaussian curvature condition is satisfied and the divergence condition guarantees Pareto optimality,
competitive equilibrium allocations may fail to be in the core.
Evidently, in an economy of overlapping generations, competitive equilibrium allocations need not be in the core [Gale (1971)].
4. Aggregate revenue at equilibrium
In finite economies, it is impossible for markets to clear if the expenditures of

each individual is at least as high as the value of his initial endowment while for
some it is strictly higher; neither if the expenditure of each individual is at most
as high, while for some it is strictly lower. For economies of overlapping
generations this is not the case.
Revenue permits the value of the consumption bundle of an individual at
equilibrium to differ from the value of the initial endowment.
1938
The budget constraint in the individual optimization problem with revenue is

p x <~p w h +
for h E I-I
"l"h
where ~.h is the revenue of the individual. Revenue may be positive or

negative.
An allocation of the revenue is an array
~-H = {~.h: h ~ H )
such that ~_h= 0, for h ~ I - I F , where H F C I~l is a finite set. That revenue
vanishes for all but finitely many individuals, is only for simplicity. An
allocation of revenue is negative if 7 ( h ' t ) ~ 0 with some strict inequality, it is
positive if ~.h /> 0 with some strict inequality and it vanishes if ~.h = 0, for h E It.
A t an allocation of revenue ~.n, aggregate revenue is
T~
hGH
A redistribution is an allocation of revenue at which aggregate revenue

vanishes.
A competitive equilibrium with revenue is a triple ( p * , x *n, ~.,n) of prices,
an allocation of commodities and an allocation of revenue such that the
c o m m o d i t y bundle x *h solves the individual optimization problem at prices p*
and revenue r *h or, equivalently,
u h ( x ) > u h ( x *h) ~
p * x > p * w h + T *h ,
forxEX h
and
p * x *h = p * w h + 7 *h
for h E It
Theorem 6. In an abstract exchange economy, under A s s u m p t i o n 1, if at

( p , , x , n , ~.,n), a competitive equilibrium with revenue,
p*w ~ ~ ,
the allocation o f revenue "r*n is a redistribution.
Proof. Since p * x *h = p * w h < ~ for h E H / H F and p * x *h = p * w h q- "r*h for

h E I-IF, while p * w < ~, p ' x * = p * w + ~- < ~. Feasibility, however, implies that
p * x * = p * w and hence ~-= O.
[]
This generalizes a well-known argument for finite economies.
Theorem 7.
In an abstract exchange economy, under Assumptions 1 and 2, in
1939
particular if individual utilty functions are weakly monotonic, if the allocation of

initial endowments, w n = {wh: h E I-I} is Pareto optimal, and (p*, x *n, i-*n) is
a competitive equilibrium with revenue, the allocation of revenue 7 *n is not
positive.
Proof. We argue by contradiction. Suppose the allocation ~.,n is positive.
From the individual optimization problem it follows that uh(x *h) >~uh(wh),
with some strict inequality; the latter follows from the weak monotonicity of
the utility functions of the individual(s) with ~.,h > 0. But this contradicts the
Pareto optimality of the initial endowment allocation.
Theorem 8 [Burke (1988)]. In abstract exchange economy, under Assumptions 1-7, if every individual is endowed with at most finitely many commodities, for any array of scalars 0 u = {(oh): 0 4 0 t' < 1 for h E l l } there exists
( p . , x.H, ~.,n), a competitive equilibrium with revenue, such that
"r*h=--Ohp*wh <~o,
for(h,t) EIt.
Proof. Consider the increasing, convergent sequence of sets of commodities,

( L " : L " C L n+l, n = l , . . . ) ,
where L n = { 1 , . . . , n } ,
and the convergent, increasing sequence of finite sets of individuals, (tin: H " C H "+~, n = 1 , . . . ) ,
where I-I" = {1 . . . . . n}.
For n = 1 , . . . , the modified truncated economy E "n is obtained from the
modified, truncated economy E 'n defined in the proof of Theorem 1 by further
perturbing the endowments of individuals according to
W " " ' h = ( 1 - - O h ) w 'n'h,
forh@Hn/{n}
and
W "n'n z W tn'n -~-
Ohwtn'h
hClln/{n}
As in the proof of Theorem 1, the sequence of prices and allocations

(( ,6" ~, ~* n,,): n = 1 , . . . ) associated with the sequence of competitive equilibria
for the modified truncated economies converges to a pair of prices and an
allocation, (fi*, . n ) , for the economy E.
As in Corollary 1, since w h vanishes in all but finitely many components,
f i , y , h = (1 oh)fi*W h. Thus (fi*, , n , ~,) is a competitive equilibrium with
revenue, where, for h E H , ~ , h = __ohfi,W h 4 0 .
[]
-
Examples of economies in which competitive equilibria with positive allocations of revenue exist are well known. Revenue can then be interpreted as fiat
money that maintains a positive price at equilibrium.
1940
Note that a competitive equilibrium with positive revenue in an economy E

can be interpreted as a competitive equilibrium in an economy E' in which the
set of commodities is L' = L tO {0}, no individual desires commodity l = 0, the
endowment of individual h in commodity l = 0 is w h = r h >1 0 and the price of
commodity l - - 0 at equilibrium is Po = 1. The characterization of the conditions under which competitive equilibrium allocations are optimal in the
economy E', such as the divergence condition in Theorems 5a and 5b then
carry over to the economy E.
No unambiguous link can be established between the positive price of fiat
money at equilibrium and the optimality of competitive equilibrium allocations
[Cass, Okuno and Zilcha (1979)].
The situation is different when the competitive equilibrium allocation is
autarkic. In that case if it is also Pareto optimal there cannot be any monetary
equilibria. Conversely, if it is not Pareto optimal, then under fairly general
circumstances, there is almost surely a monetary equilibrium ]Brown and
Geanakoplos (1985)].
5. Stationary economies and cycles

In order t o study whether recursive patterns, symmetries, in the exogenous
structure of exchange economies of overlapping generations are inherited by
competitive equilibrium allocations, or other allocations of interest, it is
convenient, and possibly necessary, to consider economies with an elementary
temporal and demographic structure.
Definition 14. In an elementary exchange economy of overlapping generations, time extends infinitely into the future as well as into the past under
certainty, T_=~, one good is available each period, L, = {t} and the consumption as well as the endowment span of each individual is two, T ~h'= T(wh' =
{t, t + l } .
This is evidently very restrictive. It is important to note, however, that, by
L e m m a 3, an elementary exchange economy of overlapping generations is
equivalent to an economy with a simple demographic structure, in which time
extends infinitely into the future but not into the past.
At strictly positive commodity prices, p >>0, relative prices are denoted by
q = ( . . . . q, . . . . ), where
qt - p'+1
P,
for t E T
~,~
The domain of relative prices is Q = { q: q >>0}. Associated with relative prices

are real rates of interest r = ( . . . . r t . . . . ), where
1
rt=---1,
qt
1941
fort~T .... .
The periods of consumption and endowment of individuals allow us to write

an individual optimization problem as
max ~(h")(Z,, Z,+I) s.t.
zt+qtz,+~=O,
for(h,t) EH,
where tTCh")(Z,, Z,+1) = U(t'")(.. . , O, "w (h,,)

(h,,)
r + Z,, "wt+
I + Z~+I,0,...). The excess
demand correspondence of an individual is, z ~h'')= (zl h'*), zlh't)): Q,--~ Z (h''),
.~h.t) + Zt,.w,+
~h,t)
and
where
Z ~h'') = {(z, z2): ( . . . , O, w~
1 + z,+~, 0 , . . . ) E X (h'')
Qt = {q~: q~ > 0 ) . The aggregate excess demand correspondence of a generation is z' = E(h,O~n ' z (h't) : Qt----~Z', where Z' = E(h.t)~u, Z (ha).
Competitive equilibrium relative prices, q*, are such that
O ~ z , t - I ( q * ~ ) + z ,t ( q , * ) ,
fortCT_~.
Associated with competitive equilibrium relative prices, there is a competitive

equilibrium allocation, x , 1 t , such that, for (h, t) ~ H, z *Ch'') = (z;*(h''), z*lh")a
is
t+l
)'
a solution to the optimization problem of individual (h, t) at q~*.
Definition 15.
An exchange economy of overlapping generations under certainty (E, ~,~, (%, ~'u)), is stationary if and only if time extends infinitely into
the future as well as into the past, T t , t T _ ~ , for t E T _ ~ , L t - - L and
H t = H and the group, G, of symmetries of E is generated by the function
( f , g ) , where f ( l , t ) = f ( l , t + l )
and g ( h , t ) = g ( h , t + l ) ,
for (l,t) E L and
(h, t) E H.
=
In a stationary economy, individuals are identical up to the calendar time of

their birth. It is often possible to allow for intragenerational heterogeneity as
long as the aggregate behavior of generations coincides up to the calendar time
of their birth.
An economy in which time extends infinitely into the future but not into the
past is stationary if and only if it can be extended to a stationary economy.
In a stationary, elementary, exchange economy of overlapping generations,
we write
z : (zl, z2)
for the aggregate excess demand function of each generation. Competitive

equilibrium relative prices, q*, are such that
z,(q*l)+Zz(q~)=O,
fortCT
~=.
1942
Definition 16. A stationary elementary economy of overlapping generations

is well behaved if and only if the aggregate excess demand correspondence
is single valued, and hence a function, and continuous, and also
lim SUpq,__,~ Zl( qt ) = lim SUpq__,~ z2( qt ) = ~.
Recall that competitive equilibrium relative prices, q*, for a stationary,

elementary, exchange economy of overlapping generations, are a cycle of order
n if and only if the associated allocation is invariant to the subgroup, G n C_G,
generated by the maps (fn, g,), where f, (t) = t + n and g, (h, t) = (h, t + n),
but not under G m, for m < n. Steady-state equilibrium prices are a cycle of
order n = 1.
Evidently, the competitive equilibrium allocation association with competitive equilibrium relative prices, q*, in a stationary, elementary, exchange
economy of overlapping generations is invariant to the subgroup G, C G if
:g
.,~
q, = q , + , ,
fortET
~.
A n y elementary exchange economy of overlapping generations that is

stationary and well behaved indeed has steady-state equilibrium relative prices
q** = ( . . . . 1 , . . . ) ,
which we refer to as the Samuelson steady-state [Samuelson (1958)]. Thus, a
time-invariant real rate of interest, r,** = 0, is associated with a competitive
equilibrium independently of the time preference of individuals. This follows
from the budget constraints in the individual optimization problems and the
observation that, at a time invariant relative price of one, when aggregated
across the individuals who belong to each generation they coincide with the
aggregate feasibility constraint. When the definition of stationarity is modified
to allow for a time invariant rate of population growth, n, the real rate of
interest at the Samuelson steady-state is n.
In addition to the Samuelson steady-state, an elementary exchange economy
of overlapping generation that is stationary and well behaved has steady-state
relative prices #* = ( . . . . f i , . . . ) obtained as solution to the equation
z,(p)=O.
A solution to this equation exists in a well-behaved economy. The function
z l:I={p:p>0}--~R
is continuous, and l i m s u p p ~ z l p = ~ ,
while
lim infp~ 0 z~(p) < 0 since z~(p) + p z 2 ( p ) = 0 and lim supp_~0 z2(p) = ~. We
refer to these steady states as autarky since they eliminate trade across
generations. Evidently, autarky steady-states may be multiple; also, the
Samuelson steady-state may be autarky even though, in a sense that can be
made easily precise, typically this is not the case.
1943
In stationary economies with multiple commodities in each period, the

definitions and arguments for the existence of the Samuelson and autarky
steady-states extend easily [Kehoe and Levine (1985)].
For a stationary, elementary economy of overlapping generations there are
robust examples of cycles of order n, for every n [Benhabib and Day (1982),
Grandmont (1985)]; as Grandmont has argued, they can be interpreted as
endogenous business cycles.
This result is very suggestive. Note, however that under the assumptions of
Theorem 5a, which are standard, all cyclical equilibria, with the exception of
the autarky steady-states, are Pareto optimal, while the theory of macroeconomic business cycles is traditionally concerned with the welfare losses from
cyclical fluctuations; that cyclical behavior is not incompatible with optimality
is perhaps an important observation for macroeconomics. Furthermore, if the
definition of stationarity is extended to allow for economies with more than
one commodity per period, it is difficult to construct robust examples of cycles
of order 2. And of course, non-stationary economies of overlapping generations, even with one commodity per period typically have no cyclical equilibria
of any order. By contrast, the multiplicity of non-periodic equilibria that we
discuss in the next section, and the suboptimality that we discussed in Section 3
are robust properties of exchange economies of overlapping generations with
multiple commodities as well as intertemporal heterogeneity. The main contribution of the literature on cyclical equilibria is that it establishes the important,
suggestive principle that simple dynamic models can have very complex
dynamic behavior at equilibrium.
6. Indeterminacy
An economy displays indeterminacy if and only if it has an uncountable infinity
of distinct competitive equilibria. Competitive equilibria are distinct if and only
if the associated allocations are distinct.
Indeterminacy arises in exchange economies of overlapping generations.
And it may be robust to perturbations in the structure of the economy, the
utility functions and initial endowments of individuals.
Example 12.
Consider an elementary stationary exchange economy of overlapping generations. One individual is born each period, (1, t) = t. The utility
function of an individual is u t x t + ( l " /Ol)O
" ~ - ~ Xt+l,
~
a < l , and his initial
endowment is w' = ( . . . , 0, wt~= 1, wi+ 1 = e, 0 . . . . ), e >0. The excess demand
of individual t as a function of the relative price of the consumption good in the
t
t
two periods of life of the individual is z ' = ( Z l , Z z ) = ( q , e - 3 q 7 / ~ 1),
6q 1/~-I)- e). Competitive equilibrium relative prices are thus obtained as
=
1944
solutions to the nonlinear difference equation
qt-1
=e-q,e+6q~/('~-1)
for t ~ T
For e = 0, this reduces to

q,-l=q,
ot
fortET
~.
Evidently, for any ~ > O, there exists an equilibrium q * ( ~ ) with qo (q~) = ql;
solving explicitly, we obtain q*
q, ( q , ) = ~ ( 1 ~' ')
fort@T
Indeterminacy does not arise only in economies that extend infinitely into
the future as well as into the past. This is evident since, for L e m m a 1, an
e c o n o m y in which time extends infinitely into the future as well as into the past
is equivalent to an economy in which time extends infinitely into the future but
not into the past.
Example 13. Consider an economy in which time extends infinitely into the
future but not into the past. Two commodities are available each period, (l, t),
for l = 1, 2, and two individuals are born, (h, t), for h = 1, 2. The utility
function of individual (1, t ) i s u (1'') = X(l., ) + (1/a)6~-~x~.,+~), a < 1 , and his
initial endowment is w (1'') = ( . . . . 0, w} L') = (1, 0), wl~+'~) = (e, 0), 0 , . . . ) , e > 0 .
The utility function of individual (2, t) is u(2,,) = (1/a)6~-~x(2.0a _]..X(2,t+l) and
his initial endowment is w (2'') = (. .. ,0, wl e'') = (0, e), w(,+~)(2'= (0, 1), 0, .. .).
In addition, an individual, (3, 1) = 0, is born in the first period, whose utility
function is u = (1/oQ6"-lx(1.1
) " + x(2,1 ) and whose endowment is w = (Wl =
(e, 1 ) , 0 , . . . ) . That this economy has a continuum of equilibria and thus
displays indeterminacy follows by observing that it is equivalent to the elementary stationary economy in Example 12. It suffices to identify (2, t) with
commodity (1, 1 - t) and individual (2, t) with individual (1, 1 - t), for t@
T I ~ . For any k > 0, the prices defined by p(~,,)= k ( ~ - ) and Pi*2,o = k(~') are
indeed competitive equilibrium prices.
Theorem 9 [Geanakoplos and Polemarchakis (1982)]. In a well behaved,
stationary, elementary economy of overlapping generations such that z ( 1 ) # 0,
there exists a non-degenerate closed interval I * C (0, w) such that for qo ~ I*
there exists competitive equilibrium relative prices q*(cl0) with qo = ct0.
Proof. Without loss of generality we may suppose that z 1( 1 ) < 0 and hence
z2(1 ) > 0. Since lim SUpq_,~ z t = o, there exists ~ > 1 such that z ' ( 4 ) = 0. Since
the excess demand function is bounded below, there exist 1 > c~ > ~ such that
z 1( ~ ) = - a < 0 while z~(q) t> - a for q ~ Q. Since lim SUpq~0 z2 (q) = ~, there
1945
Ch. 35" Overlapping Generations
exists q > 1 such that z 2 ( ~ ) = a. Consider the set K = {(z 1, z 2 ) : - a ~< z~ ~<0,
0 ~< z 2 <~ a}. Observe that for fixed fl E [ - a , 0] there exists f~ ~ [0, o~] such
that (1, fz) E K and, similarly, for fixed Y2 E [0, a] there exists ~ E [ - a, 0]
such that ( f l , z2) ~ K - Let I = {q E (0, 1): z(q) E K } C ( 0 , 1). Since a < 0 , the
set I has non-empty interior.
Choose c~0~ I. Since z(q0) E K, - a ~< z~(el0) ~<0 while 0 ~< z 2(c~0) ~ a. Let
f2 = -z~(~0 ) and f l = - z 2 ( c l 0 ) . It follows that 0 ~ f z ~ < a and - a < ~ f , ~<0.
Hence there exist q ~ E I and q*_~EI such that z 2 ( q * _ ~ ) = f 2 = - f , and
z~(q~) = f~ = -f2(c~0). It follows that for qo = qo, z2(q*l) + z~(qo) = 0 and
z2(qo ) + z~(q~)=0 or, equivalently, the markets at t = 0 and t = 1 are at
equilibrium. Most importantly, since q~ E I and also q-*l E I there exist q2 E I
and q*_2EI such that the markets at t = - I
and t = 2 are in equilibrium.
Proceeding in this manner, we construct equilibrium relative prices q* with
qo = 40.
[]
Figure 35.1 illustrates the construction.
In stationary economies with L commodities per period, the degree of
indeterminacy, the dimension of an open set of distinct equilibrium allocations
generically does not exceed 2L - 1 [Brown and Geanakoplos (1982), Bona and
Santos (1989)]; or L - 1 if time extends infinitely into the future but not into
the past. Indeed, there is a method for constructing robust examples of
indeterminacy of any dimension 0 ~< d <~ L - 1, for stationary economies into
time T l ~ [Kehoe and Levine (1985)].
The proof of Theorem 9 conveys the idea that indeterminacy in economies of
z2
qo=qo
z1
Figure 35.1. The indeterminacy of competitive equilibria in stationary elementary exchange

economies of overlapping generations.
1946
overlapping generations can be understood as lack of market clearing at

infinity, " t = ---~".
7. Implications for macroeconomics

Keynesian macroeconomics is based in part on the fundamental idea that
changes in expectations or "animal spirits" can affect economic activity at
equilibrium, including the level of output and employment. It asserts, moreover, that publicly announced government policy also has predictable and
significant consequences for economic activity and that, therefore, the government should intervene actively in the market place if investor "optimism" is
not sufficient to maintain employment at an optimal level.
The Keynesian view of the indeterminacy of equilibrium and the efficacy of
public policy has met a long and steady resistance, culminating in the sharpest
attack of all, from the so-called new classicals, who have argued that the
methodological premises of individual optimization and market clearing, considered together with rational expectations, are logically inconsistent with
animal spirits and the non-neutrality of public monetary and bond-financed
fiscal policy.
The foundation of the new classical paradigm is the model of Arrow and
Debreu, in which it is typically possible to prove that competitive equilibrium
allocations are Pareto optimal; also determinate, the equilibrium set is finite.
The hypothesis of market clearing fixes the expectations of rational investors.
In that model, however, economic activity has a definite beginning and end.
Alternatively, economic activity may be better described as a process without a
definite and possibly without a definite beginning, as it is in the model of
overlapping generations of Allais and Samuelson. In a world without a definite
end, the possibility arises that what happens "today" is underdetermined
because it depends on what individuals "tomorrow" expect to happen the day
after tomorrow, etc.
Consider an economy of overlapping generations with a simple demographic
structure and one commodity per period. Net aggregate revenue in the
economy can be interpreted as fiat money whose initial stock, z = M, is held by
individuals in the first period of their life at t--1. Commodity prices are
P = (Pl . . . . . P t , . . . ) and the prices of money is 1 every period. Real balances
at t = 1 are thus M/pl. It is helpful to interpret the model as a simple
production economy. The endowment in the first period of an individual's life
can be thought of as labor, l,, that can be transformed into output, y,,
according to y, = l,. We can then think of any purchases of good by individual
in the second period of their life, the "old", as demand for real output to be
produced by those in the first period of their life, the "young". Individuals
1947
derive utility from leisure in their youth and consumption in their old age.
Notice that the quantity equation, p,y, = M holds for this economy at equilibrium with velocity equal to one.
The indeterminacy of equilibrium has the direct implication that optimistic
expectations, which are fulfilled, by themselves can cause the economy's output
to expand or contract. The Keynesian story of animal spirits causing economic
growth or decline can be told without involving irrationality or the failure of
market clearing.
In fact, the indeterminacy of equilibrium is especially striking when seen as a
response to public, yet unanticipated, policy changes. Suppose the economy is
in equilibrium p* when at time {the government undertake some expenditures,
financed either by the lump-sum taxation of the young or by printing money.
How should rational individuals respond? The environment has been changed
and there is no reason for them to anticipate (P~*1, P*+2. . . . ). Indeed, in
models with more than one commodity, there may be no equilibrium in the
new environment with p~+l = p~+~, P~+2 = Pg+2, etc. There is an ambiguity in
what can be rationally anticipated.
We argue that it is possible to explain the differences between Keynesian and
monetarist policy predictions by the assumptions each makes about expectational responses to policy and not by the supposed adherence of one to
optimization, market clearing and rational expectations and the supposed
denial by the other of all three.
Consider the government policy of printing a small amount of money, AM,
to be spend on its own consumption of real output or, equivalently, to be given
to the old generations at {= 1 to spend on its consumption. Imagine that
individuals are convinced that this policy is not inflationary, that p~ will remain
the equilibrium price level at the initial period of the new equilibrium. This will
give the old generation at t = 1 consumption level (M + A M ) / p ~ . As long as
AM is sufficiently small, and the equilibrium p* was one of the suboptimal
equilibria different from the Samuelson steady-state, there is indeed a new
equilibrium fi* with fi~ = P l . Output has risen by A m / p ~ and in fact the policy
may be Pareto improving. On the other hand, imagine individuals are convinced that the real interest rate, r I = ( p ~ / p ~ ) - 1, will remain unchanged. In
this case, price expectations are a function of Pl. Recalling the initial period
market-clearing equation, it is clear that prices rise proportionately to the
growth of the money stock. The result is "forced savings"; output is unchanged
and the generation old at t = 1 pays for the government's consumption.
This model is only a crude approximation of the differences between
Keynesian and monetarist assumptions about expectations and policy. Nevertheless it conveys the idea that when equilibrium prices are not locally unique
there is no natural assumption to make about how expectations are affected by
policy.
1948
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1950
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Chapter 36
EQUILIBRIUM ANALYSIS WITH N O N - C O N V E X

TECHNOLOGIES
DONALD J. BROWN*
Department of Economics, Stanford University
Contents
1. I n t r o d u c t i o n
2. E x i s t e n c e
3. L o c a l u n i q u e n e s s a n d c o m p u t a t i o n
4. O p t i m a l i t y
References
1964
1974
1984
1988
1992
*Support from the National Science Foundation, Deutsche Forschungsgemeinschaft and

Gottfried-Wilhelm-Leibniz-F6rderpreisis gratefully acknowledged. I would also like to thank the
participants of BoWo'89 and the members of the General Equilibrium Seminar at Stanford (1989)
for their helpful comments.
Handbook of Mathematical Economics, VolumeIV, Edited by W. Hildenbrand and H. Sonnenschein
1964
D.J. Brown
1. Introduction
Let us begin by briefly surveying the "state of the art" regarding the ArrowDebreu model of a Walrasian economy consisting of a finite number of agents
and commodities, where we assume perfect information, complete markets, no
market imperfections such as externalities, public goods, or non-convexities in
consumption or production, firms are price-taking profit maximizers and
households are price-taking utility maximizers. In such a world, the basic
properties of the classical Arrow-Debreu model consist of the existence of
competitive equilibria, the first and second welfare theorems, the computation
of equilibria and the local uniqueness and finiteness of equilibria.
For the purpose of this chapter it is useful to adopt Walras' original
conception of a competitive equilibrium as a solution to a (non-linear) system
of equations. There are two general methods for solving non-linear systems of
equations. The first method consists of converting the problem into an equivalent fixed point problem and then invoking the appropriate fixed-point theorem
such as Brouwer's fixed-point theorem or its generalization, the Kakutani
fixed-point theorem. This was the approach used by Gale (1955), Nikaido
(1956), McKenzie (1954) and Arrow and Debreu (1954) in the 1950s to
establish the existence of a competitive equilibrium. The convexity assumptions
in their models were crucial for the fixed-point arguments used in their proofs;
in particular, the assumption that firms' production sets are convex. Convexity
also appears to be crucial in the establishment of the second welfare theorem
where the principal tool of analysis is the separating hyperplane theorem; see
Arrow (1951) and Debreu (1951). The culmination of the research on the
existence and optimality of competitive equilibria during this period is Debreu's Theory of Value, published in 1959.
The existence proof in Theory of Value is non-constructive. The first
constructive proof of the existence of a competitive equilibrium was given by
Scarf (1967). Shortly thereafter, Scarf (1973) published his influential monograph, Computation of Economic Equilibria. Scarf's constructive proof first
consisted of giving an algorithm for computing an approximate fixed-point of a
continuous map of the simplex into itself. Following Debreu, he defined a
continuous map from the price simplex into itself, derived from the excess
market demand function for the given economy; the fixed points of this map
are the equilibrium prices. They are then computed using the algorithm.
Convexity plays an essential role in Scarf's analysis, both in the derivation of
the market excess demand function from optimizing behavior on the part of
agents and in the existence of a fixed-point which follows from Brouwer's
theorem. Scarf's algorithm and its generalizations are the primary means of
Ch. 36: Equilibrium Analysis with Non-Convex Technologies
1965
doing comparative statics in general equilibrium models. Computable general

equilibrium models have replaced activity analysis and input-output analysis as
the basic method of analysing tax policy in national economies or trade policies
between nations [see Scarf and Shoven (1984) or Shoven and Whalley (1984)].
In a seminal paper, Debreu (1970) introduced the techniques of differential
topology into equilibrium analysis to resolve the question of the uniqueness of
equilibrium prices in an exchange economy. Using Sard's theorem and the
inverse function theorem, he was able to show that almost all exchange
economies- parameterized by individual endowments- have a finite number
of locally unique equilibrium prices. In addition to the standard convexity
assumptions on tastes, we now require that agents' characteristics are smooth
[see Debreu (1972)]. Debreu's paper on the finiteness and local uniqueness of
equilibrium prices inspired a number of other applications of differential
topology to problems of equilibrium analysis.
First, Dierker (1972) gave a degree-theoretic existence proof, using index
theory. Then in a series of papers published in the Journal o f Mathematical
Economics over a two year period from 1974 to 1976, Smale used the methods
of global analysis to establish all the properties of the Arrow-Debreu model of
a Walrasian economy, i.e. existence, optimality, computation, local uniqueness
and finiteness of the set of equilibrium prices. He assumed that both households and firms have smooth characteristics, i.e. smooth utility and production
functions. Smale's research on existence and optimality differs in a fundamental way from previous work in that he eschews fixed point methods and
resurrects the discredited method of counting equations and unknowns, originally used by Walras in his "proof" of existence. This technique properly
formulated within the theory of global analysis (differential topology) is a
powerful tool for analysing the existence and uniqueness of solutions of
non-linear systems of equations. In particular, we have in mind degree theory
as our second method for proving the existence of a competitive equilibrium
and for "counting" the number of equilibria.
For expositional reasons, we wish to distinguish between fixed-point arguments requiring convexity and degree-theoretic proofs which do not assume
convexity.
Smale defines extended price equilibria as a solution to a system of equations
consisting of the first-order conditions for profit maximization, the first-order
conditions for utility maximization subject to a budget constraint and the
market clearing conditions. Moreover, he assumes neither convexity of the
utility or production functions and shows that for an open, dense family of
economies- parameterized by endowments, utility functions and production
functions - the set of extended price equilibria is locally unique [see Sections 5
and 6 in Smale (1974a)] and is finite if the set of attainable allocations is
compact. Smale's results appear to have gone unnoticed by those working on
1966
D.J. Brown
the properties of general equilibrium models with non-convex production sets.

Although he does not prove the existence of extended price equilibria in this
paper, in an earlier paper on pure exchange - where again he does not assume
convexity of utility functions- he shows that extended price equilibria exist,
and presumably this proof can be extended to the case with production. It is
interesting to notice that his proof for the pure exchange case rests on a
degree-theoretic argument [see the appendix to Smale (1974b)]. Also by
restricting utility functions to be convex, but only requiring production sets to
be submanifolds, Smale gives a first-order characterization of Pareto optimal
allocations in terms of marginal cost pricing [see Proposition 2, Section 4, in
Smale (1976a)].
An important application of degree theory to equilibrium analysis is the use
of the homotopy invariance theorem as a means of proving constructive
existence theorems. Homotopy methods for solving fixed-point problems were
introduced by Eaves (1972) and are the basis for the second generation of Scarf
algorithms. The homotopy methods for solving non-linear systems of equations
do not transform the given non-linear system of equations into an equivalent
fixed-point problem, instead they construct a simple system of equations which
are trivial to solve and continuously deform this simple system into the given
system. By following the solution of this parameterized family of equation
systems, one is led to the solution of the original system of equations. The
homotopy invariance theorem states that (under certain conditions) if the
simple system has an odd number of solutions then the original system, which
is homotopically equivalent, also has an odd number of solutions. For a general
discussion of homotopy or path following methods for solving non-linear
systems of equations or equilibrium systems of equations for economic models,
see Garcia and Zangwill (1981).
Having completed our survey of the basic properties of the Arrow-Debreu
model of a Walrasian economy, we now turn to the central topic of this
chapter: the normative implications of non-convex production sets on the firm's
pricing policy. Non-convexities in production can arise from indivisibilities,
fixed costs or increasing returns to scale.
The non-convex firms in the model that we shall consider can be thought of
as privately owned public utilities, which are regulated. This type of market
structure is common in the United States but less prevalent in Europe, for
example, Electricit6 de France is a state-owned public utility. Since we discuss
public utilities which are privately owned, any pricing rule imposed by the
regulator must produce a fair rate of return on capital or normal economic
profits. Consequently these firms cannot run at a loss; see Brown and Sibley
(1986) for a partial equilibrium analysis of public utility pricing. The origins of
the pricing rules that we shall study for regulated public utilities may be found
in the marginal cost pricing controversy of the 1930s.
1967
This controversy begins with Hotelling's classic article on optimal railroad

and utility rates [see Hotelling (1938)]. He argues that marginal cost pricing
together with income taxes is Pareto superior to average cost pricing. This
controversy and its welfare antecedents are ably surveyed and analysed by
Ruggles (1949) and (1950) in two companion pieces. As Ruggles points out in
her second paper, the basis of the marginal cost pricing principle is that
marginal cost pricing meets the marginal conditions for Pareto optimality; see
the summary and evaluation section of her article. Ruggles then asks the
following two questions: (1) Is meeting the marginal conditions a sufficient
basis for recommending a pricing system? and (2) Does the marginal cost
pricing system meet these conditions?
She observes that the first-order conditions are only necessary conditions for
a maximum of welfare and that the marginal cost pricing principle does not
meet these conditions if the means for raising the subsidies necessary to cover
the losses incurred by firms, with decreasing average cost technologies, are
taken into account. This criticism applies in particular to Hotelling who
advocated income taxes as a superior alternative to excise taxes in raising the
necessary subsidies, but, as Ruggles points out, Wald had demonstrated that
income taxes are an excise tax on leisure, hence they are not lump sum taxes,
as Hotelling suggested. Moreover, Wald (1945) shows in some instances,
depending on the relevant elasticities, income taxes are inferior to other excise
taxes for raising the necessary revenue.
Finally, Ruggles considers other pricing principles such as average cost
pricing, multi-part pricing or two-part tariffs and price discrimination, all of
which have been suggested as alternative pricing systems because of the need
to raise revenue to cover the losses incurred by marginal cost pricing in
decreasing average cost firms. In the remainder of this chapter we will discuss
the existence, optimality, computation, finiteness and local uniqueness of
equilibria for three representative pricing rules, for privately owned regulated
public monopolies, in a general equilibrium model. We have chosen as our
representative pricing rules, marginal cost pricing, average cost pricing and
two-part tariffs. Not only are these pricing policies the subject of much
normative discussion in the public utilities literature, but they are also the most
commonly observed instances of regulatory pricing policy. Before discussing
explicit models, let us survey what we know about these various pricing rules.
The major methodological innovation in the general equilibrium analysis of
firms with pricing rules has been the introduction of the methods of nonsmooth analysis, as an alternative to both global analysis (differential topology)
and to convex analysis, for investigating the existence and optimality of
equilibria. These methods were introduced by Guesnerie (1975) in a seminal
paper on Pareto optimality in general equilibrium models with non-convex
production sets.
1968
D.J. Brown
N o n - s m o o t h analysis extends the local approximation of manifolds by

tangent planes, and the analogous local approximation of convex sets by
tangent cones to sets which are neither s m o o t h nor convex. H e r e the local
approximation is also by cones; in the case of Guesnerie, it is the cone of
interior displacements [see Dubovickii and Miljutin (1965)]. Subsequently
Cornet (1982) introduced Clarke's tangent cone as the appropriate local
approximation for economic analysis. To appreciate Cornet's contribution, we
must consider the polar cones of these generalized tangent cones, called
normal cones. The normal cone to a point on the boundary of a production set
represents the marginal rates of transformation at that point. In n o n - s m o o t h
analysis, the normal cone is a formal extension of the notion of normal vector
to a hypersurface and the notion of cone of normals to a convex set. The
Clarke normal cone has a n u m b e r of desirable properties. First, its polar cone,
the Clarke tangent cone, is always convex; second, if the production set is
n o n - e m p t y , closed and has free disposal, then the Clarke normal cone is always
n o n - e m p t y and closed [see Cornet (1982)]. Finally, Clarke has shown that if a
price vector maximizes profits at an efficient production plan then this price
vector must lie in the (Clarke) normal cone at that point. H e n c e in the recent
economic literature the Clarke normal cone is used to describe the necessary
marginal conditions for profit maximization. For a detailed discussion of
n o n - s m o o t h analysis, see Clarke (1983) or Rockafellar (1981).
In contrast, the cone of interior displacements need not be convex at "kinks"
(Figure 36.!), hence Guesnerie was forced to exclude this family of technologies f r o m his analysis. M o r e o v e r , when the normal cone of Dubovickii and
Miljutin is convex, closed and u p p e r hemi-continuous, as assumed in Beato
Output
\
Input
Figure 36.1. The cones of interior displacements at the production plans (a) and (c) are convex,
e.g. at (a) it is the cone generated by the vectors ad and ab shifted to the origin. But at the "kink",
production plan (b), it is the whole production set, which is not convex.
1969
(1982), then it coincides with the Clarke normal cone [see Cornet (1987)]. It is
the convexity of the tangent cones, which replaces the convexity of the
production sets, that is crucial for equilibrium analysis. See Khan and Vohra
(1987b) for additional discussion of the cone of interior displacements and the
Clarke tangent cone in economic models.
Using the normal cone of Dubovickii and Miljutin and focusing only on cases
where it is non-empty and convex, Guesnerie was the first to extend Smale's
necessary conditions for Pareto optimal allocations from economies with
smooth non-convex production sets to those with non-smooth production sets.
His welfare analysis has recently been extended to models with non-convex
technologies and pure public goods in a paper by Khan and Vohra (1987b); see
also the extension of Guesnerie's model to infinite dimensional commodity
spaces by Bonnisseau and Cornet (1988b). Both papers use the Clarke normal
cone. Guesnerie also presented the first examples of general equilibrium
models with non-convex production sets where all of the marginal cost pricing
equilibria fail to be Pareto optimal.
Subsequently, other examples were given by Brown and Heal (1979). The
intuition underlying all of these examples is clear. As illustrated by Brown and
Heal, if the aggregate production set is non-convex then the community
indifference curve defined by a marginal cost pricing equilibrium may "cut
inside the production possibility set" (see Figure 36.2). Simply put, satisfying
first-order conditions, in general, will not suffice for global optimality in the
presence of non-convexities-a point already made by Ruggles in 1950.
Continuing our discussion of the optimality of marginal cost pricing, Beato and
Mas-Colell (1983) in an influential paper presented the first example of
\
Good 2
'~A ~
P ~ i b ~
Community
"*' Indiff:rence
Good1
Figure 36.2. The community indifference curve which is tangent to the production possibility
frontier at the production plan A "cuts inside the production possibility set."
1970
D.J. Brown
marginal cost pricing equilibria which were inefficient, i.e. inside the social
production possibility set. Dierker (1986) and Quinzii (1991) have both given
sufficient conditions for a marginal cost pricing equilibrium to be Pareto
optimal. Their conditions are in terms of the relative curvature of the social
indifference curve, at equilibrium, with respect to the boundary of the aggregate production possibility set, i.e. the social indifference curve does not "cut
inside" the aggregate production possibility set.
Returning to Guesnerie's paper, we can interpret his fixed structure of
revenues condition, in a private ownership economy, as a means of imposing
lump sum taxes to cover losses incurred by marginal cost pricing, without
disturbing the marginal conditions for Pareto optimality. In the A r r o w - D e b r e u
model of a private ownership economy, the shareholdings of households are
exogenously specified and carry limited liability. Of course, in the classical
model, all firms are profit maximizers with convex technologies containing the
zero vector. Hence profits are always non-negative and the assumption of
limited liability is unnecessary. With non-convex production sets and firms
regulated to satisfy the first-order conditions for profit maximization- the
modern formulation of the marginal cost pricing principle - the assumption of
unlimited liability is of some import. By dropping the assumption of limited
liability, fixing the income distribution exogenously by giving each agent a fixed
proportion of net social wealth (the fixed structure of revenues condition), and
assuming positivity of net social wealth, we can cover all losses and maintain
the first-order conditions for optimality.
Brown and Heal (1983), by assuming both a fixed structure of revenues and
homothetic preferences, prove the existence of at least one Pareto optimal
marginal cost pricing equilibrium. Their result is an immediate consequence of
Eisenberg's aggregation theorem. The existence of at least one Pareto optimal
marginal cost pricing equilibrium for a much larger class of economies follows
from Jerison (1984), where he gives necessary and sufficient conditions for
aggregation of preferences, if the income distribution is independent of prices,
e.g. a fixed structure of revenues.
We now give a formal definition of a marginal cost pricing equilibrium. A
marginal cost pricing equilibrium (MCP equilibrium) is a family of consumption plans, production plans, lump sum taxes and prices such that households
are maximizing utility subject to their budget constraints and firms' production
plans satisfy the first-order conditions for profit maximization, i.e. at the given
production plans the market prices lie in the Clarke normal cones; lump sum
taxes cover the losses of all firms with non-convex production sets; and all
markets clear. It is important to point out that if all firms have convex
technologies which include the zero vector, then the notion of a MCP
equilibrium reduces to the notion of a Walrasian equilibrium in the classical
A r r o w - D e b r e u model. The first existence proof of a MCP equilibrium for a
1971
private ownership economy with a single firm with a non-smooth technology

was given by Cornet (1982). His theorem was extended by Brown, Heal, Khan
and Vohra (1986) to private ownership economies with a single non-convex
firm and several convex firms. Independently, Beato and Mas-Colell (1985)
proved existence for a private ownership economy with several non-convex
firms and several convex firms. Both the theorems of Beato and Mas-Colell
and Brown, Heal, Khan and Vohra are special cases of the Bonnisseau-Cornet
existence theorem which is discussed in the next section. Khan and Vohra
(1987a) have recently extended the notion of a MCP equilibrium, where the
price system consists of marginal cost pricing and Lindahl prices to non-convex
economies with public goods.
All of these theorems are proven by invoking the Brouwer or Kakutani
fixed-point theorems and rely on assumptions which guarantee that the relevant portion of each firm's efficiency frontier is homeomorphic to the simplex.
This fact was first exploited in proving the existence of marginal cost pricing
equilibria in economies with a single firm by Mantel (1979) and independently
by Beato (1982), where the firm's technology is a smooth hypersurface. For
smooth technologies, the Clarke normal cone at a point reduces to scalar
multiples of the normal vector. Later, Brown and Heal (1982) gave an
index-theoretic proof of existence for Mantel's model, using the fixed-point
index theorem introduced by Dierker (1972). Their theorem is a special case of
Kamiya's general equilibrium existence theorem which he proves using a
degree-theoretic argument, reminiscent of Smale's existence proof for extended price equilibria for smooth exchange economies. Kamiya's proof has a
number of important implications, such as local uniqueness and computational
algorithms, and his theorem is discussed in Section 3.
There is another family of existence theorems for economies where commodities are divided into the classical dichotomy of factors and products. The
most important, for the purposes of this chapter, is MacKinnon's article
(1979), in which he gives the first extension of Scarf's computational algorithm
to general equilibrium models with non-convex production sets. Also see
the non-constructive existence proof of Dierker, Guesnerie and Neuefeind
(1985).
Hence we now have the beginnings of a significant literature on marginal
cost pricing equilibria that extends the equilibrium analysis of the classical
Arrow-Debreu model in terms of existence, optimality, computation, finiteness and local uniqueness to general equilibrium models with non-convex
production sets.
As with marginal cost pricing, the modern literature on average cost pricing
begins with a seminal article on optimality. We have in mind Boiteux's paper
on second best Pareto optimality for public utilities. Boiteux (1956) derives the
necessary conditions for Pareto optimality in a general equilibrium model,
1972
D.J. Brown
where firms with increasing returns are constrained to break even. Prices
solving these first-order conditions are now called Boiteux-Ramsey prices,
since Ramsey (1927) derived similar conditions for a single agent economy.
The optimal excise taxes which result from Boiteux-Ramsey pricing have the
intuitive property, for independent demands, that the taxes are inversely
proportional to the elasticities of demand, e.g. inelastic demands are highly
taxed - a result anticipated by Ruggles in her discussion of price discrimination
as an alternative to marginal cost pricing. Existence of a Boiteux-Ramsey
pricing equilibrium was first demonstrated by Dierker, Guesnerie and
Neuefeind (1985) in a model with factor and product markets and non-convex
technologies. Of course, a Boiteux-Ramsey pricing equilibrium only satisfies
the first-order conditions necessary for second best Pareto optimality; analogous to marginal cost pricing equilibria satisfying the first-order conditions
necessary for Pareto optimality. Dierker (1989) has extended his analysis of
sufficient conditions for a marginal cost pricing equilibrium to be Pareto
optimal to include sufficient conditions for a Boiteux-Ramsey pricing equilibrium to be second best Pareto optimal.
An average cost pricing equilibrium, ACP equilibrium, is formally defined as
a family of consumption plans, production plans and prices such that households are maximizing utility subject to budget constraints, firms with convex
technologies are maximizing profits, firms with non-convex technologies are
breaking even, i.e. making zero profits; and all markets clear. The existence of
average cost pricing equilibria follows from both Kamiya's theorem and the
existence theorem of Bonnisseau-Cornet. The conventional wisdom is that
average cost pricing equilibria, since they violate the first-order conditions
necessary for Pareto optimality, are Pareto inferior to marginal cost pricing
equilibria. This intuition is challenged in an important paper by Vohra (1988a),
in which he gives examples of economies possessing second best average cost
pricing equilibria that are Pareto superior to marginal cost pricing equilibria.
Of course, this could only be true in an economy with non-convex production
sets, where marginal cost pricing equilibria may not be Pareto optimal.
Kamiya's constructive existence proof provides an algorithm for computing
marginal cost pricing equilibria and average cost pricing equilibria for general
non-convex technologies. Rutherford (1988) also has constructed computable
general equilibrium models with increasing returns to scale, that compute MCP
and ACP equilibria, for economies where the utility and production functions
can be represented as members of a "nested" family of CES functions.
Both marginal cost pricing and average cost pricing are linear pricing rules,
but in markets where resale is impossible, non-linear prices are a viable
alternative to linear pricing systems. Non-linear pricing schemes abound, e.g.
quantity discounts, bundling of commodities and multipart tariffs, see Phlips
for a discussion (1983). In his important contribution to the marginal cost
1973
pricing controversy, Coase (1946) proposed discriminating two-part tariffs as a

means of covering individual specific overhead costs.
There is an extensive partial equilibrium literature on two-part tariffs [see Oi
(1971), Brown and Sibley (1986) and their references]. This literature suggests
that if firms with decreasing average costs use a discriminating two-part tariff,
where each potential customer is charged a "hook-up" fee for the right to
consume the natural monopoly's output (this fee may differ from household to
household) and a per unit charge equal to the marginal cost of production,
then the resulting equilibrium is Pareto optimal. If we formally define a
discriminating (or non-uniform) two-part marginal cost pricing equilibrium
(TPMCP equilibrium) as a family of consumption plans, production plans,
prices and hook-up fees such that households are maximizing utility subject to
their non-convex budget sets, defined by prices and their hook-up charge; firms
with convex technologies are marginal cost pricing; firms with non-convex
technologies are marginal cost pricing and recovering any losses by charging
non-uniform hook-up fees, thus making zero profits, then Vohra (1988b) has
shown the partial equilibrium intuition concerning the optimality of discriminating two-part tariffs fails in general equilibrium models, in the sense
that the first welfare theorem does not hold even for discriminating two-part
marginal cost pricing equilibria. Quinzii (1991), in the first general equilibrium
discussion of the optimality of two-part marginal cost pricing, demonstrates
that the second welfare theorem fails for this equilibrium notion, if there is
insufficient willingness to pay on the part of consumers. It is clear that the work
of Dierker and Quinzii on sufficient conditions for optimality of a MCP
equilibrium also provides sufficient conditions for a TPMCP equilibrium to be
Pareto optimal.
Existence of a non-uniform two-part marginal cost pricing equilibrium has
recently been established by Brown, Heller and Starr (1989), using the model
of Beato and Mas-Colell (1985). The basic assumption in the Brown-HellerStarr paper is that the aggregate willingness to pay, in equilibrium, exceeds the
losses incurred by pricing the monopoly good at marginal cost. They also show
that any Pareto optimal allocation, where the aggregate willingness to pay
exceeds the losses incurred by pricing the monopoly good at marginal cost, can
be supported as a two-part marginal cost pricing equilibrium. There are no
algorithms for computing two-part marginal cost pricing equilibria, to our
knowledge, nor are there any results on finiteness or local uniqueness of
equilibria.
The existence of equilibria for linear pricing rules other than marginal or
average cost pricing is discussed in a recent special issue on increasing returns
edited by Cornet (1988). In particular, we recommend Cornet's introductory
essay which is a survey of the general equilibrium literature on increasing
returns. This completes the introduction and in the next two sections we shall
1974
D.J. Brown
discuss in detail the existence, computation, finiteness and local uniqueness of

MCP, ACP and TPMCP equilibria. The optimality of marginal cost pricing is
the subject of the final section of this chapter.
2. Existence
One of the first proofs of existence of a MCP equilibrium is due to Mantel

(1979) [see also Beato (1982)]. Mantel considers a private ownership economy
with l goods, m consumers and a single firm. The production set, Y, of the firm
is a subset of ~ t. The firm's pricing rule ~ is a mapping from a Y, the boundary
of Y , into the price simple of 9~t, denoted S. The consumption set X; of the ith
consumer is the positive orthant ~ 1+. Each consumer has a utility function Ui,
an endowment vector toi and a share 0,. in the firm. Given a production plan y
of the firm and market prices p E S, then the income of household i is
ri( p , Y) = P" toi + Oip " Y.
Mantel makes the following assumptions.

(A1) For all i:
(i) U~ is continuous, strictly quasi-concave and locally non-satiated;
( i i ) toi ~- 0/(.o , where t o E ~ + + and 0~>0, E?= 1 0i=1.
(A2) (i) Y is closed, 0 E Y, Y - 9~( C Y (free disposal);
(ii) Y is a smooth hypersurface of 9~ t, i.e. there exists a smooth function, f,
from 9~ t into 9~ such that Y = {x E ~ t I f ( x ) ~<0}, 0 is a regular value o f f , and
OY=f-l(o);
(iii) for all y C O Y , ~ ( y ) =Vf(y)/llVf(y)[[1 where Vf(y) is the gradient o f f at

y and I1" II1 is the ll-norm;
(iv) if Y = ( Y + to)N ~ + and y + t o E O Y then O ( y ) E ~t++;
(v) I~ is bounded.
Before proving the existence of a MCP equilibrium, let us discuss these
assumptions. Al(i) is standard and guarantees the existence of demand
functions, given strictly positive prices and positive income. Al(ii) implies
Guesnerie's fixed structure of revenues condition, i.e. r i ( p , y) = p (.oi -[- Oip"
y = 0~p-(y + to). A2(i) is also standard, but notice that we do not assume
convexity of Y. A2(ii) and (iii) define the marginal cost pricing rule for a firm
with a smooth technology. A2(iv) can be weakened to O(y) ~ ~ t+ [see Brown
and Heal (1982)]. A2(v), in this model, is equivalent to assuming that the set of
feasible allocations is compact.
The two central ideas in Mantel's proofs are the basis of most of the
subsequent existence proofs of equilibria in economies with non-convex technologies where firms follow pricing rules. The first idea is that a I," is
homeomorphic to the simplex, S. The second idea is to use this homeomorphism to construct a continuous map of a Y into a Y whose fixed-points are the
1975
desired equilibria. We now give Mantel's existence proof for a MCP equilibrium, where the lump sum taxation to cover the losses of the firm is implicit in
the formulation of the budget constraint, i.e. ri(p, y) = O~p (y + to) should be
interpreted as "after-tax" income.
Given assumption A1 and A2 there exists a MCP

equilibrium, i.e. there exist consumption plans x~, a production plan y and
marginal cost prices p such that each consumer is maximizing his~her utility at x i
subject to his~her budget constraint; p =Vf(y)/llVf(y)lll and ~im=lXi = y + t o .
Theorem 1 [Mantel (1979)].
Proof. That 0Y is homeomorphic to the simplex is obvious from Figure 36.3,

where the homeomorphism is simply the intersection of a ray through the
origin and the given y E ]? with the simplex S. Given y such that y + to E Y, let
p = ~O(y). Then for each i, x~(p, y), the demand of household i at prices p and
given production plan y, is well defined since p E ~t++ and r~(p, y ) > O.
The aggregate demand, x(p, y), is Elm1 Xi( p, y) and x ( p , y) E ~t+. Denote
by 2(p, y) the projection of x(p, y) onto 0~" through the origin, i.e. 2(p, y) is
the intersection of the ray through the origin and x(p, y) with 0~'. We now
define the continuous map F : 0 ~'--> 0 Y which is a composition of these maps,
i.e. F ( y + to) = 2(p, y). By Brouwer's fixed-point theorem, F has a fixed-point
37 + to. By construction, we need only show that x(fi, 37)= 37 + to, where
,5= qJ(37), to complete the proof. Since F(37 + to)= 37 + to, we know that
~(fi, 37)=37 + to. Moreover, ~(fi, 37)= yx(fi, 37) for some positive scalar 7.
Hence 7x(/~, 37) = fi + to, but by Walras' law/~, x(/5, 37) = ~iml p" xi(P, 37)
~,iml ri(p, 37) = ~,iml OiP" (y d- to) =/t)" (y -1-to). Therefore, 3' = 1, completing
the proof.
~--
Possibility Frontier
.oduction
/'* Y ~
Good 2
fl j
Y2
,'
,, . ,,,
..'<y'2
N%------Simplex
Good 1
Figure 36.3. The images of the efficient production plans y~ and Y2 under the homeomorphism
between the production possibility frontier and the simplex are the points y~ and Y2.
1976
D.J. Brown
We next prove the existence of an ACP equilibrium in Mantel's model. For

each y E 0 Y, we define the average cost pricing correspondence AC(~) = { p E
S I P" Y = 0}. We will need the additional assumption that 0 Y n ( - ~ +) = {0}.
The following lemma is due to Kamiya.
Lemma 1 [Kamiya (1988a, Lemma 12)]. IfA2(i) holds, then AC : OY---~ S is a
lower hemi-continuous correspondence with non-empty, closed convex values
for all y E c~Y\{0}.
Following Kamiya (1988a, Lemma 13), we can invoke the Michael selection
theorem, given our assumption that 0 Y is smooth at the origin, to prove the
existence of a continuous function p:OI"--~ S such that if y + oJ E 01, y ~ 0
then p ( y ) E AC(y). See Hildenbrand and Kirman (1989), Appendix IV, for a
discussion of the Michael selection theorem. Given the selection p, we now
assume that the underlying exchange economy is a regular exchange economy,
hence has only a finite number of locally unique equilibrium prices, which are
smooth functions of the individual endowments. Then, generically, p(0) is not
an equilibrium price for the underlying exchange economy. A non-trivial ACP
equilibrium is defined as an ACP equilibrium where the equilibrium production
plan is not the zero vector.
Theorem 2. Given assumptions A1 and A2, if O Y N ( _ ~ l + ) = {0}, w E ~1++
and Y N ~ = {0}, then generically there exists a non-trivial A C P equilibrium,
i.e. consumption plans xi, a production plan y and average cost prices p such
that each consumer is maximizing his~her utility at xi subject to his~her budget
m
constraint, p y = 0 and E~=
1 x~ = y + w.
The argument is exactly the same as in the proof of Theorem 1 with
the marginal cost pricing rule ~0(y) = Vf(y)/llVf(y)lll replaced by the average
cost pricing rule p(y). The no free lunch assumption, Y n ~l+ = {0}, guarantees that p(y) ~ 0. Since generically p(0) is not an equilibrium price vector, we
see that the equilibrium production plan y ~ 0.
Proof.
If there are several non-convex technologies in the economy then a different

construction is needed to formulate equivalent fixed-point problems for proving the existence of MCP or ACP equilibria. The first such argument, for MCP
equilibria, is due to Beato and Mas-Colell (1985). The intuition underlying
their proof is easily explained. Suppose the boundary of the attainable set for
each firm is contained in the interior of a compact set, and the boundary of the
firm's attainable production set is homeomorphic to the simplex. Also suppose
that each firm's boundary is smooth, hence the marginal cost pricing rule is
simply the function mapping an efficient production plan into the normalized
1977
marginal rates of transformation. Now imagine an auctioneer who announces

both market prices and an efficient production plan for each firm. Consumers
respond to prices with their utility maximizing consumption plans; and firms
respond to demand with their marginal cost prices, i.e. normalized marginal
rates of transformation. In this story households are quantity-setting pricetakers and firms are price-setting quantity-takers. The auctioneer uses the
excess demand to adjust the market prices, which are then normalized to the
price simplex, and uses the announced marginal cost prices of the firms to
adjust the production plans that are then normalized to their respective
simplices, which are homeomorphic to the relevant portions of the boundaries
of the production sets. This process defines a continuous map of the (n + 1)fold product of the simplex into itself- there are n firms in the economy - and
hence has a fixed-point by Brouwer's fixed-point theorem. This fixed-point is
shown to be a free-disposal marginal cost pricing equilibrium, by the usual
arguments. Of course, for a single firm economy this argument reduces to that
of Mantel.
The model of Beato and Mas-Colell is given next along with their existence
proof for marginal cost pricing equilibria. The consumption side of their model
is represented in reduced form, i.e. aggregate market demand is represented as
a continuous function of market prices p, and production plans y =
(Yl,...,
Y , ) into ~l+, that satisfies Walras' law when aggregate wealth is
non-negative. Hence they implicitly assume that every consumption set is a
subset of ~t t+. There are n firms in the model characterized by production sets
Yj and pricing rules gj:OY~.---~ S, where each gj is a correspondence. Let
a Y = 0 Y1 x x a Y , , then a pair (y, p) ~ 0 Y x S is a production equilibrium
if yj E OYj and p E g j ( y j ) , for all j. It is a feasible production equilibrium if
~1=1 Yj ~>0. If ( y, p) E OY x S, then define M ( y, p ) = p . ~in=l Y i" We are now
ready to state their three basic assumptions.
(H1) For all j:
(i) Y] = K i - ~t+, where K~ is compact;
(ii) let e = (1, 1 , . . . , 1) then 3 r > 0 s.t. Kj is in the interior of [{-re} +
t+], where r > 0.
(H2) For all j:
(i) gj is upper hemi-continuous and convex-valued;
(ii) if Yjh < - r and p E g j ( y j ) then Ph = 0 (see Figure 36.4).
(H3) At every production equilibrium (y, p), M(y, p) > 0.
The reader should think of the Kj as the attainable production set of firm j.
Also Beato and Mas-Colell have embedded the social endowment into the
production sets. It is H1 that allows them to assume 0Y~ f-I [{-re} + ~t+] is
homeomorphic to the simplex, S. Again, see Figure 36.4. The interpretation of
H2 is that gj is the marginal cost pricing rule for a non-smooth production set.
Bonnisseau and Cornet (1988a) have shown in their Lemma 4.2(c) that if gj is
1978
D.J. Brown
gJiY)J
~(Yj)
i Kj ~/-'
.
gj(yj)
(yj)
--
Figure 36.4.
defined by the Clarke normal cone and Hl(i) holds, then the boundary
condition H2(ii) is satisfied. Unfortunately, this boundary condition need not
hold for the average cost pricing correspondence. Hence the Beato and
Mas-Colell model does not readily extend to this case. H3 is the important
survival assumption and implies that at equilibrium the profits of the competitive sector, i.e. profit maximizing firms with convex technologies, plus the
value of the social endowment exceeds the aggregate losses incurred by firms
with decreasing average costs, i.e. firms with non-convex technologies, who
price at marginal cost. The importance of H3 is underscored by an example of
Kamiya (1988b) with three goods, two firms, and an arbitrary number of
consumers where the survival assumption does not hold and a marginal cost
pricing equilibrium does not exist.
Formally the consumption side of their model is given by a continuous
function f :OY S---~l+, where p. f(y, p) = M(y, p) whenever M(y, p)>~
O.
A free-disposal equilibrium in the Beato-Mas-Colell model is a pair
(y, p ) E OY S such that (y, p) is a production equilibrium, f(y, p)<23= 1 yj; and p . f(y, p ) = p "/=1 Yj, i.e. goods in excess supply have zero
price.
Theorem 3 [Beato and Mas-Colell (1985)].
H3, a free-disposal equilibrium exists.
Given assumptions H1, H2 and
1979
Proof. Let ~Tj be the homeomorphism of the simplex S onto aYj A [{-re} +
i+] for each j. Unlike in the Mantel model, 0 Yj need not be smooth. Hence gj
is a correspondence. Moreover, gj need not be lower hemi-continuous and
therefore we cannot invoke the Michael's selection theorem, as did Kamiya for
the average cost pricing correspondence. Instead Beato and Mas-Colell rely on
the clever trick of using Cellina's theorem on the approximation of an upper
hemi-continuous correspondence by the graph of a continuous function; see
Hildenbrand and Kirman (1988), Appendix IV, for a discussion of Cellina's
theorem and some of its applications. Hence, gj is assumed to be a function in
the proof. To be completely rigorous we would have to show that the limit of
"approximate equilibria" is an equilibrium, but these arguments are well
known. Beato and Mas-Colell define the continuous map q~ : S"+J--> S "+~
where for (x, p) E S "+1 and 7/j(xj) = yj, let
~P~h(x' P ) = (Xjh +max{0, Ph --gjh(Yj)})
for j~<n and l<~h<~l
1 + ~] max{0, Ph -- gjh(Yj)}
h=l
(Ph+max{O, fh(Y,P)-2
Yjh})
J=~
,P,+~,h(x, P) =
t
,+
h=l
m+
for h ~< l.
j=l
This map has a fixed point (2,/7) by Brouwer's fixed-point theorem. The
fixed point of the first family of equations, using the boundary condition
H2(ii), 2 j = ~pj(2,/7) gives that/7 = gj(37j), i.e. (37,/7) is a production equilibrium. Hence by H3, ft. f(37,/7) =/7.(E~= 1 )Tj); this fact a n d / 7 = ~p,+1(37,/7)
yield that f(37,/7) ~< E~_ 1 37j, completing the proof.
Although the model of Beato and Mas-Colell may not be a natural model for
investigating average cost pricing, it is excellent for outlining the recent
existence proof of Brown, Heller and Starr (1989) for a two-part marginal cost
pricing (TPMCP) equilibrium. In their model, there is a single firm with a
non-convex technology that produces a single good (the "monopoly good")
which is not produced by any other firm, and the social endowment of this
good is zero. The remaining n - 1 firms in the economy possess convex
technologies and comprise the competitive sector of the model, i.e. these firms
are price-taking profit-maximizers. We shall view the firm producing the
monopoly good as a regulated public monopoly. Regulation takes the form. of
marginal cost pricing with discriminating (or non-uniform) "hook-up" fees
charged for the right to consume the monopoly good. All firms, including the
D.J. Brown
1980
regulated natural monopoly, are privately owned and all shareholdings carry
limited liability. Hence losses of the regulated firm can only be recovered
through the hook-up fees, thus there are no taxes in this model, lump sum or
otherwise. The hook-ups are required to just recover the losses that the
regulated firm incurs by marginal cost pricing. Hence in equilibrium, the
regulated public monopoly makes zero economic profits.
Brown, Heller and Starr define T P M C P equilibrium as a family of consumption plans Yi, production plans )Tj, market prices ,6 and hook-up fees 4~, such
that consumer i is maximizing his/her utility at x~ subject to his/her budget
constraint:
fi" x i < ~ f i , w~ + ~
O~fl~. yj
ifx~l=O,
]=1
or
qi + fi" xi ~ fi" wi + ~
Oijfi" Yj
ifxil>O;
j=l
`6 = gj()Tj), where the gj are the marginal cost pricing rules in the B e a t o - M a s Colell model, Ei~ 0 t~i = min(0, - p )71), where 0 is the set of consumers who
purchase the monopoly good; and E~ml ~ ~< E nj= 1 fj + tO, where oJ is the social
endowment, Eiml to~.
The basic idea underlying the existence proof of Brown, Heller and Starr is
the notion of willingness to pay and the assumption that, in equilibrium, the
aggregate willingness to pay exceeds the losses of the regulated monopoly
resulting from marginal cost pricing.
More formally, they assume that the set of feasible allocations is compact;
hence A'i, the attainable set of the ith consumer is compact. Let Xi be a convex
compact set which contains ffg in its interior. Suppose also, in addition to the
standard assumptions on utility functions, that we assume Ui is strictly quasin
concave for all i. Let r i ( y , p ) = p . t o i + Ej.=
10,~p.yj. We can now calculate
each household's "reservation level of utility," i.e. the maximum utility level
she could obtain if the natural monopoly good were unavailable:
V/(y, p) = max Ui(xi)
s.t. p . x i <<-ri(Y, p ) , Xil = O, x i @ ) ( i .
The income necessary to obtain this utility level at prices p if the monopoly
good is available is given by
E i ( p , V/(y, p)) = min p . x i ,
Ui(xi) >1 V i ( y , p ) , x i E Xi .
Each household's "willingness to pay" for the monopolist's output, given
1981
(y, p), is si(Y, p) = ri(y, p) - Ei(P, Vi(y, p)). Notice that sj is an ordinal
concept, i.e. it is independent of the utility representation, sj(y, p) is the
amount of income at given prices, p, that must be subtracted from income,
ri(y, p), to reduce utility to its value, V~(y, p), when the monopoly good was
unavailable. As such, it is akin both to the compensating variation of adding
the monopoly good and to Dupuit's notion of benefit arising from the
introduction of a public good.
The principal assumption in the B r o w n - H e l l e r - S t a r r model is that the
aggregate willingness to pay, s(y, p) = Eiml si(Y, p) exceeds the losses of the
natural monopoly at every production equilibrium (y, p), i.e. s(y, p ) >
- P " Yl- Given this assumption, they define hook-up fees, qi(Y, P), as continuous functions of ( y , p) on the set of production equilibria. The q~(y, p) have
the following properties:
(i) Eim_~lq,(y, p) = min(O, - p - y~);
(ii) if si(Y, p) > 0 then qi(Y, P) < si(Y, P); and
(iii) if si(Y, p) = 0 then qi(Y, P) = O.
We see that if si(Y, p ) > 0 then consumer i will choose to pay the hook-up
fee, since it is less than the maximum willingness to pay. If si(Y, p) = 0 then
qi(y, p) = 0 and consumer i will not choose to consume the monopoly good.
Hence in all cases the consumer's budget set is convex and therefore the
demand correspondence is convex-valued. Assuming strict quasi-concavity of
the utility function, we define the individual demand function x i ( Y , p). Letting
f ( y , p) = Egml xi(Y , p) be the market demand function and extending it continuously but arbitrarily over OY x S, we now have reduced the TPMCP model
to the MCP model of Beato-Mas-Colell. A fixed-point ( ~ , / ~ ) of the B e a t o Mas-Colell map q~ : Sin+l--> S m+l is a production equilibrium, hence f(~, fi) is
the true aggregate demand. Moreover, the hook-ups, qi()7, fi) will, by construction, just cover the losses of the monopoly. The remaining step, to show
that the resulting allocation is a free-disposal equilibrium, is the same as in
Beato and Mas-Colell.
The final topic in this section is the existence theorem of Bonnisseau and
Cornet (1988a, Theorem 2.1) where firms follow bounded losses pricing rules.
This remarkable theorem provides a general existence result for a wide class of
general equilibrium models including the existence of Walrasian equilibria in
the classical A r r o w - D e b r e u model, the existence of MCP equilibria in the
Beato and Mas-Colell model, and the existence of ACP equilibria in general
equilibrium models with several non-convex firms. Unfortunately, their proof
is too technical for a survey of this kind. Instead, we will discuss the main ideas
and structure of their argument. The model of Bonnisseau and Cornet is
defined as follows.
The economy has l goods, m consumers and n firms. The social endowment
to is a vector in ~/. Each firm's production set, Yj, is a subset of ~t. The
1982
D.J. Brown
consumption set, Xi, of consumer i is also a subset of 5~z. Tastes are defined by
complete, transitive, reflexive binary relations >i on X~. Finally, the wealth of
the ith consumer is defined by a function r i : O Y x ~ t + ~ ~ where 0Y =
OY~ .. OY n. A special case of this wealth structure is r i ( p , Yl, , Y , ) =
n
m
p . toi + Ej=I Oijp yj for 0ij i> 0, Ei= 10ij = 1 which holds for a private ownership
economy. The behavioral assumptions are that households are maximizing
their preferences subject to the standard budget constraint and that firms are
following pricing rules. The pricing rule ffj of the jth firm is characterized by a
correspondence from OYj, the boundary of Yj, to Ytt+ where ~Oj(yj) is a cone
with vertex 0. The jth firm is in equilibrium given (y, p) if p E ~ ( y j ) and
Y = (YI,- . , Ym)" Pricing rules subsume profit maximization, since PMj(yj) =
{p E ~ l [ P" YJ ~>p. y~ for all y~ C Yj}. Assuming free disposal, PMj(yj) C
~ . A Bonnisseau-Cornet equilibrium is a family of consumption plans x~,
production plans yj and prices p, such that consumer8 are maximizing utility at
xi, subject to their budget constraints; firms are in equilibrium, i.e. for all j,
n
p E qJj(yj); and all markets clear, i.e. Zi~ 1 x i = Ej=~
yj + o~. A free disposal
equilibrium is defined in the standard way. Their principal existence theorem,
Theorem 2.1, is a consequence of the following assumptions:
(C) (i) Standard assumptions on consumptions sets and preferences, say as
in Debreu (1959); (ii) r i ( y , p ) is continuous, satisfies Walras' law, i.e.
Eiml r i ( y , p ) = p . (El= 1 yj + to) and is homogenous of degree 1 in prices.
(P) For all j, Yj is non-empty, closed and Yj - ~ t+ C Y~ (free disposal).
(B) For every to'~> to, the set a ( w ' ) = {((x/), (yj)) EHiml X / II~=, Yj[
n
~" im=1 X i ~ E j = 1
Yj + to')
is bounded.
Given the homogeneity assumptions on r i and Sj, and the local non-satiation of
preferences, the equilibrium prices will lie in the price simplex S. The
normalized pricing rule Sj is the correspondence from OYj to S defined as
~j.(yj) = ~pj(yj) fq S. The final definition is that of a production equilibrium:
(y, p) is a production equilibrium if y C IIj= 1 0 Yj, p E S and for all j, p E
~bj(Yi). PE, a subset of IIj_a OYj x S, is the set of production equilibria. The
remaining assumptions are:
(PR) for all j, the normalized pricing rule, t~j, is upper hemi-continuous with
non-empty, convex compact values;
(BL) (bounded losses assumption) for all j, there exists a real number aj
such that for all ( y j , p ) E OYj x S, p ~_ Oj(Yj) implies p . yj >/aj;
(SA) (survival assumption) (y, p) E PE implies p- (E~= 1 yj + o)) > infx~cXf
m
p ~ , i = 1 Xi;
(R) ( y , p ) ~ P E
and p-(Z~= l y ~ + t o ) > i n f p . Z i m ~ x i imply r , ( y , p ) >
inf{p x~ [ x i ~ X i } for all i.
Assumptions (C) and (P) need no discussion. (B) is implied by
a(E~f_ 1 Y~) A ( - a Z~=1 Y~) = {0}, where A(ZT=a Y~) is the asymptotic cone of
(E~.=1 Yj) [see Hurwicz and Reiter (1973)].
(PR), the pricing rule assumption is satisfied by a profit maximizing firm j
1983
with convex technology, if ~0j(yj) = PM(Yj.); a firm following the marginal cost
pricing rule where qJj(yj) is the Clarke normal cone at yj; and a firm following
average cost pricing where qlj(yj) = A C ( y j ) , if Yj N ~t+ = {0}.
Before discussing the remaining assumptions, we now give the formal
definition of the Clarke normal cone, denoted Ny(y). First, we need the notion
of the Clarke tangent cone. For a non-empty set Y C ~1 and y E ~Y, the
tangent cone of Y at y is Ty(y) = {x E ~ t I for every sequence yk E Y, yk__~y
and every sequence t k E ( 0 , )o o, t k ~ 0, there exists

a sequence x k E ~ , 1 x k ~ x,
such that yg+ tkxkE Y for all k}. For any A C ~t, the polar cone of A,
A + = {z E ~ l I x . z ~<0 for all x E A}. Then Ny(y) = [Ty(y)] . See Figure
36.5 for examples of the Clarke normal cone.
Assumption (SA) simply states that at a production equilibrium there is
sufficient income to cover all losses (through lump sum taxation) and still
provide consumers with the necessary income to purchase their subsistence
consumption bundle. (R) asserts that aggregate income (net of lump sum taxes
to cover any losses of firms) is distributed in such a manner that each consumer
has sufficient income for subsistence. As Bonnisseau and Cornet point out,
special cases of (SA) and (R) are (i) the private ownership models of
A r r o w - D e b r e u and (ii) models with the fixed structure of revenues assumption
and positive net social wealth at each production equilibrium.
With the exception of (BL), all of these a s s u m p t i o n s - a l b e i t with less
g e n e r a l i t y - have appeared in one guise or another in the work of Debreu
(1959), Dierker, Guesnerie and Neuefeind (1985), Brown, Heal, Khan and
Vohra (1986) and Kamiya (1986a). Hence the major conceptual innovation of
this paper is the notion of bounded losses pricing rules. This condition holds
for all of the models cited above, together with the model of Beato and
Mas-Colell. Notice that (BL) is not needed for economies with a single firm,
Output
Input
I0
Figure 36.5. The shaded cones at points (a), (b) and (c) are the Clarke normal cones. The Clarke
normal cone at (d) consists of all non-negative scalar multiples of the normal vector at (d).
1984
D.J. Brown
e.g. Mantel (1979) or Cornet (1982). But the most surprising consequence of
(BL) is in the case of marginal cost pricing, where the pricing rule is in terms of
the Clarke normal cone. In this instance, the (BL) assumption is equivalent to
assuming that the production set of the firm is strictly star-shaped; see Lemma
4.2 in their paper.
Star-shaped production sets were introduced by Arrow-Hahn in their discussion of monopolistic competition. These sets are a particularly well-behaved
class of non-convex sets, e.g. compact strictly star-shaped sets in ~ l are
homeomorphic to the 1-ball in ~ / [ s e e Arrow and Hahn (1971, Appendix B)].
The relevant literature on the properties of these sets for equilibrium analysis
appears to be the geometry of numbers; this connection is suggested by the
interesting and important work of Scarf (1986) on indivisibilities in production;
and non-smooth optimization [see Dem'yanov and Rubinov (1986)].
Subsequent to the paper under discussion, Bonnisseau and Cornet (1988c)
were able to drop the (BL) assumption and still prove the existence of a MCP
equilibrium. Of course for average cost pricing, (BL) holds trivially.
Returning to Bonnisseau and Cornet (1988a), we see that the existence proof
rests on another fact about production sets with free disposal. They show that
if a production set Y is a non-empty subset of ~z such that Y - ~t+ C Y and
y ~ ~t, then the boundary of Y, 0 Y, is homeomorphic to a hyperplane in ~ t
(see Lemma 5.1 in their paper). This lemma, together with (BL) and the
compactness of firms' attainable production sets, which follows from (B),
allows them to define compact, convex subsets of the hyperplanes corresponding to each 0 Yj. The interiors of these sets contain the homeomorphic images
of the relevant portions of 0Yj, analogous to the construction of Beato and
Mas-Colell regarding the 0 Yj. The final step is to use a suitable convex compact
ball defined from the sets above: products of the price simplices, one for each
firm, as proxies for the range of the pricing rules; a price simplex for market
prices; and convex, compact sets which contain the attainable consumption sets
in their interior. This ball is then the domain and range of a continuous map,
F. The fixed-points of F, which are shown to exist by Kakutani's theorem,
constitute flee-disposal equilibria. Bonnisseau and Cornet give several extensions of the basic result, Theorem 2.1, but the outline given above conveys the
structure of all of their proofs.
In the next section, we consider another method for establishing existence of
equilibria in economies with non-convex technologies.
3. Local uniqueness and computation

The non-linear system of equations which define an equilibrium in an economy
with non-convex technologies, where firms follow pricing rules, consists of the
1985
first-order conditions for utility maximization subject to a budget constraint,

the equations defining a production equilibrium, and the market clearing
equations. In the previous sections, these equations were shown to have a
solution by converting the system into an equivalent fixed-point problem and
the existence of a fixed-point was established by using the Brouwer or
Kakutani fixed-point theorem. But the arguments used give no indication of
the number of equilibria or how to compute an equilibrium. In this section, we
consider the path-following or homotopy method for solving a given system of
equations; this will allow us to derive both a uniqueness theorem and an
algorithm for computing equilibria.
The principal papers in this area are all due to Kamiya [see Kamiya
(1986a, b, 1987, 1988a)]. The assumptions in Kamiya's proof of existence
[Kamiya (1988a, Theorem 1)] differ from those of Bonnisseau and Cornet in
two important respects. Instead of assuming (B), Kamiya assumes (B'):
co A(E~= 1 I1/.)D - c o A(Ej=I, Yj) = {0}, where co(D) is the convex hull of D;
and instead of (BL), he assumes (L): for all sequences {(p~, y~)} C S 0Yj,
such that IlyTll + and, for all a,p"E~j(y~), it is the case that
lim~__,= P"'(Y~/IIyTI[~) >~o. Hence his assumption on the losses incurred by
firms is weaker than the bounded losses assumption of Bonnisseau-Cornet, but
his assumption on boundedness (B') is stronger than their assumption (B).
Kamiya also assumes that consumption sets are subsets of ~t+. The essential
difference between the models of Kamiya and that of Bonnisseau-Cornet is
not the existence theorems, per se. In fact, Bonnisseau (1988) has been able to
derive Kamiya's result from his theorem with Cornet by constructing a new
economy with different production sets and changing the pricing rule so that it
satisfied (BL). The important difference between the two models is the method
of proving existence.
Kamiya's path-following or homotopy proof of existence, given the previous
work of Dierker (1972), Smale (1987b), Scarf (1973) and Eaves (1972),
naturally suggests two results. First, a condition for uniqueness of equilibria
and second, an algorithm for computing equilibria. Conditions for local
uniqueness and uniqueness can be found in Kamiya (1988a, Theorem 3).
Algorithms for computing equilibria (in principle) can be found in Kamiya
(1986b, 1987). Unfortunately, all of the arguments in these papers are too
technical for this survey. Hence we will illustrate the main idea in his existence
theorem by showing that Mantel's model for MCP equilibria has an odd
number of equilibria. Our proof will be based on path-following and the
homotopy invariance theorem, the essential elements of Kamiya's argument.
This result on Mantel's model was originally proved by Brown and Heal
(1982), using the fixed-point index introduced by Dierker (1972). As Dierker
shows, if each of the finite equilibria in an exchange economy has the same
index then the equilibrium is unique. This condition, of course, implies
n
1986
D.J. Brown
uniqueness of Mantel's model and Kamiya's model and is the condition used by
Kamiya to guarantee uniqueness. Roughly, the index at an equilibrium is the
sign of the determinant of the excess demand at the equilibrium prices.
The computational algorithm in Kamiya (1986b) is a simplical path-following
method based on Scarf's original simplical algorithm for computing equilibrium
prices [see Scarf (1973)]. The degree of computational complexity is of the
order (l - 1)(n), where n is the number of firms and I is the number of goods.
This is quite large relative to the degree of computational complexity of Scarf's
algorithm applied to classical A r r o w - D e b r e u economies, which is of order
(!- 1). This increased complexity arises from the need to treat each firm's
production possibilities separately in the non-convex case; whereas in the
convex case, one can aggregate the technologies or in well-behaved cases only
consider market excess demand functions that depend on 1 - 1 prices. In
Kamiya (1987), using results in differential topology, he gives a second
algorithm which "generically" has the same order of computational complexity
as in the convex case, i.e. ( l - 1).
We shall need to make several additional assumptions concerning Mantel's
model for marginal cost pricing in order to prove there are an odd number of
MCP equilibria. If z E ~l, let Z@ ~ t - ~ be the first ( l - 1) components of z.
For notational convenience, when y + o~ E 0Y we shall simply say that " y E
a Y". If y E a I," then denote 7f(y) / IlVf(y) lll as p ( y ) . The aggregate demand at
these prices will be denoted x(p(y)). Finally, we define the homotopy
H : 0~" x 10, 1]----> ~ t - 1 where H(y, t) = (1 - t)(370 - 37) + t((p(y)) - 37), Yo E
a f / and (p(y)) is defined as in the proof of Theorem 1. Y0 is chosen to
guarantee assumption A4, the boundary-free condition. In this model, this is
not a realistic condition and is only intended to be illustrative. Guaranteeing
that the path defined by the homotopy does not run into the boundary for t < 1
is the crucial part of the path-following methodology. We now assume:
A3 (i) 0 is a regular value of H(y, t),
(ii) 0 is a regular value of H(y, 1).
A4 For all t @ (0, 1) and all y E 0Y, (1 - t)(370 - 37) + t(~(p(y)) - 37) ~ O.
Theorem 3 [Brown and Heal (1982)]. Given assumptions A 1 - A 4 , Mantel's
model for marginal cost pricing has an odd number of equilibria.
Proof. The proof is an immediate consequence of the homotopy invariance
theorem, which is stated below. First, suppose F is a smooth function from a
compact subset of ~n, with non-empty interior, into gt n, i.e. F : D--~ ~ . If 0
is a regular value of F and F - l ( 0 ) f30D = 0, then we define the degree of F to
be the integer, i:leg(F) = Ex~ F 1(0) sgn det F'(x), where F' is the Jacobian of
F.
1987
Homotopy Invariance Theorem [Garcia and Zangwill (1981, Theorem 3.4.3)].

Suppose D is a compact subset of ~n, with non-empty interior; H : D
[0, 1]---~ ~ " is a regular homotopy, i.e. 0 is a regular value of H; 0 is a regular
value of H(x, O) and H(x, 1). If H is boundary-free, i.e. if H(x, t) = 0 implies
x ~OD, then deg(H(x, 0)) = deg(H(x, 1)).
Applying this theorem to Mantel's model we see that H ( y , 0) has the unique
solution Y0; hence at H ( y , 1) we must have an odd number of solutions. Since
by Walras' law, all solutions of H ( y , 1) = 0 are marginal cost pricing equilibria,
this completes the proof.
Of course, the above theorem proves the existence of a MCP equilibrium,
but we now give a third proof of existence which is the basis for the
computational algorithm in Kamiya (1986a).
Theorem 4.
equilibrium.
Given assumptions
A1-A4,
Mantel's
model has a MCP
Since 0 is a regular value of H, we see that H - l ( 0 ) is a onedimensional manifold. Because of the boundary-free assumption, A4, and the
uniqueness of the solution at H(y, 0), there is a "path" from y = Y0 to y = y~,
where H(y~, 1) = 0 (see Figure 36.6).
Proof.
Path-following algorithms are simply numerical schemes for computing this

one-dimensional manifold. Garcia and Zangwill give an explicit differential
Yl
1=1
t=0
Y0
Figure 36.6. In this figure, D is the compact interval [a, b]. H ~ consists of the two paths A and B.
A is the path from Yo, a solution of H(y, 0) = 0, to Yl, a solution of H(y, 1) = 0.
1988
D.J. Brown
equation whose solution is the manifold in question [see Garcia and Zangwill
(1981, Theorem 2.1.1)]. The path following approach for computing equilibria
in economic models consists of solving a differential equation which traces out
a one-dimensional manifold to an equilibrium, was introduced into equilibrium
analysis by Smale (1976b). Smale's method is not explicitly a homotopy
method and is known in the literature as the Global Newton's method.
Returning to Kamiya's work, we ask what makes his proof so complicated?
First, there is the issue of several firms which cannot be aggregated by the use
of a market supply function and, in addition, there is the difficulty of finding at
least one production equilibrium to begin the homotopy. Finally, he must find
an economically meaningful boundary condition to guarantee that his
homotopy is boundary-free. These problems are resolved in an ingenious
fashion and the reader is invited to read the first chapter of Kamiya (1986a) for
an informal discussion of his model and proof of existence.
4. Optimality
In this final section of the paper, we present two examples which illustrate the
inefficiency of marginal cost pricing. Also we prove the second welfare
theorem for marginal cost pricing equilibria in an economy with a single
non-smooth technology. That is, we show that every Pareto optimal allocation
can be supported as a marginal cost pricing equilibrium where the marginal
rates of transformation at each efficient production plan are defined by the
Clarke normal cone and households are minimizing expenditure. Of course,
our result is a special case of the necessity of marginal cost pricing, in terms of
the Clarke normal cone, for Pareto optimality as shown by Quinzii (1991). But
the basic intuition that the separation argument depends only on the convexity
of the appropriate tangent cone and not the convexity of the production set is
due to Guesnerie (1975).
Our first example of inefficiency is taken from Brown and Heal (1979),
where they give an example of an economy having only three MCP equilibria,
all of which are inefficient. The non-convex production possibility set Y is
illustrated in Figure 36.7. There are two households, and only three production
plans are candidates for MCP equilibria, i.e. points A, B and C in the figure.
But plan C is inefficient since the relevant Scitovsky community indifference
curve is clearly below feasible production plans. Hence only A and B are
candidates for efficient MCP equilibria. But suppose the Scitovsky community
indifference curves through A and B look as they do in Figure 36.7; then points
A and B are also inefficient. Another way of making the same point is to draw
the Edgeworth boxes for distribution at these points, if we then plot the
corresponding contract curves in utility space, we find that A' and B' in utility
1989
Community
t ~
Good 2
Curveslndlfference
\,
B
%%
Production Possibility Set, Y,
Good 1
Figure 36.7.
space, corresponding to A and B, lie inside the utility possibility frontier, i.e.
are inefficient (see Figure 36.8). The interested reader is referred to Brown and
Heal (1979) for a numerical example with these properties. Please note that
the first example of this kind is due to Guesnerie (1975).
A more striking example of the inefficiency of MCP equilibria is found in
Beato and Mas-Colell (1983). In this example there are only three MCP
equilibria, and aggregate production efficiency fails to obtain in each case.
There are two goods in their economy, denoted x and y. x is used as an input
to produce y. There are two firms, one with constant returns to scale, i.e.
Yl = Xl and the other with increasing returns, i.e. Y2 = ~6(X2)2" There are two
consumers. One consumer has a utility function Ul(xl, y l ) = y l , who is
endowed with to1 = (0, 50) and owns both firms, i.e. profits and losses are paid
by the consumer. The second consumer has a utility function Uz(x2, Y 2 ) =
min{6x2, Y2} and is endowed with to2 (20, 0).
See Figure 36.9 for descriptions of the individual technologies and the
aggregate technology. H e r e we give only the intuition for their result, the
reader interested in the details should consult either the above cited reference
or Beato and Mas-Colell (1985). It is clear that py, the price of output, cannot
be 0 in equilibrium, since the first consumer's utility function is U~(xl, Y l ) =
Yl. Hence we choose output as numeraire and set py = 1. If the first firm
produces in equilibrium then Px = 1, since the first firm produces with constant
=
1990
D.J. Brown
Good 2
A
(a)
Good1
U1
M
(b)
~,
t
U2
Figure 36.8. The contract curves 0A and 0B in (a) correspond, respectively, to the curves MN and
PQ in (b). The utility possibility frontier is the outer envelope of MN and PQ.
returns to scale, where the constant marginal rate of transformation is 1. In this

case, if the second firm is also producing in equilibrium then it must be at a
point where the marginal rate of transformation is also 1. Checking the
first-order conditions for profit maximization, utility maximization and m a r k e t
clearing, we see that this is a M C P equilibrium. But we see f r o m the figure for
the aggregate production possibility set that it is never efficient for both firms
to produce.
T h e other two cases are when one firm produces and the other firm is
inactive. In both cases the active firm produces inside the production possibility
set.
Finally, we prove the second welfare t h e o r e m in an e c o n o m y with a single
n o n - s m o o t h technology. This model allows us to follow the traditional separating hyperplane argument, but in our p r o o f the convex sets are the (Clarke)
tangent cone at the efficient production plan and the sum of the sets of
consumption plans that each consumer strictly prefers to her given Pareto
1991
Yl
Y2
(a)
(b)
/
~
=1/16X22
X2
X1
(z)
(c)
7
,,p,~SS
Figure 36.9. Figures (a) and (b) are the technologies of the two firms. V ( z ) = max[f~(zl)+ f2(z2):
z~ + z z = z] and (c) is the aggregate production function, V(z).
optimal consumption plan. The standard argument, say in Debreu (1959)

separates the latter set from the (convex) aggregate production set. First, we
recall some notions from non-smooth analysis.
Let Y be a closed non-empty subset of ~t, then the cone of interior
displacements at x, denoted Ky(x), = { z E ~ / [ 3 ~ / > 0 , 0 > 0 , s.t. V~" E [0, ~/],
{x} + zBo(z ) C Y}. Again, K r ( x ) need not be convex.
In contrast, the Clarke tangent cone, Tr(x), is always convex. For a
comparison of these two cones, we consider the interior of Ty(x): Int Ty(x) =
{zE~[3~/>0,
0 > 0 , l > 0 , s.t. VzE[0,~/], V x ' @ C I ( Y ) n C I B t ( x ), { x ' } +
B o(z) C Y}. Clearly, Int Ty(x) C_Kv(x).
We consider a private ownership economy with l goods, m consumers and a
single firm. We make the same assumptions on the characteristics of households as we did in our discussion of Mantel's model in Section 2. But we only
assume that the firm has a non-smooth technology, Y (this terminology is a bit
confusing since smooth technologies are special cases of non-smooth technologies, see Section 1). The pricing rule q,(y) is the Clarke normal cone
(normalized to the price simplex). To guarantee that ~ ( y ) ~ 0 for all y C 0 Y,
we assume 0 E Y, Y - ~ t+ C Y (free disposal) and Y is closed.
1992
D.J. Brown
Second Welfare Theorem. I f (X 1 . . . . , Ym' Y ) is a Pareto optimal allocation

and Ei% 1 x i = y + oJ E ~ + + , then there exists a p E ~O(y) such that x i is the
expenditure minimizing consumption plan f o r agent i at prices p and utility level
U i = Ui(xi).
Proof. L e t B i = {z E Rt+ [ Ui(z) > Ui(xi)}, then B i is n o n - e m p t y and convex

for each i. Let B = E,-ml B/, then B is also convex. Let x = Ei~ 1 x;, then x E / ~ ,
the closure of B. Define B ' = E i B i - x. N o w consider B ' and Int T v ( y ). These
are n o n - e m p t y , convex sets (the non-emptiness of Int T y ( y ) following from
free disposal) and 0 belongs to the boundary of both sets. M o r e o v e r ,
Int T y ( y ) f3 B ' = ~1. Suppose not, i.e., there exists z C B ' fq Int T y ( y ) . The fact
that z ~ I n t T y ( y ) implies that there exists a t E (0, 1) such t h a t y + tz E Y. Let
y ' - y + tz and x' = x + tz. Since x = y + w, we have x ' = y ' + w, i.e., (x', y ' )
is feasible. The fact that z E B ' implies that there exist E E B such that
z -- ( - x). Thus x' = x + t ( E - x) = (1 - t)x + ft. By local non-satiation and
convexity, this yields an allocation which Pareto dominates (x, y ) - - a contradiction. N o w we k n o w that 0 belongs to the boundary of the convex sets
Int T v ( y ) and B ' and these sets have an e m p t y intersection. By the separating
h y p e r p l a n e t h e o r e m , there exists p ~ 0 such that p z ~< 0 for all z E Int T y ( y )
and p . z i> 0 for all z C B'. The first condition yields p ~ N y ( y ) and the second
one yields expenditure minimization.
This p r o o f is due to R. Vohra.
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LIX: 577-596.
Chapter 37
MONOPOLISTIC COMPETITION
JEAN-PASCAL BENASSY*
CNRS and CEPREMAP, Paris
Contents
1.
2.
3.
4.
5.
Introduction
History
2.1. The basic framework
2.2. Cournot
2.3. Bertrand
2.4. Edgeworth
A basic m o d e l a n d existence p r o b l e m s
3.1. A basic Chamberlinian model
3.2. A first existence problem
3.3. The Edgeworth problem
3.4. The Chamberlinian model with entry
3.5. Further reading
H o w c o m p e t i t i v e is m o n o p o l i s t i c c o m p e t i t i o n ?
4.1. The Cournot equilibrium and market size
4.2. The traditional Chamberlinian model and substitutability
4.3. Bertrand-Edgeworth and market size
4.4. The Chamberlinian model revisited
Endogenous product differentiation
5.1. The modelling of product differentiation and entry: a first approach
5.2. Product differentiation: a general view
5.3. Spatial competition
5.4. Competitiveness
5.5. Efficiency
5.6. Zero profits
1999
2000
2000
2000
2001
2001
2003
2003
2005
2005
2007
2009
2009
2009
2010
2011
2013
2015
2015
2015
2018
2019
2020
2021
2022
2024
*I am indebted to Don Brown, Jean J. Gabszewicz, Oliver Hart, Bruno Jullien, Michael Magill,
Andreu Mas-Colell, Martine Quinzii, Martin Shubik, Jacques-Francois Thisse and Xavier Vives for
useful comments on preliminary versions of this chapter. Of course I am solely responsible for any
remaining deficiencies. Support from Deutsche Forschungsgemeinschaft, Gottfried-WilhelmLeibniz-F6rderpreis, during BoWo'89 is gratefully acknowledged.
0 Elsevier Science Publishers B.V., 1991
6.
General equilibrium representations

6.1. General framework
6.2. Subjective demand curves
6.3. Objective demand curve: Cournot
6.4. Objective demand curve with price makers
7. M o n o p o l i s t i c c o m p e t i t i o n a n d m a c r o e c o n o m i c issues
7.1. The model
7.2. Objective demand curves
7.3. Equilibrium: definition and characterization
7.4. Underemployment, underproduction and inefficiency
7.5. Neutrality of monetary policy
8. C o n c l u s i o n s
References
2024
2024
2025
2026
2028
2030
2032
2032
2033
2035
2037
2038
2039
2039
2040
Ch. 37: Monopolistic Competition
1999
I. Introduction
Monopolistic competition, a term coined in the famous contribution of Chamberlin (1933), ~ is usually defined as a situation of imperfect competition with
the following features: (a) the products sold are differentiated; (b) firms
themselves set the price of these goods; (c) the number of sellers is large and
each firm disregards the effects of its price decisions on the actions of its
competitors; (d) entry is unrestricted and proceeds until profits are reduced to
zero, or the smallest possible number consistent with the fact that the number
of firms is an integer.
What has been called by Samuelson (1967) the Monopolistic Competition
Revolution was indeed quite a pathbreaking development in its time, as it
replaced the Walrasian or Marshallian implicit "auctioneers" by explicit price
setting agents internal to the economy, i.e. the firms. Since then an enormous
amount of research has been devoted to this and related topics, but it seems
fair to say that the domain of monopolistic competition has not reached the
state of synthesis that the Walrasian system has reached [see notably Arrow
and Debreu (1954), Debreu (1959), Arrow and Hahn (1971)]. The reason for
this is that the theory of monopolistic competition (and more generally all
theories which endogenize price making without an auctioneer) poses important and difficult conceptual problems. Our purpose in this chapter is to
review a number of them. Of course, given the gigantic size of the literature on
the subject, such a review can only be partial. As in the original monopolistic
competition contribution we shall mostly concentrate on models with a generally large number of price setters, and indicate in the conclusion a number of
alternative presentations.
The plan of the chapter is the following. Section 2 briefly reviews early
developments in imperfect competition prior to Chamberlin. Section 3 introduces a basic model and studies problems of existence of an equilibrium.
Section 4 discusses the issue of competitiveness of monopolistic competition.
Section 5 introduces endogenous product differentiation. Section 6 considers
general equilibrium representations of monopolistic competition. Section 7
presents macroeconomic applications. Subsections at the end of each section
indicate a list of further reading.
~See also Robinson (1933) for an important contemporaneous contribution to imperfect

competition.
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J.-P. Benassy
2. History
We shall now start, just as Chamberlin did, by briefly reviewing a few models
of imperfect competition with homogeneous goods, notably associated with the
names of Cournot, Bertrand and Edgeworth, whose conceptual problems led
Chamberlin to the idea of monopolistic competition.
2.1.
The basic f r a m e w o r k
We shall study here a market for a single homogeneous good, which may be
served by several firms. We shall assume that the demand for this good is g i v e n
by q = D ( p ) , and we shall denote the inverse demand curve as p = F(q). In
what follows we shall actually have to go beyond these basic data and make
explicit where the demand curve comes from. We shall thus make a simple and
usual assumption, i.e. that the consumer sector is made of a single "big"
consumer with a utility function
U(q) = V(q) - pq
where output is implicitly paid in a num6raire commodity whose marginal

utility is constant and normalized to one. Maximization of this with respect to q
yields immediately
D(p) = V'-'(p)
F( q) = V ' ( q) .
2.2. C o u r n o t
Cournot (1838) first explored the case where the market is served by two firms
with the same marginal cost c. These two firms are assumed to choose their
quantities ql and q2 independently. The resulting price is the one that "clears
the m a r k e t " , i.e. F(q~ + q2)- The optimization program of firm 1 is thus
maximize F( q I + q2)ql - cql ,
yielding a best response function ql = ~ b l ( q 2 ) .
Symmetrically q2 = 02(ql). A
Cournot equilibrium is characterized by quantities ql, q2 and a price p such
that
q, = O,(q2),
q2
O2(ql) ,
P : F ( q l + q2)"
2001
The Cournot price, though lower than the monopoly price, remains nevertheless strictly above the competitive price c.
2.3. Bertrand
Bertrand (1883) objected to Cournot's analysis on the basis that firms actually
do set prices, and thus considered a model where prices are the strategic
variables. In such a case a rule must be specified to allocate demand between
the two competitors. Bertrand's rule is the following: if the prices are different,
all demand will go to the lower price firm. If prices are equal, the demand is
shared between the two firms, and we shall assume for simplicity that it is split
half and half (the specific proportions actually do not matter here). As a result,
the demand going to firm 1 is
fD(pl)
D,(pt, pz)=lloD(pl)
Pl P2
Clearly, as long as one price is above c, the other firm will have an incentive
to undercut. As a result the unique possible equilibrium of this game is given
by Pl = P2 = c which is indeed the Nash equilibrium of this game. With prices
as the strategic variables, two is enough for competition.
2.4. Edgeworth
Edgeworth (1897) in turn objected to Bertrand on the basis that one seldom
sees productive processes with infinite potential supply, as costs must begin to
rise at some point. Edgeworth thus considered the constant marginal cost case
of Bertrand, but assumed there were fixed productive capacities k l and k 2.
The main change this brings to the previous analysis is that the demand to
the higher price firm is no longer necessarily equal to zero. Indeed assume for
example that p~ > P 2 , but D2(pl, P2) = D(P2) > k2. We see that firm 2 cannot
serve all demand addressed to it, and thus part of this demand will "come
back" to firm 1. T o see exactly to what extent, we must go back to the utility
maximization program of our single consumer. With two prices p~ and P2 this
program will be
maximize V( q I +
q2) -
Plqt - Pzq2
J.-P. Benassy
2002
I f p l > P 2 and D ( p 2 ) > k 2, then the consumer is rationed at price pz and buys
exactly k 2 from firm 2. The demand to firm i is the solution in q~ of the above
program with q2 = k2. The first-order condition for an interior maximum is
V'(qL + k2)
=Pl
yielding a demand equal to D ( p l ) - k 2 .2 Summarizing, the actual demand to

firm 1, its "contingent d e m a n d " , which we shall denote a s / 9 1 ( P l , P2), is now
[D(p,)
Pl <P2 ,
/9~(P,, P2) = ~max[D(p~), D ( p l ) - k2]

Lmax[O, D ( p , ) - k2]
Pl =P2 ,
P~ > P2
A resulting profit function is shown in Figure 37.1 forp2 > c and k 2 < D(p2).
We see that the undercutting argument which underlies Bertrand's result no
longer works. In particular c cannot be an equilibrium in prices as the firms will
always have an interest to jump to a higher price. One can easily check that
c
Figure 37.1
2Note that the extreme simplicity of this demand comes from the fact that there is a single
consumer and num6raire has constant marginal utility. For a thorough treatment of the general
case, see Dixon (1987b).
2003
there is no equilibrium in pure strategies with Pl = P2 = c unless min{k~, k2}/>
O(c).
The above non-existence result is actually much more general than the
particular example given by Edgeworth. It is indeed easy to see that for
increasing marginal cost functions there is no Nash equilibrium in pure
strategies for the price game [Shubik (1959), Dixon (1987a)].
3. A basic model and existence problems

Chamberlin comes thus at a point where the theory of endogenous price
making by firms is somehow in a dead end because of Edgeworth's nonexistence result. Chamberlin's way out will be to consider differentiated
products, which will in particular eliminate the discontinuities in the demand
curves associated with perfect substitutability. We should note that this idea of
product differentiation had already been used in the pioneering contribution by
Hotelling (1929) on spatial competition. 3
3.1. A basic C h a m b e r l i n i a n m o d e l
Chamberlin thus considers n firms indexed by j = 1 , . . , n each producing a

different good, also indexed by j. 'In order to reflect the fact that these products
are imperfect substitutes, we shall assume that the utility functions of the
agents in the consumer sector are strictly quasi-concave. T o make exposition as
simple as possible, let us again assume that this sector consists of a single "big"
consumer with a utility function
U( q l ,
" " ,
qn, x) = U ( q , x)
where x (a scalar) is a num6raire good representing somehow "the rest of the

e c o n o m y " and q is the vector of the n differentiated goods. The demands for
goods j = 1 . . . . . n will be simply given by the solution q of the following
program:
maximize U( q, x ) s.t. p q + x = R
where R is the num6raire income of the consumer, assumed given in this
partial equilibrium framework. We shall denote the solutions as
3For
a modern restatement of Hotelling's model and the corresponding existence problems, see
notably D'Aspremont, Gabszewicz and Thisse (1979).
2004
J.-P. Benassy
qj = O j ( p , . . . .
, p , ) = D j ( p j , p_j)
where p_j is the vector of all prices but pj. We can now define an equilibrium
with monopolistic competition [cf. for example Friedman (1982)].
Definition 1. An equilibrium with monopolistic competition consists of prices
PT, J = 1 . . . . . n such that
p7 maximizes p j D j ( p j , p* j) -- Cj[Dj(pj, p*j)]
Vj.
We can easily relate this equilibrium to Chamberlin's traditional "short-run"

equilibrium picture (Figure 37.2). Assume identical cost curves Cj and symmetrical demand curves Dj. The average revenue curve has for its equation
P ~I~
MC
AC
MR
q*
Figure 37.2
~-q
2005
q = Dr(P, fi-s),
i.e. it is the demand forthcoming to a representative firm, assuming all other
firms' prices are held constant and equal to fi (this curve depends thus on the
value of fi). The short-run equilibrium is characterized by the equality of
marginal cost and marginal revenue, with f i = p * . Figure 37.2 displays a
situation where firms can still earn a profit, represented by the shaded area.
This corresponds to the equilibrium of Definition 1.
3.2. A first existence problem

As we shall see below, the problem of the existence of a monopolistic
competition equilibrium will be a recurrent theme in this chapter. Taking the
simple Definition 1, an equilibrium will be a fixed point of the mapping
pj---~argmax ~/(p/, p _ / ) ,
j= 1,... , n
where rrr(ps, P-r) = PsD/(P/, P-J) - CflDs(Pr, P-/)]"

Whether the demand function D s comes from one or many consumers,
nothing in the traditional assumptions on utilities ensures that this mapping will
have the required properties to have a fixed point. So it has been customary in
the field to directly assume boundedness, convexity and upper-hemicontinuity
of the above mapping (or to make assumptions trivially implying them;
quasi-concavity in Ps of the profit functions ~rs. is a usual favorite) so that
Kakutani's fixed point theorem can be applied.
It must be noted, however, that recently a few authors have sought not to
use these assumptions directly. In particular Caplin and Nalebuff (1989), E.
Dierker (1988), H. Dierker (1989) derive the quasi-concavity of the profit
function from well-specified hypotheses on the distribution of consumers'
characteristics.
3.3. The Edgeworth problem

A question we may now ask is whether product differentiation actually solves
the Edgeworth non-existence problem, which was one of the main motivations
for which Chamberlin (and others such as Hotelling) studied differentiated
products. To make the issue particularly clear, we shall assume that the
function 7r/(ps, p_/) is strictly quasi-concave in p / ( F i g u r e 37.3). We shall now
show that, in spite of this, the Edgeworth non-existence problem may still arise
because the function 7rs(pj , P-s) is not the " t r u e " profit function.
J.-P. Benassy
2006
n)
",I
\
\
\
Pj l
Pj 2
Figure 37.3
Indeed this profit function is based on the Walrasian demand Dj(p~, p_j),
itself derived from the assumption that each firm will serve any demand at any
price. Edgeworth pointed out that this could not possibly be true with fixed
capacities, and we shall now see that , even without fixed capacities, this may
also be inconsistent with profit maximization. Indeed let us consider some
starting point (pj, p j) and imagine that firm j considers raising its price pj. If
goods are gross substitutes (which we shall assume in all that follows), demand
will be increasing for the competing products. However, it is clear that none of
the competing firms, i j, if they are true profit maximizers, will serve more
than their profitable capacity ki(pi ) = C~r 1 (pi), so that the demand actually
forthcoming to j, its "contingent d e m a n d " , is solution of the program in qj:
maximize U( q, x) s.t.
pq+x=R,
qi ~ ki ,
i ~ j,
which, since each k i is a function of the corresponding pi, yields a function
2007
/gj(pj, p_j) which notably differs from the Chamberlinian one because of the
quantity constraints k~(pi ). In particular, each time a competitor hits his
capacity limit (which occurs at prices pj~, Pj2 in Figure 37.3), the function/)j
has a kink, becoming less elastic as more substitutes are rationed to the
consumer. Consequently the "true" profit function 77-j, given by
ffJ(PJ, P-t)= pjfgj(pj, P - t ) - Cj[i)j(pj, P - t ) ] ,

is also kinked as in Figure 37.3. As a result ffj need not be quasi-concave and
existence may be jeopardized [Shapley and Shubik (1969), Benassy (1986b,
1989a)].
Of course, investigating existence in a general "Bertrand-EdgeworthChamberlin" model such as we have just described would be exceedingly
difficult, and the problem has been investigated in symmetric models with
identical cost curves and symmetric utility functions. The reader can find in
Shapley-Shubik (1969) and Benassy (1989a) characterizations of how existence
of a pure strategies equilibrium depends on the relations between the number
of competitors, the degree of substitutability among the goods and the level of
excess profitable capacities. It is shown in particular in Benassy (1989a) that a
sufficient condition for the traditional Chamberlin equilibrium still to be a Nash
equilibrium in this model is that
( n - 1 ) ( k * - q*)/> q * ,
(1)
i.e. that excess productive capacities of the competitors be greater than each
firm's production at the Chamberlin equilibrium q*, a quite intuitive condition.
Conversely if q* is sufficiently greater than excess capacities, the equilibrium in
pure strategies can be destroyed.
All this shows quite clearly that, contrary to a traditional belief, consideration of differentiated commodities only partially solves the existence problem
which Edgeworth posed in the case of perfect substitutes.
3.4. The Chamberlinian model with entry

As we indicated, the equilibrium studied in the two preceding subsections is a
short-run one, which generates profits for all firms, as shown in Figure 37.2.
Now Chamberlin assumes that such an equilibrium with positive profits cannot
last, as the mere existence of these profits will lead to entry of new firms. As a
result, the demand curve (and the associated marginal revenue curve) will
J.-P. Benassy
2008
MC
AC
'AR
~q
q~
Figure 37.4
move to the southwest until one reaches the famous tangency condition (Figure
37.4) where all profits have been wiped out by entry.
Now we should note that, as compared to the equilibrium without entry
(Definition 1 and Figure 37.2), there is a very serious conceptual problem
associated with the potential definition of the equilibrium with entry implicit in
Figure 37.4. Indeed we used in Definition 1 the "traditional" formalization of
an equilibrium where the set of goods is given a priori. Entry in this framework
means that we are adding new goods to the list of goods, and thus changing the
space of goods in which we are working. Even if adding new firms does not
pose much problem if they are assumed to have identical technologies, it is far
from clear how preferences in the "old" and "new" space will relate to each
other, and in particular how to derive them from underlying characteristics of
potential goods. We shall see in Section 5 that there are many different
approaches to this problem, but first we shall consider an economy with a given
set of goods and tackle an important problem, that of the "competitiveness" of
a monopolistic competition equilibrium.
2009

Existence of a pure strategies price equilibrium is further investigated in Vives
(1990). In the case where a pure strategies Nash equilibrium does not exist,
one may look for mixed strategies equilibria [see Glicksberg (1952) for
continuous payoff functions and Dasgupta and Maskin (1986) for discontinuous
ones].
4. How competitive is monopolistic competition?

In this section we study an important conceptual and practical question, that is,
how close to perfect competition is a monopolistic competition equilibrium. In
order to be precise, we have to choose an index of competitiveness. We shall
take Lerner's "degree of monopoly":
Lj-
pT-C'(qT)
,
Pj
The closer to zero this index is, the more "competitive" the market. Now at
least two factors are often cited in the literature as conducive to a close to
competitive outcome. The first is often referred to as "market size"; competition will obtain if each competitor is small as compared to the market he
operates in. A second factor is substitutability; a market will be competitive if
competitors produce goods which are very close substitutes to the goods you
produce. We shall now study how various concepts of imperfect competition
allow us to relate competitiveness to these two factors.
4.1. The Cournot equilibrium and market size

We shall now see that the Cournotian model quite naturally leads to market
size as a fundamental determinant of competitiveness. Assume thus there are n
firms producing perfectly substitutable goods with cost functions Cj(qj), j =
1. . . . . n. Call Q total production and F(Q) the inverse demand curve.
Definition 2. A Cournot equilibrium is defined by a set of quantities q~,

j = 1 , . . . , n and a price p* such that:
(a) q~ maximizes F( qj + Ei~j q*i)qj - Cj( qj), Vj,
(b) p* = F(Q*) = F(Ej q~.).
Now the first-order condition of the maximization program giving q7 yields
immediately
2010
J.-P. Benassy
F(Q) + qj. F'(Q) - C;( qj) = O.

Thus the Lerner index is easily computed as
F ( Q ) - C~(qj)
qj QF'(Q)
qj
F(Q)
= - - Q " F(Q) =-Q.qb
where ~b is the absolute value of the elasticity of the inverse demand curve.4 We
thus see that, other things equal, the Lerner index is proportional to q/Q, i.e.
the size of firm j's production as compared to the total production of the good,
which will be equal to 1/n if the model is symmetric.
We should point out that the relation between "market size" and competitiveness has been quite refined beyond the above computations based on the
number of competitors. In a series of contributions [Novshek and Sonnenschein (1978), Novshek (1980) and several others], competitiveness is
related to the ratio of optimum productive size to demand at minimal cost
(there are thus increasing returns). Useful surveys of this important line of
research can be found in Fraysse (1986), Mas-Colell (1982) and Novshek and
Sonnenschein (1986, 1987). We shall see other generalizations of the above
idea in Section 6.3.
4.2. The traditional Chamberlinian model and substitutability

Let us now consider the Chamberlinian model presented in Definition 1, where
the products j = 1 , . . . , n are imperfect substitutes. Recall that the program
leading to pj is written
maximize piDj(pj, p j) - Cj[Dj(pj, p j)].
The first-order conditions lead to
Lj-
p j - C;(qj)
Pj
~Tj
where rtj -- -(pj/Dj) ODj/Opj. We want now to relate this own-price elasticity
of the demand curve Dj to more basic parameters. Recall that the demand Dj is
obtained by maximization of the utility U(q, x) under the budget constraint
4Note that, though the goods j = 1 , . . . , n considered are perfect substitutes, ~b represents
s o m e h o w an index of substitutability with the other goods in the economy, as we shall see in the
next subsection.
2011

pq+x=R.
Denote by o-q the A l l e n - H i c k s elasticity of substitution between goods i and

j [Allen and Hicks (1934), Allen (1938)]. This is related to the term sit of the
Slutsky matrix by
R
O'/j~ mSij
qiqj
Using the Slutsky relation it is easy to compute

0log Di _ pjqj (o'q - ein )
0log pj
R
where eiR is the income elasticity of D i with respect to R. Now using this
formula and differentiating the budget constraint with respect to pj we obtain
~?j= l + E
Piqi
( % -- ein) +
-- exR )
We see that TIi is equal to 1 plus a weighted sum of the elasticities of

substitution of good j with goods i j and the num6raire x. 5 What this
expression shows us is that in this Chamberlinian model the number of
competitors does not really matter in determining competitiveness. What
matters is the degree of substitutability among the goods, as described by the
elasticities of substitution. In particular considering the limit case where two of
the goods are perfect substitutes, we obtain the Bertrand result that "two is
enough for competition". We have thus now quite clearly obtained substitutability as a factor of competitiveness, but, compared to the Cournot
model, this is at the price of the disappearance of market size as a factor of
competitiveness, which is somewhat unfortunate. We shall now see in the next
two subsections that Edgeworth's qualification of the Bertrand and Chamberlin
models does yield a significant role to market size in a market with explicit
price makers.
4.3. B e r t r a n d - E d g e w o r t h and m a r k e t size
Let us now consider the B e r t r a n d - E d g e w o r t h model of Section 2.4, but

assume this time that there are n firms, each with marginal cost c and capacity
5With more than one consumer we would obtain a weighted sum (this time across consumers) of
similar expressions for each consumer.
2012
J.-P. Benassy
kj. Call K total capacity. We shall now see that in this B e r t r a n d - E d g e w o r t h

model competitiveness does relate to size.
As a simple example, let us first consider the case where D ( c ) < K (Figure
37.5). T h e reader can easily check that the price p = c will be a Nash
equilibrium for the B e r t r a n d - E d g e w o r t h g a m e provided that
max kj <~ K - D ( c )
1
i.e. there must be excess capacity in the m a r k e t as a whole, and this excess
capacity must be greater than the m a x i m u m capacity of every single competitor. T h e intuitive reason behind this condition is that in such a case all
d e m a n d lost by a high price firm can actually be served by the other
competitors. If all competitors have the same capacity, this can be rewritten as
K-
D(c)
K
1
n
i.e. the relative excess capacity must be greater than 1 / n , which naturally
relates competitiveness to m a r k e t size.
If we now m o v e to the cases where a pure strategies equilibrium does not
exist, a n u m b e r of studies have shown that a different f o r m of Nash equilibrium could exist, and would s o m e h o w " c o n v e r g e " towards c as n became large.
p.
I
I
I
I
I
I
o[c)
Figure 37.5
2013
Shubik (1959), Allen and Hellwig (1986a,b) and Vives (1986) have shown that
mixed strategies equilibria would exist in the Bertrand-Edgeworth game, and
converge in probability towards the competitive price. Similar results are
obtained by Dixon (1987a) for a concept of approximate Nash equilibrium.
Introducing quantity constraints in the Bertrand model thus allows us to
re-introduce market size as a main determinant of competitiveness, both in
pure and mixed strategies senses.
4.4. The Chamberlinian model revisited

In light of the above Bertrand-Edgeworth formalization, we now see that
there was not much chance for market size to play a role in the traditional
Chamberlinian model, as it is implicitly assumed in the construction of the
demand curve that each firm can (and will) serve any amount of demand
forthcoming at any price. Under this assumption any small firm is assumed to
be potentially able to serve the whole market demand, and under such
circumstances it must come as no surprise that market size does not matter in
the competitiveness of a traditional Chamberlinian equilibrium.
We saw however in Section 3.3, that the assumption that any firm would
serve any demand forthcoming at any price was not consistent with profit
maximization, and should be replaced by the assumption that each firm would
not serve more than its profitable capacity. Under such circumstances market
size naturally re-appears in the corresponding model. We saw indeed [equation
(1)] that a sufficient condition for the Chamberlin equilibrium still to be a Nash
equilibrium in this model is that
(n - 1)(k* - q*)/> q*
(1)
where profitable capacity k* is defined by
C'(k*) = p * .
(2)
To get an intuitive grasp of how (1) relates competitiveness to size, let us

consider an example and assume isoelastic demand curves (this is actually
derived from a specific utility function in Section 5.1)
qj = A j p j -~,
(3)
e>l
as well as cost functions of the form
Cj(qi ) = c q ~ + f ,
/3/>1,
(4)
J.-P. Benassy
2014
i.e. constant (/3 = 1) or increasing (/3 > 1) marginal costs. Under (3), the
traditional equality between marginal revenue and marginal cost is written
C'(q*)=p*(1-1),
(5)
which allows us to compute the Lerner index
L * - p* - C'(q*) _ 1
p*
(6)
While using (2), (4) and (5), equation (1) is rewritten
( ~ 1) 1/(/3-1)- l ~ > - - 1
n-1
which, using simple manipulations, yields the slightly stronger condition

n-l~>(/3-1)e.
(7)
Though (7) is only a sufficient condition for the existence of a pure strategies
equilibrium, its discussion is quite enlightening.
We first see that for perfect substitutes (e infinite) and increasing marginal
costs (/3 > 1 ) , condition (7) is never satisfied, which corresponds to the
Edgeworth non-existence problem. Secondly for /3 = 1 (constant marginal
costs), condition (7) imposes no constraint, and competitiveness only requires
high e, corresponding to high substitutability. In this case "two is enough for
competition".
If, however, marginal costs are increasing (/3 > 1), we see immediately that
condition (7) will be satisfied for large e (i.e. by (6) for near competitive
outcomes) only if n itself is suitably large. The lesson from these simple
calculations is clear: unless marginal costs are constant throughout (which is
quite unrealistic), competitiveness in a price setting game results from two
factors: (a) the existence of close substitutes, so that the Walrasian demand has
a high elasticity; (b) a large market size, which in the above framework yields
sufficient unused capacities for competing products.
We should finally point out that we have only considered here pure strategies
equilibria. Intuition suggests that a full characterization of equilibria, for
example i, terms of mixed strategies Nash equilibria, would make both the
degree of substitutability and market size appear as determinants of competitiveness, but such characterization unfortunately does not yet exist.
2015

As we have seen here, in the traditional Chamberlinian model competitiveness
is clearly related to substitutability between competing goods, but not to
market size. In order to validate the important "Cournotian" insight that
market size also plays an important role, we introduced (rationally perceived)
quantity constraints, as in Edgeworth. But a full characterization of the
resulting model still remains to be done in the imperfect substitutes case.
Another interesting link between the Cournotian and Bertrand-Edgeworth
lines has been studied by Kreps and Scheinkman (1983) who showed that a first
round capacity competition followed by a second round Bertrand-Edgeworth
price competition could lead to a Cournotian-type equilibrium. Though the
exact equivalence has been shown to be fragile (Davidson and Deneckere
1986), this may be a line worth pursuing.
In a different vein, direct comparison of the competitiveness of price versus
quantity competition for a given demand system is carried out in Vives (1985).
Finally an alternative way of making market size appear as a determinant of
competitiveness, while staying within the "traditional" Chamberlinian approach, is to assume that goods must become very close substitutes as their
number becomes large, based on the idea that there is limited diversity of
potential goods, an insight found in Mas-Colell (1975), Hart (1979) and Jones
(1987). In order to better study this issue we must now move to models where
the number of competitors and the nature of products is endogenous.
5. Endogenous product differentiation

We have so far considered economies with a given number of products and
operating firms. Consideration of the entry phenomenon in the Chamberlinian
model now leads us to consider models where the set of products and of firms
is itself endogenous, and therefore to examine in more detail the issue of
product differentiation.
5.1. The modelling of product differentiation and entry: a first approach

The method usually employed to formalize product differentiation is to postulate a set of "potential" goods, which is a priori quite bigger than the set of
goods actually produced, and to specify both the preferences of consumers and
the productive possibilities of potential firms in terms of these potential goods.
A first and popular method is that of the "representative consumer"
J.-P. Benassy
2016
approach [see for example Dixit and Stiglitz (1977), Spence (1976)]. A typical
model assumes that there is a set of countably infinite potential goods. Each is
produced by a different firm so that the (endogenous) number of firms will be
equal to that of the differentiated goods. The consumption sector is assumed to
be represented by a "big" consumer with income R and a utility function
U ( q l , . . . , q,,, x)
(8)
where this time the utility function U must be defined for any value of n. Quite
often a particular parametrization is chosen, for example involving a subutility
index for the differentiated goods, such as a CES one,
U(q, . . . . , q , , , x ) = V
~, q
o)" ]
,x
(9)
j=l
where 0 < 0 < 1 and V is homothetic. Note that such a function displays
"preference for diversity", as the consumer will always want to consume some
amount of each of the n goods available. Maximization of a function such as
(9), subject to the budget constraint
j=l
pjqj + x = R ,
yields for large n approximately isoelastic demand curves for each product j of
the form
qj = a j p j ~
(10)
with e = 1 / ( 1 - 0 ) . To solve such a model fully, let us assume that each

potential firm operates with constant marginal cost c and a fixed cost f, and
further specify the utility function (9) as
U(q,,...,
qn, x) =
:)o,o
x '-"
(11)
First take the number n as given (short-run equilibrium). Each firm maximizes
profit ( p j - c ) q j - f subject to the demand constraint (10), which yields
immediately
f i - 1 - ( i / e ) - O"
(12)
Secondly maximization of utility function (11), assuming all prices pj equal to

p, yields
2017
aR
q J - np
(13)
so we obtain with the help of (12),
4=
OaR
nc
(14)
Now t5 and 4 represent short-run equilibrium values relative to a given n.

The number of products actually produced will be given by the zero profit
condition
(fi- c)4- f=O,

yielding the equilibrium number of firms
n*= ( 1 - 0 ) a R
(15)
and, with the help of (12) and (14) the equilibrium price and quantity
c
p* = -
O'
q* =
of
( 1 - O)c
(16)
We may note that this model displays the particularity that, even if the
number of firms goes to infinity, which will occur for example if f/R goes to
zero, the price will nevertheless remain bounded away from the competitive
price c, due to the CES form of the subutility function in (9). A similar result
can actually be obtained with a multitude of consumers consuming each a finite
number of goods [Hart (1985b)]. 6
As we have just seen, the representative consumer approach to product
differentiation allows us to characterize quite easily a situation of Chamberlinian equilibrium with an endogenous number of goods and firms. It poses
however serious problems of interpretation, as it is notably quite unclear from
which underlying characteristics of the potential goods particular families of
utility functions as in (8), (9) or (11) come. For this reason a substantial body
of literature has developed to examine this issue.
6Other symmetric Chamberlinian type models with a multitude of consumers are built in Perloff
and Salop (1985) and Sattinger (1984).
J.-P. Benassy
2018
5.2. Product differentiation: a general view

In this more general view of product differentiation, found for example in
Mas-Colell (1975), it is assumed that a good is fully described by a set of
characteristics, which may include the full physical description of the good,
location and time of availability, etc. Each potential good is described by a
point in a characteristics set K. In that framework a consumption plan or a
production plan are represented by a measure on K. Consumption sets o r
production sets are the sets of all feasible such measures. Preference relations
can be defined on these measures. An assumption of continuity of preferences
allows us to define a notion of "closeness" or "substitutability". Two goods will
be highly substitutable if they are topologically close (Mas-Colell, 1975).
O f course it is difficult to obtain general results in monopolistic competition
equilibria using such a general characterization. Research has thus proceeded
along several lines, each using a particular, and often more intuitive, specification of characteristics and preferences. T h e r e are a few well-known examples.
(a) The original "characteristics" approach notably pioneered by Lancaster
(1966, 1975, 1979) assumes that what the consumers are interested in is a set of
l characteristics. A good " k " is described by the vector of quantities of each
characteristic k m , . . . , k~ which it embodies. The set K is the set of vectors k
corresponding to technologically feasible goods. 7 If a consumer consumes a
"distribution" /x(K) on K, his utility will be given by U(q, x), where x is a
num6raire good and q E R ~ is the sum of characteristics obtained via the
distribution/x, i.e.
q = f kd/z(k).
K
(b) In models of vertical differentiation, the characteristic is for example a

"quality" variable, s. The name "vertical differentiation" comes from the fact
that at equal prices, all consumers will rank goods in the order of descending s.
For example Gabszewicz and Thisse (1979, 1980), Shaked and Sutton (1982,
1983), use utility functions of the following form (assuming one unit of only
one quality s is consumed)
v
= sx = s(U
- p(s))
where R is numdraire income, p(s) the price of quality s and x the numdraire
left. An interesting feature of these models of pure vertical differentiation is
the "finiteness property" according to which there is a maximum number of
7K will be defined in an (l - 1)-dimensional subspace to avoid colinearities.
2019
firms which can co-exist with a positive market share at a free entry equilibrium
[see Gabszewicz and Thisse (1980), Shaked and Sutton (1983, 1987)].
(c) Conversely, in models of horizontal differentiation, no good is everybody's first choice, and which product will be chosen at equal prices depends
on the consumer. The consumer sector is generally represented by a distribution of consumers, each with a different ranking of the goods. A typical model
of horizontal differentiation is the spatial competition model, which started
with Hotelling (1929) and of which we shall now give an example.
5.3. Spatial competition

We shall consider in this section a model of horizontal differentiation which
comes fairly close to the ideas of monopolistic competition and will allow us to
show oil a precise example how to model both the price decisions of firms and
the endogenous determination of the range of products offered to the consumers. This is the so-called spatial model of monopolistic competition which
depicts spatial competition " a r o u n d a circle" [see Salop (1979)]. The consumer
sector is depicted by a circular market of length L, along which consumers are
uniformly distributed with a density A. These consumers must travel along the
circle to purchase output from a firm, and we shall assume that in so doing a
consumer incurs transportation costs amounting to ~-d2, where d is the distance
travelled between the firm and the consumer. Each consumer is assumed to
demand inelastically one unit of output.
On the production side, we assume there is a very large number of
"potential" firms. Each firm which enters the_market bears a fixed cost f, and
thereafter has constant marginal costs c. Products are differentiated from the
point of view of the consumers, since they must bear the transportation costs.
Firms must decide sequentially (i) whether or nor to enter, (ii) which " g o o d "
to produce (i.e. where to locate in the circle) and (iii) which price to set.
Let us first consider the post-entry stage and suppose that n firms have
entered. It has been shown by Economides (1989) that with quadratic transportation costs, the firms will seek maximal differentiation from each other in
the location game, and thus that they establish at equidistant locations so that
each firm has two nearby competitors at distance L/n. We shall look for a
symmetric equilibrium, so consider a firm j surrounded by other firms who
have all set prices ft. Then a consumer situated at distance ~ E [0, L/n] from
firm j will be indifferent between j or one of his neighbors if
pj+r~'2=d+~-
(L )2
--~"
n
2020
J.-e. Benassy
which easily solves in ~" and yields demand to firm j,
(PJ
(pj- c)Dj, which yields
Firm j maximizes
L
_
n
~
(PJ
+ -;- (PJ
c)
and allows us to compute prices and profits at a symmetric equilibrium,
TL 2
pj=/~=c+
n2'
A~'L 3
q~'=
n~-f.
Now, in the "first" stage of the game, entry will proceed until this profit has
been drawn to zero, which immediately gives the equilibrium values
/
n*=L~-f-]
p * : c + T ~{}f
(17)
This model of spatial monopolistic competition will allow us to study in a

simple manner a number of important issues such as competitiveness, efficiency
and the zero profits assumption.
5.4. Competitiveness
Looking at equations (17), we first see that we may have a large variety of
equilibrium situations, as far as competitiveness is concerned:
(a) a very competitive situation with a small number of firms if 7 is low,
which corresponds somehow to very high substitutability (note that the
Edgeworth problem does not arise here since marginal costs are constant and
there is no capacity limit),
(b) a very competitive situation with a large number of firms, which will
occur if f is low or A is high;
(c) but we may also have a non-competitive situation with a large number of
firms if L is high.
We may first observe that, in accordance with our discussion of Section 4.2,
competitive situations occur here when the goods of two competing firms have
become very substitutable. But this situation itself may come from two
different causes. In case (a), all goods in the characteristics space (the circle)
are highly substitutable because of low transport costs. In that case, two or a
2021
small number of firms is enough for competitiveness. In case (b), the market
can support a large number of competitors which somehow "crowd in" the
restricted characteristics space, so that each firm has two nearby competitors
which produce goods which are very substitutable to his. We should note that
this last insight has been studied in more generality by Jones (1987) who
showed that in a two stage game where firms choose first the type of good they
will produce, and then prices, a large number of operating firms (due to small
fixed costs) will lead to a near competitive outcome if the set of possible
products is compact.
A second remark, inspired by the comparison of cases (b) and (c) is that
whether or not large numbers of competitors lead to a competitive outcome
depends very much on which underlying parameter (or combination or parameters) leads in the first place to a large number of operating firms. Notably, a
quick look at formulas (17) shows that one can easily construct examples where
the number of firms tends to infinity while the price does not converge towards
its competitive value. In particular, case (c) shows that convergence to competition can fail to obtain if the increase in numbers is due to a larger set of
characteristics.
5.5. Efficiency
The model of spatial monopolistic competition also allows a simple investigation of the problem of the optimum number of firms (and thus of products).
From the social point of view, it would be optimal to minimize the sum of
transportation costs and fixed costs, i.e.
L/2n
ATL3 + nf.
A~'~a d~ + n f - 12n2
L/2n
Minimization of that function yields the optimal number of firms n
opt
(AT) '/3
/AT\ 1/3
nP' = C ~7
<C/7 )
=n*.
We thus see that at the monopolistically competitive equilibrium there will
always be too many firms and products, i.e. there is excessive product
diversity.
We can also compare the optimal number of firms and production level in
the simple model of Section 5.1. With n firms, the remaining amount of
num6raire, once production costs are covered, is
J.-P. Benassy
2022
x=R-nf-c~
j=l
qj,
so that the optimum will be obtained by unconstrained maximization of
q])
~R-nf-cL
qi
j=l
which yields
Of
qOpt _
(1 -
nOVt=
0)c
'
(1-0)aR
(0 + a - aO)f"
Comparison with the equilibrium values q* and n* [equations (15) and (16)]
shows that
qOpt =
q,,
n pt > H * ,
i.e. this time there is insufficient product diversity, even though the level of
production is the correct one.
Of course both results are particular to the two specific models studied here.
Dixit and Stiglitz (1977) and Spence (1976) have shown in the framework
described in Section 5.1 that almost any configuration of n pt and n*, qOpt and
q*, could obtain by suitably choosing the utility function.
An interesting byproduct of the above computations is to show that the
presence of "excess capacity" at the monopolistically competitive equilibrium
is not per se a proof of inefficiency, as was believed for some time after
Chamberlin, since the optimum also takes place here in the decreasing portion
of the average cost curve.
5.6. Zero profits

The characteristics approach, and notably spatial competition theory, also
allows us to re-examine one of the basic assumptions of traditional monopolistic competition, i.e. that free entry leads to zero profits. In particular a number
of authors have studied sequential entry in location models, and shown that
free entry was consistent with positive long-run profits if each producer had to
commit irrevocably to a particular location (i.e. a product with given charac-
2023
teristics) when entering [Eaton and Lipsey (1978), Eaton and Wooders (1985),
Hay (1976), Prescott and Visscher (1977)]. Indeed the zero profit condition
actually comes from two distinct sources: (a) entry occurs if potential profits
are non-negative; (b) after entry profits of all firms are the same. Clearly free
entry corresponds to (a) only. Condition (b) is a consequence of particular
formalizations. In particular, in the spatial monopolistic competition model,
(b) comes from the fact that all firms costlessly and symmetrically relocate after
they have all entered. If entry is sequential and relocation is costly or
impossible, then pure profits will subsist in the long run even if entry and
location decisions are fully rational.
The following simple example, inspired from one in the insightful survey by
Gabszewicz and Thisse (1986) will illustrate the point. Consider the model of
competition on the circle (Section 5.3), and assume AT = f a n d L = 4, so that in
the equilibrium where all firms enter simultaneously, there would be exactly
four firms at distance 1 from each other, charging the same price c + ~- and
making exactly zero profits (Figure 37.6a).
Imagine now that firms enter sequentially in the order 1, 2, 3 . . . . . Firm 1
will locate anywhere on the circle. Clearly if firm 2 locates at distance 2 - e
from firm 1, only firm 3 will be able to enter and will choose the location at
distance 1 + (e/2) from firms 1 and 2 (Figure 37.6b). Firm 4 cannot enter in the
other segment between firms 1 and 2, as it would not cover fixed costs. Thus at
equilibrium there are only three firms. Taking an infinitesimal e, we find after
tedious calculations that
4
3
Figure 37.6
2024
J.-P. Benassy
P~=P2=C+
7r
4 '
83f
7 q = T r z = 64 '
P3
%=
c+
11~"
8
57f
64 "
In that case the persistence of positive profits in the long run is consistent with
free entry.
5. 7. Further reading
A problem which immediately strikes the reader of this domain is the large
variety of different formalizations of product differentiation, a variety which
the above compact presentation very much understates. For a more complete
view, the reader may consult the surveys of Archibald, Eaton and Lipsey
(1985), Encaoua (1990), Ireland (1987), as well as the survey on spatial
competition in Gabszewicz and Thisse (1986).
Fortunately a number of authors have recently tried to draw bridges between
various approaches. Anderson, De Palma and Thisse (1987) show that the
representative consumer approach can be derived from the characteristics
approach with an adequate distribution of characteristics. It turns out that with
n products, the dimension of the characteristics space is n - 1. Deneckere and
Rothschild (1989) construct a synthetic model which admits as particular cases
the Chamberlinian symmetric model and the model of spatial competition on
the circle.
6. General equilibrium representations

All the previous developments have been cast in a fairly partial equilibrium
framework in order to make the conceptual problems clearer. Already in 1940,
Triffin had forcefully advocated a full general equilibrium approach. We shall
thus develop in this section a number of general equilibrium representations of
monopolistic competition. For that we shall revert to an a priori given set of
goods, as really general concepts have been developed in that case only.
6.1. General f r a m e w o r k
We shall consider here an economy with m households i = 1 . . . . . m and n

firms j = 1 . . . . , n. Goods exchanged in this economy are a num6raire good
and non-monetary goods h E H = {1 . . . . , l}, with prices Ph.
2025
Firm j has a production vector y / ~ R ~which must belong to a production set

Y~ C R I with 0 E y/.8 We shall assume that the objective of the firm is to
maximize profits 7rj = pyj.
Household i has a vector of endowments of goods and num6raire toi E R~
and i >i 0, and a utility function Ui(w ~ + z~, xi) where z i is the/-dimensional
vector of net trades in goods and x~ is the final holding of num6raire good. The
household maximizes utility subject to his budget constraint, which reads
PZi + Xi = "~i + E Oi}Tri
jEJ
where 0ij is household i's share of firm j's equity.
6.2. Subjective d e m a n d curves

We shall now describe a concept of general equilibrium with subjective demand
curves, as developed in the pathbreaking work of Negishi (1961, 1972). It will
be assumed that the price makers are the firms (the concept actually extends
easily to price making households). Call Hj the set of goods whose prices are
controlled by firm j. We have
Hj n Hi, = { 0 } ,
j#j',
i.e. each good has its price set by at most one firm. The fundamental element
in the decisions of the firm is the subjective demand curve which shows how
much the firm expects to sell as a function of the price it sets. This expectation
is subjective, hence the name of subjective demand curves.
Negishi actually uses a perceived inverse demand curve which shows at
which price the firm expects to be able to sell an output as a function of the
quantity put on the corresponding market. This inverse curve is denoted as
Ph=Ph(Y/h,P,)Tjh),
hEH i
w h e r e / ~ and )Tjh are the observed price vector and production of good h (we
shall see below in the definition of equilibrium that these will be those actually
observed at equilibrium). This perceived demand curve satisfies a natural
consistency condition,
8We may note that the num6raire does not enter the production sets. This assumption is solely
made to simplifynotation and to facilitate transition to the next section where the num6raire good
is explicitly assumed to be fiat money.
J.-P. Benassy
2026
= e,,(Yjh, #, Y;,,),
Vh e
,%,
i.e. the curve "goes through" the observed point [Bushaw and Clower (1957)].
Definition 3. An equilibrium with subjective demand curves is defined as a set
of p*, Z i ,* i = l , . . . , m , y ~ , j = l ,
.. . , n s u c h t h a t
(a) z i maximizes U~(w~ + zi, xi) s.t. p * z i + x i = ~ + F,j Oqp y j,
(b) Y7 maximizes Eh~Hj P~Yjh + EhcHj Ph(Yjh, P*, Yj*h)Yjh s.t. yj E Yi,
(e)
~iEi
* ~< Ej~j y *j.
z i
Part (a) is the traditional condition saying that households maximize utility as
price takers; (c) is the traditional condition of consistency between aggregate
plans; (b) says that each firm maximizes profit taking all other prices for goods
h ~"Hj as given, and fully taking into account the effect of its quantity decisions
Yih, h E Hi, on the prices of the corresponding markets. We may note that the
Negishi concept contains the traditional competitive model as a particular case.
It suffices to take
Ph(Yjh, P, .Yjh) =--fit, "

Existence conditions are of course a bit more stringent than for a Walrasian
equilibrium. In particular the solution in yj of the profit maximizing program
max ~] P2Yjh + ~ Ph(Yjh, P*, Yjh)Yjh
h~'/tj
he/tj
should be convex and u.h.c, in its arguments. This is usually obtained by
assuming that the profit function is quasi-concave in the Yjh" This assumption is
not as demanding as it might seem. Indeed, since the family of perceived
demand curves is imagined, they can be chosen so that the various profit
functions are actually quasi-concave in the vectors Yjh (a natural example is that
of isoelastic perceived demand curves).
We may note that we have assumed for notational convenience that the
perceived clearing price Ph depends only on Yjh" The concept generalizes
naturally to the case where Ph depends upon the whole set of {Yjh [ h ~ Hi}
[Negishi (1972)].
6.3. Objective demand curve: Cournot

In the preceding section, the prices that would result from a vector yj were only
conjectured by firm j. The idea of an objective demand curve is to replace
2027
these conjectures by the prices which would actually obtain, should all firms j
take actions yj, j = 1 . . . . , n. This was notably developed in the seminal paper
by Gabszewicz and Vial (1972).
In order to make these things more precise, let us simplify the economy in
the following way. We assume there are in the economy only non-produced
goods (factors of production) sold by households to firms, and produced goods
sold by firms to households. In that way no firm sells to another firm. In fact it
seems that the concept we shall present below does not generalize readily to a
situation where price makers sell to other price makers.
The implicit picture is a two-stage one. In the first stage the firms decide
non-cooperatively the production vectors yj, j E J, in a way we shall describe
below. In the second stage a Walrasian equilibrium (possibly) obtains. This
Walrasian equilibrium is defined as a price/~ such that
i=1
~, p,
o,jpyj =
yj
j=l
where the vector functions ~i are the Walrasian demand functions of households i = 1 , . . . , m. Of course this Walrasian equilibrium, when it exists, will
depend on the vectors y~ . . . . , y , . We shall call F Y (for feasible y / s ) the set of
vectors yj such that a Walrasian equilibrium exists. We shall further assume
that in such a case the equilibrium price is unique, and denote it as
/~(Yl . . . . , Ym)" It is also convenient to rewrite this function from the point of
view of firm j as P(Yi, Y J) where y_j = { y k l k j } .
D e f i n i t i o n 4. A Cournot-Walras equilibrium is defined by a price vector p*,
vectors of production y~ and of net trades z *i such that
(a) z* maximizes U i ( o ) i -~ z i , Xi) s.t. p * z i + X i = Xi "~ E/=I 06p*Y~,

(b) y~ maximizes/~(yj, y*j)y~ for all yj such that (yj, Y ' i ) ~ F Y ,
(c) p* = P ( y T , . . . , y*).
Conditions (a) and (c) simply restate that p* and x *1 , . . . , x m
* form a
Walrasian equilibrium relative to the yj's. Condition (b) says that we have a
Nash equilibrium in quantity strategies where each firm maximizes its profit,
taking all other firms' quantity strategies as given, and forecasting the price
consequences of its choice through the objective price function/~.
We may note that existence in this model poses much more serious problems
than in the preceding Negishi concept. Indeed the profit function/~(yj, y j)yj
is no more arbitrary, as it is in the subjective demand curve approach, but is
fully given by the data of the model. As it turns out, robust examples have
been constructed where an equilibrium does not exist and in particular the
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J.-P. Benassy
profit function is not quasi-concave. Roberts and Sonnenschein (1977) have

exhibited examples where a pure strategies equilibrium does not exist. Dierker
and Grodal (1986) have an example where even a mixed strategies equilibrium
does not exist.
Another important point, noted and discussed in Gabszewicz and Vial
(1972) and Dierker and Grodal (1986) is that, contrary to the Walrasian case,
the equilibrium depends on the normalization rule chosen for prices (we
implicitly chose such a normalization by setting the price of the num6raire
equal to 1).
We have already noted in Section 4 that in a simple partial equilibrium
framework, the Cournot equilibrium is close to a competitive one when each
firm is small compared to its market. This issue has been studied in a general
equilibrium framework as well, starting with Gabszewicz and Vial (1972), who
showed that under suitable conditions the Cournot-Walras equilibrium of a
replicated economy would converge towards the competitive equilibrium of the
original economy. The point was further studied by Roberts (1980). Hart
(1979) analyzed the issue in the case where products could be endogenously
selected in a compact set of characteristics, as described in Section 5.2.
6.4. Objective demand curve with price makers
We shall now revert to the framework of Section 6.2, where agents are setting
prices. A number of concepts of an objective demand curve with price makers
have been developed, starting with the pioneering contributions of Marschak
and Selten (1974) and Nikaido (1975). 9 We shall describe here a concept
developed in Benassy (1988) which takes full advantage of the symmetry
between the price-setting and the quantity-setting games. 1 We assume that
households as well as firms can set prices. We shall denote by A = I U J the set
of agents and by/-/, the set of prices controlled by agent a. We shall further
assume that
H nH., ={0},
U H~=H.
Agents set non-cooperatively prices Pa, a E A and the equilibrium will be a

Nash equilibrium in prices. In order to construct this Nash equilibrium
concept, we must be able to forecast the "consequences" of every price vector.
The situation is quite symmetric to that encountered in Cournot-Nash equilibrium. There we had to compute the Walrasian equilibrium prices conditional
9See also Laffontand Laroque (1976) and Hart (1985a).
1Note that the method described below is also fullyapplicable to the subjective demand curve
approach. See Benassy (1976, 1982, 1990).
2029
on every quantity strategy. Here we must be able to predict quantities

demanded, supplied and exchanged conditional on any given price system. Of
course the natural theory to use is the theory of fixprice (or non-Walrasian)
equilibria which gives an answer to precisely that question. Before constructing
the "objective demand curves", let us thus summarize briefly a few concepts
[see for example Benassy (1982, 1990) for more details]. At non-Walrasian
prices, one should first distinguish between demands and transactions. Call ~,
the vector of net demands of agent a, z* the vector of his net transactions. On
each market h they are related by
~ min{z~h, dah)
Zah
Zah ~ - 0 ,
[maX{~ah,~ah } ~ah ~ O ,
(18)
where d.h /> 0 and S-~h<~0 are quantity signals which tell agent a the maximum
quantity he can respectively purchase or sell on market h. For a price maker
doh=-- ~ Z~h i f a i s a p u r c h a s e r ,
bV-a
S-~h=--~,Zbh
bC-a
if a is a seller,
(19)
For the other agents the rationing scheme is usually more complex as there
may be many rationed agents on the long side of the market. Transactions and
quantity signals will be functions of effective demands,
*
F,(~,
ZA)
(20)
da = G ad( Z~l , - ' ' ,
ZA),
(21)
g, = G ~ ( 2 , , . . . ,
~a)"
(22)
Of course in view of relation (18), the functions F,, Gad , G~ are not
independent. Conversely effective demands are functions of price and quantity
signals,
L = ~i(P, di, ~?i, 7r),
(23)
_~j : [,(p, a/, }-/),
(24)
where 7r is the vector of all firm's profits; ~r~ = pzj, ] ~ J.

An equilibrium consists of a set of ~., z.*, d., g. satisfying equations
(20)-(24). As it turns out, for a given rationing scheme it can be proved that
J.-P. Benassy
2030
an equilibrium exists for all positive prices under fairly standard conditions
[Benassy (1982)]. We shall further assume that this equilibrium isunique, 11 and
thus write the values of E., z*, d., Y. for price p functionally as Z . ( p ) , Z * ( p ) ,
/5.(p), S.(p). Now clearly the objective demand and supply curves for agent a
are simply represented by the functions S.(p) and D a ( p ) which represent
respectively the maximum quantity of goods h he can respectively sell or
purchase as a function of the price vector p. Accordingly the programs
determining p. for a E A are easily derived. For firm j, pj is the solution of
maximize pyj = - p z i s.t.
y j E Yj,
Sj(p) ~< - yj ~</)j(p),
yielding pj = ~bj(p_j). For household i, call 7r;(p) = - Z j c J OqpZ~(p) his profit
income. The vector Pi is the solution of
maximize Ui(w i + z i, xi) s.t.
PZi + xi = xi + ~i(P) ,
D,(p),
yielding Pi = ~bi(P i).
Definition 5. An equilibrium with price makers and objective demand curves
is defined as a set of p~, p* such that
(a) p* E 6/(P'i), Vi; p7 if_ thj(p*j), Vj;
(b) E,, z~*, d,, Y,, a E A, are a fixprice equilibrium relative to p* and the
given rationing schemes, i.e. they are respectively equal to Z , ( p * ) ,
Z*,(p*), D o ( p * ) , So(P*).
Sufficient existence conditions are given in Benassy (1988). As for all models
with objective demand curves, these conditions are stronger than the standard
assumptions on utility and production functions.
The concepts presented in this section can be differentiated along several lines.
l~See Schulz (1983) for intuitive sufficient conditions.
2031
One line is that of objective versus subjective demand curves. Subjective

demand curves are simpler to use, and do not require more information than
that actually observed on markets (i.e. price-quantity pairs). They imbed
however a large degree of arbitrariness, notably as far as their slopes are
concerned, which leads to a large number of potential equilibria. Objective
demand curves on the other hand do not have such arbitrariness, but are very
complex objects requiring that each price setter has as much information on
the economy as the model maker himself, quite a strong assumption. Some
authors have investigated intermediate concepts. Notably Silvestre (1977a)
investigates an ingenious equilibrium concept where each firm knows locally
the true slope of its demand curve. Gary-Bobo (1989) shows that under
suitable assumptions these equilibria are the same as objective demand curves
equilibria.
Another line of differentiation is that of quantity-setting models (Cournot)
versus price-setting models (Chamberlin), which we have already seen in
Section 4. An interesting attempt at reconciliation is the idea of rational
conjectures put forward by Hahn (1977, 1978), according to which each agent
would (rationally) conjecture the price-quantity responses of other agents. A
fully satisfactory concept does not seem to exist yet, however.
Throughout this section we have assumed that firms maximize profits.
Though this is a most traditional assumption, it is clear that the adequate
criterion should rather be some kind of weighted average of shareholders'
utilities. On this issue see for example Dierker and Grodal (1986), Gabszewicz
and Vial (1972) and Mas-Colell (1984).
Another most interesting development in the field is the relation with
increasing returns, which was forcefully put forward by Sraffa (1926). We have
already mentioned general equilibrium Cournotian models with increasing
returns. A number of contributions ]Arrow and Hahn (1971), Silvestre (1977b,
1978)] have included increasing returns in general equilibrium models with
price making agents. See also the 1988 special issue of the Journal of
Mathematical Economics on the subject.
Finally, following the monopolistic competition tradition, we have restricted
ourselves to models with one sided price (or quantity) setting. Strategic market
games with two sided price and (or) quantity setting have been constructed,
following notably Shubik (1973) and Shapley and Shubik (1977). In Cournotian-type market games, the equilibrium price system generally converges
towards the Walrasian one as the number of agents on each side of the markets
becomes large [see for example Dubey and Shubik (1978), Postlewaite and
Schmeidler (1978), Dubey, Mas-Colell and Shubik (1980), Mas-Colell (1982)].
In Bertrand-Edgeworth type games a Walrasian outcome can be obtained with
only a few agents one each side of every market ]see for example Dubey
(1982), Benassy (1986a)].
J.-P. Benassy
2032
7. Monopolistic competition and macroeconomic issues

The use of general equilibrium models such as the ones presented in the
preceding section allows us to construct rigorous "micro-macro" models of
monopolistic competition. Within such a framework one can study macroeconomic issues, such as the existence of unemployment or the effectiveness of
government policies, as well as more traditional microeconomic issues, such as
the efficiency of equilibrium. We shall present in this section a complete model
of this type, which will show that with respect to the above issues, monopolistic
competition leads to results somehow "intermediate" between Walrasian models and traditional Keynesian fixprice models.
7.1. T h e m o d e l
We shall consider a monetary economy with three types of goods: fiat money,
which is the num6raire, medium of exchange and a store of value; different
types of labor indexed by i = 1 , . . . , m; and consumption goods indexed by
j = 1 . . . . . n. T h e r e are three types of agents: households indexed by i =
1 . . . . , m; firms indexed by j = 1 . . . . . n; and government. Consumer i is the
only one to be endowed with labor of type i, firm j is the only one to produce
good j. We shall call w i the money wage for type i labor, pj the price of good j,
w and p the corresponding vectors:
p = (pjl j = 1,... , n},
w = (w, l i = 1 , . . . ,
m}.
Firm j produces a quantity of output yj according to a production function

yj = F ~ ( l j ) ,
lj = { l q l i = 1 . . . . .
m}
where lq is the quantity of labor i used by firm j (and thus purchased from
household i). We shall assume Fj strictly concave in its arguments. Firm j
maximizes its profits ~-j:
% = p j y j - wlj = p j y j - ~
wil q .
i=1
Household i has initial endowments li0 of type i labor and rfi i of money. H e
consumes a vector c i = {cq [ j = 1 , . . . , n} and works a quantity of labor li:
Ii = ~
j=l
lq <~ lio .
(25)
2033
Household i's budget constraint is

p c i -t- m i = wit i q- ].~r?li at- ~ OijTl-j
j=l
where mg is the final quantity of money and O~j the share of firm j owned by
household i. The f a c t o r / x is a government policy instrument whereby government can increase proportionately all money holdings by the same factor/x.
This particular (but popular) policy has been chosen because it is known to be
"neutral" in Walrasian equilibrium, ~2 which will allow an easy comparison.
Household i maximizes a utility function of the form
Ui(ci, li, mi/l~)
which is assumed to be strictly quasi-concave in ci, li and mi/l~ and separable in

its arguments. We shall assume that the disutility of labor becomes so high near
I~o that constraint (25) is never binding. The argument mg/l~ represents the
indirect utility of money, which should be homogeneous of degree zero in
money and expected prices. Thus the implicit idea behind our assumption is
that, other things being equal, future prices are expected to move proportionately t o / z . As we shall see in Section 7.5, this proportionality of prices t o / x is
consistent with the working of the model. 13
This model has a particular market structure where each good (labor or
consumer good) is sold by a single agent to many other agents; labor of type i
is sold by household i to all firms j = 1 . . . . , n. Output j is sold by firm j to all
households i = 1 . . . . , m. We shall assume that the price is decided upon by
the single seller. Firm j sets price pj, household i sets wage w~, taking all other
prices and wages as given. We shall assume that they do so using objective
demand curves, as described in Section 6.4. The equilibrium is thus a Nash
equilibrium in prices and wages, conditionally on these objective demand
curves.
7.2. O b j e c t i v e d e m a n d curves
Each seller sells only one good, and, as we shall see below, sets his price high
enough so as to be willing to satisfy all demand for that good. In equilibrium
each agent will thus be constrained only on his sales, and we shall have
12See for example Grandmont (1983) for a thorough discussion of this issue in Walrasian models.
13For explicitlydynamic models with perfect foresight which exhibit this proportionality property, see for example Benassy (1989b, 1991).
J.-P. Benassy
2034
somehow a situation of "general excess supply". We shall now compute the

objective demand curves in this zone of general excess supply. These objective
demand curves will be functions of the vectors p and w, and of the policy
parameter ix. So for given p, w and ix we must find out which demands for
goods and labor types will arise once all feedback effects have been taken into
account. As indicated in Section 6.4 this boils down to finding total demand for
goods i and j at a fixprice equilibrium corresponding to p, w and ix.
For given (p, w, ix) firm j is constrained on its sales of output j. It thus
solves the following program in lj:
maximize pjyj - wlj s.t. yj ~ Fj(lj)
where Yi is a binding constraint exogenous to the firm. The solution is a set of
labor demands Lq(yj, w) and a cost function Xj(Yj, w).
Similarly consider a household i which solves the following program:
maximize Ui(ci, l i, mi/ix ) s.t.
pc i + mi = ixrh~ + wil ~+ ~ Oq~rj

j=l
where p, w, ix, /~ and the profits 7rj are given. The solution is a set of
consumption demands,
Cq(ixrh, + wgl~ + ~ OqTrj, p, ix) .

j=l
Consider now the following mapping:
i~l
j=l
li-'-'~ ~ Lij(yj, w) ,
j=l
~j---~PjYj - Xj(Yj, w).

Assuming a unique fixed point, this yields functions Y j ( p , w , ix),
Li(p, w, IX) and rri(p, w, ix) which represent respectively the objective demand for good j, for labor i and the associated profits of firm j.
Secondly let us note that the functions Lq are homogeneous of degree 0 in w,
the functions Cq are homogeneous of degree 0 in ix, wi, p and 7rj, and profits
are homogeneous of degree 1 in p and w. From that we deduce Yj and Li are
homogeneous of degree 0, and 7rj homogeneous of degree 1, in the arguments
p, w and ix.
2035
7.3. Equilibrium: definition and characterization

Following Section 6.4 we shall describe the equilibrium as a Nash-equilibrium
in prices and wages, conditional on the objective demand curves. The quantities are those corresponding to a fixprice equilibrium associated with the
prices and wages. We shall now derive the optimal price and wage responses of
the agents.
Consider first firm j; it will solve the following profit maximization program
Aj in pj, yj and l~:
maximize pjyj - wlj s.t.
yj ~< Fj(Ij),
yj<~ Yj(p, w, tz) .
(At)
We assume this program has a unique solution, which thus yields optimal
price pj as a function of the other prices and wages,
pj = q,,(p j, w, ~ )
where p j = {pk ]k j}. In order to characterize the equilibrium quantities

simply, we shall also need to describe the optimal production plan of the firm
(yj, lj) as a function of the same variables, so that we shall write this optimal
plan functionally as
(yj, lj) -- q~(p_j, w, ~ ) .
Consider now household i. It chooses the wage w~, labor sales li and
consumption vector c~ so as to maximize utility according to the following
program A~ in w~, li and ci:
maximize Ui(ci, li, mi/tz ) s.t.
pci + m, : ~r~, + wd~ + ~ o,~j(p, w, ~) ,

li ~ Li(p,
w , /2,) ,
(Ai)
j=l
which yields the functions

wi = q,~(w ~, p , t~),
(l,, c,) = ~i(w_~, p, ~,) ,
where w i = (w k ] k i). We can now define our equilibrium with monopolistic competition as a Nash equilibrium as follows:
J.-P. Benassy
2036
(a) w,*.= ~i(w*,, p*,/2,), Vi;

(b) P7 = OJ(P-*J, w * , / Q , Vj,
(c) (l*, c*) = ~Pi(w*i, p*, I~), Vi;
(d) (YT, 17)= q~J(P*-J, w*,/.), Vj.
The first two sets of equalities express the Nash property in prices and
wages, and determine p* and w*. The last two sets of equations give the
optimal production, work and consumption plans of the agents, which correspond to their transactions on all markets. Note that because of the definition
of the objective demand curves, which is based on a fixprice equilibrium
notion, the consistency of transactions is automatically ensured, so that we do
not need to add the traditional equations stating the equality between purchases and sales on every market.
Of course the equilibrium will change as/.t changes. In what follows we shall
assume that to a given government policy is associated a unique equilibrium. In
order to study its various properties, we shall now characterize it by deriving a
number of relevant partial derivatives.
Consider first firm j and recall the program yielding its optimal actions:
maximize pjyj - wlj s.t.
Yj= Fj(li),
yj-< Yj(p, w, I~).
(Aj)
Let us assume an interior solution, so that in particular all components of lj
are strictly positive. Then the K u h n - T u c k e r conditions associated with this
program yield immediately
0 F j _ wi
Olij
pj 1 - (1/ej)
(26)
where ej = - ( & / y j ) OYJOpj is the absolute value of the own price elasticity of
objective demand. At an equilibrium, ei is greater than 1. These conditions can
also be rewritten, using the cost function Xj(Yj, w) of firm j:
~Xj - p j ( 1 - 1 )
Oyj
ej
(27)
which is the traditional "marginal cost equals marginal revenue" equations. Let
us turn now to the optimal program of household i:
maximize Ui(ci, li, mJla.) s.t.
pci + mi= ~mi + wili + ~ Oijrri(P, w, t*),

l, <- Li(p, w, pc).
j=l
(Ai)
2037
We shall assume an interior solution so that in particular all consumptions

are positive. Call Ai the "marginal utility of wealth", i.e. the K u h n - T u c k e r
multiplier of the budget constraint. We obtain the following conditions: 14
OU i
cgmi
ol i
c9U i
-= AiPy ,
Oc~i
- Ai ,
--
l~iW i
(1)
1- ~
(28)
(29)
where e i = - ( w i / l i )
O L / O w i. Again, at equilibrium e i > 1. With the help of
these differential characterizations, we can now describe some salient properties of our equilibrium.
7.4.
Underemployment,
underproduction
and inefficiency
We shall now show that, even though prices are fully flexible and rationally
decided upon by agents, the equilibrium allocation has properties which
strongly differentiate it from those of a Walrasian equilibrium.
First we see that at equilibrium there is both underemployment and underproduction. Indeed equation (27) shows that at the going price and wage, firm j
would be happy to produce and sell more if the demand was forthcoming, thus
displaying underproduction. Symmetrically, equation (29) shows that household i would like to sell more of its labor if the demand was present, thus
displaying underemployment.
We shall further show that employment and production throughout the
economy are inefficiently low in the following strong sense: it is possible to find
increases in production and employment which would increase all firms' profits
and all households' utilities at the equilibrium prices and wages.
Consider indeed at the given price and wage system p* and w*, some small
arbitrary increases dlij > 0 . These yield extra amounts of employment and
production:
dl i = ~ dlij > 0
j=l
14We actually assume for simplicity that the influence of wi on household i's profit income is
negligible, which will be the case if there are many households, and each owns negligible shares of
each firm.
J.-P. Benassy
2038
Consider first the profit variation for firm j:
dTrj = pj dyj - ~
w i dlq
i=l
In view of equations (26), this is easily found equal to

dTrj -
pj dyj
ej
> 0
(30)
Now we shall assume that the extra production in the economy is redistributed to households in such a way that the values of the extra consumptions for
each household add up to the value of his extra labor and profit income, which
is written for household i,
p, dci/= widl ` + ~ Oqdlrj.

j=l
(31)
j=l
The increment in utility is, since mi and ~ do not change,
OUi
oui
dU~ = 2.,
dcq +
dli
,=1 q---~
0
-~/
which, using equations (23)-(26) becomes
dU i =
[ widli
Ai
Ei
~ OiYPY-dyj ]
j=1
Ej
> 0
(32)
Equations (30) and (32) clearly show that the incremental employment and
production will increase all agents' utilities or profits: We may note that this
inefficiency result is quite stronger than Pareto inefficiency since we have
constrained the incremental trades to be consistent with the equilibrium price
wage system, whereas such a constraint is not required to obtain Pareto
inefficiency. We should also note that these inefficiencies are quite similar to
these observed in "Keynesian type" general excess supply states [see for
example Benassy (1977, 1982)]. We may also finally note that the "efficiency
losses", as described by equations (30) and (32) are higher, the higher the
Lerner indices 1/e i and 1/ej on the various markets.
7.5. Neutrality of monetary policy

We have seen in the preceding subsections that our imperfect competition
equilibrium displayed some inefficiency properties very akin to traditional
Ch. 37: Monopol&tic Competition
2039
Keynesian excess supply states. We shall now investigate a traditional

"Keynesian" policy to cure such inefficiencies, a monetary policy, and we shall
now see that, in spite of its "Keynesian" characteristics, the system described
above reacts to monetary policy in a more "Walrasian" than "Keynesian"
manner. Namely, monetary policies taking the form of proportional increases
in initial money holdings (i.e. /x > 1) are ineffective, or "neutral", just as in
Walrasian models. As a response to such a policy, production, employment
and utilities do not change. Prices, wages and profits are multiplied by/x.
The proof of that result is actually quite trivial in view of the homogeneity
properties of our system. Let us look indeed at the programs A/ and A i
yielding the optimal actions of agents; from program A i it is clear that
q~j(/xp i,/zw, ~) =/z~0j(p j, w, 1),

~;(~p j, ~w, ~) = ~j(p_j, w, 1).
Similarly program A i yields
~,(~,w ,, . p , ~) = ~q,,(w_,, p, 1),

q~i(/xw , , / z p , / x ) = ~o~(w_,, p, 1).
In view of these homogeneity properties, y~, l~, l*, c i are homogeneous of
degree 0 in k~, whereas p* and w* are homogeneous of degree 1 in /x.
7.6. F u r t h e r r e a d i n g
The model presented here, developed in Benassy (1987, 1990), is a model with
explicit price makers and objective demand curves. Similar models with
unemployment were presented in Benassy (1977) and Negishi (1977) for
subjective demand curves with price makers, and in Hart (1982) for an
objective "Cournotian" demand curve with quantity setting agents.
Other macroeconomic models with imperfect competition are found in
Benassy (1982, 1989b, 1991), D'Aspremont, Dos Santos and G6rard-Varet
(1989, 1990), Dehez (1985), Dixon (1987c), Jacobsen and Schultz (1990),
Negishi (1979), Silvestre (1988), Sneessens (1987), Snower (1983), Svensson
(1986) and Weitzman (1982, 1985).
8. Conclusions
Traditional microeconomic theory, whether Marshallian or Walrasian, was

clearly in need of an explicit theory of price making by agents internal to the
2040
J.-P. Benassy
system. Monopolistic competition is obviously an interesting and fruitful

attempt in this direction. It allows us to deal with problems which competitive
theory could not cope with, such as increasing returns. It yields new insights in
fields such as macroeconomics or international trade [on the latter, which we
did not survey at all, see for example the recent expositions by Helpman
(1989), Helpman and Krugman (1985), Krugman (1989)].
In view of the size of the field, the overview of this chapter could only be a
partial one, and the reader will find complementary insights in other surveys,
such as for example Archibald (1987), Archibald, Eaton and Lipsey (1985),
Eaton and Lipsey (1989), Gabszewicz and Thisse (1986), Hart (1985a), Ireland
(1987), Lancaster (1979), Mas-Colell (1982), Negishi (1987), Novshek and
Sonnenschein (1986, 1987), Shubik (1959, 1985), Shubik and Levitan (1980)
and Stiglitz (1986).
As indicated in the introduction, in order to have a fairly homogeneous
presentation, we restricted our exposition to the traditional vision of a monopolistic competition equilibrium as a one period Nash equilibrium with perfect
information. Already in this apparently simple framework we encountered a
number of important conceptual problems. In particular it appears that a
synthesis between the lines of research initiated by Cournot, Bertrand,
Edgeworth, Hotelling and Chamberlin remains to be done.
In spite of the potential difficulties, it is nonetheless clear that research on
the monopolistic competition paradigm should be pursued in a number of
directions. Notably more complex strategic interactions should be considered,
such as those found in the theory of oligopoly or industrial organization [see
for example Friedman (1982), Shapiro (1989), Tirole (1988)], imbedding of
course the time dimension of the games actually played. Also, in view of the
extremely high amount of information implicit in the games we described, as
compared with the competitive price taking paradigm, the study of imperfect
information seems a natural extension of the theory of monopolistic competition [see for example Stiglitz (1989)]. All this should be the subject of fruitful
further research.
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Chapter 38
COMPUTATION
AND
MULTIPLICITY
OF EQUILIBRIA
TIMOTHY J. KEHOE*
University of Minnesota and Research Department, Federal Reserve Bank of Minneapolis
Contents
1.
2.
Introduction
Static exchange economies
2.1.
2.2.
2.3.
2.4.
2.5.
2.6.
2.7.
3.
Equilibrium and optimization

3.1.
3.2.
4.
Welfare theory and existence of equilibrium

Computation and multiplicity of equilibria
Static production economies

4.1.
4.2.
4.3.
4.4.
5.
Existence of equilibrium
Scarf's algorithm
The global Newton method
Regularity and the index theorem
Path following methods
Multiplicity of equilibria
Other computational methods
Existence of equilibrium
The index theorem and multiplicity of equilibria
A t~tonnement method
Computation in the space of factor prices
Economies with a finite number of infinitely lived consumers

5.1.
5.2.
5.3.
5.4.
5.5.
Deterministic exchange economies

Dynamic production economies and dynamic programming
Stochastic economies
Differentiability and regularity
Computational methods
2051
2051
2052
2055
2057
2059
2061
2065
2068
2072
2072
2075
2078
2078
2082
2085
2086
2089
2089
2092
2099
2102
2103
*I would like to thank participants in BoWo89 for helpful comments and suggestions, especially
Robert Anderson, Donald Brown, Gerard Debreu, Hildegard Dierker, Michael Jerison, Reinhard
John, Andreu Mas-Colell, Harald Uhlig and William Zame. I gratefully acknowledge support from
Deutsche Forschungsgemeinschaft, Gottfried-Wilheim-Leibniz-F6rderpreis during BoWo89 and
from National Science Foundation grants SES 87-08616 and SES 89-22036.
The views expressed herein are those of the author and not necessarily those of the Federal
Reserve Bank of Minneapolis or the Federal Reserve System.

6.
Overlapping generations economies

6.1. Existence of equilibrium
6.2. Multiplicity of equilibria
6.3. Computational methods
7. E c o n o m i e s with t a x e s a n d e x t e r n a l i t i e s
7.1. Static economies with taxes
7.2. Dynamic economies with taxes and externalities
7.3. Characterizing equilibria as solutions to optimization problems
References
2112
2112
2115
2122
2127
2127
2131
2134
2137
Ch. 38: Computation and Multiplicity of Equilibria
2051
1. Introduction
In recent years the Walrasian general equilibrium model has become an

important tool for applied work in such fields as development economics,
international trade, macroeconomics and public finance [see, for example,
Shoven and Whalley (1984) and Lucas (1987)]. Unfortunately, economic
equilibria are usually solutions to fixed point problems rather than solutions to
convex optimization problems. This leads to two difficulties that are closely
related: first, equilibria may be difficult to compute; second, a model economy
may have more than one equilibrium.
In this paper we explore these two issues for a number of stylized economies.
We start with static exchange economies and then add a production technology. We later analyze economies with infinite numbers of goods, economies in
which time and uncertainty play important roles. Studying economies of this
sort is interesting not only for its own sake but because of the insights it
provides into the properties of economies with large, but finite numbers of
goods. Finally, we extend our analysis to economies that include distortionary
taxes and externalities.
Although our emphasis is on computational issues, the approach is fairly
theoretical. As Scarf (1973, 1982) has stressed, a precondition for developing
computational methods for finding an equilibrium is to know that one exists.
Furthermore, existence proofs often suggest algorithms for computing equilibria. Consequently, much of this paper deals with proofs of the existence of
equilibria for a variety of economies. The paper is also filled with simple
numerical examples, however, that illustrate the theory and could serve as test
problems for algorithms. The reader who wishes to implement any of the
algorithms suggested here on the computer should consult a good book on
numerical methods, such as Acton (1970), who provides a wealth of practical
advice, and Press, Flannery, Teukolsky and Vetterling (1986), who provide a
large number of useful computer programs.
2. Static exchange economies
We begin by reviewing results for exchange economies with a finite number of

consumers and a finite number of goods. We use two alternative specifications
of such an economy, the first in terms of utility functions and endowment
vectors, the second in terms of aggregate excess demand functions. Although
the first specification is in some sense the more primitive, we alternate between
the two as is convenient.
T.J. Kehoe
2052

Consider an economy with m consumers and n goods. Each consumer has
preferences given by a utility function u i : R~---> R that is strictly concave and
monotonically increasing. He is endowed with a vector w e = (W~l,..., wi,) that
is strictly positive. An equilibrium of this economy is a price vector/3 E R~\{0}
and an allocation (21. . . . ,2m), where 2 ~C R~, such that
2 i, i= 1 . . . . . m, solves max ui(x ) subject to 15'x<-~'w i, x ~ O ,
r,i~=l 2 i <- r~i~=~w i.
Alternatively, we could specify this economy in terms of an aggregate excess
demand function f : R~\{0}---> R". We assume that f is continuous; that it is
homogeneous of degree zero, f ( O p ) ~ f ( p ) for all 0 > 0 and all p E R~\{0};
and that it obeys Walras's law, p ' f ( p ) =-0 for all p E R~\{0}. An equilibrium
is now a price vector/3 E R~\{0} such that
0.
Notice that Walras's law implies that f~(/5)= 0 if/)~ > 0 .

To motivate our assumptions on f, we can think of f as being derived from
the first specification of this economy. Let x~(p) be the solution to the
consumer's utility maximization problem. Our assumptions on u~ and w i imply
that x i is continuous, at least for all strictly positive price vectors; that is
homogeneous of degree zero, x~(Op) --xi(p) for all 0 > O, p E R~+ ; and that it
obeys the budget constraint, p'xi(p)=--p'w ~. The aggregate excess demand
function
f ( p ) = ( x i ( p ) -- W i)
i=l
therefore, is continuous, at least at all strictly positive price vectors, is

homogeneous of degree zero and obeys Walras's law.
Unfortunately, utility maximization does not imply that f is continuous on all
R+\{0}. Rather, it implies that f is continuous and bounded below on all R++.
For some, but not necessarily all, pOE R+\{0} where p~ = 0 , some i, if
pk__~pO, pk E R++, then IIf(pk)ll---~oo. [See, for example, Arrow and Hahn
(1971, Chap. 2)]. One way to handle the possibility that f becomes unbounded
at price vectors that have some zero elements is to impose a constraint like
x~<2 E mj= 1 w j in each consumer's utility maximization problem. With such a
constraint xi(p), and therefore f, is continuous on all R+\{0}. Furthermore,
such a constraint cannot bind in equilibrium. An alternative way to handle this
possibility is to show that, for any f:R++---~R that satisfies the conditions
implied by utility maximization, there is another function f* that satisfies our
assumptions, agrees with f on some open neighborhood of every equilibrium of
f, and has no equilibria that are not equilibria of f [see, for example, Kehoe
(1982)]. In any case, since the potential unboundedness of excess demand
2053
when some prices are zero does not play a significant conceptual role in any of
the issues discussed in this paper, we shall ignore it.
There is a close connection between equilibria of such economies and fixed
points of continuous mappings of the simplex S = { p E R~ I e'p = 1, p 1> 0}
into itself. (Here and subsequently, e = ( 1 , . . . , 1).) T o prove the existence of
equilibrium we employ Brouwer's fixed point theorem.
Brouwer's Fixed Point Theorem. L e t S C R" be any n o n - e m p t y , compact,

convex set, and let g : S---> S be continuous. Then g leaves s o m e c E S fixed, that
is, ;c = g( ;c) .
Homogeneity allows us to restrict our attention in studying equilibria to the
simplex: if f(/~) ~ 0 for/3 ~ S, then f ( f i ) ~<0 for fi --/~/(e'/3). S is non-empty,
compact and convex. Consider the function g : S--~ S that associates with any
point p ~ S the point g ( p ) E S that is the closest point in S to p + f ( p ) in terms
of euclidean distance. In other words, g ( p ) solves the problem
min ~ ( g - p - f ( p ) ) ' ( g - p - f ( p ) )
e'g = 1,
subject to
g>~O.
Since the objective function is strictly convex in g and continuous in p and the
constraint set is convex, g ( p ) is a continuous function.
Proposition 2.1.
/3 is an equilibrium o f f if a n d only if it is a f i x e d p o i n t o f g,
/3 =
Proof. g ( p ) solves the minimization problem that defines it if and only if

there exists A E R such that
g(p)-
p - f(p)-
g(p)'(g(p)
Ae>~0,
- p - f ( p ) - Ae) = O.
If g(/3) =/3, then the second, the complementary slackness, condition becomes
- / 3 ' ( f ( / ~ ) + Ae) = )t/3'e = A = O.
The first condition then becomes f(/3)~< O.
Conversely, if/3 is an equilibrium, we set A = 0 and observe that/3 satisfies
the above conditions that define g ( p ) .
Remark. This result can easily be extended to economies where excess
demand is a non-empty, bounded, upper-hemi-continuous, convex-valued cor-
2054
T.J. Kehoe
respondence rather than a continuous, single-valued function. We need to alter

g, however, because, as defined above, g ( p ) is not necessarily convex-valued.
Let D be the convex hull of the image o f p + f ( p ) f o r p E S. Since f i s bounded
and upper-hemi-continuous and S is compact, D is compact. Let q : D - + S be
the function that associates any point p ~ D with the point q ( p ) E S that is
closest to p. Now let g : D---~ D be the correspondence g ( p ) = q ( p ) + f ( q ( p ) ) .
In other words, instead of first adding excess demand and then projecting into
the simplex, we first project into the simplex and then add excess demand. The
advantage is that g is now convex-valued as well as being upper-hemicontinuous. By Kakutani's fixed point theorem, it has a fixed point/3 ~ g(/3).
A n easy argument, similar to that above, implies that/~ is a fixed point if and
only if it is an equilibrium. In practice, however, working with a domain like D
is often more difficult than with one like S.
The above result is useful because it allows us to reduce the problems of
computing equilibria and establishing the uniqueness of equilibrium to the
analogous problems for fixed points. The question arises whether this is the
easiest approach. In many circumstances it is. If the only assumptions that we
make on f are those of continuity, homogeneity and Walras's law, then an
argument due to Uzawa (1962) says that the study of equilibria is in a sense,
equivalent to the study of fixed points. Suppose that y : S---~ S is continuous.
Consider the function 4 ~ ' R + \ { O } - + R n defined by 4 , ( p ) = y ( p / ( e ' p ) ) A(p)p, where A(p) = y ( p / ( e ' p ) ) ' p / ( p ' p ) . By construction, th is continuous, is
homogeneous of degree zero and obeys Walras's law.
~ b a fixed point of Y if only it is an

equilibrium of ffa, that is, 4)(15) <~0 and ~ ~ S.
Proposition 2.2 [Uzawa (1962)].
Proof.
If ~b(/6) ~< 0 a n d / ) E S, then
i=l,...,n.
Since Walras's law implies ~bi(/~)< 0 only if/~ i = 0 and since Yi(P) ~ O, this can
be rewritten as
A(/~)/~i = y~(/~),
i = 1. . . . .
n.
Consequently, e'/~ = e'y(/3) = 1 implies/~ = 3'(/~). Conversely, if/~ = y(/~) then

A(/~) = 1 and ~b(/J) = 0.
Remark. Suppose that we are willing to impose no stronger conditions on u i
and w i than those given previously and that m/> n, in other words, that there
are at least as many consumers as goods. Then a series of results due to
Sonnenschein (1973), Mantel (1974), D e b r e u (1974), McFadden, Mas-Colell,
2055
Mantel and Richter (1974) and Mas-Colell (1977) says that the only assumptions that we are justified in imposing on f are continuity, homogeneity and
Walras's law; for any f that satisfies these assumptions there is an economy with
n consumers whose excess demands aggregate to a function f * whose equilibria
coincide with those of f and that agrees with f on any compact set of prices
where f is continuous [see Sharer and Sonnenschein (1982)]. Imposing stronger
restrictions on u i and w i, however, can sometimes make the study of equilibria
easier than the study of fixed points.
Interpretations of Uzawa's result are delicate. It is not surprising that we can
show that the equilibrium existence theorem holds if and only if Brouwer's
fixed point theorem does, since both are theorems given the axioms of modern
mathematics. What is important is how easy and trivial the result is. Any
t h e o r e m that proves the existence of a fixed point can be translated into a
t h e o r e m that proves the existence of equilibrium by adding a few lines to the
proof, and conversely. A n y computer program that computes fixed points can
be translated into a program that computes equilibria by adding a few lines to
the code, and conversely. Any conditions that imply uniqueness of a fixed
point can be easily translated into conditions that imply uniqueness of equilibrium, and conversely.
There is an important caveat to this interpretation of Uzawa's result. It
relates fixed points to equilibria of economies specified in terms of aggregate
excess demand functions. At this point it would seem that, to relate fixed
points to equilibria of economies specified in terms of preferences and endowments of individual consumers, we would need to use some method, such as
that of Geanakoplos (1984), that constructs an economy of n consumers for
any arbitrary aggregate excess demand function. Thus, if we had an algorithm
for computing equilibria of arbitrary economies specified in terms of preferences and endowments, using it to compute fixed points would be complicated.
We would first use Uzawa's method to turn the mapping whose fixed points we
wanted to compute into an excess demand function. We would then use
Geanakoplos's m e t h o d to turn this excess demand function into n pairs of
utility functions and endowments vectors. Although the first step is trivial, the
second is not. Rather than go into details, however, let us postpone discussion
of this issue to Section 3, where we shall see that there is another connection
between fixed points and equilibria of economies specified in terms of preferences and endowments.
2.2. Scarf's algorithm

Uzawa's result says that any algorithm that is guaranteed to compute equilibria
of arbitrary economies specified in terms of aggregate excess demand functions
2056
T.J. Kehoe
must be guaranteed to compute fixed points of arbitrary mapping of the

simplex into itself. Scarf (1967, 1973, 1982) has developed such an algorithm.
N u m e r o u s researchers have further improved algorithms of this type, known as
simplicial algorithms; see, for example, Merrill (1971), Eaves (1972), Kuhn
and Mackinnon (1975), Todd (1976a) and van der Lann and Talman (1980).
This type of algorithm can also be used to compute fixed points of set-valued
correspondences.
In R " a k-dimensional simplex is the convex hull of k + 1 points, called
vertices, v ~ , . . . , v k+l , that have the property that the k vectors v ~ - v k+l
k
k+l
.... v - v
are linearly independent. The price simplex S, for example, has
vertices e i, i = 1 , . . . , n, where e i = 1, e ji = 0 , j i. A face of a simplex is a
lower dimensional simplex whose vertices are vertices of the large simplex. In
R 3, for example, the point e I is a 0-dimensional face of S and the convex hull of
e ~ and e z is a 1-dimensional face. A subdivision of S divides S into smaller
simplices so that every point in S is an element of some subsimplex and the
intersection of any two subsimplices is either empty or a face of both.
Scarf's approach to computation of equilibria is based on a constructive
proof of a version of Sperner's lemma: Assign to every vertex of a simplicial
subdivision of S a label, an integer from the set { 1 , . . . , n}, with the property
that a vertex v on the boundary of S receives a label i for which v~ -- 0. Then
there exists a subsimplex whose vertices have all of the labels 1 , . . . , n.
Scarf's algorithm for finding this completely labeled subsimplex is to start in
the corner of S where there is a subsimplex with boundary vertices with all of
the labels 2 , . . . , n (see Figure 38.1). If the additional vertex of this subsimplex
(0,0,1)
I or2
2or3
(1, 0, O)
Figure 38.1
1 or3
(0, 1, O)
2057
has the label 1, then the algorithm stops. Otherwise, it proceeds to a new
subsimplex with all of the labels 2 , . . . , n. The original subsimplex has two
faces that have all of these labels. One of them includes the interior vertex.
The algorithm moves to the unique other subsimplex that shares this face. If
the additional vertex of this subsimplex has the label 1, the algorithm stops.
Otherwise, it proceeds, moving to the unique subsimplex that shares the new
face and has the labels 2 , . . . , n. The algorithm cannot try to exit through a
boundary face. (Think of what labels the vertices of such a face must have.)
Nor can it cycle. (To cycle there must be some subsimplex that is the first that
the algorithm encounters for the second time; but the algorithm must have
previously encountered both of the subsimplices that share the two faces of this
subsimplex with the labels 2 , . . . , n.) Since the subdivision consists of a finite
n u m b e r of subsimplices, the algorithm must terminate with a completely
labeled subsimplex.
To see the connection of this algorithm with Brouwer's theorem, we assign a
vertex v with a label i for which g i ( v ) >i v i. Since e ' g ( v ) = e ' v = 1, there must
be such an i. Notice that, since gi(v) >i O, i can be chosen such that the labeling
convention on the boundary is satisfied. A completely labeled subsimplex has
vertices v 1, . . . , v n such that g~(vi)>~v~,i i = l , . . . , n .
T o prove Brouwer's
theorem, we consider a sequence of subdivisions whose mesh, the maximum
distance between vertices in the same subsimplex, approaches zero. Associate
each subdivision with a point in a completely labeled subsimplex. Since S is
compact, this sequence of points has a convergent subsequence. Call the limit
of this subsequence ~. Since g is continuous, we know gi(~)/> xi, i = 1 , . . . , n.
Since e' g(.f) = e'.f = 1, g(Yc) = ~.
Scarf does not consider an infinite sequence of subdivisions, which is the
non-constructive aspect of this proof. Instead, he works with a subdivision with
a small mesh. A n y point in a completely labeled subsimplex serves as an
approximate fixed point in the sense that IIg(x) - xll < , w h e r e , depends on
the mesh and the modulus of continuity of g.
2.3.
T h e global N e w t o n m e t h o d
An alternative algorithm for computing fixed points has been developed by

Smale (1976), the global Newton method. It is based on Hirsch's (1963) proof
of Brouwer's theorem. A similar method has been developed by Kellogg, Li
and Yorke (1976). Let S now be the disk {x E R n [ x ' x <~ 1); like the simplex it
is a non-empty, compact, convex set. Smale starts with an algorithm for
computing fixed points of a continuously differentiable map g : S---~ S that has
the property that g ( x ) = 0 for every x on the boundary of S, the sphere
OS = { x E R n [ x ' x = 1}. Smale (1976) and Varian (1977) show how to extend
2058
T.J. Kehoe
this algorithm to situations where g is an arbitrary continuous map and S is

again the simplex.
If S has no fixed points, we could define a map
h ( x ) = A(x)(x - g ( x ) )
where A(x)= ( ( x - g ( x ) ) ' ( x - g(x))) -1/2. This map would be a retraction of S

into its boundary: it would continuously map S into OS and be the identity on
0S. Hirsch proves that no such map could exist, thereby proving Brouwer's
theorem. Smale proposes starting with a regular value of x - g ( x ) , a point
E 0S such that I - D g ( ) is non-singular. Sard's theorem says that the set of
regular values has full measure and, in particular, that there exists such a point
2. T h e algorithm then follows the solution to
A(x(t))(x(t) - g(x(t))) = .
Since the path x ( t ) cannot return to any other boundary point, and since it
cannot return to because it is a regular value, it must terminate at a fixed
point (see Figure 38.2).
Differentiating the above equation with respect to t, we obtain
A(x)(l - D g ( x ) ) 2 + X(x - g ( x ) ) = O.
Smale shows that x ( t ) can be chosen as the solution to the differential equation
(I - Og(x))x
= t~(x)( g(x) - x)
where /z(x) has the same sign as d e t [ I - D g ( x ) ] and is scaled so that ~ has
constant velocity. Except for the factor t~ this is a continuous version of
Figure 38.2
2059
Newton's method for solving x - g ( x ) = 0:

x , + , = x, - ( I - O g ( x t ) ) - l ( x ,
2.4.
Regularity
- g(xt) ) .
a n d the i n d e x t h e o r e m
Merely establishing the existence of equilibria and developing methods for

computing them leaves important questions unanswered. Are equilibria
unique? If not, are they locally unique? Do they vary continuously with the
parameters of the economy? In recent years, economists have used the tools of
differential topology to investigate these questions. Debreu (1970) has investigated the questions of local uniqueness and continuity with continuously
differentiable excess demand functions. See Dierker (1982) and Mas-Colell
(1985) for surveys of this and subsequent work. Analogous results to those
derived in the differentiable framework can be obtained in a piecewise-linear
framework applicable to Scarf's approach to computing equilibria. See, for
example, Eaves and Scarf (1976) and Eaves (1976).
Debreu (1970) defines a regular economy to be one that satisfies conditions
sufficient for there to be a finite number of equilibria. Dierker and Dierker
(1972) simplify these conditions to the requirement that the Jacobian matrix of
excess demands_Df(~) with the first row and column deleted, the ( n - 1)
(n - 1) matrix J, is non-singular at every equilibrium. The first row is deleted
because of Walras's law, the first column because of homogeneity. We are left
with a square matrix because, as Wairas (1874, Lesson 12) pointed out, the
number of equations equals the number of unknowns in the equilibrium
conditions. The inverse function theorem implies that every equilibrium of a
regular economy is locally unique. Since the set S is compact and the
equilibrium conditions involve continuous functions, this implies that a regular
economy has a finite number of equilibria.
Let us rewrite the equilibrium conditions as f ( p , b) = 0 where b E B and B is
a topological space of parameters. If f and its partial derivatives with respect to
p are continuous in both p and b, then the implicit function theorem implies
that equilibria vary continuously at regular economies. Furthermore, in the
case where B is the set of possible endowment vectors w i, Debreu uses Sard's
theorem to prove that, for every b in an open set of full measure in B, f(., b) is
a regular economy. When B is the function space of excess demand functions
with the uniform C ~ topology, an open dense set of B consists of regular
economies. Consequently, if we are willing to restrict attention to continuously
differentiable excess demand functions, a restriction that Debreu (1972) and
Mas-Colell (1974) have shown in fairly innocuous, almost all economies, in a
very precise mathematical sense, are regular.
T.J. Kehoe
2060
Dierker (1972) has noticed that a fixed point index theorem could be used to
count the number of equilibria of a regular economy. Let us define the fixed
point index of a regular equilibrium/~ as s g n [ d e t ( I - Dg(/~))] whenever this
expression_is non-zero. Dierker shows that the index can also be written as
s g n ( d e t [ - J ] ) . The index theorem says that ~ i n d e x ( / ~ ) = +1 where the sum is
over equilibria of a regular economy. This result is depicted in Figure 38.3
where n = 2 , Pl = 1 - P 2 , and gl(Pl, P2) = 1 -g2(P~, P2). H e r e index(/~) =
sgn(1 - Og2/Op2) and a regular economy is one where the graph of g does not
become tangent to the diagonal.
Mas-Colell (1977) shows that any compact subset of S can be the equilibrium
of some economy f. If we restrict ourselves to regular economies and n ~> 3,
then the only restrictions placed on the n u m b e r of equilibria are those given by
the index theorem. (If n = 2, an equilibrium with index - 1 must lie between
two with index + 1.) This implies that the n u m b e r of equilibria is odd and that
there is a unique equilibrium if and only if index(/~) = +1 at every equilibrium.
It is easy to see that there are an odd number of solutions to Scarf's
algorithm and to Smale's global Newton method. To see this in the case of
Scarf's algorithm, let us argue that there are an odd number of completely
labeled subsimplices. The path followed from the corner missing the label 1
leads to a unique subsimplex. Suppose there is an additional completely
labeled subsimplex. T h e n it shares the face with labels 2 , . . . , n with a unique
other subsimplex. Restart Scarf's algorithm at this subsimplex. Either the
additional vertex to this subsimplex has the label 1, in which case it is
completely labeled, or it does not, in which case it has another face with all of
the labels 2 , . . . , n. Move to the unique other subsimplex that shares this face
and continue as before. The algorithm cannot encounter any subsimplex in the
O(P)
P
Figure 38.3
2061
path from the corner to the original subsimplex. (To do so there must be some
subsimplex in the path that is the first that it encounters; but it must have
previously encountered both of the subsimplices that share the two faces of this
subsimplex with the labels 2 , . . . , n.) The algorithm must therefore terminate
in yet another completely labeled subsimplex. Consequently, all completely
labeled subsimplices, except the original one located by the algorithm starting
in the corner, come in pairs. There is a definition of index of a completely
labeled subsimplex that agrees with that of a fixed point/~ in the case where the
mesh of the subdivision is sufficiently small and f is regular [see Eaves and
Scarf (1976) and Todd (1976b)]. The original subsimplex located by the
algorithm starting in the corner has index + 1. All other completely labeled
subsimplices come in pairs as described above, one with index + 1 and one with
index - 1.
Likewise, it can be shown that the global Newton method has an odd
number of solutions. Starting at ~ on the boundary the algorithm locates one,
which has index + 1. All other solutions are matched up in pairs, one with
index +1 and one with index - 1 . Indeed, it is a general feature of these and
related algorithms that, unless they are restarted at a fixed point different from
the one originally computed by the algorithm, they always lead to fixed points
with index +1. This, combined with Mas-Colell's (1977) result about the
arbitrariness of the number of fixed points, suggests that, unless for some
reason we know that index(/~)= +1 at every fixed point, there can be no
method except for an exhaustive search that locates all fixed points. There is an
important possible exception to this remark involving the all-solutions algorithm of Drexler (1978) and Garcia and Zangwill (1979, 1981). This method,
which depends on being able to globally bound g using complex polynomial
functions, is further discussed in the next section.
2.5. Path f o l l o w i n g m e t h o d s
Much recent work on the computation of fixed points has been based on the
idea of path following. The idea is to follow the path of solutions to H ( x , O) = 0
where H : S [0, 1] ~ R n is chosen so that H ( x , 0) = 0 is trivial to solve and
H ( x , 1) = x - g ( x ) , which means a solution to H ( x , 1) = 0 is a fixed point. The
function H is called a homotopy [see Garcia and Zangwill (1981) for a survey
and references].
Suppose that g : S---~ S is twice continuously differentiable. Define
H ( x , O) = x - (1 - 0)Y - Og(x)
where is an interior point of S. Notice that, for any 1 > 0 >/0 and x E S,
T.J. Kehoe
2062
(1 - 0)~ + Og(x) is also interior to S. We start at the trivial solution H(, 0) --- 0
and follow the solution path until we reach the boundary where 0 = 1 and
H(x, 1) = x - g(x) = 0. We require that 0 be a regular value of H(x, O) in the
sense that the n (n + 1) matrix DH(x, O) has rank n whenever H(x, O) = O.
Sard's theorem says that we can always choose so that this condition is
satisfied and, indeed, that it is satisfied for almost all . (It is here that second
differentiability is important.) The implicit function theorem then implies that
solutions to H(x, 0) = 0 form a compact one-dimensional manifold with boundary, a finite number of paths and loops, and that the boundary points of this
manifold are also boundary points of S [0, 1]. By construction, H is such that
(, 0) is the only possible boundary solution except for points where 0 = 1,
where solutions are fixed points of g (see Figure 38.4).
Although the path that starts at (, 0) cannot return to the boundary where
0 = 0, it need not be monotonic in 0. Consequently, we do not want to think of
the path in terms of x as a function of 0. Rather, let us write y(t) = (x(t), O(t)).
Differentiating H(y(t))=--0 with respect to t, we obtain
D H ( y ) ~ = O.
This is a system of n linear equations in n + 1 unknowns that has an infinite
Figure 38.4
2063
n u m b e r of solutions. One is
))i "~" ( - 1 ) "-~+~ det D H ( y ) _ ~ .
H e r e D H ( y ) _ i is the n n matrix formed by deleting column i from D H ( y ) .
That 0 is a regular value of H implies that at every point y along the path some
matrix D H ( y ) _ i is non-singular. To see that the above differential equation
does indeed follow the solution path to H ( y ) = 0, we suppose that D H ( y ) _ I is
non-singular and rewrite DH))= 0 as
n+l
E DiH))i = - D 1 H ) ) I
i=2
where DiH is column i of DH. We choose

))2 . . . . , ))n+l using Cramer's rule:
))1 ~ ( - - 1 ) n
det D H 1 and solve for
.9 = O e t [ D 2 H ' " D ~ 1H(-1)n+~(det D H 1 ) D I H D i + ~ H ' "

+ det D H
D~+~H]
= ( - 1 ) n-i1 det DH_ i .

As with the global Newton method, we have reduced the problem of
computing fixed points to that of solving a system of ordinary differential
equations. T o solve such equations, we can use a variety of methods, such as
the R u n g e - K u t t a m e t h o d or the Bulirsch-Stoer method [see, for example,
Gear (1971) and Stoer and Bulirsch (1980, Chap. 7)]. The h o m o t o p y approach
can also be applied to piecewise-linear problems [see, for example, Merrill
(1971), Eaves (1972), Kuhn and MacKinnon (1975), Eaves (1976) and Eaves
and Scarf (1976)].
The homotopy approach yields a very simple proof of the index theorem.
Notice that at 07, 0)
O = det[DH(,
O)_(n+l)]
~-- det
I = 1 > O.
Following the path of solutions to H(x(t), O(t)) = O, O may change signs, but
when 0 = 1
O = det[DH(x, 1 ) _ ( n + l ) ] = d e t [ I - Dg(x)]
must be non-negative. ( T a k e a n o t h e r look at Figure 38.4.) If 0 is a regular
value of x - g(x), if the economy is regular, then d e t [ I - Dg(x)] > 0. Other
fixed points come in pairs, with each one the endpoint of a path that starts and
ends on the boundary where 0 = 1. At one endpoint 0 ~< 0 and at the other
I> 0. In the regular case we define index(~) = sgn(det[I - Dg(~)]). Summing
2064
T.J. Kehoe
over all fixed points, all solutions to H ( x , 1) = 0, yields +1. This proof of the
index theorem is easily extended to maps that are continuously differentiable
only of first, rather than second, order [see Garcia and Zangwill (1981, Chap.
22)1.
A fascinating possibility presented by the path following idea is that of being
able to compute all of the fixed points of a function g : S--> S. The all-solutions
algorithm of Drexler (1978) and Garcia and Zangwill (1979) is easiest understood in terms of computing zeros of polynomials. We first approximate
g ( x ) - x by a finite order polynomial f : S---~ R" and then extend f t o a function
f : R"--> R n. Weierstrass's approximation t h e o r e m says that we can choose f to
approximate g ( x ) - x arbitrary closely on S [see, for example, Lang (1983, pp.
49-53)] We then convert f into a complex function by allowing both its
domain and range to be C n, the space of complex n vectors. We can expand the
,
vector z E C n into a vector z* E R 2n by writing z = ( z ~ + Z z, l ,- . . , Z2n
1 .~_
Z~ni). Consequently, we can expand f into f * : RZn---> R 2n by writing f ( z ) =
( f ~ ( z * ) + /~2 \* t z * l ]i ' " . . , f 2*, 1(z * ) + f 2 *n ( Z * ) t") . We now discuss a m e t h o d that
can c o m p u t e all the zeros of f * . Notice that not all of the zeros of f * are
approximate fixed points of g; some may be complex and some may lie outside
of S.
Letting rnj be the highest order of the polynomial fj(z), we consider the
h o m o t o p y H : C n [0, 1]--> C ~ defined by the rule
Hj(z,O)=(1-O)(z~
'n'+')- l)+Ofj(z),
]=1 ....
,n.
At 0 = 1, solutions to H ( z , 0 ) = 0 are zeros of f. At 0 = 0, H i ( z , 0 ) = 0 has

m i + 1 solutions
zj = c o s ( 2 1 r a / ( m j + 1)) + i s i n ( 2 ~ a / ( m j
n
+ 1)),
a - 0, 1 . . . . .
rnj .
Consequently, there are IIj= 1 (rnj 1) solutions to H ( z , 0) = 0. We can expand
,
2n
~
2n
H into H : R [0, 1] R . The crucial insight involved in the all-solutions
algorithm is that any solution path to H * ( z * , 0) = 0 is monotonic in 0,
0 = det[DH*(z*,
0)_(2n+1) ]/> 0 .
The proof is simple: D H * ( z * ,
oH oH ]
o-i oHll
0)_(2,+1) consists of 2 2 blocks of the form

r
2065
r
z~j_ 1 is the real part of zj, zj = z~. is the imaginary part, and H i and
H i are the real and imaginary parts of H i. The C a u c h y - R i e m a n n equations,
which follow easily from the chain rule, say that
Here zj =
OHT_ OHI
oz;
oz', '
OHT_
OHI
Consequently, the 2 2 blocks that make up

special form
DH*(z*, 0)_(2n+l) all have the
aij bij]
-bij aqj"
These matrices have important properties: their special form is preserved when
such a matrix is multiplied by a scalar or inverted; it is also preserved when two
such matrices are added or multiplied together. Consequently, performing
Gaussian elimination on these 2 x 2 blocks, we can reduce the 2n 2n matrix
DH*(z*, 0)_(2n+l) to a lower block triangular matrix with n such 2 x 2 blocks
on the diagonal. The determinant is the product of the determinants of these
blocks, each of which is non-negative.
Since 0 is monotonic along any path, there can be no paths that both start
and end at 0 = 0 or at 0 = 1. To guarantee that every solution at 0 = 1 is the
endpoint of a path that starts with 0 = 0, we need to rule out paths diverging to
infinity for 0 ~ < 0 < 1. It is here that the polynomials (z~m j + l ) - 1) play their
role. Suppose that I l z l l - ~ . Then, for at least one i, fj(z)/(z~ '+l)- 1)--->0,
which implies that Hi(z, O)/(z~ '+1) - 1)---> (1 - 0). Consequently, Hi(z, O) = 0
cannot hold for any path along which Ilzll--, ~ and 0 ~< 0 < 1. Following each of
the paths that starts at 0 = 0 either leads to a zero of f or diverges to infinity at
0 = 1. No path can start at 0 = 1 and diverge to infinity going backwards,
however, so this m e t h o d necessarily locates all of the zeros o f f [see Garcia and
Zangwill (1981, Chap. 18) for further discussion].
This method can easily be applied to functions other than polynomials. What
we need is a function f : R'---->.R" than can be extended to C" and polynomials
( z q i - 1 ) such that some f~(z)/(zq'-l)--->O as Ilzll--'~. The all-solutions
algorithm is obviously a promising direction for future research.

By constructing an example of an economy with an equilibrium with index - 1 ,
we can easily construct an example of multiplicity of equilibria.
T.J. Kehoe
2066
Example 2.1. Consider a static exchange e c o n o m y with two consumers and

two goods. C o n s u m e r i, i = 1, 2, has a utility function of the form
2
Ui(X1, X2) =
i, x jb, _ 1 ) / b i
ajl,
j=l
where aji ~ 0 and b i < 1. This is, of course, the familiar constant-elasticity-ofsubstitution utility function with elasticity of substitution ~i = 1/(1 - b;). Given
an e n d o w m e n t vector (wil, w2),
i consumer i maximizes this utility subject to his
budget constraint. His demand functions are
2
i
"Y j Z
xij(pl
P2) =
pkWk
k=l
2
p~i Z
ilrli
i -= 1, 2, j = 1 ~ 2 "
YkPk
k=l
H e r e 7ii = ( a ' y j. T h e two consumers have the ( s y m m e t r i c ) p a r a m e t e r s given

below.
Commodity
Consumer
1
2
1024
1
1
1024
b I = b 2 = -4,
w;
Commodity
Consumer
l
2
12
1
1
12
O f c o u r s e "ql = 7 2 = 1 / 5 , Yl = Y2 = 4 a n d Y2 = Yl = 1.
This e c o n o m y has t h r e e e q u i l i b r i a , w h i c h a r e listed b e l o w .
Equilibrium 1: pl = (0.5000, 0.5000)
Commodity
Consumer
1
2
ui
10.400
2.600
2.600
10.400
-0.02735
-0.02735

Equilibrium 2:p2 = (0.1129, 0.8871)
Commodity
Consumer
1
2
1
8.631
1.429
2
4.369
11.571
Equilibrium 3:p3 = (0.8871, 0.1129)
Commodity
Consumer
1
2
1
11.571
4.369
2
1.429
8.631
2067
u~
-0.10611
-0.01497
u~
-0.01497
-0.10611
This example has been constructed by making p~ = (0.5, 0.5) an equilibrium

with index - 1
"~'Jt/~')
'~':
3.2
-3.2
-3.2 ]
3.2 '
index( p l ) = s g n ( - 3 . 2 ) = - 1.
Remark. A similar example has been constructed in an Edgeworth box
diagram by Shapley and Shubik (1977).
Two assumptions have played significant roles in discussions of uniqueness of
equilibria since the time of Wald (1936). They are gross substitutability and the
weak axiom of revealed preference. Gross substitutability says that, if p/> q
and Pi qi for some i, then f / ( p ) >~f,(q) and, if f ( p ) = f ( q ) , then p = q. (This
actually combines the two conditions often known as weak gross substitutability and indecomposability.) The weak axiom of revealed preference says that if
p ' f ( q ) ~ 0 and q ' f ( p ) ~< 0, then f ( q ) = f ( p ) .
The argument that gross substitutability implies uniqueness is easy: Suppose
that there are two vectors p, q, such that f ( p ) = f ( q ) ~ 0. It must be the case
that p, q > 0. Otherwise, for example, pg = 0 and 2p ~>p would imply f/(2p) >
f / ( p ) , which would contradict homogeneity. Let , / = m a x qJpj. T h e n ,/p
satisfies ,/p >t q, ,/Pi = qi some i. Consequently, f ( , / p ) = f ( p ) = f ( q ) = 0 implies
,/p = q. It is also easy to show that, when f is continuously differentiable, gross
substitutability implies that index(/~) = + 1, since 0fi(/~) / Opj >I O, i ~ j implies,
in general, that - J is a P matrix, a matrix with all of its leading minors positive
[see H a h n (1958) and K e h o e (1985b)].
The weak axiom implies that the set of equilibria is convex. If f is regular,
this implies that it has a unique equilibrium. Suppose that there are two vectors p , q such that f ( p ) = f ( q ) ~ O .
Then p ( O ) = O p + ( 1 - O ) q ,
0~<0~<1,
=-
2068
T.J. Kehoe
satisfies p(O)'f(p)<~O and p(O)'f(q)<~O. Walras's law implies that (Op +

( 1 - O)q)'f(p(O))= 0. Consequently, it cannot be the case that p ' f ( p ( O ) ) > O,
otherwise q ' f ( p ( O ) ) < O , which contradicts the weak axiom. Consequently,
p ' f ( p ( O ) ) <~O, which implies f(p(O)) = f ( p ) <<-O. In the case where f is differentiable, the weak axiom implies that D r ( p ) satisfies x ' D f ( p ) x <~0 for all x such
that x ' f ( p ) = 0 [see Kihlstrom, Mas-Colell and Sonnenschein (1976_), Kehoe
(1985c) and Freixas and Mas-Colell (1987)]. This implies that d e t [ - J ] > 0 if/3
is a regular equilibrium.
One problem with the weak axiom is that, in contrast to gross substitutability, it does not aggregate: the two functions in Example 2.1, for example,
satisfy the weak axiom because they come from utility maximization; their
sum obviously does not. Mas-ColeU (1989) discusses a condition called monotonicity that both implies the weak axiom and aggregates: f is monotone with
respect to the normalizing vector a E R n+ if p'a = q'a = 1 and p # q imply
( p - q ) ' ( f ( p ) - f ( q ) ) < 0. Unfortunately, monotonicity is not implied by utility maximization. Mas-Colell (1989), however, presents sufficient conditions on
utility functions and endowments for monotonicity to hold.
2. 7. Other computational methods
Despite not being guaranteed to converge for arbitrary economies, methods for
computing equilibria other than fixed point algorithms are popular in practice.
Let us briefly consider three such methods, tfitonnement, a non-linear GaussSeidel method and Newton's method.
Samuelson (1941) has formalized Walras's (1874) concept of tfitonnement,
or groping to equilibrium, as the system of differentiable equations
,6 =f(p).
Notice that
Ilptl
stays constant under this adjustment process:
d(p'p)
dt
= 2p'lJ = 2 p ' f ( p ) = 0.
In other words, if IIp(0)t[ = 1, then Ilp(t)ll = 1; the path followed by tfitonnement always remains on the intersection of the sphere and the positive orthant.
This process converges to the set of equilibria if f satisfies the weak axiom, as
shown by Arrow and Hurwicz (1958), who use the Liapunov function L ( p ) =
( p - / ~ ) ' ( p - / ) ) . Notice that L ( p ) > 0 unless p =/~ and that
L( p) = ( p - ~)'1~ = - Y f l P) .
Ch. 38: Computationand Multiplicity of Equilibria
2069
Unless p is an equilibrium, f ( / 3 ) = 0 and the weak axiom imply that L ( p ) < O.

Arrow, Block and Hurwicz (1959) further argue that gross substitutability
implies that the weak axiom holds in comparisons with an equilibrium vector of
an exchange model; that f(/3) = 0 implies y f ( p ) > 0 unless f(p) = f(/3). Consequently, tfitonnement is also globally asymptotically stable if f satisfies gross
substitutability.
If, however, f does not satisfy the weak axiom or gross substitutability, the
tfitonnement process may not converge to an equilibrium. In fact, Scarf (1960)
constructs a simple example with unique equilibria in which, unless p ( 0 ) = ,6,
the process converges to a limit cycle. Indeed, the Sonnenschein-MantelDebreu result on the arbitrary nature of aggregate excess demand implies that
the behavior of tfitonnement is also arbitrary. See Hahn (1982) for a survey of
results related to tfitonnement. From our point of view there are two points
worth noting. First, the process can be generalized to allow different adjustment speeds
/ii = 0if~(p) ,
i=1 .... ,n.
For any 0i > 0, i = 1 , . . . , n, the process remains globally stable i f f satisfies the
weak axiom or gross substitutability. In general, however, changing the weights
0i can greatly affect the stability properties of t'~tonnement. Second, if we want
to avoid problems with negative prices we have to alter the process to
something like
/ii =/fi(P)[o
if p i > 0 or fi(p) > 0 ,

otherwise.
A l t h o u g h / i can be discontinuous at a point where Pi = 0, it can be shown, as

done for example by Henry (1972, 1973), that the path p(t) is continuous.
Van der Laan and Talman (1987) have developed a tfitonnement-like
algorithm that is guaranteed to converge under weak regularity assumptions:
start with an initial price vector/~ interior to the simplex. The algorithm sets
pj/fij = m i n [ p , / f i , , . . . , P,/fi, l if fj(p) < 0 ,

PJ/fii=max[pl//)l,''', P,/fin]
iffj(p)>0.
When fj(p) = O, pj is allowed to vary to keep market j in equilibrium. The set

of points that satisfy these conditions generically form a collection of loops and
paths in S. The algorithm operates like the global Newton method and the path
following methods described earlier, following the path that starts at fi until
another endpoint is reached. This endpoint is an equilibrium.
T.J. Kehoe
2070
Walras (1874, Lessons 12 and 24) originally conceived of tfitonnement as

clearing one market at a time. With linear equations the analogous process is
called the Gauss-Seidel method. The idea is to update a guess at a solution to
the equations
f j ( l , P2, P3 . . . . , Pn) = 0,
j = 2,... , n
one equation at a time: Given the guess p 2 k , . . . , p~, we let p/~+~ be the
solution gi(p k) to
f~(1 , g z ( p k ) , . ,
",
g,(pk),
P ik+ ~ , ' ' ' , P n ) = O k,
i=2,...,n.
In the case where f is linear, this method converges if there exists some Oj> O,
j = 2 , . . . , n, such that
oi
OPi
>~
j:~i
Opj
i,]=2
....
,n,
with strict inequality some i [see Young (1971) for a collection of conditions
that guarantee convergence of this method]. This, however, is the familiar
diagonal dominance condition satisfied by the Jacobian matrix of an excess
demand function that exhibits gross substitutability. Consequently, it is possible to show that, if Df(~) satisfies gross substitutability at some equilibrium
/~, there is some open neighborhood N of/~ such that if p0 C N, the non-linear
analog of this algorithm converges to/~. The weak axiom does not guarantee
diagonal dominance, and it is easy to construct examples that satisfy the weak
axiom but for which this method is unstable.
Perhaps the most popular method for solving systems of equations such as
g(p) = p is Newton's method,
p k =p k-l_Ak(/_Dg(pk-1))
l(pk-l_g(pk-~)).
Frequently, the scalar Ak > 0 is chosen by a line search to make ]]pk _ g(pk)]]
as small as possible. Furthermore, the elements of Dg are usually approximated numerically rather than calculated analytically. In many versions of this
algorithm I - Dg is never explicitly inverted. Rather, an approximation to its
inverse is successively updated; these are called quasi-Newton methods. See
Ortega and Rheinboldt (1970) and Jacobs (1977) for surveys of these methods.
An important warning is in order here: Most work in the mathematical
programming literature on Newton-type methods relates to minimizing a
convex function h : R n---~ R,
2071
x k = x k-1 _ A k D 2 h ( x k - 1 ) D h ( x k - 1 ) , .
Although this does amount to solving the system of equations D h ( x ) = 0, this

system has two special properties. First, D2h is symmetric and positive
semi-definite. Second, Ak can always be chosen small enough so that h ( x k)
decreases at every iteration. Unless I - D g satisfies strong integrability conditions, these sorts of properties do not carry over to solving for equilibria.
Arrow and Hahn (1971, Chapter 12) have shown that a continuous version
of Newton's method
t~ = - ( I - D g ( p ) ) - '( p - g ( p ) )
is globally stable if d e t ( I - D g ( p ) ) never vanishes. (We ignore the minor

technical problem caused by the potential discontinuity of D g ; as in the case of
t~tonnement where some price is zero, p ( t ) can be shown to follow a
continuous path.) In this case, the index theorem implies that there is a unique
fixed point /~ =g(/~). L ( p ) = ( p - g ( p ) ) ' ( p - g ( p ) )
provides a Liapunov
function: L ( p ) > 0 unless p = g ( p ) , and
L ( p ) = ( p - g ( p ) ) ' ( l - Dg(p))15 = - ( p
- g(p))'(p - g(p)) .
Consequently, L ( p ) < 0 unless p =/3.

Although this method may cycle if ( I - D g ( p ) ) is singular for some p, L ( p )
always serves as a local Liapunov function near a regular equilibrium/~. That
is, every regular equilibrium/3 has some open neighborhood N such that, if
p(0) E N, this method converges t o / L This suggests a stochastic method for
computing equilibria, which is frequently used in practice: Guess a value for
p(0). Apply Newton's method. If it does not converge, guess a new value for
p(0). Continue until an equilibrium is located. Since every open neighborhood
of an equilibrium occupies a positive fraction of the volume of the price
simplex, this method must eventually work.
Newton's method is in some sense the simplest algorithm that has this local
convergence property for any regular equilibrium. Saari and Simon (1978) and
Traub and Wozniakowski (1976) show that, in a precise sense, any locally
convergent method must use all of the information in g(p_) and D g ( p ) .
Furthermore, Saari (1985) shows that for any step size Ak/> A > 0, there are
examples such that a discrete version of Newton's method is not even locally
convergent. Since we cannot always choose Ak so that l i p - g(p)ll is decreasing, we have to bound A~ from below so the method does not get stuck away
from an equilibrium. Saari shows that this may result in the method overshooting the equilibrium.
T.J. Kehoe
2072
Notice that the global Newton method has a global convergence property. It
uses global information, however, because it is only guaranteed to work if
started on the boundary or at an equilibrium with index - 1 . Otherwise, it may
cycle [see Keenan (1981)]. Notice too that the global Newton method diverges
from any equilibrium with d e t [ l - D g ( / 3 ) ] < O . Because the scale factor
/z(p) < 0 in some open neighborhood of/3, L ( p ) is actually increasing in that
neighborhood.
3. Equilibrium and optimization

The problem of computing an equilibrium of an economy can sometimes be
simplified by transforming it into a problem of maximizing a concave function
on a convex constraint set. Such transformations typically exploit the Pareto
efficiency of the equilibrium allocation: Pareto (1909) first realized that the
allocation ( 2 1 . . . , 2m) associated with an equilibrium/3 has the property that
there is no alternative allocation (2 t . . . , m) that is superior in the sense that
m
"
m
-i
. m, with strict
it is feasible, E~: 1 3~t~,,i= 1 w i and ui(x ) ~ ui(xhi ), i= 1,
inequality for some i.
. .
3.1. Welfare theory and existence of equilibrium

That every competitive allocation is Pareto efficient is the first theorem of
welfare economics. The second welfare theorem says that for any Pareto
efficient allocation ( 2 1 , . . . , 2 m) there exists a vector of prices /3 such that
(/3, YcL,..., 2 " ) is an equilibrium with transfer payments t i =/3'(2 i - wi). In
other words, each consumer solves the problem of maximizing utility subject to
the budget constraint/3'x ~/3'w ~+ t i rather than his usual problem [see Arrow
(1951), Debreu (1954) and Koopmans (1957)].
For every Pareto allocation (21. . . . , 2 m) there exists a vector of nonnegative welfare weights ( a l , . . . , o~m) such t h a t ( . ~ 1 , . . . , ) ~ m ) solves the Pareto
problem
max ~ aiui(x i) subject to
i=1
~ xi ~ ~ wi xi ~ O.
i=1
i=1
If a > O, then any solution to this problem is Pareto efficient. The KuhnTucker theorem says that the allocation (xl(a) . . . . . xm(a)) solves this problem
if and only if there exists a non-negative vector p(cQ such that
o~,u,(x'(,~)) + p ' ~
i=l
(w'-
2073
x'(o~))
i=l
E (w'-
i=1
i=1
>t ~ aiui(x') + p(a)' ~ ( w ' - x')

i=1
i=1
for all p~>0 and ( x l , . . . ,xm)~>0.

Similarly, each consumer solves his utility maximization problem in equilibrium if and only if there exists Ai ~>0 such that
u,(i') + a,p'(w'
fc') >1 u,(, i) + ~,p'(w' - x~') >

~ ui(x ' ) + i , p ' ( w ' - x')
for all A~1> 0 and xi~ O. Notice that the strict monotonicity of ui implies that
A~> O, otherwise we would violate the second inequality simply by increasing
x i. Dividing the second inequality through by '(i and summing over i-1 , . . . , m produces
i~l
~'
i=1
E (1/,X~)u,(x )
i=l
~ (w'- x')
i=1
for all (x 1. . . . , x m) >i O. Moreover, since ,3' Xi~ 1 (w' - 2') = 0 because of strict
monotonicity and E i~ 1 (w' - ~')/> 0 because of feasibility,
i~l
i=1
i=1
i=1
for all p/> 0. Consequently, every competitive equilibrium solves the above
Pareto problem where a~ = 1/A i, i = 1 . . . . . m and p ( a ) = f t . This can be
viewed as a proof of the first welfare theorem.
Notice, too, that, if ( x l ( a ) , . . . , xm(a)) is a solution to the Pareto problem
for arbitrary non-negative welfare weights a, it must be the case that
~,u,(x i (~)) + p(~)'(x'(~) - 2 ( ~ ) ) / > ~,u,(x') + p(~)'(x'(,~) - x ~)
for all x i ~> O. Otherwise the allocation that replaces xi(a) with the x g that
violates this inequality but leaves xJ(a), j # i, unchanged would violate the
conditions required for ( i f ( c O , . . . , xm(a)) to solve the Pareto problem. Since
p ' ( f f ( a ) - xi(a))= 0 for all p, this implies that any solution to the Pareto
problem is such that, if a i > O, xi(a) maximizes ui(x ) subject to p(a)'x <~
p(a)'xi(a). Ignoring for a moment the possibility that a i = O, some i, we can
compute the transfer payments needed to decentralize the allocation
2074
T.J. Kehoe
(xl(a),...
,xm(ol)) as an equilibrium with transfer payments t i ( a ) =
p ( a ) ' ( x i ( a ) - wi), i = 1 , . . . , m.
Suppose now that oti = 0, some i. Then our earlier argument implies 0 ~>
p ( a ) ' ( x ~ ( a ) - x ~) for all x~>~0. Combined with p(a)>~O, this implies that
p ( a ) ' x i ( a ) -- 0, that consumers with zero weight in the welfare function receive
nothing of value at a solution to the Pareto problem. Since the strict monotonicity of ug implies p ( a ) ~ 0 and since w ~> 0, we know that te(a ) > 0 if a i = 0.
Our arguments have produced the following characterization of equilibria.
Proposition 3.1.
A price-allocation pair (/3, ~ l , . . . , . f , , ) is an equilibrium if

and only if there exists a strictly positive vector o f welfare weights (&l, , &m)
such that (cI, . . . , fcm) solves the Pareto problem with these welfare weights, that
/3 is the corresponding vector o f Lagrange multipliers, and that/3'(~i _ w i) = O,
i=1,...
,m.
Remark. The assumption that w i is strictly positive serves to ensure that the
consumer has strictly positive income in any equilibrium and, hence, has a
strictly positive welfare weight. Weaker conditions such as McKenzie's (1959,
1961) irreducibility condition ensure the same thing. Unless there is some way
to ensure that the consumer has positive income, or, with more general
consumption sets, can afford a consumption bundle interior to his consumption
set, we may have to settle for existence of a quasi-equilibrium rather than an
equilibrium. In a quasi-equilibrium each consumer minimizes expenditure
subject to a utility constraint rather than maximizing utility subject to a budget
constraint.
Unless we are willing to assume that ui, i = 1 , . . . , m, is continuously
differentiable, there may be more than one price vector p ( a ) that supports a
solution to the Pareto problem because of kinks in u i. This makes t(a) a
point-to-set correspondence. Nevertheless, it is still easy to prove the existence
of equilibrium using an approach due originally to Negishi (1960).
Proposition 3.2 [Negishi (1960)]. There exists a strictly positive vector of utility
weights (dq, . . . , &m) such that 0 E t(&).
Proof.
The strict concavity of each ui, i = 1 , . . . , m, and continuity of

aiUi(X i) in a implies that x z :R+\{O}---~ R" is a continuous function.
Furthermore, p : R + \ { 0 } - - - ~ R n is a non-empty, bounded, upper-hemi-continuous, convex-valued correspondence. Consequently, the correspondence
t : R+\{0}--~ R m defined by the rule
Z m
i=1
2075
is also non-empty, bounded, upper-hemi-continuous and convex-valued. It is

homogeneous of degree one since xi(a) is homogeneous of degree zero and
p ( a ) is homogeneous of degree one. It also obeys the identity
2 ti(a)~p(a)'
~ (xi(Ol) -- Wi)~--0.
i=1
i~l
Let S C R m n o w be the simplex of utility weights. Since S is compact, t is

bounded and upper-hemi-continuous and ti(a ) < 0 if a E S with a i = O, there
exists 0 > 0 such that
g(a) -- a - Ot(a)
defines a non-empty, upper-hemi-continuous, convex-valued correspondence
g" S---~S. By Kakutani's fixed point theorem there exists & ~g(&). This
implies that 0 E t(3).
Remark. The correspondence f : R+\{O}--~R m defined by the rule
f ( a ) = - ti(a ) / a i has all of the properties of the excess demand correspondence
of an exchange economy with m goods.
3.2. Computation and multiplicity o f equilibria

Negishi's approach provides an alternative system of equations a = g(a), that
can be solved to find equilibria. Mantel (1971), for example, proposes a
tfitonnement procedure & = - t ( a ) for computing equilibria. Similarly, we
could apply Scarf's algorithm, the global Newton method, a path following
method, the non-linear Gauss-Seidel method, or Newton's method to compute
the equilibrium values of a.
We have reduced the problem of computing equilibria of an economy
specified in terms of preferences and endowments to yet another fixed point
problem. The obvious question, in analogy to Uzawa's (1962) result, is
whether any arbitrary g:S----~S, S C R m c a n be converted into a transfer
function t(a). The answer is obviously yes if the only properties that t needs to
satisfy are continuity, homogeneity of degree one and summation to zero.
Bewley (1980), in fact, proves the analog of the Sonnenschein-Mantel-Debreu
theorem is the case where t is twice continuously differentiable and n i> 2m: for
any such transfer function t there is an economy with m consumers and n goods
that generates it. In closer analogy with the Sonnenschein-Mantel-Debreu
theorem, however, it is natural to conjecture that this result holds for t
continuous and n/> m.
2076
T.J. Kehoe
Example 3.1 (2.1 revisited). The Pareto p r o b l e m for the exchange e c o n o m y

with two goods in E x a m p l e 2.1 is
max
2
~'~
ffl
xj1 _1_ X~
2
1/,"
1 xb
Z., a j t t x j )
- 1 ) / b + c~2 ~ , ajttx~)2" 2,b _ 1 ) / b subject to
j=l
~
j=1
2
w i1 ...]_ w~,
j=l,2,
Xj~ > 0
(It is only in the case b~ = b 2 that we can obtain an analytical expression for the
transfer functions.) The first-order conditions for this p r o b l e m are
il
otia/[xj)
ixb-1
--
pj = O,
i = 1, 2, j = 1, 2 .
These are, of course, the same as those of the consumers utility maximization
p r o b l e m when we set ai = 1/A~. The difference is that here the feasibility
conditions are imposed as constraints, and we want to find values of a i so that
the budget constraints are satisfied. In the previous section the budget constraints were imposed as constraints, and we wanted to find values of pj so that
the feasibility constraints were satisfied.
The solution to the Pareto p r o b l e m is
2
(aiaij) n ~
w~
i=1,2,
j=l,2.
(aka~) n
k=l
H e r e , once again, 7/= 1/(1 - b). T h e associated Lagrange multipliers are
pj(o,)
Equilibria are now solutions to the equation

ti(oq, a2) = p ( a ) ' ( x i ( a ) - w i) = O,
i = 1, 2 .
Since t l ( a ) + t 2 ( a ) - - - - - 0 , w e need only consider the first equation. Since t I is

h o m o g e n e o u s of degree one, we can normalize a~ + ot2 = 1. There are three
2077
solutions, each of which corresponds to an equilibrium of Example 2.1. They

are a I = (0.5000, 0.50000), a 2 = (0.0286, 0.9714) and a 3 = (0.9714, 0.0286).
In some cases equilibria solve optimization problems that do not involve
additional constraints like ti(a ) = 0. Two notable cases are (1) where utility
functions are homothetic and identical but endowments arbitrary and (2)
where utility functions are homothetic but possibly different and endowment
vectors are proportional. In the first case, considered by Antonelli (1886),
Gorman (1953) and Nataf (1953), the equilibrium allocation (~1. . . . . ~m)
maximizes U(~im=lX') subject to feasibility conditions; here u is the common
utility function. In the second case, considered by Eisenberg (1961) and
Chipman (1974), the equilibrium allocation maximizes Eim~ 0; log ui(xi); here
u~ is the homogeneous-of-degree-one representation of the utility function and
0 i is the proportionality factor such that w ~= 0 i Zjm=l W j.
The characterization of equilibria as solutions to optimization problems is
useful to the extent to which it is easy to find the optimization problem that an
equilibrium solves. The Negishi approach is useful in situations in which the
number of consumers is less than the number of goods and the Pareto problem
is relatively easy to solve.
It is worth noting that there is always a trivial optimization problem that an
equilibrium (~,/)) solves:
min(llx - [l 2 + lip -/3ll2)
The only way that we can find this problem, however, is to compute the
equilibrium by some other means. Another point worth noting is that the
Pareto problems that we have considered are convex problems, which have
unique solutions that are easy to verify as solutions and relatively easy to
compute. Any fixed point problem, and hence any equilibrium problem, can be
recast as an optimization problem,
mini[ p - g(p)[[ 2 .
Because the objective function is not convex, however, it is relatively difficult
to compute equilibria using this formulation. Nevertheless, this problem does
have one aspect that makes the solution easier than that of other non-convex
optimization problems: Although we may possibly get stuck at a local minimum, at least we know what the value of the objective function is at the global
minimum, II/~ - g(/))l[ 2 = o.
A recent development that may allow efficient solution to non-convex
optimization problems is the simulated annealing algorithm. This algorithm,
developed by Kirkpatrick, Gelatt and Vecchi (1983), is based on the analogy
T.J. Kehoe
2078
between the simulation of the annealing of solids and the solution of combinational optimization problems [see van L a a r h o v e n and Aarts (1988) for a survey
and references]. Although this m e t h o d has been applied principally to combinatorial problems, which involve discrete variables, there have been some
applications to continuous optimization problems (see, for example, Vanderbilt
and Louie (1984) and Szu and Hartley (1987)]. So far, this method has not
b e e n applied to solve economic problems, however, and it remains an intriguing direction for future research.
4. Static production economies

We can add a production technology to our model in a variety of ways. Perhaps
the easiest, and in many ways the most general, is to specify the production
technology as a closed, convex cone Y C R n. If y @ Y, then y is a feasible
production plane with negative components corresponding to inputs and
positive components to outputs. We assume that - R + C Y, which means that
n
any good can be freely disposed, and that Y 91 R+ = {0}, which means that no
outputs can be produced without inputs.
The production cone specification assumes constant returns to scale. With
the introduction of fixed factors, it can also account for decreasing returns. It
cannot account for increasing returns, however, which are not compatible with
the competitive framework that we employ here. See Chapter 36 for a survey
of results for economies with increasing returns.

In an economy in which consumers are specified in terms of utility functions
and endowment vectors, an equilibrium is now a price v e c t o r / ) E R+\{0}, an
allocation ( ~ , . . . , :fro), where ~ E R~, and a production plan 3~E Y such that
x , / = 1 , . . . , m , solves
max
ui(x ) subject t o / ) ' x <~p w, x ~ 0 ,
/)')3 = 0 a n d / ) ' y ~<0 for all y ~ Y,
r~iml ~i ~<33 + Ei"=l w ~.

The second condition is the familiar profit maximization condition for a
constant-returns technology.
In an economy in which consumers are specified in terms of an aggregate
excess demand function, an equilibrium is now a price vector/) E R+\{0} such
that
2079
/)'y~<0forallyEY,
I(D
Y.
Notice that Walras's law implies that )3 = f(/~) is such that/~')3 = 0.
Specifying the production technology as a cone is often too abstract an
approach for many applications. Alternatively, it may be specified by an n x k
activity analysis matrix A, where each column of A represents a feasible
production plan. [See, for example, Koopmans (1951).] In this case
Y={xER"]x=
A y , some yERk+} ,
and Y is the polyhedral cone spanned by k columns of A. Another alternative

is to specify production in terms of a finite number of concave, homogeneousof-degree-one production functions hj : Rn---> R, j = 1 , . . . , k. In this case
Y= x~R"lx=~, z ] , h i ( z J ) > ~ O , j = l , . . . , k
j=l
For example, h(Zl,Z2, z3)='O(-Zl)(-z2) 1 - - Z 3 is the familiar C o b b Douglas production function. (Of course, the activity analysis specification
is a special case of this one since, for example, h(zl, z 2, z3) = m i n [ - z l / a u ,
--z2/a2j ] -- z3/a3j i s a concave production function.)
Another alternative is to allow decreasing returns to scale, where the
production function hi is strictly concave. In this case, the problem of maximizing p ' z subject to hi(z)>~ 0 has a unique solution zJ(p). Unless z](p) = 0 there
are positive profits 7r](p)=p'zJ(p) that must be spent. Letting 0~>~0,
Em
i=~ 0ii --- 1, j = 1 . . . . . k, be profit shares, we change the budget constraint of
c o n s u m e r / t o p ' x <-p'wi+ E~= 10~Tr](p). We could define the excess demand
function to include production responses,
k
f(p) =
i-I
(x'(p)- w')-
j-1
zJ(p).
Although we have to restrict ourselves to the convex set of prices for which
zr](p) < ~, j = 1 , . . . , k, this approach is frequently very convenient for computation. From a theoretical viewpoint, however, it is easier to view even this
as a special case of constant returns, defining a new good, an inelastically
supplied factor of production, to account for each industry's profits and
endowing consumers with this factor in the proportions 0~ [see, for example,
McKenzie (1959)].
A simple extension of our previous argument demonstrates the existence of
equilibrium in a production technology and suggests algorithms for computing
equilibria. Again we use homogeneity to normalize prices so that e'p = 1.
T.J. Kehoe
2080
Consider the set
S r={PER
"le'p=l,p'y<~O,
ally@Y}.
Sy is obviously closed and convex. Since -R~_ C Y implies that Sy C S, it is

compact. Since Y n R~_ = {0}, the separating hyperplane theorem implies that
there exists f i 0 such that fi'y<-O for all y ~ Y . This implies that Sy is
non-empty. Now let g:Sv---~ Sy be the function that associates any point
p E Sy with the point g(p) that is the closest point in Sy to p + f ( p ) in terms of
euclidean distance. In other words, g(p) solves the problem
min 1 (g _ p _ f ( p ) ) , ( g _ p _ f(p)) subject to g ~ S y .
Once again, since the objective function is strictly convex in g and continuous
in p and the constraint set is convex, g(p) is a continuous function. (See Figure
38.5.)
Proposition 4.1 [Eaves (1971) and Todd (1979)].
only if it is a fixed point of g, ~ = g( ~ ).
Proof.
~ is an equilibrium if and
g(p) solves the minimization problem that defines it if and only if
( g(P) - p - f( P))'g(p) <~( g(P) - p - f ( P))'q

for all q @ S v. If ( p + f ( p ) ) ~ f S r , then this inequality says that the hyperplane
{plpA <O,p.e=l}
p + f(p)
P2
Pl
Figure 38.5
2081
passing through g with normals ( g ( p ) - p - f ( p ) ) separates g(p) from Sy. If

( p + f ( p ) ) E S t , then g ( p ) = p + f ( p ) and the inequality is trivial.
Suppose that /3 =g(/3). Then the above inequality becomes q'f(/3)</3'f(/3) = 0 for all p E Sy. Since we can multiply this inequality by any positive
constant without changing it, we obtain q'f(/3)<-O for all q ~ Y*, where
Y* = {q E R" [ q'y <~O, all y E Y} is the dual cone of Y. This says that f(/3) is
an element of the dual cone of Y*, Y** = {y ~ R n [ y'q <~0, all q E Y*}. Since
Y is convex, Y** = Y. Consequently,/3 is an equilibrium.
Conversely, if/3 is an equilibrium, then q'f(/3)<~O for all q E Sy, which
implies that g(/3) =/3.
Remark. Once again, this approach can be used to deal with demand
correspondences rather than functions. Again letting D be the convex hull of
the image of p + f ( p ) for p @ Sy, we define q : D ~ Sy as the least-squares
projection onto Sy. As in the exchange case, the correspondence g : D ~ D
defined by the rule g ( p ) = q ( p ) + f ( q ( p ) ) satisfies the conditions required by
Kakutani's fixed point theorem to have a fixed point/3 ~ g(/3), and/3 is a fixed
point if and only if it is equilibrium.
Computing equilibria by computing fixed points of the function g is easiest
when the production technology is specified by an activity analysis matrix. In
that case, g ( p ) can be calculated by solving the quadratic programming
problem
min X(g _ p _ f ( p ) ) , ( g _ p _ f ( p ) ) subject to
A ' g <~0, e'g = 1.
Let B be the n x l matrix of columns of A associated with strictly positive

Lagrange multipliers yj in the first-order conditions
g-p-f(p)
+ A y + Ae = 0 .
Let C b e t h e n x ( l + l )
matrix [B e], and let e t+l be the ( l + l ) x l vector
with eZt++l= 1 and etj+1 = 0 , j l + 1. Then elementary matrix manipulation
yields an explicit formula for g(p):
g ( p ) = (I - C ( C ' C ) - I c ' ) ( p + f ( p ) ) + C ( C ' C ) - l e '1 .
Furthermore, the matrix C changes only when a Lagrange multiplier yj that has
been previously positive becomes zero or one that has been previously zero
becomes positive.
Suppose that the production technology specified by k concave production
T.J. Kehoe
2082
functions. Let at(p) be the restricted profit corresponding to the production

function hi(z), the value of the objective function at the solution to
max p ' z subject to ht(z ) >! O, Ilzll = 1 .
(For
more
at(p)
zt(p)
production functions with only one output i a restriction like z i = 1 is

natural than Ilzll = 1.) if this problem has a unique solution zt(p), then
is continuously differentiable and, by Hotelling's lemma, D a t ( p ) =
' [see, for example, Diewert (1982)]. In this case g(p) is found by solving
min ( g - p - f ( p ) ) ' ( g - p - f ( p ) )
at(g)<--.O,
subject to
j=l .... ,k,
e'g = 1.
Because the constraints are non-linear, however, solving this problem is more
difficult than it is in the activity analysis case.
4.2. The index theorem and multiplicity of equilibria

Mas-Colell (1975, 1985) and Kehoe (1980, 1983) have extended the concepts
of regularity and fixed point index to production economies. They prove that
regular production economies have the same desirable properties as regular
exchange economies and that, in a precise sense, almost all economies are
regular. Kehoe (1980) further calculates the index of a regular equilibrium of
an economy with an activity analysis production technology as
index, ,-sgntdet[_ ,
Here /3 is the ( n - 1 ) x l matrix formed by deleting the first row from the
matrix of activities used at equilibrium/). In the case of more general profit
functions, let H(/)) be the n x n weighted sum of the Hessian matrices of profit
functions used at/), H(/)) = Z kj= t Yt
~ D 2at (/)); the weights 39t are the appropriate
activity levels. In this case, Kehoe (1983) calculates
index(/)) = sgn(det[ - ]+_/~,H B])O
where / t is the (n - 1) x (n - 1) matrix formed by deleting the first row and
column from H(/)).
2083
Once again, if f satisfies the weak axiom, the set of equilibria is convex, and
in the regular case there is a unique equilibrium. Unfortunately, even if f
exhibits gross substitutability, the economy need not have a unique equilibrium, as the following example illustrates.
Example 4.1. Consider a static production economy with two consumers and
four goods. Consumer i, i = 1, 2 has a utility function of the form
4
Ui(X 1 , X 2, X 3, X4)
j=l
aij log x~
i
i
i
where a'j i> 0. Given an endowment vector (wi~, w2,
w3,
w4),
consumer i maximizes this utility function subject to his budget constraint. The aggregate excess
demand function is
4)
aji ~
(Pl'Pe'P3'P4)=~(i=I
pkWik
k=l
j=1,2,3,4.
4
i
Pj ~ ak
k=l
The consumers have the parameters given below.
Commodity
Consumer
1
2
O.8
0.1
0.2
0.9
0
0
0
0
w'j
Commodity
Consumer
1
2
0
0
0
0
10
0
0
20
The production technology is specified by a 4 x 8 activity analysis matrix
A=
-1
0
0
0
0
-1
0
0
0
0
-1
0
0
0
0
-1
3
-1
-1
-1
5
-1
-1
-4
-1
5
-1
-3
(The first four columns are disposal activities.)
-1_!]]
"
2084
T.J. Kehoe
This e c o n o m y has three equilibria, which are listed below together with the
welfare weights for which the corresponding Pareto problem yields the same
equilibrium.
Equilibrium 1:
p l = (0.2500,0.2500,0.2500,0.2500),
y l = (0,0,0,0,5.00000,0,5.0000,0),
a 1= (0.3333,0.6667).
Commodity
Consumer
1
2
ui
8.000
2.000
2.000
18.000
0
0
0
0
1.8022
2.6706
Equilibrium 2:
p2 = (0.2500,0.2222,0.3611,0.1667),
y~=(0,0,0,0,5.1806,0.3611,4.4583,0),
a = (0.5200,0.4800).
Commodity
Consumer
1
2
ui
11.555
1.333
3.250
13.500
0
0
0
0
2.1935
2.3719
Equilibrium 3:
p~=(0.2500,0.2708,0.1667,0.3125),
Y3 (0, 0, 0, 0, 4.3690, 0, 5.1548, 0.1190),
a
(0.2105,0.7895).
Commodity
Consumer
1
2
ui
5.333
2.500
1.231
20.769
0
0
0
0
1.3807
2.8217
This example has been constructed by making pl = (0.25, 0.25, 0.25, 0.25) be
an equilibrium with index ( p l ) = - 1 .

-40
/-/J~//
0 32
,,
I
0
0
-8o
72
0
0
0
0
{ [800
index(p~) = sgn | d e t |
8 7 2 1
0
0 -1
0
0 -1
1
1
0
0
3
0
index( p l ) = s g n ( - 4 1 6 ) = - 1.
-1
-
2085
That this example has multiple equilibria means that gross substitutability
does not imply the weak axiom. Kehoe and Mas-Colell (1984) prove that gross
substitutability does indeed imply the weak axiom if n ~<3, so at least four
goods are needed for this example. Kehoe (1985b) presents an example with
multiple equilibria in which the f exhibits strong gross substitutability, 0f~/
Opj > 0. The simple form of a Jacobian matrix in this example, which satisfies
gross substitutability but implies a violation of the weak axiom is due to
Mas-Colell (1986) [see also Hildenbrand (1989) and Kehoe (1986)].
Unfortunately, as Herbert Scarf has demonstrated to the author, the weak
axiom is the weakest condition on f that guarantees that a production economy
has a unique equilibrium. Suppose that there are two distinct price vectors p
and q such that p'f(q)~< 0 and q'f(p)<~ O. Let
Y = {x G- R" I x <-f ( P ) Y l + f( q)Y2, yj >~O) .

Then both p and q are equilibria of (f, Y). Aggregation conditions like those
of Antonelli-Gorman-Nataf and Eisenberg-Chipman guarantee that f satisfies
the strong axiom of revealed preference, a much stronger condition than the
weak axiom. To make further progress on developing economically meaningful
conditions that guarantee uniqueness of equilibrium, we need to develop
economically meaningful conditions that imply that the weak axiom holds in
the aggregate. A step in this direction has been taken by Hildenbrand (1983),
who places restrictions on income distribution in an economy with a continuum
of agents that imply the weak axiom. See Jerison (1984) for more results in this
same direction.
4.3. A tgttonnement method

The function g whose fixed points are equilibria suggests a tfitonnement process
for computing equilibria in production economies. Let /3(p) be the n l
matrix whose columns are those vectors Daj(p) such that a i ( p ) = 0. Let/~ be
the vector q that solves
min l ( q _ f(p)),( q _ f ( p ) ) subject to B ' ( p ) q ~ 0 .
Suppose that we start this process at p ( 0 ) E R" such that aj(p(O))<~0, j =
1 , . . . , k. Unfortunately, t5 is discontinuous when p(t) runs into a new constraint aj(p(t))= 0. This is the same problem as that in the exchange case
where some coordinate of pi(t) becomes zero, however, and it can be argued
that p(t) is continuous in spite of it. Notice that, since d/dt(aj(p)) = Daj(p)13
and Daj(p)t 5 <~0 whenever ai(p(t)) = O, p(t) stays in Y* = {p ~ R" I aj(p) <~O,
j = 1 . . . . . k}. Notice too that, if/~ = 0 at/), then/3 is an equilibrium: q solves
the above problem if and only if there exists a non-negative l x 1 vector of
TJ. Kehoe
2086
Lagrange multipliers y such that
q-f(p)+
B(p)y=O,
y@'(p)q=O.
At q = 0 this becomes f(/)) =/~(/~)y.

Let B(p) be the n x I submatrix o f / ~ whose columns are associated with
strictly positive Lagrange multipliers. Then we can solve explicitly for q to
obtain
D = (I - B(p)(B'(p) B(p))- 1B '( p))fl p).

Like the tfitonnement process for exchange economies, this process leaves ]l P 11
constant. Also like the tfitonnement process for exchange economies, this
process is globally asymptotically stable if the weak axiom of revealed preference holds in comparisons between arbitrary price vectors p and the equilibrium price vector/~. Suppose that p ~ Y*. Then f(/3) ~ Y implies p'f(fi) <~O.
The weak axiom then implies ~ ' f ( p ) > O. The Liapunov function is again
L(p) = l ( p ,
L(p) = (p - ~)/1~ - ~ ' f ( p ) + ~'B(p)(B'(p)B(p))-~B'(p)f(p) .

Notice that y = (B'(p)B(p)) -1, B'(p)f(p) > 0 and 13'B(p) <~0 since t3 ~ Y*.
Consequently, L(p) < 0 unless p =/~.
Van den Elzen, van der Laan and Talman (1989) have generalized the path
following method of van der Laan and Talman (1987) for computing equilibria
of exchange economies to compute equilibria of economies with activity
analysis production technologies. Their method, like the method for exchange
economies, is similar to tfitonnement, and, like the above method, always stays
in the set of prices where p ' A ~<0.
4.4. Computation in the space of factor prices

The dimension of the space in which we must search for an equilibrium is
usually the critical determinant of how difficult it is to find one. In production
economies with a generalized input-output structure, where goods can be
partitioned into produced goods and factors of production, we can reduce the
dimension of the space to the number of factors. This reduction has often been
used by applied general equilibrium modelers to improve computational
efficiency [see, for example, Helpman (1976)]. It has also been used by
international trade theorists in their discussions of factor-price equalization
[see, for example, McKenzie (1955)]. Kehoe and Whalley (1985) exploit a
Ch. 38: Computationand Multiplicityof Equilibria
2087
reduction in dimension of this sort to carry out exhaustive searches to verify

that two large-scale applied general equilibrium models have unique equilibria.
We begin with the activity analysis case. A production economy (f, A) has a
generalized i n p u t - o u t p u t structure if it satisfies the following conditions:
T h e r e are h < n factors of production: aij~<0 for i = l . . . . . n and j =
1,...,k.
T h e r e is no joint production: for every j = 1 , . . . , k, aq > 0 for at most one i.
Production of all produced goods is possible: there exists y/> 0 such that
Ej~ a j / > O , i = 1 . . . . , n - h.
Every good that can be produced is actually produced at every equilibrium.
T o ensure that this final condition holds, we could require that fg(p)~>0,
i = 1 , . . . , n - h, for all p or, what is almost the same thing, that consumers
have no endowments of produced goods. In the case where h = 1 these
conditions are those of the non-substitution theorem [see Samuelson (1951)].
Let p E R n-h now be the vector of prices of produced goods and q E R h be
the vector of factor prices. Partition A into
m
[A:]
where A~ is ( n - h ) k and A 2 is h k. Similarly, partition f(p, q) into
(f~(p, q), f 2 ( p , q)).
In the case where A consists of 2n - h activities, n disposal activities and an
n (n - h) matrix B with .one activity to produce each of the produced goods,
the reduction of the search to the space of factor prices is easy. Our
assumptions imply that the (n - h) (n - h) matrix Ba is a productive Leontief
matrix. Under a mild indecomposability assumption, B~-~ is strictly positive.
The equilibrium condition B133= f l ( / ~ , q) implies that )3 = B~-lfl(/~, q), and
the zero profit condition/~'B~ + 4 ' B 2 = 0 implies that/~ = - ( B 2 B l - 1 ) ' 4 . We are
left with the equilibrium condition B2~ = f 2 ( / % 4). We define the function
q," Rh+\ {0} ~ R h by the rule
~b(q) =f2(-(B2Bl')'q, q) - B2B ~f'(-(B2Bl')'q, q).

It is easy to verify the ~0 is continuous, is homogeneous of degree zero and
obeys Walras's law because f satisfies these properties. Notice that ~0(q) = 0 is
equivalent to
f2(/~, q) = B2B?' f l ( P , 4) = B2f~.
Consequently, 4 is an equilibrium of the h-good exchange economy qJ is and
only if (/~, q) is an equilibrium of the n-good production economy ( f , A).
2088
T.J. Kehoe
When there is more than one possible activity for producing each good the
situation is slightly more complicated. To calculate qJ(q) we start by solving the
linear programming problem
min - q ' A z y
subject to A ~ y = e, y >~0.
Our assumptions imply that this problem is feasible and has a finite maximum.
The non-substitution theorem says that the solution is associated with a feasible
basis,
-q'B2]
B, J~
that is, a matrix of n - h columns associated with positive activity levels yj that
does not vary as the right-hand side varies, although the activity levels
themselves do. Furthermore, there is a vector of prices p such that p'B~ +
q ' B 2 = 0 and p ' A a + q ' A 2 4 0 [see Gale (1960, pp. 301-306)]. When the basis
is uniquely defined, we can proceed as above.
There may, however, be more than one feasible basis possible in the
solution. Although the linear programming problem may be degenerate, the
economy itself need not be. Such is the case in Example 4.1, where the
economy has this generalized input-output structure with n = 4 and h = 2. At
two of its three equilibria, this example has 3 > 2 = n - h activities in use.
When there is more than one feasible basis possible, the demand for factors
becomes a convex-valued, upper-hemi-continuous correspondence; 0 E qJ(O) is
then the equilibrium condition [see Kehoe (1984) for details].
With more general production technologies, the situation is similar to the
activity analysis case with many activities. For any vector of factor prices q we
find the cost minimizing production plan for producing an arbitrary vector, say
e, of produced goods. This plan is associated with a vector of prices p ( q ) ,
which can be plugged into the demand function f l to find the production plan
that satisfies the feasibility condition in the produced goods markets. This
production plan induces a demand for factors of production. We systematically
vary q to make the excess demand for factors equal zero.
The transformation of an economy with production into an exchange
economy in factors is also useful for developing conditions sufficient for
uniqueness of equilibrium. If q, satisfies the weak axiom of revealed preference
or gross substitutability, for example, then there is a unique equilibrium.
Mas-Colell (1989) uses this approach to show that an economy with a
generalized input-output structure in which all utility functions and production
functions are Cobb-Douglas has a unique equilibrium because q, then exhibits
gross substitutability. (He also reports that similar results have been obtained
2089
Ch. 38: Computation and Multiplicity o f Equilibria
by Michael Jerison.) Mas-Colell (1989) further generalizes this to the assumption that utility and production functions are super-Cobb-Douglas in that they
locally exhibit as much substitutability as a C o b b - D o u g l a s function. The
precise condition on u : R~_ ~ R, for example, is that for every x E R~ there
exists a C o b b - D o u g l a s function u x : R~ ~ R and a neighborhood Ux of x such
that Ux(X) = u(x) and ux(z)<~ u~(x) for all z E U~. For generalized i n p u t output economies where n - h = h = 2 and all utility and production functions
are CES, John (1989) has developed necessary and sufficient conditions for
uniqueness of equilibrium
5. E c o n o m i e s with a finite n u m b e r of infinitely lived c o n s u m e r s
We now consider economies in which goods are indexed by date and, possible,
state of nature. We assume that both time and uncertainty are discrete If there
are a finite number of time periods and a finite number of states of nature, then
there is a finite n u m b e r of goods, and this type of economy fits into the
previous framework H e r e , and in the next section, we consider economies
with an infinite n u m b e r of goods Mas-Colell and Zame (1991) study questions
related to existence of equilibrium in this type of economy in detail in Chapter
34; here we focus on questions related to computation and multiplicity
5.1. Deterministic exchange economies

We begin by analysing a deterministic stationary exchange economy with m
consumers and n goods in each period. Each consumer is specified by a utility
function of the form E~= a y i - l u i ( x , ) and a vector of endowments that is the
same in every period H e r e 1 > % > 0 is a discount factor We assume that
u i : R ~ R is strictly concave and monotonically increasing and that w i is
strictly positive
Let p, = (Pat . . . . . Pn,) be the vector of prices in period t. An equilibrium of
this economy is a price sequence / S a , / ~ 2 , . . - , where /~, E R~\{0}, and an
allocation (3~1, .
X^m ) , Xîl , X2,
î . .
where xtER+,
î ~i
Xl,X2,...
, solves
.,
t-1
~'i ui(x,) subject to
max
t=l
PtXt<~
t=l
pt w,
X t>lO,
t=l
m
î
rn
~ i = I Xt ~ E i = I
i
W,
t = 1, 2 . . . . .
î
2090
T.J. Kehoe
Using the Negishi (1960) approach, we characterize equilibria as solutions to

social planning problems. This approach has been applied to dynamic
economies by Bewley (1982) and Yano (1984).
Consider the Pareto problem
max
a i ~. yi-lui(xl)
i=l
xt~
i=l
subject to
t=l
t = 1,2 . . . . .
i=1
Xt>~O ,
for a vector ~ of strictly positive welfare weights. Using the same reasoning as
before, we can argue that, if ozi = 1/Ai where Ai is the equilibrium value of the
Lagrange multiplier for the budget constraint of consumer i, then the competitive allocation (~1. . . . . ~m) solves this problem where p t ( a ) = P t is the vector
of Lagrange multipliers for the feasibility constraint in period t. Consequently,
the first welfare theorem holds for this economy.
The crucial step in the reasoning is taking the necessary and sufficient
condition for the solution to the consumer's maximization problem,
"yit-I/~i()~:)
~_ i~i ~ pt(wAt i
t=l
)c:)~ ~ ~it 1ui'xt)lAi\_]_~i ~ P't( wt-"
t=l
t=l
t=l
uitx,)+ Xi
>I
t=l
t=l
for all Ai/>0 and x 11>0, dividing through by Ai>0, and summing over
consumers to produce
i=1
t=l
i=1
t=l
i=l
t=l
t=l
i=1
for all xl ~>0. Since E~=I pA,

, w i must be finite for the consumer's utility maximim 1 E~=
_ 1 p~'
t w must also be finite.
zation problem to have a solution, Ei_
The second welfare theorem holds for this economy as well. The transfer
payments needed to decentralize a solution to the Pareto problem
( x l ( a ) , . . . , xm(a)) as an equilibrium with transfer payments are
_
ti(ol) =
pt(a)
t=l
t(xt(oz
i )
- w') ,
i= l ....
, m .
2091
Once again we can argue that t is a convex-valued, bounded, upper-hemicontinuous correspondence. Consequently, Proposition 3.2 applies and there
exists a vector of welfare weights 6 such that (p(&), ( x l ( & ) , . . . , x m ( ~ ) ) ) is an
equilibrium 0 ~ t(&).
It is possible to extend our analysis to the more general stationary preferences described by Koopmans, Diamond and Williamson (1964). This extension is most easily done using the dynamic programming framework described
in the next section.
Example 5.1. Consider a simple economy with one good in each period and
two consumers. Suppose that u l ( x t ) = Uz(Xt) = log x t and that w 1 = w 2 = 1. The
only difference between the two consumers is that 71 < Y2- A solution to the
utility maximization is characterized by the conditions
tlti
7i lXt = hiPt ,
P,Xl :
t=l
Pt t=l
An equilibrium satisfies these conditions and the condition that demand equals
supply:
1
c t +c t
=2,
t=l,2,....
The Pareto problem is

ce
t
max a 1
Y 1 log x t
+ O~2
t=l
1
t--I
E 72
log X~ subject to
t~l
xt +xt =2,
t=l,2,....
A solution to this problem is characterized by the conditions

t
aiy i
"
/ x 't = p , ,
i=1,2,
and the feasibility conditions. These equations can easily be solved to yield
i
xt=
2ai7~
t-1
Og17 1
Pt =
-1
t-1 ,
i=1,2,
~- O~27 2
t
(O~17t1-1~- 0/272
)"
The transfer payments needed to implement as a competitive equilibrium the

allocation associated with the weights a I and o~2 are, therefore,
T.J. Kehoe
2092
t , ( a I , o t z ) = ~f, p,(x~ - 1 ) t=l
Ol__l
Yl
t2(a,, a2) = E pt(x~ - 1) -a2

t=l
1 T2
Ol2
1-T2 '
Ot~l
1--Yl
Notice that these functions are continuously differentiable, are homogeneous

of degree one and sum to zero. The unique equilibrium is found by setting
these transfer payments equal to zero. It is (&l, &2)= ( ( 1 - y ~ ) / ( 2 - y 1 - Y z ) ,
(1 - 3,2)/(2 - y~ - Yz)).
5.2. Dynamic production economies and dynamic programming

It is possible to analyse economies with production and durable goods in much
the same way as we have just done with exchange economies. Frequently,
however, it is convenient, both for computing equilibria and for studying their
properties, to recast the problem of determining an equilibrium of a dynamic
economy with production as a dynamic programming problem.
Consider an economy with m infinitely lived consumers and n C perishable
consumption goods. Each consumer has a utility function E ~=~ y'-lui(xt). Here
u i is strictly concave and monotonically increasing and y is a discount factor
common to all consumers; we later discuss heterogeneous discount factors. The
endowment of these goods held by consumer i in each period is w ~E R +nc
; it
may include different types of labor. In addition, there are n k capital goods,
reproducible factors of production. The endowment of these goods held by
consumer i in the first period is kil E R~+k.
There are many ways to specify the production technology. One of the
easiest is to define an aggregate production function h : R~~ R~~ x Rn~---~R
that is continuous, concave, homogeneous of degree one, increasing in the first
vector of arguments, and decreasing in the second and third. A feasible
production-consumption plan in period t is then a triple that satisfies
i=1
Here k t is the input of capital goods, kt+ 1 is the output of capital goods that can
be used in the next period and Eiml (x I - w') is the net output of consumption
goods. To keep the equilibrium path of capital stocks bounded, we assume that
there exists a vector k max ~ R+k such that if [[kt[[/> l[kmax][ and [[kt+l[ [ >/[kt[[,
where kt, k t + x E R ~ k, then h(kt, k t + l , Z ) < O for all z ~ > - Z i=1
n w i ; in other
words, it is not feasible to sustain a path of capital stocks with Ilk,[[ i> [kmax[[.
A simple example of such a function h is
h(k,,
kt+
, Zlt
, z2t )
2093
= ~ K, ot.~. - z l t ) ..1-o + ( 1 - / 3 ) k t - k t +
1 -Zzt.
Here there is a single capital good, k~, and two consumption goods, leisure, zl,,
and consumption z2t. The feasibility constraint says that consumption and
investment net of depreciation must be less than the output of a C o b b - D o u g l a s
production function.
An equilibrium of this economy is a sequence of prices for the consumption
^
goods p~,
P^2 , . - . , where/~, E R +n c\ { 0 } , . a price f E R + k for the initial capital
stock; an allocation, X"~1 , X~2 , . . . where 21E R+ ~, for each consumer i; a
sequence of net outputs of consumption goods 21, 2 2. . . . . where ~, E R~c; and
a sequence of capital goods/c~,/cz . . . . . where /c, ~ R+k such that
hi
î
Xl,X2~...
solves
max ~ 7 , 1ui(x,) subject to
t=l
PAtt X ~ E
t=l
p~tt w i + r^r kl,i x~>~O.
t=l
zl, z2," "- , and kl,/~2,- .. solve

max ~
/~,z, - ~k I subject to
t=l
h(kt, kt+ I , z , ) ~ > 0 ,

kt~0
t=l,2 .....
m Xt
hi z Zt + E i m= l w i ' t = 1 , 2 , . . . .
~'i=1
~ i m l kil = k , .
Again, an equilibrium is Pareto efficient and solves a Pareto problem of the

form
of.i
max
i=1
uAxt) subject to
t=l
h(kt, kt+l,~(xi-wi)t~O,
\
i=1
t=l,2
....
i=1
i
Xt, k t ~ 0 ,
for an appropriate vector a of strictly positive welfare weights.
T.J. Kehoe
2094
In principle, we have all that we need to characterize equilibria of this

economy: using the Lagrange multipliers 75 for this problem and the derivatives of h, or subgradients if h is not continuously differentiable, we can
calculate
e t ( a ) -- -Tr,(a)D3h kt(o O, k , + , ( a ) ,
ki,, k2(a ),
r ( a ) = 1r~(a)Dlh
( x i ( a ) - w')
i=1
(x
a) - w i
t=1,2,...,
i=l
--i=I
p , ( a ) ( x , ( a ) - w i) - r(a)'kSl ,
i = 1.....
m .
t=l
Once again, equilibria are solutions to the equation t ( a ) = 0.

We can greatly simplify the characterization of solutions to the Pareto
problem, and computation of equilibria, however, using the theory of dynamic
programming [see Bellman (1957) and Blackwell (1965); Harris (1987),
Sargent (1987) and Stokey, Lucas and Prescott (1989) provide useful summaries and economic applications]. Given an aggregate endowment of capital
in the first period kl ~ R+~, an aggregate endowment of consumption goods in
each period w ~ R+c and welfare weights a ~ R+\(0}, we define the value
function V ( k l , w, ~) as
max
~i
i=1
t-1
ix
uitx,) subject to
t=l
. . ,
i=l
i
xt, k t/> 0.
It is easy to show that V is continuous, concave in k I and w and convex in a.
If it is continuously differentiable, the envelope theorem allows us to
D 1 V ( k 1, w, a ) as a price vector of capital, r', and D 2 V ( k l , w, ce) as a price
vector for the present value of the endowment of consumption goods, E~_l p',.
If V is not continuously differentiable, we can work with subgradients. ]Benviniste and Scheinkman (1979) provide genera! conditions that ensure the V is
continuously differentiable.] The value of the total endowment of consumer i is
DIV
k~,
-j=l
w j, ~ k~ + D 2 V
j~l
k~,
-j=i
w ],
j=l
Ol
W i .
2095
Ch. 38: C o m p u t a t i o n a n d Multiplicity o f Equilibria
To calculate the transfer functions ti(a), we need to calculate the value of

expenditures. To do this in terms of the value function, we introduce m consumer specific goods and define U i : R~+c R"~+ --* R as Ui(x, y) = YiUi(x/Yi).
Notice that U i is h o m o g e n e o u s of degree one and that Ui(x, e) = u i ( x ) where
e = (1 . . . . . 1). We e n d o w consumer i with the entire aggregate e n d o w m e n t of
one unit of yi. We now define V ( k l , w, y, a ) as the m a x i m u m of weighted sum
of the a u g m e n t e d utility functions subject to the feasibility constraints. If xl is
the optimal consumption of consumer i in period t, its value is
yt-'ot, D u i ( x l ) x I = ,yt-'otiDiUi(xl, e ) x I .
Since Ui is h o m o g e n e o u s of degree one, we know that
D i U i ( x l , e ) x I = Ui(xl, e ) -
D 2 U i ( x I, e)e .
Using the envelope t h e o r e m , we can show that

E
t-1
31
.re
OW
aiUil, Xt, e) = a i ~
kl,
w, e, a
t=l
i=1
and that
~1t - , oliD2Ui(xl, e)e = OV
k ' ,,
t=l
w,e,i
i=1
Consequently, the value of the expenditures of consumer i is
~1
OlitllUitXt,
e)xl = ol i ~
At'
w,e,a
i=1
t=l
ka,
OYi
t'= 1
w , e, a
i= 1
We can now define the transfer function t : R+\{O} ~ R m as

OV
t i ( o t ) = Oli ~ i
OlV
k~,
j=l
-j=l
w j, e, a
w i, e , a
j=l
~Y/
k~,
j=l
w j, e, a
j=l
w j, e , ot
w i .
"=
If V is continuously differentiable, t is a continuous function. If V is not

continuously differentiable, t is a non-empty, upper-hemi-continuous, convex-
T.J. Kehoe
2096
valued correspondence. Once again, t is homogeneous of degree one and

satisfies the identity
i=1
ti(ol ) -~ O .
See K e h o e , Levine and R o m e r (1989b, 1990) for details. Furthermore, if

a E R+\{0} and a i = 0, then ti(a) < 0. The same argument as in the proof of
Proposition 3.2 now implies the existence of equilibrium
Using dynamic programming theory, we can investigate the properties of V
and, therefore, of t. We define the return function v(k,, kt+ ~, w, y, ~) as
max ~
aiUi(x i, y) subject to
i=1
h(kt, kt+l, ~ X i - w) >~O, xi >~o.

i=1
If h ( k , , k , + l , - W ) < O , we let v(kt, k t + l , w , y , a ) - - - - ~ . The function o is

upper-semi-continuous on the extended real line R t_J { - ~ } [see Kehoe, Levine
and R o m e r (1989b, 1990)]. The value function V can be found by choosing
k2, k3, . . . to solve
max
3' t--1 v(k,, k,+l, w, y, a) subject to k,/> O.
t=l
The direct approach to this problem focuses on the first order conditions,
often referred to as Euler equations,
"yDlv(k,, kt+ ~, w, y, a) + D2v(k , 1, k,, w, y, a) = O.

This is a system of n k second-order difference equations in the state variables
k t. T h e r e are, however, only n k initial conditions, the fixed values of k 1. For
some choices of k 2 the corresponding path kl, k2, k3, . . . eventually leads to
negative capital stocks and the system breaks down. For others, we need
additional boundary conditions to single out the unique path that is optimal.
These are given by the transversality conditions
lim 7t-lDtv(k,, kt+ l)k , = O .
t--)~
Showing that the transversality conditions together with the Euler equations
are sufficient for optimality is relatively easy [see, for example, Stokey, Lucas
and Prescott (1989, pp. 97-99)]. U n d e r additional assumptions they can also
2097
be shown to be necessary [see Peleg and Ryder (1972), Weitzman (1973) and
Ekeland and Scheinkman (1986)].
An alternative approach to finding the value function involves solving the
functional equation
V(kt, w, y, a) = max[v(k,, kt+l, w, y, a) + yV(kt+l, w, y, c01

subject to kt+ ~ t> 0
for the function V. The vector kt+ 1 = g(kt, w, y, a) that solves this problem is
referred to as the policy function. Calculating optimal paths is much easier
using the policy function than it is using the Euler equations: we simply run the
n k first-order difference equations
kt+l=g(kt,~
i=1
wi, e, ot)
forward from k x without worrying about the transversality conditions. The

difficulty is in finding the policy function g. Keep in mind that, using either the
Euler equation approach or this second, the dynamic programming approach,
we must somehow calculate the equilibrium values of a.
Example 5.2. Consider an economy with two consumption goods, leisure and
consumption, and one capital good. There is a representative consumer with
utility
E
~/t--lu(l,, Ct)~-- ~
t=l
,yt-I log c t .
t=l
(This function does not actually satisfy our assumptions because u is not strictly
concave in It and it is not continuous at c t = 0; this is not essential, however.)
The endowment is (w, 0) of labor and consumption every period and k 1 of
capital in the first period. The production function is
h(k t, k,+,,
Zl, , Z2t ) = r / k t ( - Z l , )
1-0
- k,+,
- z2t.
The return function is
v(k t, kt+l, w, y, a) = a y log(~qk~w 1- - kt+l) - ay log y .

This return function is special in that we can analytically solve for the value
function V(kt, w, y, a). This example is a member of a class of examples first
studied by Radner (1966). Notice that we do not allow the per period
T.J. Kehoe
2098
endowment of consumption to vary from zero; if we do, we cannot solve for

the value function analytically. The value function has the form a~ + a 2 log k t.
Using the functional relation
a 1 + a 2 log k t
m a x [ a y l o g ( r l k T w 1- - k t + l ) - a y log y
+ 3"(a 1 + a 2 log k,+l) ]
subject to k,+l I>0,

we first solve for k,+ 1, then substitute in the results and solve for a~ and a 2. We
obtain
1ozy
--- 3' [ l o g r / ( 1 - y 0 ) +
V(k t,w,y,a)-
~ 3,0
log 3,70 - log y
1-0
+ 7 ~
log w + -0 -- 3'0 log kt ]j
1-ytl
1 3"0
The policy function is

g ( k , , w , y , a ) = 3"vrl
~ w i o,o
Kt .
Notice that, for any initial value k l , the sequence k l ,

steady state /~= (3"Orl)l/1-w. To see this, consider
k2,
. . .
converges to the
log k,+ I = log y O r l w 1 o + 0 log kt.

Since 0 < 0 < 1, log k, converges to (log 7 0 " q w a - ) / ( 1
The Euler equation is
yvrl w
1-010-1
'rl wl-k''t
Kt
kt+l
1
'rlw
1-OkO
=0,
- 0).
t=2,3,....
.~t 1 - kt
We know the initial value k 1, but we need a value for k 2 to get started. If we
use any value other than k 2 = 3"O'owl-k~, however, we eventually have a
negative capital stock, at which point the different equation breaks down, or
we violate the transversality condition. (To see this rewrite the Euler equation
as a first-order linear difference equation in K t = k t + i k ~ . )
Since this example has a representative consumer, the transfer function is
identically equal to zero. Although the transfer function itself is not particularly interesting, we can use the value function V ( k t , w , y , a ) t o find the
equilibrium value of the endowment
2099
r = Dy(k,,
w, 1, 1) = (1 - yO)k,
~,
t=l
P,t=DzV(k,,w,I,1)=
1-0
(1-)(1-y0)w"
'y
Consequently,
rkl + t=l p l t w -
3'
is both the value of the endowment and the value of expenditures.

Remark. This example is a special case of the model developed by Brock and
Mirman (1972). Long and Plosser (1983) work out a multisector version of a
model with the same functional forms that permit an analytical solution.
Many extensions of this sort of analysis are possible. One is to economies
with more general preferences of the sort described by Koopmans, Diamond
and Williamson (1964). Letting tc = (c,, c , + ~ , . . . ) , these preferences satisfy the
functional relation
U(,c) = W(c,,
u(,+lc))
for an aggregator function W:R~+ C x R---~R that satisfies certain properties

[see, for example, Lucas and Stokey (1984), Dana and Le Van (1987) and
Streufert (1990)].
Another possible extension is to retain additively separable utility functions
but allow heterogeneous discount factors. One approach is to allow the return
function v(kt, kt+l, w, y, or, t) to vary over time as the solution to maximizing
m
t
i
Zi= 1 ai(fli/[31) Ui(x, y) subject to feasibility constraints; here/31 is the largest
discount factor [see Coles (1985)].
Yet another extension is to allow kt and x, to grow without bound. This is
particularly useful in growth models of the sort considered by Romer (1986)
and Lucas (1988). For an example that fits clearly into the competitive
framework used here, see Jones and Manuelli (1990). In this sort of model care
must be taken to ensure that x t cannot grow so fast that the present value of
utility can become infinitely large.
5.3. Stochastic economies
The analysis of the previous section can be easily modified to include random
events. To do so, we follow the approach of Arrow (1953) and Debreu (1959)
T.J. Kehoe
2100
in indexing goods by both date and state of nature. Suppose that in period t
one of a finite n u m b e r of events 77, = 1 . . . . 1 can occur. A state is a history of
events s, = (~7~. . . . . r/,), a node on the event tree. The event T~t can effect
preferences, endowments or technology. Since the set of date-state pairs is
countable, the analysis of Section 5.1 can be applied to prove the existence of
equilibrium. We can again reduce the p r o b l e m of computing an equilibrium to
finding a set of welfare weights for which the corresponding Pareto efficient
allocation can be decentralized as a transfer equilibrium with all transfers equal
to zero.
Suppose that the probability of event i is ~i > 0 where E tj=x .n'j = 1. The
induced probability distribution even states is given by zr(st) = zrnl. zrn. Let S
be the set of all possible states; let t(s) be the date in which s occurs, that is, the
length of the history s; let s 1 be the history of length t(s) - 1 that coincides
with s; and let "qs -- T/t(s), that is, the last event in the history s. Assuming that
consumers maximize expected utility, we can write the Pareto p r o b l e m as
max 2 0 ~ i
i=l
sES
~/ t ( s ) - I "JT(S)Ui(Xi (S), rh) subject to
i=1
w(ns)),ns >-0, s ~ S ,
i=1
x i ( s ) , k ( s ) ~ O.
H e r e k I is the amount of capital before the event in the first period occurs.
As before, we define the return function v(k,, k,+l, ~,, w, y, a) as
max 2
aiUi(x i, Y, nt) subject to
i=1
h( kt, kt+ l , xi - w(rlt), "rlt) >~O, xi >~o .

i=1
(Notice that now w is a vector of dimension n c x l.) The value function

V(kl, ~71, w, y, a) can be found by choosing k(s), s ~ S, to solve
max ~'~ 7'(s)-llr(s)v(k(s_l), k(s), "qs, w, y, a) subject to k(s) >!0.
sES
Once again we can characterize solutions to the Pareto p r o b l e m using either

the Euler equations
2101

l
Dzv(k, a, kt, "0,-1, w, y, a) + y ~
% D a v ( k t, k,+ a, "0, w, y, a) = 0
rl=l
and an expected value version of the transversality condition or using the

functional equation
V(k,, '0. w, y, a ) = m a x [ v ( k , , k,+l, "0. w, y, a )
'
+y ~
%V(k,+a, "0, w, y, a)
rt=a
subject to k,+ 1 / > 0 .

This approach can be generalized to allow events to be elements of a
continuum. In this case xi(s) and k(s) are functions and we can rewrite both
Euler equations and the dynamic programming functional equation using
integrals. We can further generalize the probability distribution to be a Markov
process [see Stokey, Lucas and Prescott (1989) for details].
Example 5.3 (5.2 rev&ited).
ple 5.2 except that
Consider an economy identical to that in Exam-
h(kt, k t + j , z l t , z2,,'0,) ~-- " 0 t10,

K t ~ - - Z l t ) ,i-o
--
kt+ 1 - - Z2t
where "0, = "01 with probability % and '0, = '02 with probability % . The return
function is
v(k,,k,+ 1,'0, , w, y , a ) = ay .log~'0,x,

, .0 w 1-0 - k,+l) - a y log y ,
the Euler equation is
0 O-lwl-O
1
--
.0
-- 1-0
"0t_lKt_l w
010-1
%'01 k ,
--
k,
-[- "~
"01Kt W
"/T2"02Kt
q-
1--0 ]
~ - - ' ~ ' - - -
"02Kt w
-- Kt+ 1
= 0 ;
the value function is

ay
V(kt, "or, w, y, a) - f T y
3'
log(1 - TO) + ~
+ 1_-w70
y0
log TO
1-3/
(% log "01 + % log "0z) + ~
1-0
O-3,O
+ ~ l o g w + ~ l o g k
]
t ;
log 'or - log y
T.J. Kehoe
2102
and the policy function is
g(k,, ~,, w, y, o~) = yO~7,w~-k~ .

In the case where ~/t is a continuous random variable, for example, when
log~q, is normally distributed with mean zero and variance cr2, the Euler
equation and the value function are easily modified and the policy function
remains the same. (This latter feature does not hold in general, however.)
Once again our analysis can be extended in many directions. For an example
of a stochastic equilibrium with recursive preferences that are not additively
separable, see Epstein and Zin (1989).
5.4. Differentiability and regularity

The analysis of the previous two sections allows us to easily extend the
regularity analysis for static exchange economies to dynamic production
economies. In economies where the value function V(k 1, w, y, ~) is continuously twice differentiable (C2), the transfer function t is continuously differentiable (C~). In this case the analysis is very similar to that of static exchange
economies: An equilibrium is a vector of welfare weights ~ for which t(t~) = 0,
a system of m equations in m unknowns. Since t is homogeneous of degree
one, we can eliminate one unknown with a normalization. Since r,t= t ti(a ) =- O,
we can eliminate one equation. A regular economy is one for which the
Jacobian matrix of the transfer function Dt(&) with the first row and column
deleted, an (m - 1) (m - 1) matrix, is non-singular at every equilibrium. As
with static exchange economy, a regular dynamic economy with production has
a finite n u m b e r of equilibria that vary continuously with the parameters of the
economy. Kehoe, Levine and R o m e r (1990) have extended Debreu's (1970)
analysis to show that almost all economies with C 2 value functions are regular.
T h e problem has been to develop conditions that ensure that the value
function is C 2. As we have mentioned, Benveniste and Scheinkman (1979)
have shown that V is C 1 under fairly general conditions on u i and h. Araujo
and Scheinkman (1977) show that under suitable conditions on u i and h that a
C 2 value function follows from a global turnpike property. In other words, if
all socially optimal paths converge to a unique steady state (which may depend
on the welfare weights o~), then V is C 2 and equilibria are generically
determinate. Recently, Santos (1989a, b) has shown that V is C 2 under far
more general conditions. The most restrictive of these conditions serves only to
ensure that k t remain uniformly separated from the boundary of R n+k. [Montrucchio (1987), Boldrin and Montrucchio (1988) and A r a u j o (1989) present
m
2103
earlier partial results.] A different approach to proving that value functions are
C 2 in stochastic economies has been pursued by Blume, Easley and O ' H a r a
(1982).

The case of computing equilibria depends on how easy it is to solve dynamic
programming problems. In this section we discuss two popular procedures,
value function iteration and linear-quadratic approximation. These and a
variety of other methods, together with applications to an example similar to
Example 5.3, are discussed in a collection of papers edited by Taylor and Uhlig
(1990).
Consider a dynamic programming problem expressed in terms of the functional equation
V(k,, b) = max[v(k,, k,+l, b) + TV(kt+l, b)] subject to k,+ 1/>0.

Here b is a vector of parameters that includes the variables (w, y, a ) discussed
previously. The standard approach to proving the existence of a solution V to
this functional equation relies on the contraction mapping theorem.
Contraction Mapping Theorem.
Let S be a complete metric space with metric

d : S---> R +. Suppose that T : S--> S is a contraction with modulus fl ; that is,
suppose that, for some 0 < / 3 < 1 , d( Tx, Ty) <~jgd(x, y) for all x, y E S . Then
there is a unique fixed point of T in S, fc = T2.
The proof of this theorem suggests an algorithm for computing a fixed point:
Start with x E S and let x "+ t = Tx". Since
d(x "+l x n+2)
d(Tx", Tx~+')<~fld(x",x ''+l)
the sequence x , x 1, . . . is a Cauchy sequence and, since S is complete,

converges to a limit ~ E S that satisfies d(~, T.~) = 0, or 2 = T~. To see that this
fixed point is unique, suppose to the contrary, that there exists another fixed
point = 7". Then
d(T2, T) = d(x, ) > fld(fc, ) ,

which contradicts T being a contraction [see, for example, Luenberger (1969,
Chap. 2) or Stokey, Lucas and Prescott (1989, Chap. 3) for details].
To apply this theorem to our dynamic programming problem, we need to
T.J. Kehoe
2104
give the space of functions V(., b) a topological structure. Let S be the set of
continuous bounded functions that map R+ k into R with
d(V 1, V 2) = suplVl(k, b) - vz(k, b)[.

k
S is a complete metric space. There is a technical problem in that the return

function v, and therefore the value function V, may not be bounded. We can
get around this problem either by bounding v in a way that does not affect
solutions or by using special properties of the mapping T [see, for example,
Bertsekas (1976, Chap. 6) or Stokey, Lucas and Prescott (1989, Chap. 4)]. In
either case, the generalization is straightforward but technically tedious, and
we shall ignore it.
There exists a unique V E S that satisfies

the functional equation of the dynamic programming problem.
Proposition 5.1 [Blackwell (1965)].
Proof.
Consider the mapping T : S--~ S defined by
( T V ) ( k , , b) = max[v(k,, k,+l, b) + yV(k,+l, b)] subject to k,+ l t>0.

If v and V are bounded and continuous, then so is TV. It therefore suffices to
demonstrate that T is a contraction:
d(TV 1, TV 2) = suplmax[v(k,, kt+ 1, b) + yVl(kt+l, b)]

kt
kt+l
-max[v(kt, k,+l, b) + yg2(kt+l, b)]]

kt + I
t
~ s u p l y V (k,+~, b ) - yVZ(kt+,, bll.

kt + I
This last expression is just y d ( V I, V2),

with modulus y.
which means
that T is a contraction
Remark. It is easy to prove that V satisfies such properties as being monotonically increasing and concave in k,. Using the properties of v, we can argue
that, if V is monotonically increasing and concave, then so is TV; that is, T
maps the subset of S whose elements are monotonically increasing and concave
into itself. Since this set is itself a complete metric space, the fixed point
1~"= TV lies in it.
T o implement this approach on the computer, we need to discretize the
space of capital stocks. In particular, let K = {k 1, k 2, . . . , k, l}, kj E Rn+~, be a
2105
finite, but large, set of capital stocks. The method of successive approximation
treats V as an 1 dimensional vector [see Bertsekas (1976, Chap. 5)]. Starting
with a simple guess for V , for example, V(kj, b ) = O, j = 1 . . . . , l, we
compute V'+l(kj, b) by solving
max v(kj, k, b) + y V ' ( k , b) subject to k E K .
The same argument as the proof of Proposition 5.1 establishes that this
procedure is a contraction magping. Furthermore, if the grid K is fine enough,
then its fixed point is a good approximation to the true value function V.
Variants on this method do not restrict k to the finite set K in the above
maximization but interpolate or use polynomial approximations [see, for
example, Tauchen (1990)].
Unfortunately, although the method of successive approximation is guaranteed to converge, convergence can be very slow. An algorithm that greatly
speeds convergence involves applying Newton's method to the equation
v= v(v)
where we think of T as a mapping R z into R ~. This method is known as the
policy iteration algorithm. [See Bertsekas (1976, Chap. 6); Rust (1987) and
Christiano (1990) discuss variations and present economic applications.] The
updating rule is
V "+' = V" - [ I - D T ( V ' ) ] - t [ V " - T ( V ' ) ] .

Although the l l matrix [I - D T ( V ' ) ] is very large if the grid K is very fine, it
typically contains a large number of zeros.
To apply these sorts of methods to stochastic problems, we must discretize
the distribution of events ~7 if it is not already discrete. In the case of the
method of successive approximation, for example, we compute V "+l(ki, rlj , b )
by solving
max v(k~, k, 7tj, b) + y ~ 7r(v)V'(k, ~7, b)
where k is restricted to the grid K and 77 ranges over the discrete distribution of
in the summation.
Example 5.4 (5.2 revisited).
Consider the functional equation
V(k t, b) = max[log(bk~ - kt+l) + yV(k,+l, b)] subject to kt+ 1 >!0.
T.J. Kehoe
2106
Because of the special form of this problem we can solve for V(k,, b)
analytically using the method of successive approximation. Let V(k,, b) = 0
for all k,, b. Maximizing log(bk 7 - k,+~) with respect to k,+~, we obtain the
policy function
g~(k,, b) =0
and the value function
Vl(k,, b) = log b + 0 log k,.

Now maximizing [log(bk~-k,+1)+ y V l ( k , + , , b)] with respect to k,+l, we
obtain the policy function
g2(kt, b)= ( 3"06 )k 0

\l+yO! '
3"Ob
V2~t.ct,lt.b) = log -1 +- 3'0
-1 +-3 ' 0
+3'logb+y01og
+ 0(1 + 3'0) l o g k , .
In general, at iteration n we obtain the policy function
g" ( k , , b)= [1 ~ - -(3"0)"-113"0bk:

~-~r
gn(k,,
b) = i=i
~ 3 i - i log 1 - (3'0)" i+1
i)]
-~-3"0 n-,
E 3i 1[ 1 -" (3"0)n i ] log [3"Ob(1_(3"O)n
.....
~=~
1-3,0
J
1 - ( 3 , 0 ) n '+~
+ o[ l_- (_3"O)" ] log k,
1-yO J
"
In the limit these converge to
g(k,, b) = 3"Obk~ ,
1
3'0
b(1 - 3"0) + ~ l o g 3 , 0 b
V(k,, b ) - 1 - 3' [log
L
]+~ 0
log k, .
2107
Writing
g "( k , , b ) = aokt
" o,
n
V"(k,, b) = a] + a 2 log k t ,
we compute successive approximations for the problem with 7 = 0.95, 0 = 0.3
and b = 2.
n
l
2
5
10
a~
a~
0
0.693147
0.443580 0.869208
0.567306 1.150158
0.569995 1.719038
0.57
2.672261
a~
0.3
0.3855
0.418791
0.419579
0.419580
Remark. Notice that the successive approximations for V converge monotonically. It is a general property of this algorithm that, if V~(k, b) > V(k, b) for
all k, then V"+~(k, b) > Vn(k, b) for all k. This property, which is the result of
v(k,, k,+l, b) increasing in kt, is frequently useful for proving convergence
when v is unbounded and for developing more efficient algorithms [see, for
example, Bertsekas (1976, Chap. 6)].
Value function iteration methods can be very costly in terms of computer
time when the number of state variables, nk, is more than two or three or if
there is uncertainty. A n o t h e r solution method that is popular in applications is
to solve the linear-quadratic approximation to the original problem (see, for
example, Bertsekas (1976, Chap. 4), Kydland and Prescott (1980, 1982) and
Sargent (1987)]. The idea is to approximate the return function v(k I, k,+l, b)
by a quadratic function or, equivalently, to linearize the Euler equations. The
approximate model can then be solved exactly.
We start by computing a steady state, a capital stock /~ ~ R'+k that satisfies
the Euler equation
D2v(f , k, b) + yD~v(k, k, b) = O.
The problem of computing a steady state can be easily formulated as a fixed
point problem. Let S = {k~R+k[l[k[[<~ I[km"x[[} and let K(k) be the vector
K E R nk that solves
max v(k, K, b) + TV(K, k, b) subject to [[K[[ ~ [[kmax[[,
~0.
2108
T.J. Kehoe
Notice that K(k) is continuous and maps S into S and that S is non-empty,
compact and convex. Consequently, K has a fixed point/~ = K(/~) that can be
computed using the methods of Section 2. Unfortunately, although the
dynamic programming problem itself always has a unique solution because of
the concavity of o, there may be multiple steady states [see Burmeister (1980,
Chap. 4) for a discussion].
We approximate v ( k , , k,+~, b) by the second-order Taylor series
O(Xt,
Xt+l)
= V + DlVX t + D2vxt+ l
1
+ ~ ( X t O l U X t + Xt+lD22oXt+1 + x t D 1 2 o x t + 1 + X t + l D 2 1 v X t ) .
H e r e , for example, D~v is the 1 n k gradient vector of v with respect to its first
vector of arguments evaluated at (k, k, b) and D l l v is the n k n~ matrix of
second derivatives, also x, = k, - k. T h e r e are two approaches to solving the
dynamic programming problem with v replaced by its quadratic approximation
g. The first is like the method in Example 5.2: we guess the functional form of
g(x,), in this case a quadratic,
("(x,) = a, + a~x, + l x ; A 3 x ,
where a~ is 1 1, a 2 is n k 1 and A 3 is n k nk, and then solve for al, a 2 and

A 3. The second method is to directly attack the linear Euler equations
D21vxt_ l +
(TDllO +
O220)x t + yDi2oxt+ l = O.
If we follow the first method, we solve

,'
1 tA
max g(x,, x,+l) + y(a 1 + a2x
t + ~x,
3x,)x
to find
x,+ 1 = -(D22u + Y A 3 ) - l ( D 2 1 v x , + y a 2 + D2v' ) .
Since we know that x, = 0 implies xt+ 1 = 0 because/~ is a steady state, we can
easily solve
a 2 = -T-1D2v ' = Dlv' ,
al=v/(1-y
) .
Plugging xt+ ~ = - ( D 2 2 v + y A 3 ) - ~ D 2 1 v x , into the functional equation that defines V, we obtain the matrix equation
209
A 3 = D l l v - D12o(O22v + T A 3 ) = I D 2 1 v ,
often called the Riccati equation. One approach to solving this is to guess A~
and iterate
A "3 = D l l V - D l z V ( D 2 2 v + y A ~ - l ) - I D a l v
Bertsekas (1976, Chap. 3) presents conditions under which this algorithm

converges.
Alternatively, we could turn the linear Euler equations into the system of
2n k first order difference equations
Xt+!
-T-ID12oD21U
-Dtzv-l(Dll
v + 3' 1Dz2v)JL x, j -
Denote the 2n k 2n k on the right side of the equation as G. As long as the

eigenvalues of G are distinct, we can write G = X A X
-~, where A is the
2n k x 2n k diagonal matrix of eigenvalues of G and X is the 2n k 2n k matrix
whose columns asre the associated eigenvectors. The theory for systems with
repeated eigenvalues is similar but more tedious; we ignore this possibility,
however, because it is easy to show that having distinct eigenvalues holds for
almost all v [see, for example, Hirsch and Smale (1974, Chap. 7)]. Writing
LXt+x, 1
X2
=xA, ,x l[X,]
X2
'
we see that x, converges to zero if and only if the 2n k x 1 vector

c=X
,[x,]
LX2J
has non-zero elements only where the corresponding eigenvalues h i has modulus less than one. This means that the vector (xl, x2) must lie in the subspace
of R "k, called the stable subspace of G, spanned by the (possibly) complex
eigenvectors of G associated with eigenvalues less than one in modulus.
An easy way to see this is to rewrite the above relationship as
2n k
Xt+l
where
(Zi,
i=1
CiA i
[~iZi]
I~iZi) ~ C 2n is the eigenvector associated with h i and also write

2n k
X2
= .=
Ci ~ i Z i
"
2110
T.J. Kehoe
For x, to converge to zero, the vector c must be such that (x 1, x2) is a linear
combination of eigenvectors associated with stable eigenvalues. If x t converges
to zero, then k t = X t + k satisfies the transversality conditions
! i m y ' - ~ D ~ v ( k , k , b ) k , = O.
A case of particular interest is when exactly half, n k, of the eigenvalues of G

are stable and the other half are unstable. This case is often called saddlepoint
splitting of the eigenvalues. If this condition holds, we can uniquely solve
2n k
X I ~ Z CiZi
i-1
for the n k constants c i associated with the stable eigenvectors and use the result
to uniquely determine x 2. There would be a continuum of solutions if there
were more than n k stable eigenvalues. If, however, there were fewer than n k
stable eigenvalues, then there would be, in general, no solution at all that
converges to the steady state.
Since v and its quadratic approximation b~ are concave, we would not expect
there to be multiple solutions to the dynamic programming problem. (Remember, however, that there may be multiple equilibria corresponding to
different welfare weights a.) To see that there cannot be more than n k stable
eigenvalues of G, we can write the characteristic equation as
det[Dz,v + A ( y D l l v
Oz2v ) -+- AZ'YOl2 v] = 0.
Suppose that there is a vector x G R nk such that
[DzlO + A(TD11 v + Dz2V ) q- A 2 T D 1 2 v ] x
=- O .
Then, since D l , v and D z 2 v are symmetric and
D21v = D12v' ,
x ' [ D 2 1 v + I ~ ( y D ~ , v + D220 ) + I ~ y D , 2 v ] = 0
w h e r e / ~ = (yA) 1 Consequently, if A is an eigenvalue of G, so is (yA) ~. This

implies that n k eigenvalues are smaller than y 1/2> 1 in modulus and n k
eigenvalues are larger.
If y is close to one, then we would expect the eigenvalues of G to exhibit
saddlepoint splitting. Indeed, there are turnpike theorems that guarantee
convergence to a steady state in this case [see McKenzie (1987) for a survey of
such results]. If y is not close to one, there may be less than n k stable
eigenvalues, and the solution may converge to a cycle or even exhibit chaotic
dynamics [see, for example, Ryder and Heal (1973), Benhabib and Nishumura
2111
(1979) and Boldrin and Montrucchio (1986)]. Indeed, Boldrin and Montrucchio (1986) prove that, if K is a compact subset of R n* and g : K---> K is twice
continuously differentiable, then there exists a return function v and a discount
factor y such that g is the optimal policy function. Since the dynamics of the
solution path are governed solely by the policy function, this says that
equilibrium dynamics are arbitrary. The construction used in the proof of this
theorem, not surprisingly, relies on small discount factors.
Example 5.5 (5.2 revisited). The return function v ( k , , k,+l, b ) = l o g ( b k ~ k,+~) can be linearized around the steady s t a t e / ~ = ( y O b ) l/~z-) as
log ( + (y~7) Ix, - ~-lx,+ 1
-- 1 [ ( ( 1 -- 0 ) ( ~ ( k ) - '
-J- ( ' ~ c )
2)x~ -J- ( - 2 x ~ + 1 -
2y-'(
Zx,x,+,].
1
Here ( = b k - f:. The value function ~'(kt) = a I + a2x , + ~a3x
t2 is such that
a 1 = (log c ) / ( 1 - 0), a 2 = (y~?)-i and a s can be solved for using the Riccati
equation
a 3
= -((1
- 0 ) ( ' ~ ( ] ~ ) -1 Jr- ( ' ~ ( )
2) _ ")/ - 2 c- - 4 ( ~ a 3 - c
2)
1.
a r e two solutions to this equation, a 3 = - - ( 1 "y0)T 20 1 ( - 2 a n d a 3 =

( 1 - O ) y ld 2 the first of which is the non-positive number (in general,
negative semi-definite matrix) that we need for V to be concave. The policy
function is ~(x,) = Ox,.
An alternative for finding this policy function is to analyse the Euler
equation
There
c- - 2 x , + , - ( ( 1 - o ) ( ( )
~+ - 1 ( - 2 + ( 2)x, +~
-1--2
c x,_,
~-'=0
The corresponding characteristic equation has two roots, A = 0 and A = (A0)-~,

only the first of which satisfies
< 1.
To see the relative accuracy of the linear-quadratic approximation, we again
consider the model where 3' =0.95, 0 = 0 . 3 and b = 2 and solve for the
equilibrium path_for k, starting at k 1 =0.1 using both the linear-quadratic
policy function, k + O(k, - k ) , and the true policy function, "yObk~.
1
2
3
4
5
10
Exact
Linear-Quadratic
0.1
0.285677
0.391415
0.430196
0.442563
0.447958
0.447971
0.1
0.343580
0.416654
0.438576
0.445152
0.447964
0.447971
2112
T.J. Kehoe
Remark. This example has the property that the 1~ is the second-order Taylor
series approximation to V and ~ is the first-order approximation to g; this is not
a general feature of this method. An alternative approach is to use the
linear-quadratic approximation where x , - - ( l o g k , - log k). For our specific
example, such an approximation is exact as can be easily verified.
Another promising approach to approximating solutions to dynamic programming problems relies on restricting the policy functions that solve the
Euler equations to a finite dimensional function space. The linear-quadratic
approximation restricts the policy function to being linear. Other possibilities
include polynomials of a fixed finite order or various finite sequences of
polynomial and trigonometric functions. For an exposition and economic
applications of these methods, known as minimum weighted residual methods,
see Judd (1989). A closely related method, which parameterizes the expectations of next period's value function, rather than the policy function, using a
finite dimensional approximation to the function space, has been proposed by
den Haan and Marcet (1990).
6. Overlapping generations economies

Even though they have an infinite number of goods, the economies in the
previous section are relatively easy to study because the two welfare theorems
allow us to characterize their equilibria as solutions to welfare maximization
problems. Many dynamic economies have equilibria that do not solve such
maximization problems. An important example is the overlapping generations
model originally studied by Samuelson (1958). Frequently, to approximate
equilibria of such an economy on the computer, we must truncate it so that it
has a finite number of goods. Studying the properties of economies with infinite
numbers of goods, however, provides insights into the properties of those with
large, but finite, numbers of goods.

To keep the discussion simple we focus on exchange economies. Overlapping
generations economies with production can be analysed using a similar approach [see, for example, Burke (1986) and Muller and Woodford (1988)].
Consider a stationary economy with n goods in each period and in consumers
who live for two periods in the generation born in period t, t = 1, 2 . . . . . In
addition there are m 0 consumers, generation 0, who live only in the first
period. Balasko, Cass and Shell (1980) present a simple procedure for convert-
2113
ing a m o d e l in which consumers live for k periods into one in which they live
for two: Redefine generations - k + 2 , - k +
1 . . . . . 0 to be generation 0,
generations 1, 2 . . . . , k - 1 to be generation 1, and so on. Similarly, redefine
periods. Notice that the n u m b e r of goods in each period and the n u m b e r of
consumers in each generation increase by a factor of k - 1. The important
feature of the p r o c e d u r e is that each redefined generation lives for two
redefined periods.
n2n
Each consumer in generation t has a utility function u s : K+ ~ R that is
strictly concave and monotonically increasing and an e n d o w m e n t (wSl, w 2 ) E
R z"++. Faced with prices Pt, Pt+~, the consumer solves
max ui(x,, x,+l) subject to
t
ptxt-F
t
Pt+lXt+l
~
p i
t
i
~PtW1
+ Pt+lW2 ,
Xt, Xt+ 1 ~ 0 .
Each consumer in generation 0 solves the p r o b l e m

max Uio(Xl) subject to
r
r i0
plx~
<~plw2
+ M~, x 1 >t0.
H e r e M s is the c o n s u m e r ' s e n d o w m e n t of fiat money, which can be positive,

negative or zero.
We define the aggregate excess d e m a n d functions
m0
Zo(Pl) = E
[ X liO( P l ) -
w~O] '
S=l
Y(P,, Pt+l)
i
= ~ [Xti, (Pt, Pt+l)-- W1],
i=l
z(Pt, P,+1) = ~ tlxi't+I~P,,
P,+I) - w'2]
S=I
These functions are continuous at least for strictly positive prices; they are
rn 0
i0
m
i
m
i
b o u n d e d below by - Z i = 1 w 2 , - Z i = 1 w 1 and - Z s = 1 w2, respectively; y and z
are h o m o g e n e o u s of degree zero while z 0 is h o m o g e n e o u s of degree zero if and
only if M i = 0 , i = 1 , . . . , m0; and z0, y and z obey the following versions of
Walras's law:
2114
T.J.
Kehoe
mo
p[zo(pl ) - ~ M , ,
i=l
P~Y(Pt, P,+,) + P;+~x(pt, Pt+l)=-0 .

An equilibrium of this economy is a price sequence/31,/32,.., such that
z0(/31) + Y(P~, P2) ~ 0,
z(/~, 1,/3,)+y(/3,,/3,_~)~<0,
t=2,3,...
where there is equality whenever the price/3~, is strictly positive.

Consider a truncated version of this economy, an economy that ends in
period T. There is a terminal young generation with excess demand function
Y r ( P r ) that satisfies
m 0
P~YT(Pr) = - - ~ , Mi .
i=1
There are many ways of constructing such a function. One is to set

YT(PT) = --
e.
This is now a finite economy with transfer payments.

To prove the existence of equilibria we consider a sequence of truncated
economies where the truncation date T tends to infinity. To keep our discussion simple we focus on economies without fiat money. In the simple economy
that we study here, this is often the only case in which we can prove existence
[see, for example, Balasko, Cass and Shell (1980)]. There are, however,
modified versions of this economy in which the only equilibria that exist
involve non-zero quantities of fiat money [see Wilson (1981) and Burke
(1988)].
In a truncated economy without fiat money existence of equilibrium follows
directly from the arguments in Section 2.1. To ensure that the equilibrium does
not involve prices being all equal to zero in any period, we employ two
i
additional assumptions: first, there exists _a>0 and B > m a x [ E m 1 w0+
rn
i
w
"
t
Ei= 1 wl, Ei: 1 (w'1 + wi2)] such that e p,+i/e p, < _a implies I l z ( p , p,+l)l] > B;
second, there exists 6 > _a such that e'p,+i/e'p, > 6 implies ]]y(p,, P,+I)]] > B.
See Balasko, Cass and Shell (1980) for conditions on preferences and endowments that imply these conditions.
2115
Proposition 6.1 [Balasko, Cass and Shell (1980) and Wilson (1981)].
There
exists an equilibrium ~ , P2, for the overlapping generations model without
fiat money.
Proof. Consider the economy truncated at period T. Proposition 2.1 and
Brouwer's fixed point theorem imply that it has an equilibrium (/31 . . . . , ,fir).
Consider now the sequence of prices p r = ~ t / ( e ' ~ l ), t = 1 , . . . , T, p r = e,
t=T+l,T+2,....Ourassumptionsonyandzimplythatpr,
t=l, 2,...,
is an element of the non-empty, compact and convex set
S t = { p E R n [ p>~0,_a t-~ <~e'p-~ d t-l} .
The product II~_1 S t is compact in the product topology. Consequently, the
sequence (of sequences) p~, P ~ 2 , . . . , P~, P~, has a convergent subsequence.
Let ill, P2, be the limit of this subsequence. Notice that, since the functions
z0, y and z involve only a finite number of variables, the functions z 0 + y and
z + y, t = 2, 3 , . . . ,
are continuous in the product topology. Consequently,
since each sequence p~, p f , . . . satisfies the equilibrium conditions in periods
t = 1, 2 . . . . . T - 1, the sequence p l , P2, satisfies them in all periods.
Remark. The only role played by stationarity, the assumption that y and z do
not change over time, is to provide the bounds ff and ci. Consequently, this
result applies to non-stationary economies in which such bounds are assumed
to hold. In particular, it applies to economies that are stationary after a given
date.

Unfortunately, in contrast to economies with a finite number of infinitely lived
consumers, there are robust examples of overlapping generations economies
with an infinite number of equilibria. As we shall see, this has strong
implications for computational methods for approximating equilibria, including
methods that truncate the economy at a finite date. Our discussion of multiplicity follows Gale (1973) and Kehoe and Levine (1985, 1990b).
Ignoring the possibility of free goods, we can write the equilibrium conditions as
zo(p,) + y ( p l , p2) = 0,
z(p,_~,p,)+y(p,,pt+,)=O,
t=2,3 .....
T.J. Kehoe
2116
Once p~ and P2 are determined, the second condition acts as a non-linear

difference equation determining p~+~ as a function of (p~_~, p~). In this section
we focus attention on the behavior of equilibrium price paths near a steady
state Pt =/3t-~p, where p E R~\{0} and /3 E R++, to the second condition,
z(/3
t-2
p , / 3 ' - ' p ) + y(/3t-'p, /3'p) = z ( p , /3p) +
y(p,/3p)
= 0.
We are interested in prices that converge to a steady state, (p,, p,+~)/

]](pt, p,+l)[]---~(p,/3p)/]](p,/3p)][ as t---~ ~.
Focusing on prices that start and remain in some neighborhood of a steady
state has two advantages. First, the implicit function theorem says that, if
Dzy(p,/3p) is non-singular, a condition that according to K e h o e and Levine
(1984) holds almost always, Pt+l can be calculated as a unique, continuously
differentiable function of (P,-1, Pt) in some neighborhood of ( p , / 3 p ) . In
general, there may be multiple solutions Pt+l. Second, the local stable manifold
t h e o r e m says that the qualitative behavior of the non-linear dynamical system
generated by the equilibrium conditions is almost always the same as that of its
linear approximation [see Scheinkman (1976) and Irwin (1980, Chap. 6)].
F u r t h e r m o r e , using the same sort of redefinition of generations and periods
that we use to transform an economy with consumers who live for many
periods into one in which they live for two, we can formally transform an
e c o n o m y with a k cycle, (pl, p2, . . . , pk), into an economy with n k goods
in each period in which this cycle is a steady state. What we are missing
therefore is a study of chaotic equilibria that converge neither to steady states
nor to cycles. See Benhabib and Day (1982) and G r a n d m o n t (1985) for
examples of such equilibria.
T h e r e are two types of steady states, those in which there is fiat money and
those in which there is not. Using Walras's law and the equilibrium conditions,
we can show that
P;Zo(Pl) = -P~Y(P~, P2)= P;z(Pl, P2) . . . . . .
P;Y(P,, P,+~).
Let M = -p'y(p,/3p). Walras's law, p'y(p,/3p) +/3p'z(p,/3p) = 0 and the

steady state condition imply that (/3 - 1)p'y(p,/3) = 0; that is,/3 = 1 or M = 0.
K e h o e and Levine (1984) prove that these two possibilities almost never occur
simultaneously. Steady states in which /3 = 1 and M 0 are called monetary
steady states; those in which /3 0 and M = 0 are called real steady states.
Proving the existence of, and computing, steady states of each type is similar to
doing the same for static exchange economies. Monetary steady states are
given by a price vector p E R+\{0} that satisfies
f ( p ) = z ( p , p) + y ( p , p) = o.
2117
Here the function f has all of the properties of the excess demand function of a
static exchange economy. Real steady states are given by a pair ( p , / 3 ) that
satisfies
z(p,/3p) + y ( p , / 3 p ) = O,
p ' y ( p , tip) = O.
Using arguments similar to those in Section 2, Kehoe and Levine (1984)

characterize the solution to this system of equations as the solution to a fixed
point problem in R "+~. As well as proving the existence of each type of steady
state, they argue that there is almost always a finite number of each type, and
they provide index theorems that imply uniqueness conditions for each type.
Let us now study the question of how many equilibria converge to the steady
state (p,/3p) by linearizing the equilibrium conditions. Making use of the
homogeneity of y and z, which implies that their derivatives are homogeneous
of degree minus one and that
D l y p +/3D2y p = D~zp +/3D2z p = O,
we write the linearized system as

Dey p + (D~y + Dzo)p~ = Dzop - Zo(p) - y ( p , t i P ) ,
D 2 y p , + ~ + ( D ~ y + / 3 D z z ) p t+/3D~zp, ~ = 0 ,
Here D2y
respect to
We can
first-order
G=
t=2,3 .....
is, for example, the n x n matrix of partial derivatives of y with

its second vector of arguments evaluated at (p, tiP).
write the equilibrium conditions in periods t = 2 , 3 , . . . as the
system qt = Gq,-i where q, = (Pr, Pt+l) and
_/3Dzy-lDlZ
_Dzy
l(Dly + /3D2z)
As in the linear-quadratic model of Section 5.5, the stability properties of this

difference equation are governed by the eigenvalues of G. The homogeneity of
y and z imply that/3 is an eigenvalue since
Differentiating Walras's law and evaluating the result at (p,, Pt+l)= (P, tiP)
implies that
T.J. Kehoe
2118
y' + p'D~y +/3p'D~z = 0 ,

z' + p ' D 2 y + / 3 p ' D 2 z = 0 .
Consequently, 1 is another eigenvalue since
[ /3p' D , z - p ' D z y l G = [ /3p' D~z - p' Dzy ] .
In the case where/3 = 1, these are generally the same restriction and we have
information only about one eigenvalue.
Again solutions to the difference equation q, = Gq,_~ take the form
2n
P,+1
i=1
c,,,-,r z,
~ i
[,~/z/j
where the (possibly) complex constants c~ are determined by the initial

conditions
i=l
To ensure convergence to the steady state ( p , / 3 p ) we need to put positive

weight on the eigenvector ( p , / 3 p ) and zero weights on eigenvectors (z i, Aizi)
for which the modulus ]A~I is greater than/3.
The situation is in many ways similar to that in the linear-quadratic model of
Section 5. In place of the n k initial conditions k I of the 2n k conditions (kl, k2)
that we need to start up the difference equation, we have n restrictions
Dzy p + ( D , y + Dzo)pl = DzoP - Zo(p) - y ( p , /3p)
on the 2n required initial conditions (Pl, P2)' Unlike the linear-quadratic
model, however, there is no need for there to be fewer than n stable
eigenvalues of G.
By counting the number of eigenvalues of G less than/3 in modulus, we can
determine the dimension of the stable manifold, the sets of points ( P l , P2) E
R 2n that serve as starting values for the implicit difference equation generated
by the equilibrium conditions in periods t = 2, 3 , . . . , and converge to the
steady state ( p , / 3 p ) . If we then subtract the n u m b e r of restrictions on ( p l , P2)
implied by the equilibrium conditions in the first period, we can, in general,
determine the dimension of the manifold of equilibria that converge to the
steady state. We need to distinguish between two cases, economies without fiat
money and economies with fiat money. The distinction is crucial because
Walras's law and the equilibrium conditions in the first period imply that
2119
m0
[/3P'Dlz
-P'D2Y] Pz
i=1
This, in turn, implies that the eigenvector associated with the eigenvalue A = 1
m0
must receive zero weight c i in the initial conditions if Ei=
1 Mi = 0 and must
receive non-zero weight if E~2'1 Mi ~ 0 [see K e h o e and Levine (1985, 1990b)
for details]. In the case where there is fiat money, the dimension of the set of
equilibria is generically n ~ + 1 - n, where n" is the n u m b e r of eigenvalues with
</3; there is one eigenvalue A----/3, and n is the n u m b e r of restrictions
implid by the initial conditions. This n u m b e r can be as large as n. In the case
where there is no fiat money, the dimension of the set of equilibria is
generically r ~ ' + 1 - n, where r~" is the n u m b e r of eigenvalues with ]A I < / 3
excluding, if need be, the eigenvalue A = 1. This n u m b e r can be as large as
n - 1 and is equal to zero when there is saddlepoint splitting, when half of the
2n - 2 eigenvalues of G, not counting A = 1 o r / 3 , are less t h a n / 3 in modulus
and the other half are greater.
A n o t h e r possibility, of course, is that there are too few stable eigenvalues. In
this case, for almost all initial generations z0, there is no equilibrium that
converges to the steady state. In this case we call the steady state unstable.
Example 6.1. Consider overlapping generations in which generation t, t = 1,
2 , . . . , contains a single consumer who lives for three periods. There is one
good in every period. Using the procedure described in Section 6.1, we could
convert this to an e c o n o m y with two consumers who live for two periods in
each generation and two goods in each period. The consumer born in period t
has the utility function
3
u(x,,x,+,,x,+2)
~.
~ aJ-l( X b,+j-I__ 1)/b
j-I
where a > 0 and b < l . Given an e n d o w m e n t stream (w~, w2, W3) , the consumer maximizes this utility function subject to the constraint
3
p,+j_,x,+j_l ~<~ p,+j_lWj.

j=l
j=l
The consumer's excess d e m a n d functions are

3
~j E
zj(p,, Pt+l, Pt+2) =
Pt+k-lWk
-w~,
k=13
rt
Pt+j 1
E
k=l
1 7/
TkPt+k
H e r e r / = 1/(1 - b) and yi = a (~-1)', j = 1, 2, 3.
j=1,2,3.
2120
T.J. K e h o e
In addition to these consumers, there are two others, an old consumer who
lives only in period 1 and a middle-aged consumer who lives in periods 1 and 2.
The old consumer, consumer - 1 , derives utility only from consumption of the
single good in the first period, so we need not specify a utility function. If he
has M 1 units of fiat money, which may be positive, negative, or zero, his
excess demand function is
z3t(pl) = M_,/pl
The middle-aged consumer, consumer 0 has the utility function

2
/-10(X2 , X3) = Z a J(xi+
b l - 1)/b ,
j=l
an endowment stream of goods, (w , w3), and an endowment of fiat money,

M o. His excess demand functions are
2
pkWk+l
z~(p,,p2)=
Mo
-w j,
j=2,3.
P j 1 ~ Yk+~Pk
k=l
The equilibrium conditions for this economy are

1
0
z3 ( P ~ ) + z2(P~, P z ) + Z , ( P , , P2, P3) = 0 ,
z3(Pl,
P2) + z 2 ( P l , P2, P3) + z I ( P 2 , P3, P4) = 0 ,
z3(Pt-2, P , - , , P t ) + Z z ( P , - 1 , P , , P t + , ) + z l ( P t ,
Pt+,, P,+2) = 0 ,
The equilibrium condition for period t, t = 3, 4 , . . . ,

steady state (1,/3,/32) as
/32Dlz3P, 2 + (/32D2z3 q- / 3 D l z 2 ) P t - I
+ (/3DBZ 2 +
H e r e all
condition
condition
the roots
D2Zl)p,+l +
JBZlPt+
t = 3 , 4-
can be linearized at a
(/32D3z3 q-/3D2z2
q-
D1Zl)P,
2 ---- 0 .
derivatives are evaluated at the (1,/3,/32). Corresponding to the

that D2Y is non-singular in the general two-period-lived case is the
that D3z I is non-zero. Corresponding to the eigenvalues of G are
of the fourth-order polynomial
2121
/32DIZ 3 + (/32D2z 3 q--/3DIZ2)A + (/32D3z 3 + / 3 D 2 z 2 + D I Z I ) A 2

4- ( / 3 D 3 z 2 + D 2 z 1 ) A 3 q- D 3 z l A 4 = 0 .
The consumer has a = 1, b = - 4 , and (wl, w2, w3) = (5, 20, 1). To calculate
the roots of the fourth-order polynomial, which determine the determinacy
properties of equilibria near a steady state, we start by evaluating the derivatives of excess demand at (Pt, Pt+l, Pt+2) = (1,/3, /32). At/3 = 1, for example,
these derivatives are
Dlzl D2zl
Dlz2 D2z2
DIZ3 O2z3
D3Zl]
D3z2/=
I-3.0869
D3z3_]
-0.8401
-0.9650
4.9881
2.6201
3.7803
-1.9013]
-1.6551 / .
-2.9402J
(Notice that, since this matrix has some negative off-diagonal elements,
(z~, z 2, z3) violates gross substitutability.) The polynomial that we are interested in is
-0.8401 + 2.8153A - 3.4070A 2 + 3.3330A 3 - 1.9013A 4 = 0 .
The four roots are A = 1, 0.4860, 0.1335 + 0.9441i and 0.1335 - 0.9441i as can
easily be verified. This example has four steady states. The steady states and
the corresponding roots are listed below.
fl
0.0976
0.4286
1
903.6581
Other roots
1
1
0.4861
1
-0.0102
0.3845
0.1275 0.3337i
0.1335 0.9441i
-1196.3574
2.2889
As the steady state/3 = 0.4286 the modulus of the pair of complex conjugates is
0.3572; a t / 3 = 1 it is 0.9535.
To generate examples with multiplicity of equilibria, we can choose the
initial two consumers, generations - 1 and 0, so that (1,/3,/32,/33) satisfies the
equilibrium conditions in the first two periods. When /3 = 0.4286, we can
generate an example without fiat money that has a one-dimensional manifold
of equilibria since f f s = 2 and r i S + l - n = l .
(To do so we set (w,w~)=
(12.0650, 1).) W h e n / 3 = 1, we can generate an example with fiat money that
has a two-dimensional manifold of equilibria since n ~= 3 and nS+ 1 - n = 2
[see K e h o e and Levine (1990b) for details].
A similar analysis of the possibility of indeterminacy in economies with
production and a mixture of overlapping generations and infinitely lived
2122
T.J. Kehoe
consumers is presented by Muller and Woodford (1988). Similar analyses for

non-stationary economies, economies in which the functions y, and z, vary over
time, have been presented by Geanakoplos and Brown (1985) and Santos and
Bona (1989).
T h e r e are two alternatives for approximating an equilibrium of an infinite

horizon overlapping generations model: The first is to linearize the equilibrium
conditions around a steady state (or cycle) and then solve the linearized model
[see Laitner (1984, 1990) and Kehoe and Levine (1985, 1990b)]. The second is
to truncate the model and to compute an equilibrium of the truncated model.
The crucial question is: What terminal conditions should we impose? A
popular choice is to impose the condition that the equilibrium converges to a
given steady state [see, for example, A u e r b a c h and Kotlikoff (1987)]. Care
must be taken in this case to make sure that the truncated economy as a whole
satisfies Walras's law.
The two methods proposed above are probably best viewed as complements
rather than substitutes. Indeed, before computing a truncated equilibrium
using as terminal conditions the requirement that the equilibrium converge to a
given steady state, we should linearize the model around the steady state. This
would allow us to check for indeterminacy, where a continuum of equilibria
converge to the steady state, or instability, where no equilibrium converges to
it. We would not want to impose the condition of convergence to an unstable
steady state in a truncated model. Indeterminacy is more problematical, but we
would certainly want to be aware of it since it indicates that the equilibrium
that is computed is acutely sensitive to the truncation date T and the exact
form of the terminal conditions. Figure 38.6 depicts three different equilibria of
the economy in Example 6.1, each of which converges to the steady state
/3 = 0.4286. Notice how small differences in the equilibrium paths at T = 20
correspond to large differences earlier in the path [see Kehoe and Levine
(1990b) for a discussion].
To compute an equilibrium of a truncated model, we could use the methods
developed for static economies. The truncated model may be very large,
however, and it is often more convenient to view the problem of computing an
equilibrium as a two-point boundary-value problem. Auerbach and Kotlikoff
(1987) and Lipton, Poterba, Sachs and Summers (1982) have proposed alternative methods for solving this sort of problem. The equilibrium condition in
period t, t = 2, 3 . . . . . T - 1 , implicitly defines a system of n second-order
non-linear difference equations. The equilibrium conditions in period 1 implicitly provide n of the 2n necessary boundary conditions. The equilibrium
2123
PI+I/PI
1.0
0.8-
0.6-
0.4-
0.2-
10
15
20
25
Figure 38.6
conditions in period T implicitly prove the other n. Auerbach and Kotlikoff

(1987) solve this problem using a non-linear Gauss-Seidel method. They start
by guessing a solution, the steady state for instance. They then solve the model
going forward using this guess as expectations for future variables. After they
are done, they use the calculated solution as a new guess and repeat the
process. They stop when, and if, the calculated solution agrees with the
previous guess.
We write the equilibrium conditions in period t as
f ( P , 1, P , , P t + l ) = z ( P ,
1, P t ) + Y ( P , , P , + ~ ) = 0 .
Suppose that we are interested in equilibria that converge to the steady state
(p,/3p). We perform a change of variables, deflating prices in each period by
the factor/3, so that/7, =/3-'p~ and
f(/Tt 1, /7,, /7,+,) =f(/Tt-,, /3/7,, /32ff,+,) =f(P,-l, Pt,

We henceforth write Pt for/7t and f for j~
P,+I) -
T.J. Kehoe
2124
Given the guess plk . . . . , p~-, the non-linear Gauss-Seidel method sets
in the system
P,k+l = g,(pk)
fl(g,(pk), pk2)=O,
f(g,_,(pk),gt(pk),pk+l)=O,
t=2,...,T-1,
fr(gr_1(pk), g,(pk)) = O.
Near the equilibrium/3~, /)2 .....
it)T, this algorithm converges to the linear
Gauss-Seidel method for solving
11
DlfllD2fl
D2f- Dlf
I
L
!
D2f71D1f
0
...
D2f XD3f ""
I
0
0
0
...
"i
"'" D2frlDlfr
-1r-p1-1
|/p2[
Dzf'-lD3f i ] Pr_l l
I
JLPTJ
V t), + D,f;'D2Lp2 ]
/ i /
LD2fr'D, fri3r , + Pr-]
(Depending on whether there is no fiat money, we may need to normalize

fill = 0 and delete one equation in the first period.) In this system of equations
the derivatives are evaluated at/~l, 102 ....
, fir rather than at the steady state
p. Notice, however, that, if the equilibrium of the infinite horizon model
converges to p, then as we move down the matrix the derivatives approach
those at the steady state.
The Gauss-Seidel method splits the coefficient matrix of this system, which
we write as
Ap=c,
into a strictly upper-triangular component U, a strictly lower-triangular component L and a diagonal component D. We then solve
(D + L)p k+1 = -Up k + c
2125
recursively. This method converges if and only if the eigenvalues of - ( D +

L ) - I u are less than one in modulus. Young (1971) provides conditions for
convergence. It can be shown, for example, that, if f exhibits gross substitutability and there is no fiat money, the method converges ]compare with
Kehoe, Levine, Mas-Colell and Woodford (1986)].
The speed of convergence is -log]A I where A is the eigenvalue of - ( D +
L)-~U with the largest modulus. If the infinite horizon model exhibits indeterminacy, then the matrix A is almost singular and -logIA [ is close to zero. To
see this, notice that there would then be two vectors p~ p 2 such that, for T
large,
A p I ,.~ Ap2,-~ c ,
A(pL _p2) ~ 0 .
A slight perturbation in A would then make it singular. Standard results in
linear algebra then imply that A has an eigenvalue very close to zero and,
therefore, that - ( D + L ) - ~ U has an eigenvalue very close to one. Similarly,
instability in the infinite horizon model, where no solution converges to the
steady state, also corresponds to A being almost singular. This is because,
while indeterminacy corresponds to the infinite version of A not being one-toone, instability corresponds to it not being onto [see Kehoe, Levine, MasColell and Zame (1989)].
This means that the Gauss-Seidel method does not work if there is
indeterminacy or instability: One possibility is that convergence may be
impossibly slow. If there is indeterminacy, another possibility is that the
algorithm may stop at a point far from the true equilibrium of the truncated
model but close to an equilibrium of the infinite horizon model. If there is
instability, in contrast, the algorithm may stop at a point far from either. In
either case, a crucial factor determining the results is the convergence criterion,
the degree to which the equilibrium conditions must be satisfied for the
algorithm to stop [see Kehoe and Levine (1990a)].
Our analysis sugests directions for further research. One way to speed up the
Auerbach-Kotlikoff algorithm would be to linearize the equilibrium conditions
around a guess and then solve, not using Gauss-Seidel, but a successive
overrelaxation method,
(D + a L ) p k+l = ((1 - a ) -
aU)p k + ac,
for a good choice of a [see Young (1971)]. The system can then be linearized
around the new guess and the procedure repeated. This method is just
Newton's method with a fast way of inverting the sparse matrix A. Unfortu-
T.J. Kehoe
2126
nately, of course it does not work well when A is almost singular or when
- ( D + L ) - t U has an eigenvalue greater than one in modulus.
An alternative method for solving this sort of equilibrium problem has been
suggested by Lipton, Poterba, Sachs and Summers (1982). This is a method
widely used by engineers and physical scientists called multiple shooting [see,
for example, Keller (1968)]. They start by guessing the initial values for prices
and solving forward for the resulting price path up to T:
L ( P , , Pz(P~)) = O,
f ( P t - , ( P l ) , P,(P,), P,+,(P,))= O,
t= 2,...,
T.
They then apply Newton's method to solve P r ( P l ) - ]1Pr(Pl)I]/~P = 0, where

(p,/3p) is the steady state. Unless the equilibria are completely indeterminate,
however, most paths diverge very rapidly. Because of this the algorithm is very
numerically unstable. They therefore propose dividing the time period into
difference time segments, then solving
PrI(Pl)-Pr, =0
Pr2(Pr,) - Pr2 = 0
P~,,,(Pr,,, ,)-]]Pr,,,(PT,,, ,)]]/3p = 0
for Pl, Prl, " " ", PL,, ~ where m is the number of time segments.
Unfortunately, this method is not a good one for many economic problems
for at least three related reasons: First, it is often difficult to solve
f(Pt-1, P,, P,+I) = 0 for p,+l as a function of (p, 1, P,). There may be multiple
solutions (this, however, is a problem with most methods). Furthermore, any
small divergence from the true solution for (Pt-1, P,) can cause P,+I to become
negative or not to exist. Second, dividing the time horizon into segments causes
the number of variables in Newton's method to go up rapidly. In Auerbach and
Kotlikoff's model the number of variables in what corresponds to Pl is 54 and T
is 150. Dividing into three time segments produces 3 x 54 variables, which is
greater than the original number of variables in the system, 150. Even dividing
into three segments is probably inadequate, however, since, as Laitner (1990)
reports, the linearization of Auerbach and Kotlikoff's model has unstable
eigenvalues 1.6 times as large in modulus as the largest stable eigenvalue. This
implies that almost all small errors in guessing pl have a non-zero complement
that is blown up by a factor of 1.6 ~, which has order of magnitude 10 ~, in
prl(pl). Third, and most importantly, shooting methods work well on ordinary
two-point boundary-value problems, not saddlepoint problems. In fact, it is
2127
exactly this sort of problem for which Press, Flannery, Teukolsky and Vetterling (1986, pp. 580-581) advise that shooting methods should not be used.
Kehoe and Levine (1990a) suggest several methods for computing approximate equilibria that combine the advantages of solving the linearized model
with those of solving the truncated model. The simplest is to replace the
terminal condition of convergence to a steady state by date T with the
condition of convergence to the stable subspace of the linearized equilibrium
conditions. When the equilibrium path is close to the steady state, this
subspace is a very good approximation to the stable manifold of the non-linear
system defined by the original equilibrium conditions.
All of the methods proposed in this section are applicable to non-stationary
economies that are stationary after some date. Extensions to economies with
uncertainty seem much more difficult, however; see Duffle, Geanakoplos,
Mas-Colell and McLennan (1988) for a discussion of some of the problems
involved in even proving the existence of equilibria with the sort of stationarity
properties that make them tractable.
7. Economies with taxes and externalities
In applications many economies fail to satisfy the conditions of the two welfare
theorems because of such features as distortionary taxes, externalities, rationing and institutionally fixed prices.
7.1. Static economies with taxes

Large scale general equilibrium models with taxes and government spending
are frequently used in policy analysis [see Shoven and Whalley (1984) for a
survey]. An early approach to proving the existence of, and computing,
equilibrium of such models is given by Shoven and Whalley (1973). Here, as
do Todd (1979) and Kehoe (1985a), we follow an approach similar to that in
Sections 2.1 and 4.1 for proving the existence of equilibrium in static
economies without taxes.
Consider an economy similar to that in Section 4. Consumer i now faces the
budget constraint ET=1 pj(1 + ~-j)xj <~p'w' + Oir where zj is the ad valorem tax
on good j and 0/, 0i >f 0, Eiml 0/ = 1, is the share of government revenue r
received by consumer i. In many applications 01 = 1 while 02 . . . . .
0m = 0;
that is, the first consumer is the government.
The responses of the consumers to a vector of prices and a level of
government revenue can be aggregated into an aggregate excess demand
function f : (R+\{O}) x R+---~R" and a tax function t" (R+\{O}) R+--~R+,
2128
T.J. Kehoe
t( p, r ) = ~ pj~) ~ xij( p, r) .
j=l
i=1
Both f and t are continuous, f is also homogeneous of degree zero, is bounded

below by - Z i ~ , w i, and satisfies H f ( P , r')lt---" ~ as r'--, ~ for any p ~ R+\{0}. t
is homogeneous of degree one. Together f and t satisfy a modified version of
Walras's law, p ' f ( p , r) + t ( p , r) ~: r. Analogously with the model without
taxes, we can specify the consumers either in terms of utility functions and
endowment vectors or in terms of excess d e m a n d functions and tax funct!ons.
T o keep the presentation simple, let us specify the production technology
using an n k activity analysis matrix A. We again assume that A includes free
disposal activities and does not allow outputs with inputs. Production taxes are
specified by an n x k matrix A* that satisfies A* ~< A. Here a~ = aij - ri~la~i[
where r 0 is the ad valorem tax on the output or input of commodity i in activity
j. T h e r e are no taxes on disposal activities. The revenue from production taxes
at prices p E R+\{0} and activity levels y ~ Rk+ is p ' ( A - A * ) y .
A n equilibrium of an economy ( f , t, A, A*) is a price vector/~ ~ R+, a
revenue level f E R+, and a vector of activity levels 3~E Rk+ such that
fi'A* < O,
f ( / ) , ?) = Aft,
~= t(~, ~) + ~ ' ( A - A*)y.

Walras's law implies that fi'A*)~ = 0.
Once again we can use homogeneity to normalize prices to lie in the unit
simplex S. To bound the set of potential levels of government revenue, we note
that the assumption of no outputs without inputs implies that there exists some
a > 0 such that Hx]] < a for all x in the production possibility set {x E R" [x =
A y / > --Egm~ Wi, y /> 0}. Our assumptions on l i m p l y that there exists/3 > 0 such
that H f ( P , r)ll ~>~ for all p e S, r>~/3. Consequently, we can restrict our
attention to the non-empty, compact, convex set S x [0,/3] in searching for
equilibria. To define g : S x [0,/3]---~ S x [0,/3], we let g ( p , r) = ( g l ( P , r),
g2(P, r)) be the vector (gl, g2) that solves
min [(gl - p - f ( p , r))'(gl - P - f ( P , r)) + (g2 - t ( p , r)) 2] subject to
g'lA - (1 + g2 - r ) p ' ( A - A * ) <~0
g ; e = l, 0<~g2<~/3.
Notice that the assumption of free disposal and the first constraint imply that
gl ~ 0 .
2129
Proposition
7.1 [Kehoe (1985a)]. ( ~ , ~, f~) is an equilibrium if and only if

( ~ , ~) is a fixed point of g, (p, ~) = g(p, ~).
Proof. The K u h n - T u c k e r theorem implies that ( g j ( p , r), g2(P, r)) = g ( p , r)

solves the minimization problem that defines it if and only if there exist
Lagrange multipliers y E Rk+, A E R and /z, v E R+ such that
gl(P, r)-p-f(p,
r) + A y + AE = O,
g z ( P , r) - t ( p , r) - p ' ( A
- A * ) y + tx - v = O,
[gl(P, r)'A - (1 + g2(P, r) - r ) p ' ( A - A*)]y = 0,

t z g 2 ( p , r) = 0 ,
v(/3 - g2(P, r)) = O.
Suppose that (/~, ? ) = g(/), P) and, for the moment, that /2 = h = 0. This
implies t h a t / ) ' A * <~0 and ~ = t(p, ~) + ~6'(A - A*)3Z To obtain the remaining
equilibrium condition, we multiply the first condition above by ,3' to produce
-/~'f(/~, ~) +/~ 'A j3 + J, = O.
Walras's law now implies that A=O, and the first condition becomes
- f ( / ~ , f) + A)3 = 0. That t(/), ~) ~>0 and/9'(A + A*)33 i> 0 justifies us in ignoring the possibility that fi > 0. Suppose, however, that 17,> 0 at a fixed point
(/),/3). Our above reasoning then implies that - f ( / ~ , / 3 ) + A ) 3 > 0 , which
would contradict our choice of /3. Consequently, any fixed point is an
equilibrium.
To demonstrate the converse, that any equilibrium is a fixed point, we set
y = )3 and A = / z = v = 0 in the K u h n - T u c k e r conditions.
Kehoe (1985a) develops regularity analysis and an index theorem for
economies with taxes and government spending. The index of an equilibrium
(p, P, )3) is
sgn(tl
Here B and B* are the matrices whose columns are the activities of A and A*,
respectively, that are associated with strictly positive activity levels )3j. A
T.J. Kehoe
2130
regular e c o n o m y has this expression n o n - z e r o at all equilibria. O n c e again,

E i n d e x ( p , r) = + 1 w h e r e the sum is o v e r all equilibria of a regular e c o n o m y .
U n f o r t u n a t e l y , not even the a s s u m p t i o n s of a r e p r e s e n t a t i v e c o n s u m e r or a
non-substitution t h e o r e m t e c h n o l o g y and e n d o w m e n t p a t t e r n , each of which
g u a r a n t e e s uniqueness of equilibrium in an e c o n o m y without taxes, rules out
multiplicity of equilibria. T h e following e x a m p l e illustrates this point. It is
b a s e d on the analysis of Foster and S o n n e n s c h e i n (1970) [see also H a t t a (1977)
and K e h o e , Levine and R o m e r (1989b)].
E x a m p l e 7.1. C o n s i d e r an e c o n o m y with two c o n s u m p t i o n goods a n d labor.
T h e r e is a r e p r e s e n t a t i v e c o n s u m e r with utility function
_(3_xl)2(x2+2)
X1 - 3
U(Xl'Xz'X3)=
ifxl~<3,
i f x L~>3,
and e n d o w m e n t (w 1, w 2, w3) = (0, 0, 2). T h e r e is an ad v a l o r e m tax 71 = 2 on

the c o n s u m p t i o n of the first good. All tax r e v e n u e s are r e t u r n e d to the
c o n s u m e r in the f o r m of a l u m p and r e b a t e , r. T h e excess d e m a n d functions
are
L(p,
r) =
if 9pl
2r)/3px
( - 9 p l + 4p 2 + 4p3 +
[(2p 3 +
L(p,
4p2
2p3 - r/> 2p3 + r ,
if 2p3 + r / > 9 p l - 4p2 - 2p3 - r / > 0 ,
r)/3pl
if 0 ~> 9pl
4p2
2p3 - r ;
r) =
(2p +
r)/p2
if 9pl
09Pl - 4p2 - 2p3
4p2
2p3 - r/> 2p3 + r ,
- r) @2 if2p3 + r i>9pl - 4 p 2 - 2p3 - r / > 0 ,

if 01>9pl - 4 p 2 - 2 p 3
f 3 ( P , r) = - 2 .
T h e tax function is t(p, r ) = 2 p i l l ( p , r).
T h e p r o d u c t i o n t e c h n o l o g y is specified by the matrix
A=A*=
1 - 10
0
0
00
-1
-1
-1
i]
-
T h e r e are three equilibria, given below.
- r ;

Equilibrium 1
Pl
Pz
P3
Y4
Ys
21
22
fi
1/3
1/3
1/3
4/3
4/3
2/3
2
0
-1/2
Equilibrium 2
2131
Equilibrium 3
1/3
1/3
1/3
2/3
1
1
1
1
-4/3
1/3
1/3
1/3
0
2/3
4/3
0
2
-9/4
Equilibria 1 and 3 have index +1, and equilibrium 2 has index - 1 .
7.2. Dynamic economies with taxes and externalities

The existence of equilibrium in economies whose equilibria are not necessarily
Pareto efficient can be established using sequences of truncations as in Section
6. Similar computational techniques can be used to approximate equilibria.
Unfortunately, dynamic economies with taxes and externalities, like overlapping generations economies, can have robust continua of equilibria.
Example 7.2. Consider a dynamic economy with a representative consumer
and a one-sector production technology. The consumer derives utility not only
from consumption but also from investment. The consumer purchases the
investment good, perhaps human capital in the form of education that is valued
for its own sake, in one period and sells it to the representative firm in the
next. He faces an ad valorem tax on purchases of the consumption good. All
tax revenues are rebated in lump-sum form to the consumer. He chooses
(cl, xl), (c 2 , x 2 ) , . . . , to solve
max
3'
t--I
u(c,, x,) subject to
t=l
2 (p,(1 + "r)c, +p,x,)<~ 2 (Y, + r , k , ) ,

t=l
t=l
k 1~</~, k,~<x,_~, c , , x , / > 0 .

Here x, is the amount of the investment good purchased by the consumer in
period t, p, is the price paid, r,+ ~is the price paid by the firm for the same good
in period t + 1 and y, is the consumer's labor income plus tax rebate
y, = ( p , f ( k , ) - r,k,) + "rp,k, .
2132
T.J. Kehoe
The representative firm chooses k~, k 2 to solve

ac
max ~'~ ( p , f ( k , ) - r , k , ) .
t=l
In equilibrium, consumers maximize utility taking p,, Y, and r, as given,

producers maximize profits taking Pt and r t as given, k, = x , _ ~ and
c,+k,+ l<-f(k'),
t=l,2
.....
The first-order conditions for the consumer's problem are

r
3'
t-I
t--1
u , ( c , , k,+~) - a p , ( 1 + "0 = O,
t=l,2,....
u2(c,,k,+,)-a(pt-r,+~)=O,
The first-order condition for the firm's problem is

p,f'(k,)-
t=l,2,....
r,=O,
Combining these three conditions to eliminate p, and r,, we obtain

(1
+ T)u2(ct,
kt+l)
Ul(ft,
kt+l)
q- 3 ' U l ( C t + l ,
k,+2)f'(k,+2) = 0 ,
t=1,2,....
Substituting in the feasibility condition
c, = f ( k , ) - k,+ l
yields a second-order difference equation in k t.

This difference equation requires two initial conditions. The value of k~ is
given. To find how much freedom there is in choosing k 2, we linearize the
difference equation around a stationary solution of/~. We obtain
~2(k,+2 - ~) + ~ ( k , + l - ~) + ~o(k,
-~)=o
where
O/o
= ((1 + ".)u2, - u . ) I ' ,
O~1
= - ( 1 + r)u21 + (1 + r)u22 +
OL2 = 3 ' ( U 1 2 - -
Ull)f',
b / l l - - ['/12 -I-
3"Ullf '2 -~- 3" U l Jz'! ,
2133
C o n s i d e r the e x a m p l e where 3' = 3 / 4 , r = 2,
u(c, k) = 8c + (14-~)k- (5c 2 + 4 c k + k 2 ) ,
f(k) =
55 + lOk - k 2
32
In this case 6 =/~ = 1 is a stationary solution where u n = - 5 , u~2 = u21 = - 2 ,

u22=-1,
u~=l, f'=l/4
and f " = - 1 / 1 6 .
This implies that % = - 1 / 4 ,
a~ = - 9 / 3 2 and % = 9 / 1 6 . T h e two roots of the characteristic e q u a t i o n
%A 2 + alA + % = 0
are A = 0.2500 +- 0.7120i. Since b o t h roots have moduli less t h a n one, there is a
c o n t i n u u m of equilibria for which k, converges t o / ~ = 1.
E x a m p l e 7.3. C o n s i d e r a n o t h e r d y n a m i c e c o n o m y with a representative cons u m e r and a o n e - s e c t o r p r o d u c t i o n technology. T h e c o n s u m e r chooses Cl,
c 2 , . . , to solve
t--I
31
max
u(c,) subject to
t--1
E
t
plcr <~
1
y,, C,>~O.
t=l
H e r e y, is the total o f labor and capital i n c o m e in period t. T h e r e is a

congestion externality in that o u t p u t d e p e n d s not only o n the inputs of capital
k t and the fixed a m o u n t of labor but on the average a m o u n t capital K t. T h e
representative firm chooses kl, k 2 . . . . to solve
max ~
( p , f ( k , , Kt) - ptkt+l) - r l k I .
t=l
H e r e the firm c a n n o t control the average K, although, in equilibrium K t = k t.

T h e o t h e r equilibrium conditions are
y, = p , f ( k , , K , ) ,
c, + k,+ 1 <~f ( k , , K,) ,
kl <~ f~l
T h e first-order conditions for the c o n s u m e r ' s p r o b l e m
2134
T.J. Kehoe
~,
t-I
u'(c,)-
Xp, = 0
can be combined with the first-order conditions for the firm's problem
p , + l f l ( k , + l , K,+l) - p, = 0
to yield
~u'(c,+,)L(k,+,,
K,+,) - u'(c,) = O.
Substituting in the equilibrium conditions, we obtain a second-order difference

equation in k,
yu'(f(k,+,,
k , + , ) - k,+z)f~(k,+ , , k,+,) - u ' ( f ( k t, k t ) - k , + , ) = O.
Once again, we have only one initial condition k~. Linearizing around a
stationary solution/~, we obtain
a 2 ( k , + 2 - k) + a,(k,+, - k ) + a 0 ( k , - k ) = 0
where
~0
= -u"(f, +L),
O/I
= ru"f,(L + L ) + r u ' ( f , , + f , 2 ) + u",
% = - ~/u"L
In the case where / = / ~ = 1 ,
y=3/4, u'=2, u"=-l,
f1=4/3, f2=-l,
fll = - 1 and fl 2 = 2, we can calculate % = - 1 / 3 , a~ = 1/6 and o/2 ~-- 1. The two
roots of the characteristic equation are 1/2, - 2 / 3 . Since both roots have
moduli less than one, there is a continuum of equilibria for which k, converges
to / c = l .
As in Example 7.2, we can choose u and f as quadratic functions so that the
linear approximation to the equilibrium conditions is exact.
Remark. Similar examples of multiplicity of equilibria in economies with
externalities have been constructed by Howitt and McAfee (1988), Spear
(1988) and Kehoe, Levine and R o m e r (1989a).
7.3. Characterizing equilibria as solutions to o p t i m i z a t i o n p r o b l e m s
As we have mentioned, the computational methods for overlapping generations economies can also be applied to economies with taxes and externalities.
2135
An alternative is to characterize equilibria as solutions to optimization problems where some of the p a r a m e t e r s of the optimization p r o b l e m are endogenously determined. The characterization is formally similar to the Negishi
approach described in Section 3, where the welfare weights a are endogenously
determined, although there is now no interpretation in terms of Pareto
efficiency.
Example 7.4 (7.1 revisited).
Consider the " P a r e t o " p r o b l e m
max u(x~, x 2, x3) - zx~ subject to x - w <~A y , x, y >10,

where the function u, the vector w and the matrix A are as in E x a m p l e 7.1.
Letting p E R 3 be the Langrange multipliers, we can write the first-order
conditions as
lgl(Xl,X2, X 3 ) - - Z - - p l ~ O ,
Uz(Xl'X2'X3)--P2 <~0'
p ' A <~0,
=0ifxl>0,
=0ifxz>0,
p ' A y = 0,
Ay-x+w=O.
These are the same as the equilibrium conditions of E x a m p l e 7.1 in the case
where z = ~'Pl- Equilibria are, therefore, fixed points of g(z) = "cpl(z ).
For a fixed value of z, we can solve the maximization p r o b l e m and find the
solution (x(z), y(z), p(z)). For any value of z there is a unique solution.
15/16>~z>~3/4
3/4>~z
x,
x2
Y4
Ys
Pl
P2
0
2
2/3
4/3
9/16
9/16
4 (1 - - Z ) 1/2
(l-z)
1/2_2
2-(l-z)
~/213
(1 - z) 1/2/3
2 z - 2(1
Z) 1/2
2 - - Z - - 2(1 -- Z) 1/2
2
0
413
2/3
1 Z
1-- Z
P3
9/16
2 - z - 2(1 - z) 1~2
1- z
z~>15/16
- -
The function g ( z ) = 2 p l ( z ) has three fixed points, z j = 2 / 3 , z 2 = 8 / 9

z 3 = 9 / 8 , which correspond to the three equilibria of E x a m p l e 7.1.
and
The equilibria of the dynamic economies in Examples 7.2 and 7.3 can also be
characterized as solutions to optimization problems with endogenous p a r a m e ters. In each case, however, there is an infinite n u m b e r of endogenous
2136
T.J. K e hoe
parameters. In the case of the dynamic economy with externalities, for

example, the " P a r e t o " problem is to choose (Cl, k l ) , (c2, k 2 ) . . . . t o solve
max
u(cr) subject to
t=l
c, + kr <~f(k,, z , ) ,
kl </~l ,
c~, k t >t 0 .
For the solution to this problem to be an equilibrium, the parameters zl,
z 2 , . . , must solve the fixed point problem z, = k,(zt), t = 1, 2 . . . . [see Kehoe,
Levine and R o m e r (1989a) for details and references].
Sometimes the equilibrium of an economy with taxes or externalities solves
an optimization problem without additional equilibrium conditions. Becker
(1985), for example, considers a model in which the representative consumer
solves
max
u(c,) subject to
t=l
~ , p,(c, + k,+l) <~

t=l
(y, + (1 - r ) r , k , ) ,
t=l
kl~]~
1,
Ct , k t ~ O .
Here y, = p , f ( k , ) - r,k, + rrtk , is the consumer's labor income plus a lump sum
rebate. Becker shows that an equilibrium also solves
max ~ (y(1 - r))tu(c,) subject to
t=0
c , + k t + ~<~f(k,),
t=l,2 ....
c,, k, >1 0 .
Danthine and Donaldson (1986) extend Becker's analysis to economies that
2137
allow uncertainty. Judd (1987) shows that some similar, continuous time tax
models also have equilibria that solve optimization problems without side
conditions. He further argues that, although there are few cases in which
equilibria of tax models can be computed exactly by solving an optimization
problem without additional conditions on some of the parameters, research in
this area may be helpful in updating guesses in iterative methods for computing
equilibria.
Suppose, for example, that we characterize the equilibria of either the
dynamic economy with taxes in Example 7.2 or the dynamic economy with
externalities in Example 7.3 as solutions to optimization problems that depend
on a sequence z~, z 2. . . . of endogenous parameters. We start with a guess for
this sequence, say, the steady state. We then solve the optimization problem
for this guess of z, and then use the solution to update z t and so on. Kydland
and Prescott (1977) and Whiteman (1983) discuss algorithms of this sort for
computing equilibria in economies with externalities; Braun (1988), Chang
(1988) and McGrattan (1988) have applied such algorithms to economies with
taxes; and Ginsburgh and van der Heyden (1988) have applied such an
algorithm to an economy with institutionally fixed prices. Further research is
needed to see whether this algorithm has any advantages over alternatives.
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Chapter 39
NON-STANDARD
ECONOMICS
ANALYSIS
WITH
APPLICATIONS
TO
ROBERT M. ANDERSON*
Department of Economics and Department of Mathematics, University of California at Berkeley
Contents
1. Non-standard analysis
1.1. Introduction
1.2. When is non-standard analysis useful?
1.3. Ideal elements
1.4. The ultraproduct construction
1.5. Internal and external sets
1.6. Notational conventions
1.7. Standard models
1.8. Superstructure embeddings
1.9. A formal language
1.10. Transfer principle
1.11. Saturation
1.12. Internal definition principle
1.13. Non-standard extensions: enough already with the ultraproducts
1.14. Hyperfinite sets
1.15. Non-standard theorems have standard proofs
2. Euclidean, metric and topological spaces

2.1.
2.2.
2.3.
2.4.
2.5.
2.6.
2.7.
Monads
Open and closed sets
Compactness
Products
Continuity
Differentiation
Riemann integration
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*The author is grateful to Andreu Mas-Colell, Don Brown, Chang, Hung-Won, Gerard Debreu,
Eddie Dekel-Tabak, Greg Engl, Jerry Keisler, Peter Loeb, Paul MacMillan, Mike Magill, Mike
Rothschild, Max Stinchcombe, Cathy Weinberger and Bill Zame for their helpful comments.
Support from Deutsche Forschungsgemeinschaft, Gottfried-Wilhelm-Leibniz-F6rderpreis is
gratefully acknowledged.
Handbook of Mathematical Economics, VolumeIV, Edited by W. Hildenbrand and H. Sonnenschein

2.8. Ordinary differential equations

3. L o e b m e a s u r e
3.1. Existence of Loeb measure
3,2. Construction of Lebesgue measure
3.3. Representation of Randon measures
3.4. Lifting theorems
3.5. Weak convergence
4. L a r g e e c o n o m i e s
4A. Preferences
4.2. Hyperfinite exchange economies
4.3. Loeb measure economies
4.4. Budget, support and demand gaps
4.5. Core
4.6. Other work in large economies
5. C o n t i n u u m of r a n d o m v a r i a b l e s
5.1. The problem
5.2. A continuum of random variables on a Loeb space
5.3. Keisler's price adjustment model
6. T r a n s l a t i o n of n o n - s t a n d a r d proofs
7. F u r t h e r r e a d i n g
References
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Ch. 39: Non-Standard Methods in Economics
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1. Non-standard analysis
1.1. Introduction
In this chapter, we present an introduction to non-standard analysis and survey

its applications in mathematical economics. Non-standard analysis is a mathematical technique which has been widely used in diverse areas in pure and
applied mathematics, including probability theory, mathematical physics and
functional analysis. Our primary goal is to provide a careful development of
non-standard methodology in sufficient detail to allow the reader to use it in
diverse areas in mathematical economics. This requires a careful study of the
non-standard treatment of real analysis, measure theory, topological spaces,
and so on. In order to accommodate this extended treatment of methodology,
the survey of work to date using non-standard methods in mathematical
economics will be relatively brief; however, an extensive set of references will
be provided. This chapter is a condensation of Anderson (1990); further details
may be found there.
1.2. When is non-standard analysis useful?
Non-standard analysis can be used to formalize most areas of modern mathematics, including real and complex analysis, measure theory, probability
theory, functional analysis and point set topology; algebra is less amenable to
non-standard treatments, but even there significant applications have been
found.
Complicated E-6 arguments can usually be phrased more simply in nonstandard analysis. Given the dependence of work in mathematical economics
on arguments from real analysis at the level of Rudin (1976) and R o y d e n
(1968), a very large n u m b e r of papers could be significantly simplified using
non-standard arguments. Unfortunately, there is a significant barrier to the
widespread adoption of non-standard arguments for these kinds of problems, a
barrier very much akin to the problems associated with the adoption of a new
technological standard. Few economists are trained in non-standard analysis,
so papers using the methodology are necessarily restricted to a small audience.
Consequently, relatively few authors use the methodology if more familiar
methods will suffice. Therefore, the incentives to learn the methodology are
limited. Accordingly, the use of non-standard methods in economics has
largely been limited to certain problems in which the advantages of the
methodology are greatest.
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R.M. Anderson
Large economies
Most of the work in Economics using non-standard methods has occurred in

the literature on large economies. Suppose Xn : A n - ~ P R k+ is a sequence of
exchange economies with IA n t --> ~. In other words, A n is the set of agents and
]Anl the number of agents in the nth economy, P a set of preferences, and Xn
assigns to each agent a preference and an endowment vector. A natural
approach to analysing the sequence X, is to formulate a notion of a limit
economy X : A--> P x Rk+. This limit economy can be formulated with A being
either a non-atomic measure space or a hyperfinite s e t - - a non-standard
construction. The properties of measure spaces and hyperfine sets are closely
analogous. Indeed, using the Loeb measure construction which we describe in
Section 3, a hyperfine set can be converted into a measure space. The theory of
economies with a hyperfinite set of agents in analogous in many respects to the
theory of economies with a measure space of agents.
However, there are certain p h e n o m e n a that can occur in hyperfinite
economies which are ruled out by the measure-theoretic formulation. For the
most part, these relate to situations in which a small proportion of the agents
are endowed with, or consume, a substantial fraction of the goods present in
the economy. In the hyperfinite context, certain conditions inherent in the
measure-theoretic formulation can be seen to be strong endogenous assumptions. Using hyperfinite exchange economies, we can state exogenous assumptions which imply the endogenous assumptions inherent in the measuretheoretic formulation, as well as explore the behavior of economies in which
the endogenous assumptions fail.
The power of the non-standard methodology is seen most clearly at the next
stage, in which one deduces theorems about the sequence X, from the
theorems about the limit X. A central result known as the Transfer Principle
asserts that any property which can be formalized in a particular formal
language and which holds for X must also hold for Xn for sufficiently large n.
Viewed in this context, the Transfer Principle functions as a sweeping generalization of the convergence theorems that can be formulated using topology and
measure theory. The Transfer Principle converts results about the limit
economy X into limiting results about the sequence Xn in a few lines of
argument. Consequently, for those properties which hold both in measuretheoretic and hyperfine economies, non-standard analysis provides a very
efficient tool to derive limit theorems for large finite economies. On the other
hand, in the situations in which the behavior of the measure-theoretic and
hyperfinite economies differ, it is the hyperfinite economy rather than the
measure-theoretic economy which captures the behavior of large finite
economies. The literature on large economies is discussed in Section 4.
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Continuum of random variables

Probability theory is currently the most active field for applications of nonstandard analysis. Since probabilistic constructions are widely used in general
equilibrium theory, game theory and finance, these seem fruitful areas for
further applications of non-standard methodology.
Non-standard analysis provides an easy resolution of the so-called continuum
of random variables problem. Given a standard measure space (A, ~ , / z ) and
an uncountable family of independent identically distributed random variables
X~ : A---~ R, one would like to assert that there is no aggregate uncertainty; in
other words, the empirical distribution of the X A equals the theoretical
distribution with probability one. Typically, however, the set of a E A for
which the empirical distribution of the X Aequals the theoretical distribution is
not measurable; by extending/x, it can be assigned any measure between 0 and
1. Note that, with a large finite number of random variables, the measurability
issue does not even arise. Thus, the problem is a pathology arising from the
formulation of measure theory, and not a problem of large finite systems. If A
is a hyperfinite set, and/x is the Loeb measure, then the empirical distribution
does equal the theoretical distribution with probability one. Moreover, as in
the large economies literature, the Transfer Principle can be used to deduce
asymptotic properties of large finite systems. The Continuum of Random
Variables Problem is discussed in Section 5.
Searching Jbr elementary proofs
Non-standard analysis allows one to replace many measure-theoretic arguments by discrete combinatoric arguments. For example, the Shapley-Folkman
Theorem plays the same role in hyperfinite sets as Lyapunov's Theorem plays
in non-atomic measure spaces. Thus, non-standard analysis is an effective tool
for determining exactly which parts of a given proof really depend on arguments in analysis, and which follow from more elementary considerations.
Occasionally, it is possible to replace very step in a proof by an elementary
argument; as a consequence, one obtains a proof using neither non-standard
analysis nor measure theory. Examples are discussed in Section 6.
1.3. Ideal elements

Leibniz' formulation of calculus was based on the notion of an infinitesimal.
Mathematics has frequently advanced through the introduction of ideal elements to provide solutions to equations. The Greeks were horrified to discover
2150
R.M. Anderson
that the equation x 2 = 2 has no rational solution; this p r o b l e m was resolved by

the introduction of the ideal element X/2; ultimately, the real numbers were
defined as the completion of the rationals. Similarly, the complex numbers
were created by the introduction of the ideal element i = X ~ ] - . Leibniz
introduced infinitesimals as ideal elements which, while not zero, were smaller
than any positive real number. Thus, an infinitesimal is an ideal element
providing a solution to the family of equations
x>O;x<l,x< {,x<
~.....
(1)
Infinitesimals played a key role in Leibniz' formulation of calculus. F o r

e x a m p l e , the derivative of a function was defined as the slope of the function
o v e r an interval of infinitesimal length. Leibniz asserted that the real numbers,
a u g m e n t e d by the addition of infinitesimals, obeyed all the same rules as the
ordinary real numbers. Unfortunately, neither Leibniz nor his successors were
able to develop a formulation of infinitesimals which was free from contradictions. Consequently, in the middle of the nineteenth century, the e - 6 formulation replaced infinitesimals as the generally accepted foundation of calculus and
real analysis.
In 1961, A b r a h a m Robinson discovered that model theory, a branch of
mathematical logic, provided a satisfactory foundation for the use of infinitesimals in analysis. In the remainder of Section 1, we will provide an informal
d e v e l o p m e n t of Robinson's non-standard analysis [Robinson (1966)].
1.4. The ultraproduct construction

A very simple construction which produces elements with infinitesimal properties is R N, the space of real sequences. We can e m b e d R into R N by mapping
each r E R to the constant sequence ~ = (r, r, r . . . . ). N o w consider the sequence defined by x n = 1/n. Let R++ denote the set of strictly positive real
numbers. Given any r E R++, observe that x , < i n for all but a finite n u m b e r of
values of n. In other words, if we were to define a relation < v on R TMby
x <F Y ~
Xn < Yn
for all but a finite n u m b e r of n E N ,
(2)
then x would be infinitesimal in the sense that x < F ~ for every positive r E R.
Unfortunately, this very simple construction does not yield a satisfactory
theory of infinitesimals. For example, consider y defined by Yn - - 2 for n odd
and Yn = 0 for n even. Neither y < F 1 nor 1 < F Y is true; in other words, < F is
only a partial order on R N. In order to construct a satisfactory theory of
2151
infinitesimals, we consider a slightly more elaborate construction, known as an

ultraproduct.
Definition 1.4.1. A f r e e ultrafilter on N is a collection 9/ of subsets of N

satisfying the following properties:
(1) i f A , B E g / , t h e n A M B E g / ;
(2) i f A ~ 9 1 a n d A C B C N ,
thenBEg/;
(3) if A is finite, then A~:"9/;
(4) if A C N, either A ~ 9 / o r N \ A E 9/.
Remark 1.4.2. Note that by item (4) of Definition 1.4.1, we must have either
{2,4, 6 . . . . } ~ 9/ or {1, 3,5 . . . . } E 9/; however, by items (1) and (3), it is
impossible for both of these sets to belong to 9/.
Proposition 1.4.3. S u p p o s e N = A I U . - - U A
f o r i j. Then A i ~ O~for exactly one i.
, with n E N, and A i fq A j = fJ
Proof. Let B i = N \ A i. If there is no i such that A i E 9/, then B i E all for each
i. Then I~ = B 1 M (B 2 M M ( B n 1 A B n ) " " ") E 9/ by n - 1 applications of
property (1) of Definition 1.4.1, which contradicts property (3) (since ~ is
finite). Thus, A i E 9 / for some i. If A i E 9 / and A j E g / with i j , then
~) = A i M A j E )1, again contradicting property (3). Thus, A i ~ 9/ for exactly
one i.
Definition 1.4.4.
The equivalence relation =o~z on R TM is defined by
x=o~ y ::> { n : x , = y , } E 9 / .
(3)
Given x E R N, let [x] denote the equivalence class of x with respect to the
equivalence relation =ou. The set of non-standard real numbers, denoted *R
and read "star R " , is {[x]: x @ RN}.
Any relation on R can be extended to *R. In particular, given [x], [y] E *R,
we can define
[x] <ou [Y] <=> {n: x~ < y , ) ~ 9/ .
(4)
The reader will easily verify that this definition is independent of the particular
representatives x and y chosen from the equivalence classes [x], [y].
Proposition 1.4.5. S u p p o s e [x], [y] E *R. Then exactly one o f [x] <~u [Y],
[x] =~u [Y], or [x] >~u [Y] is true.
R.M. Anderson
2152
Proof. Let A = { n ~ N :
x.<y,,}, B={n@N:
x n = y . } , and C = { n E N :
x. > y . } . By Proposition 1.4.3, exactly one of A, B or C is in 0//.
Example 1.4.6. Let x E R N be defined by x n = 1/n, and F = (r, r , . . . ) for
r E R. If r > 0, then {n: x, < F,} ~ 0//, since its complement is finite. Thus,
[ x ] < ~ [F] for all r E R + + , i.e. [x] is an infinitesimal. We write [ x ] = [ y ] if
[ x ] - [y] (defined to be [z] where zn = x, - y , ) is an infinitesimal.
Definition 1.4.7. [x] E *R is said to be infinite if [x] >0u rh for all m G N.
Given any function f :R-->R, we can define a function * f : *R-->R by
*f([x]) = [(f(x,),
f(x2),...)].
(5)
In other words, *f is defined by evaluating f pointwise on the components of x.
1.5. Internal and external sets

In order to work with the non-standard real numbers, we need to be able to
talk about subsets of *R. We extend the ultraproduct construction to sets by
considering sequences in ( ~ ( R ) ) N, where ~ ( R ) is the collection of all subsets of
R, and extending the equivalence relation =0u from Definition 1.4.4.
Definition 1.5.1. Suppose A, B ~ ( ~ ( R ) ) TM, [x] @ *R. We define an equivalence relation =ou by
A =o~ B :> {n: A . = B.} ll .
(6)
Let [A] denote the equivalence class of A. We define

Ix] E ~ [A] :> {n: x n E An} E ~ .1
(7)
Note that [A] is not a subset of *R; it is an equivalence class of sequences of

sets of real numbers, not a set of equivalence classes of sequences of real
numbers. However, we can associate it with a subset of *R in a natural way, as
follows.
Definition 1.5.2. (Mostowski collapsing function).

a set M ( [ A ] ) C *R by
Given A E ( ~ ( R ) ) N, define
~As above, the reader will have no trouble verifying that the definition does not depend on the
choice of representatives from the equivalence classes.
M ( [ A ] ) = {[x] E ' R : [x] ~
[A]}.
2153
(8)
A set B C * R is said to be internal if B = M ( [ A ] ) for some A E (~(R))N;

otherwise, it is said to be external. A function is internal if its graph is internal.
Definition 1.5.3. Suppose B C R . Define *B = M([A]), where A E ( ~ ( R ) ) N is
the constant sequence A , = B for all n E N.
Example 1.5.4.
The set of non-standard natural numbers is
* N = {[x] E ' R : {n: x. E N } E 0//).
(9)
Let lq = {[n]: n E N}. Then lq C *N. Indeed, 1~ is a proper subset of *N, as can
be seen by considering [x], where x~ = n for all n @N. If m E N, {n: x , =
th,} = { m } ~ / / , so Ix] [rh].
Proposition 1.5.5.
*N\lq is external.
Proof. Suppose *N\iq = M([A]). We shall derive a contradiction by constructing [y] E *N\N with [y]~M([A]).
Let J = { n : A , CN}. We may choose x E R N such that x, EAn\N for
nEN\J, and x , = 0 for n E J . Therefore, { n E N : x , EN}=O, so [x]~E'*N.
Since M([A])C*N, [x]~M([A]), so NXJ~R, so J E ~ .
Without loss of
generality, we may assume that A , C N for all n E N.
For m E N , let Tm={nEN: m ~ A , } ; since [rh]~E'M([A]), TmEll. For
m E N U {0}, let
Sm={nEN: A, C {m,m+ l , m + 2 .... }}.

m
(10)
Then S m = ~'~k:l Tk, s o S m E ~ . S 0 = N . Let S= = ( ' ~ m C N am = { n E N :

A, =
0}. If S~ E ag, then M ( [ A ] ) = 0, a contradiction since *N\N ~ 0 by Example
1.5.4. Hence, S~ ~ ~ .
Define a sequence y @ R TM by y , = m if n E Sm+l\Sm+2, y , = 0 for n E S~.
Then { n : y , E N } = N \ S ~ E / / ,
so [_y]E*N. Given m E N , { n : y , = m } =
Sm+l\Sm+zCN\gm+2~6ll, s o [y]~E'N, and hence [ y ] E * N \ l q . However,
{n: y . E A . } C S~ JE'-//, so [y]~M([A]), so M([A]) *N\N.
Corollary 1.5.6.
N is external.
Proof. Suppose 1~1= M([A]). Let B, = N \ A n for each n E N. M ( [ B ] ) C *N.

Suppose [y] E *N; we may assume without loss of generality that y , E N for all
n E N. Then
R.M. Anderson
2154
[ylEM([B]) ~ { n E N : y, E B , } E ~
~ [ y ] ~ M ( [ A ] ) .
(11)
Thus, M ( [ B ] ) = *N\lq, so *N\lq is internal, contradicting Proposition 1.5.5.
1.6. Notational conventions

It is customary to omit the * in m a n y cases. N o t e first that we can e m b e d R in
R by the m a p r--~ [F]. Thus, it is customary to view R as a subset of *R, and to
refer to IF] as r. Thus, we can also write N instead of the m o r e awkward l~l.
Basic relations such as < , > , ~<, /> are written without the addition of a *
Functions such as sin, cos, log, e x, ['1 (for absolute value or cardinality) are
similarly written without a *
Consider the function g(n) = R n. If n is an infinite natural number, then *R"
is defined to be (*g)(n); equivalently, it is the set of all internal functions from
{ 1 , . . . , n} to *R. The summation symbol Z represents a function f r o m R n to
n
R. Thus, if n is an infinite natural n u m b e r and y @ *R n, ( E)i= 1 yz is defined. It
is customary to omit the * from summations, products, or Cartesian products.
Thus, the following expressions are acceptable:
VxE*R
3nE*N
eX>0;
(12)
2 xi=O.
(13)
i=1
1.7. Standard models

We need to be able to consider objects such as topological spaces or probability
measures in addition to real numbers. This is accomplished by considering a
superstructure. We take a base set X consisting of the union of the point sets of
all objects we wish to consider. For example, if we wish to consider real-valued
functions on a particular topological space (T, 3-), we take X = R U T. The
superstructure is the class of all objects which can be obtained from the base
set by iterating the operation of forming subsets; we will refer to it as the
standard model generated by X.
Definition 1.7.1. Suppose X is a set in all of whose m e m b e r s are atomic, i.e.
0 ~ X and no x E X contains any elements. Let

Y'o = X;
2155
(14)
&
ux0
(n=0,1,2 .... )
(15)
where ~ is the p o w e r set operator, which associates to any set S the collection
of all the subsets of S. Let
~=0~,;
(16)
tl=O
is called the superstructure determined by X . For any set B E ~, let o ~ ( B )

denote the set of all finite subsets of B.
The superstructure determined by X contains representations of subsets of
X, functions defined on X , Cartesian products of subsets of X, and indeed
essentially all the classical mathematical constructions that can be defined using
X as the initial point set. 2 The exact form of the representation can b e c o m e
quite complicated; fortunately, we need never work in detail with the superstructure representations, but only need to know they exist. The following
examples illustrate how various mathematical constructions are represented in
the superstructure.
Example 1.7.2.
An ordered pair (x, y ) ~ X 2 is defined in set theory as {{x},

{x, y}}. x, y ~ ~o, so {x} E ~l and {X, y} ~ ~ l , so {{x}, {x, y}} E ~2-
Example 1.7.3.
A function f : A ~ B, where A, B C X, can be represented by

its graph G = {(x, f(x)): x @ A ) . F r o m the previous example, we know that
each ordered pair (x, f(x)) in the graph G is an element of ~2, so G E ~3-
Example 1.7.4. The set of all functions f r o m A to B, with A, B C X, is thus

represented by an element of ~f4-
Example 1.7.5.
If N C X, an n-tuple ( x l , . . . , x,,) ~ X n can be represented as

a function from {1 . . . . . n} to X. Thus, if A C X, then A n is an element of ~4.
Example 1.7.6.
~fn is an element of ~l+1"
Example 1.7.7.
Let (T, 3-) be a topological space, so that T is the set of

points and ~- the collection of open sets. T a k e X = T. Then ~- E ~2.
2Indeed, formally speaking, the definition of each of these constructions is expressed in terms of
set theory; see for example Bourbaki (1970).
R.M. Anderson
2156
Example 1.7.8. Consider an exchange e c o n o m y with a set A of agents and

commodity space Rk+. Let X = A t 0 R . An element of R~+ is a k-tuple of
elements of X, and hence is an element of ~3. A pair (x, y) with x, y ~ Rk+ can
be viewed as an element of R 2k, and so is also an element of ~f3. A preference
relation is a subset of R k+ x Rk+, so it is an element of ~f4- A preferencee n d o w m e n t pair (>'a, e(a)) with e(a)E Rk+ is an element of ~f6. The exchange
economy is a function from A to the set of preference-endowment pairs, so it is
an element of ~fg.
Remark 1.7.9. If Z E ~f, then Z E ~ , for some n; thus, there is an upper
bound of the number of nested set brackets, uniform over all elements x E Z.
In particular, the set {x, {x}, {{x}}, {{{x}}} . . . . } is not an element of the
superstructure ~f. Moreover, ~f is not an element of ~.
1.8. Superstructure embeddings

Given a standard model ~f, we want to construct a non-standard extension, i.e.
a superstructure ~ and a function * : ~--> ~ satisfying certain properties.
Definition 1.8.1. Consider a function * from a standard model ~f to a
superstructure 9. A @ ~ is said to be internal if A @ *B for some B E ~f, and
external otherwise. The function * : X---~ ~ is called a superstructure embedding 3 if
(1) * is an injection;
(2) ~ ) C 2/o; moreover x E ~) ~ *x = x.
(3) *Xo = %;
(4)
(5)
(6)
(7)
(8)
*X, C eg,,;
*(~,,+,\~,,) C ~ , + , \ e g , (n = O, 1, 2 , . . . ) ;
x I . . . . ,x,, ~ ~ L ~ * ( x ) , . . . ,Xn} = {*x 1. . . . ,*Xn} ;
A,B@~{AEBC~*AE*B};
A, B E X ~
(a) *(A N B) = *A VI *B;
(b) *(A O B) = * A O ' B ;
(c) * ( A \ B ) = *A\*B;
(d) *(A B) = *A x *B;
(9) If F is the graph of a function from A to B, with A, B @ X, then *F is

the graph of a function from *A to *B;
(10) A E * 2 ~ , B E A ~ B E * 2 ~ ,
1;
(11) A internal, A C B, B @ * ( ~ ( C ) ) ~ A E * ( ~ ( C ) ) .
3Some of the properties listed can be derived from others.
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A E 0~ is said to be hyperfinite if A E *(Of~(B)) for some set B E ~ (recall

Of~(B) is the set of all finite subsets of B). Let * ~ denote { y E ~ : y is
internal}. A function whose domain and range belong to ~ is said to be
internal if its graph is internal.
Example 1.8.2. Suppose X = R. Take Y = *R, defined via the ultraproduct
construction. Let eg be the superstructure constructed with Y as the base set.
Then * as defined by the ultraproduct construction is a superstructure embedding. Note that ~1 contains both internal and external sets; thus, the embedding is not onto.
1.9. A formal language

I shall not today attempt further to define the kinds of material I understand
to be embraced within that shorthand description; and perhaps I could never
succeed in intelligibly doing so. But I know it when I see it. Justice Potter
Stewart, concurring in Jacobellis v. Ohio, 378 U.S. 184 at 197.
In order to give a precise definition of a non-standard extension, one must
define a formal language ~ [see H u r d and Loeb (1985) or Anderson (1990) for
details]. While we cannot give a precise statement here, the reader should not
be deterred. In practice, one quickly learns to recognize which formulas belong
to 5f. The formal language 5f is rich enough to allow us to express any formula
of conventional mathematics concerning the standard model ~, with one
caveat: all quantifiers must be bounded, i.e. they are of the form Vx E B or
3 x C B where B refers to an object at a specific level ~ , in the superstructure
~. Thus, the quantifier V f E Of(R, R), where Of(R, R) denotes the set of
functions from R to R, is allowed; the quantifiers Vx C ~ and Vx are not
allowed.
1.10. Transfer principle

Leibniz asserted, roughly speaking, that the non-standard real numbers obey
all the same properties as the ordinary real numbers. The Transfer Principle
gives a precise statement of Leibniz' assertion. The key fact which was not
understood until Robinson's work is that the Transfer Principle cannot be
applied to external sets. Thus, the distinction between internal and external
sets is crucial in non-standard analysis. Given a sentence F E 5 which describes
the standard superstructure ~, we can form a sentence * F by making the
following substitutions:
R.M. Anderson
2158
(1) F o r any set A E Y, substitute *A.

(2) For any function f : A--~ B with A , B ~ g~, substitute *f.
(3) For any quantifier over sets such as VA ~ ~ ( B ) or 3 A E ~ ( B ) , where
B E ~f, substitute the quantifier VA E * ( ~ ( B ) ) or 3 A E * ( ~ ( B ) ) which ranges
o v e r all internal subsets of *B.
(4) F o r any quantifier over functions such as V f E Of(A, B) or 3 f C
Of(A, B), where Of(A, B) denotes the set of functions from A to B for
A, B E ~f, substitute the quantifier V f ~ *(Of(A, B)) or 3 f E *(Of(A, B)) which
ranges o v e r all internal functions from *A to *B.
We emphasize that quantifiers in *F range only over internal entities. The
Transfer Principle asserts that F is a true statement about the real numbers if
and only if *F is a true statement about the non-standard real numbers.
Example 1.10.1.
VS E ~ ( N )
Consider the following sentence F:
[S=Ov3nESVmESm>~n].
(17)
F asserts that every n o n - e m p t y subset of the natural numbers has a first

element. * F is the sentence
VSE*(5~(N))
[S=0
/x 3 n E S V m @ S m > ~ n ] .
(18)
*F asserts that every n o n - e m p t y internal subset of *N has a first element.

External subsets of *N need not have a first element. Indeed, *N\N has no first
element; if it did have a first element n, then n - 1 4 would of necessity be an
e l e m e n t of N, but then n would be an element of N.
1.11. Saturation
Saturation was introduced to non-standard analysis by L u x e m b u r g (1969).
Definition 1.11.1. A superstructure e m b e d d i n g * from ~ to 0gt is saturated 5 if,
for every collection {Aa: h ~ A} with Aa internal and IAI < I 1,
(') AA = ~ ~ 3 h l , . . . , ~n
AEA
~ AA i = ~"
(19)
i-I
4We can define a function f :N---~NU {0} by f(m) = m - 1. Then n - 1 is defined to be *f(n). It
is easy to see that, ifn=[x] f o r x ~ R N , n - l = [ ( x l - l , x 2 - 1 .... )].
SOur use of the term saturated, differs from the use in model theory and most treatments of
non-standard analysis.
2159
One can construct saturated superstructure embeddings using an elaboration

of the ultraproduct construction described above. T o make the saturation
property plausible, we present the following proposition.
Proposition 1.11.2.
Suppose *R is constructed via the ultraproduct construction

o f Section 1.4. f f {An: n E N ) is a collection o f internal subsets o f *R, and
["]~cN A , =~t, then (']"no I A n = ~ f o r some n o E N .
Proof. Since A n is internal, there is a sequence Onm (m E N ) such that

A , = M([B,,]). If A 1 n - - n A , ~ for all n E N, we can find [x,,] E *R with
Ix,] E A~ n - - . n A , for each n. Note that x n E R TM,so let Xnm denote the mth
c o m p o n e n t of x , . Then {m: X,m E Blm n . . . n Bnm } E ~l. We may assume
without loss of generality that Xnm E B l m A " " " 0 B n m for all n and m. Define
[z] E *R by Zm = Xmm. T h e n {m: Zm E B,m ) D {n, n + 1 , . . . } E 0//. Thus, [z] E
A n for all n, so r"]nc N A n ~ .
Theorem 1.11.3. Suppose * : ~--> ~/ is a saturated superstructure embedding.
f f B is internal and x l , x 2 . . . . is a sequence with x , E B f o r each n E N, there is
an internal sequence y,, with y , E B f o r all n @ *N such that Yn = X, f o r n E N.
Proof.
Fix b E
we see
internal
Let A , = {internal sequences y: Yi = xl (1 ~ i ~< n), Yi E B(i E *N)).

B. If we consider y defined by yi = x~ (1~< i~< n) and yi = b for i > n,
that A,, ~ 0 . By saturation, we may find y E O , c N A , . Then y is an
sequence, y,, E B for all n E *N and y,, = x, for all n E N.
1.12. Internal definition principle
One consequence of the Transfer Principle, the Internal Definition Principle, is

used sufficiently often that it is useful to present it separately. The informal
statement of the Internal Definition Principle is as follows: any object in the
non-standard model which is describable using a formula which does not
contain any external expressions is internal. For a formal statement, see Hurd
and Loeb (1985) or Anderson (1990).
Example 1.12.1. The following examples will help to clarify the use of the
Internal Definition Principle.
(1) If n E ' N , {m E ' N : m > n} is internal.
(2) If f is an internal function and B is internal, then f ~(B) is internal.
(3) If A, B are internal sets with A C B, then {C @ ~ ( B ) : C D A}, the class
of all internal subsets of B which contain A, is internal.
R.M. Anderson
2160
(4) {X E *R: x = 0} is not internal; the presence of the external expression

x = 0 renders the Internal Definition Principle inapplicable.
1.13. Non-standard extensions: enough already with the ultraproducts

Definition 1.13.1. A non-standard extension of a standard model ~ is a
saturated superstructure embedding * : ~----~ 0~ satisfying the Transfer Principle
and the Internal Definition Principle.
As we noted above, the real numbers R are defined as the completion of the
rational numbers Q. Two c o n s t r u c t i o n s - - D e d e k i n d cuts and Cauchy seq u e n c e s - a r e c o m m o n l y used. In practice, mathematical arguments concerning
R n e v e r refer to the details of the construction. Rather, the construction is
used once to establish the existence of a set R satisfying certain axioms. All
further arguments are given in terms of the axioms.
In the same way, the ultraproduct construction is used to demonstrate the
existence of non-standard extensions. Non-standard proofs are then stated
wholly in terms of those properties, without reference to the details of the
ultraproduct construction.
1.14. Hyperfinite sets

Definition 1.14.1. Suppose that A E ~o and * : ~---~ 0~ is a non-standard extension. Let o%~(A) denote the set of finite subsets of A. A set B G *A is said to
be hyperfinite if B E *(o%~(A)).
Example 1.14.2. Suppose m is an infinite natural number. Consider B = {k E
N: k ~< m}. The sentence
VmEN
{k~N:k~<m)~of~(N)
(20)
is true in the standard model ~. By the Transfer Principle, the sentence

VmE*N
{kE*N:k~<m}E*(~(N))
(21)
is true, so B is hyperfinite.
R e m a r k 1.14.3. The Transfer Principle implies that hyperfinite sets possess all
the formal properties of finite sets.
2161
Theorem 1.14.4. Suppose * : ~--> ~I is a non-standard extension. I f B E ~ and

n ~ *N\N, then there exists a hyperfinite set D with [D[ < n such that x E
B~*xED.
Proof, Since n E * N \ N , n > m for each m E N . Let A = B , A ~ = { D

* ~ ( B ) : *A E D, [D[ < n}. A~ is internal by the Internal Definition Principle
and Ih[ = [B[ < [~[. Given h i , . . . , A m with m GN, {*h I . . . . , *Am) E nim=l a~i,
so the intersection is not empty. Accordingly, na~ A Ax ~ 0 by saturation; if D
is any element of n a ~ A AA, then D E * ~ ( B ) , so D is hyperfinite, [Di < n
and D D {*x: X@ D}.
Proposition 1.14.5. Suppose that * : ~--> ~l is a non-standard extension. Suppose that B is hyperfinite and A C B, A internal. Then A is hyperfinite.
Proof.
See Hurd and Loeb (1985) or Anderson (1990).
1.15. Non-standard theorems have standard proofs
Although non-standard proofs never make use of the details of the ultraproduct construction, the construction shows that the existence of non-standard
models with the assumed properties follows from the usual axioms of mathematics. Any non-standard proof can be rephrased as a proof from the usual
axioms by re-interpreting each line in the proof as a statement about ultraproducts. Consequently, any theorem about the standard world which has a
non-standard proof is guaranteed to have a standard proof, although the proof
could be exceedingly complex and unintuitive. The important point is that, if
we present a non-standard proof of a standard statement, we know that the
statement follows from the usual axioms of mathematics.
2. Euclidean, metric and topological spaces

In this section, we explore the non-standard formulation of the basic results in
Euclidean, Metric and Topological Spaces. The results are due for the most
part to Robinson (1966) and Luxemburg (1969). The results stated here are of
considerable use in applications of non-standard analysis to economics. In
addition, the proofs given here illustrate how the properties of non-standard
extensions are used in writing proofs. We form a superstructure by taking ~0 to
be the union of the point sets of all the spaces under consideration, and
suppose that * : ~f--> ~ is a non-standard extension.
2162
R.M. Anderson
2. I. Monads
Definition 2.1.1. Suppose (X, g-) is a topological space. If x ~ X, the monad
of x, denoted ix(x), is N z ~ r e ~ - * T . If y E * X and y E ix(x), we write y = x
(read " y is infinitely close to x").
Definition 2.1.2. Suppose (X, d) is a metric space. If x E *X, the monad of x,
denoted ix(x), is {y C *X: *d(x, y) = 0 } . If x, y E *X and y E ix(x), we write
y = x (read " y is infinitely close to x " ) .
Proposition 2.1.3. Suppose (X, d) is a metric space, and x @ X. Then the
monad of x (viewing X as a metric space) equals the monad of x (viewing X as a
topological space).
Proof. Suppose y is in the metric monad of x. Then *d(x, y ) - 0 .

x E T E J-. Then there exists 6 ~ R++ such that the formula
d(z,x)<6
zET
Suppose
(22)
holds in 9?,. By Transfer,
*d(z,x)<6
zE*T
(23)
holds in *~f. Since this holds for each T satisfying x E T E J-, y is in the
topological monad of x.
Conversely, suppose y is in the topological monad of x. Choose 6 E R++ and
let T = { z E X : d ( z , x ) < 6 } , x E T E ~-, so y ~ * T . Therefore, *d(x, y) < 6 for
each 6 G R + + , so *d(x, y) = 0 . Thus, y is in the metric monad of x.
Remark 2.1.4. The topological monad of x can be defined for an arbitrary
x ~ *X, not just for x @ X. However, it is not very well behaved.
Proposition 2.1.5 (Overspill). Suppose (X, 3-) is a topological space, x E X
and A is an internal subset of *X.
(1) If x E A C Ix(x), there exists S E * ~- with A C S C ix(x).
(2) If A D ix(x), then A D * T for some T satisfying x E T @ J-.
(3) If (X, ~-) is a T I space and ix(x) is internal, then ix(x) = {x} E .
Proof. Let ~-' = { T E g-: x ~ if}.

(1) Suppose A C Ix(x). By T h e o r e m 1.14.4, there exists a hyperfinite set
5 e C * S ' such that T E g - ' implies * T E 5 ~. Let O ' = { T E S e : T D A } ; 5' is
internal by the Internal Definition Principle, and hyperfinite by Proposition
1.14.5. Let S = f"l rE~' T. Then A C S C Ix(x). Since g-is closed under finite
2163
intersections, * J-is closed under hyperfinite intersections, by Transfer. Therefore S E * ~-.

(2) Suppose A D tz(x). Given T E g-', let A r = * T \ A . A r is internal by the
Internal Definition Principle. n r e ~ ' A r = ( n r e ~ ' * T ) \ A = tx(x)\A = ~. By
Saturation, there exist T ~ , . . . , T n ( n E N ) such that n T=~ A r i = ~ , so A D
AT= l * T 1 = * ( h i = 1 Ti). Since x ~ n i = a T i E ~-, the proof of (2) is complete.
(3) S u p p o s e / x ( x ) is internal and (X, g-) is a T 1 space. By (2), there exists
T E * ~- such that /z(x) C * T C/x(x), so/x(x) = * T. If y C X, y ~ x, then there
exists S E ~- with x ~ S and y ~ S . By Transfer, y ~ * S , so y ~ l z ( x ) = *T. By
Transfer, y JE' T. Since y is an arbitrary element of X different from x, T = {x}.
Then /z(x) = * T = {x} by Transfer.
t/
Proposition 2.1.6. (Overspill). Suppose A is an internal subset of *N.

(1) l f A D * N \ N , then A D { n, n + 1 , . . . } for some n E N.
(2) If A D N , then A D { 1 , 2 , . . . n }
for some n E * N \ N .
Proof. We could prove this as a corollary of Proposition 2.1.5 by considering
X = N n {~} with the one-point compactification metric. However, we shall
present a direct proof. Every non-empty subset of N has a first element; by
transfer, every non-empty internal subset of *N has a first element.
(1) Let B = { n ~ * N :
VmE*N [m~>n~mEA]}.
B is internal by the
Internal Definition Principle. Let n be the first element of B. Since A D *N\N,
BD*N\N, sonEN.
(2) Let B = {n E *N: V m E *N [m ~< n ~ m E A]). B and *N\B are internal
by the Internal Definition Principle. If *N\B = ~J, we are done. Otherwise, let n
be the first element of *N\B. Since A D N, B D N, so n E *N\N.
Suppose (X, J-) is a topological space. Then X & Hausdorff

if and only if for every x, y E X with x ~ y, tz(x) N tz( y) = ~.
Proposition 2.1.7.
Proof. Suppose X is Hausdorff. If x, y E X and x y, we may find S, T with

xESEJ-, y~TE3-and
SNT=O. *SN*T=*(SNT)=O,
by Transfer.
n
c *s n * T = ~J.
Conversely, suppose /x(x) n tz(y) = ~. By Proposition 2.1.5, we may find S,
T E * 3 - with x E S C l x ( x ) and y E T C / x ( y ) , and thus S N T = 0 . Thus, the
sentence
3SG*3-3TE*J-
[xES/x yET/xSNT=~]
(24)
holds in *~. By Transfer, the sentence
3S~3TEJ-
[xESA
holds in ~f, so X is Hausdorff.
yET/xSNT=~]
(25)
2164
R.M. Anderson
Definition 2.1.8. If (X, 3-) is a Hausdorff space, y E *X and y E ~(x), we

write x = Oy (read " x is the standard part of y " ) .
Proposition 2.1.9.
Suppose {x,: n E *N) is an internal sequence o f elements o f

*R. Then the standard sequence {x,: n E N} converges to x E R if and only if
there exists no E *NkN such that x , = x f o r every n <, no, n E *NXN.
Proof. Suppose x, converges to x. Fix 6 E R + + . T h e r e exists n~ E N such

that n~>n 8, n E N implies [ x , - x [ < 6 / 2 ;
thus, [ x , - x [ < &
Thus, given
6 E R + + and k E N , let A~k = i n E * N : n>>-k and [ X m - - X [ < 6 for each m E
{ k , . . . , n } } . For any finite collection i(61, k l ) , . . . ,(6., k,)} with k iI> nni,
t'-)inlA~iki~.
Let A = i ( 3 , k) E R + + N :
k>/nn}.
By Saturation,
f'q(n.k)~a An\ # ~ " Choose n o E I'](~.k)c a A~k. Then n o E *N\N; given n E *NkN
with n ~< no, Ix, - x[ = 0.
Conversely, suppose there exists n o E *N\N such that n E *N, n ~< n o implies
x , = x . Given ~ E R + + , let A = { n E ' N : [x, - x[ < 6/2} U i n E ' N : n > no}. A
is internal and contains *N\N. By Proposition 2.1.6, A D {n, n + 1 . . . . } for
some n E N. Thus, [xm - x[ < 6 for m @ N satisfying m >I n. Therefore x,
converges to x.
Proposition 2.1.10. Suppose {x,: n E N} is a sequence o f elements o f R. Then

x , --->x E R if and only if x , = x for every n E *N\N.
ProoL Suppose x,---~x. Given e E R + + ,
there exists n 0 E N such that the
sentence
VnEN
[n> n0 lx.-xl<d
(26)
holds in ~. By Transfer, the sentence

Vn@*N
[n >l n o ~
Ix, - x[ < e]
(27)
holds in *~. If n E *N\N, then [xn - x[ < e; since e is an arbitrary element of
R++,
x n ~x.
Conversely, suppose x , = x for all n E *N\N. For n E N, x, = x , , so x~ ~ x

by Proposition 2.1.9.
2.2. Open and closed sets
Proposition 2.2.1. Suppose (X, 3-) is a topological space. Then A e X is open

if and only if ~ ( x ) C * A f o r every x E A .
2165
Proof. If A is open and x E A, then Ix(x) C *A by Definition 2.1.1. Conversely, suppose Ix(x)C *A for every x E A. By Proposition 2.1.5, we may find
S ~ "3- with x E S C Ix(x). Thus, the sentence
qSE*3-
xESC*A
(28)
holds in *~f, so the sentence

3SE3-
x E S C A
(29)
holds in ~ by Transfer. Thus, A is open.
Proposition 2.2.2.
Suppose (X, 3-) is a topological space. Then A C X is

closed if and only if y ~ * A implies x E A for every x @ X such that y @ Ix(x).
Proof. Let B = X~A.
Suppose A is closed. If y E *A and y E Ix(x) with x E X~A, then x E B.
Since A is closed, B is open. Since y E Ix(x), y E *B by Proposition 2.2.1.
*B fq *A = *(B fq A) = ~, by Transfer. Thus, y ~ * A , a contradiction.
Conversely, suppose y E *A implies x E A for every x E X such that y E
Ix(x). Suppose x E B. Then we must have y E * X \ * A = *B for every y ~ Ix(x).
Accordingly, B is open by Proposition 2.2.1, so A is closed.
Proposition 2.2.3.
Suppose (X, 3-) is a topological space, and A C * X &

internal. Then {x E X : 3 y E A [y E Ix(x)]} is closed.
Proof. Let C = {x E X: 3 y E A [y ~ Ix(x)]}; we shall show that B = X~C is

open. Let D = *X~A; D is internal by the Internal Definition Principle. If
x E B, then D D Ix(x), so D D * T for some T satisfying x E T @ 3-, by Proposition 2.1.5. If y E T, then Ix(y) C *T, so D D Ix(y), so y C B. Thus, B is open,
so C is closed.
2.3. Compactness
Definition 2.3.1. Suppose (X, 3-) is a topological space and y E *X. We say y
is nearstandard if there exists x @ X such that y - x. We let ns(*X) denote the
set of nearstandard points in *X.
Theorem 2.3.2.
Suppose (X, 3-) is a topological space. Then (X, 3-) is

compact if and only if every y E *X is nearstandard.
2166
R.M. Anderson
Proof. Suppose (X, ~ ) is compact, and there is some y E *X which is not

nearstandard. Then for every x E X, there exists T x with x E T x E ~- and
y ~ * T x. {Tx: x @ X } is thus an open cover of X; let {T~, . . . . . Tx,,} be a finite
subcover (so n E N). Since * is a superstructure embedding, U 'i'=1 *T~ =
( U i"-1 T~i) = *X, so y ~ * X , a contradiction.
Conversely, suppose that every y E * X is nearstandard. Let {TA: A E A} be
an o p e n cover of X. L e t C A = X'xT A. If there is no finite subcover, then for
every collection { A 1 , . . . , A,} with n E N ,
f~in=l CA~O.. f~in_l *CAi =
(NT+l CA) 0. IAI <I ,I, so by saturation, C = f')AeA*CA 0 . Choose any
yEC.
Given x E X , there exists A such that x E T A. Since y ~ C C * C A ,
y ~ * T A , so y / x . Since x is an arbitrary element of X, y is not nearstandard, a
contradiction. Thus, {TA: ,~ ~ A} has a finite subcover, so X is compact.
x ~ *R is said to be finite if there is some n E N such that
Definition 2.3.3.
x~n.
Proposition 2.3.4.
Suppose y E *R, and y is finite. Then y is nearstandard.
Proof. L e t A = { z ~ R : z < y } , x = s u p A .
Given6ER++,wecanfindz~A
withz>x-6.
But z < y , s o x - 6 < y .
On the other hand, x + 6 > y
by the
definitions of A and x. T h e r e f o r e x - 6 < y < x + & Since 6 is an arbitrary
element of R++, y ~ x, so y is nearstandard.
Theorem 2.3.5. (Bolzano-Weierstrass).

of R k (k E N), then C is compact.
Proof.
If C is a closed and bounded subset
Suppose y ~ *C. Since C is bounded, there exists n E N such that

n .
(30)
Vz *Clzl<-n
(31)
vz E Clzl
By Transfer
and so each c o m p o n e n t Yi of y is finite. By Proposition 2.3.4, yi is nearstandard, with yi = x i for some xi E R. Let x = (x I . . . . . x~). Then y = x. Since
C is closed, x E C. Thus, C is compact by T h e o r e m 2.3.2.
Suppose > is a binary relation on a compact topological space

(X, J-) satisfying
irreflexivity (for all x ~ X, x2Zx);
transitivity (for all x, y, z E X, x > y, y > z ~ x > z);
continuity ({(x, y) E X2: x > y} is open).
T h e o r e m 2.3.6.
2167
Then X contains a maximal element with respect to >, i.e. there is some x E X
such that there is no z E X with z > x.
Proof. By Theorem 1.14.4, there exists a hyperfinite set A such that T E

3- ~ 3x E A Ix ~ * T]. Since > is irreflexive and transitive, any finite set B C X
contains a maximal element with respect to >. By Transfer, any hyperfinite set
contains a maximal element with respect to *>. Let y be such a maximal
element of A. Since X is compact, there exists x ~ X such that y = x by
Theorem 2.3.2.
Suppose z E X and z > x . Then there exists S, T with x ~ T E 3 and
z E S E 3- such that v > w for each v E S and w E T. By transfer, v * > w for
each v E * S and each w E * T . But there exists v @*S FI A , and so v * > y, a
contradiction. Thus, x is maximal in X with respect to >.
Proposition 2.3.7.
Suppose (X, 3-) is a regular topological space, and A C * X

is internal. Suppose further that every y E A is nearstandard. Then {x E X :
3y @ a [y E/x(x)]) is compact.
Proof. Let C = {x E X: 3 y E A [y E tz(x)]}. Suppose {CA: h E A} is a collection of relatively closed subsets of C, with F~AEA C A = 0, but f')~'=l CAIII for
every finite collection {hi . . . . . h,}; C is closed by Proposition 2.2.3, so C A is
closed in X. Given x @ C with x J~"C A, we may find sets SAx, TAx E 3- such that
CACSAx, x E T A x and SAxNTA =ft. Let a ' = { ( h , x ) :
x ~ C A } . Given any
finite collection {(hi, x i ) , . . . ,.(An, x,)} C A ' , A i " 1SAixi is an open set; because it contains f"lT=1 C A 0, it is not empty. Choose c G ("17=1 Ca. Then
c E C, so there exists a ~ A with a C/z(c). N~'=l*S Aixi = * f~i=
n I S~i~ D /.~(C) by
Proposition 2.2.1. Therefore,
By saturation, A n
([")(A.x)~A' * S ~ ) e f t ; choose y E O ((')(A.~)~A' *SA,~)" Since y E A, y is nearstandard, so y E ~(x) for some x E X. By the definition of C, x ~ C. Since
A ~ A CA = 0, there exists h E A with x ~ h . Since *TAx D/x(x), *S~ A * T ~ =
*(S~ M T ~ ) = 0, we get y ~ t z ( x ) , a contradiction. Therefore, C is compact.
A["]([~in_l*SAixi)~.
2.4. Products
Proposition 2.4.1. Let (XA, 3-a) be a family o f topological spaces, and let
(X, 3-) be the product topological space. Then
*X = {y: y is an internal function f r o m *A
a n d V h E * A YA E * X A } .
Given x E X ,
to
['-JA~*A *XA
(32)
R.M. Anderson
2168
/,(x) = { y E * X : V A E A Ya---x,}.
Proof.
(33)
The formal definition of the product is
X = { f E ~ ( A , U a e A X,): VA E A f ( a ) E Xa}
(34)
where Y(A, B) denotes the set of all functions from A to B. By the Transfer
Principle,
*X = { f E *(o~(A, U a e a Xa)): Va E *A f ( a ) E *Xa}
= {y: *A-+ UAe*A *XA-"y is internal, VAE *A Ya E *Xa}.
(35)
(36)
Suppose y E / ~ ( x ) with x @ X. Fix A E A. Given T ~ ~-A with x, E T, let

z a E T } . S E J - and x E S , so y E * S . therefore, y a E * T , so
S=(z~X:
Ya = xx.
Conversely, suppose y E *X and y , --- x~ for all A C A. If x E T E if, then

there exist A1. . . . . A,,@A with n E N and T x E ~ such that if S = { z E
X:z,@TA,(l~<i~<n)},thenxESCT.
But*S={z@*X:za@*T~,(l~<i~<
n }) by Transfer, so y E *S C * T. T h e r e f o r e y = x.
T h e o r e m 2.4.2. (Tychonoff). Let (Xa, J-~) ( a E A) be a family of topological
spaces, and (X, J-) the product topological space. If (Xa, ~-~) is compact for
each h E A, then (X, ~-) is compact.
Proof. Suppose y E * X . For each A E A , there exists x A@X, such that

Ya = x,. By the Axiom of Choice, this defines an element x C X such that
ya = x a for each h E A. Therefore, y - x by Proposition 2.4.1. Thus, every
y E *X is nearstandard, so X is compact by T h e o r e m 2.3.2.
2.5. Continuity
Proposition 2.5.1. Suppose (X, ow) and (Y, J-) are topological spaces and
f :X---> Y. Then f is continuous if and only if *f(Ix(x))Ctz(f(x)) for every
xEX.
Proof. Suppose f is continuous. If y = f(x) and y E T @ 3-, then S = f - ~ ( T ) E
5e. Hence, the sentence Vz E S f(z) E T holds in ~. By Transfer, the sentence
Vz E *S *f(z) E * T holds in *:T. If z E / x ( x ) , then z E *S, so *f(z) E * T. Since
this holds for every T satisfying f(x) E T E ~-, *f(z) E ix(f(x)). Thus,
f ( ~ ( x ) ) C tx(f(x)).
2169
Conversely, suppose *f(/z(x)) C/x(f(x)) for every x ~ X. Choose T such that

f(x) ~ T ~ 9". By Proposition 2.1.5, we may find S E *fie such that x E S C
p,(x). Accordingly, the sentence
3SE*fie
[x~S
^ *f(S) C * T ]
(37)
holds in *~; by Transfer, the sentence

3SEfie
[xES ^ f(S) CT]
(38)
holds in ~, so f is continuous.
Corollary 2.5.2. If f : R---->R, then f is continuous if and only if y = x E R

implies *f(y) ~- f(x).
Definition 2.5.3. Let (X, fie) and (Y, 9-) be topological spaces with (Y, J-)
Hausdorff, and suppose f : *X---> * Y is internal, f is said to be S-continuous if
f(x) is nearstandard and f(/x(x)) C/x(f(x)) for every x E X.
Definition 2.5.4. A topological space (X, J-) is regular if it is Hausdorff and,
given x E X and C C X with x ~ C and C closed, there exist S, T E J- with
xES, CCTandSNT=O.
Proposition 2.5.5. Suppose (X, fie) and (Y, ~ ) are topological spaces with
(Y, i f ) regular, and f : *X--> * Y is S-continuous. Define of : X---> Y by
(f)(x) = (f(x)) for each x E X. Then of is a continuous function.
Proof. Because f(x) is nearstandard for each x E X, there exists y E Y such
that f ( x ) ~ / x ( y ) ; since (Y, 0-) is Hausdorff, this y is unique by Proposition
2.1.7. Thus, the formula for of defines a function.
Suppose x E X, y = f(x). If y E V E J-, then X~V is closed. Since (Y, J-) is
regular, we may find S, T ~ 3- with y E S, A~V C T, and S n T = 0. Since f is
S-continuous, f - l ( * s ) D / x ( x ) , f - l ( * s ) is internal by the Internal Definition
Principle, so it contains *W for some W satisfying x E W E fie, by Proposition
2.1,5. If w E W, then w E *W, so f ( w ) E *S. If f ( w ) ~ V , then f(w) E X ~ V C
T. Since T E 3-, f ( w ) E * T by Proposition 2.2.1. But *S n * T = *(S n T) = 0,
so f ( w ) ~ * S , a contradiction which shows f ( w ) E V for w E W. Thus, of is
continuous.
Remark 2.5.6. In the proof of Proposition 2.5.5, one is tempted to consider
the function g = .(of) and apply Proposition 2.5.1. However, since of is
constructed using the non-standard extension, using the properties o f f propels
R.M. Anderson
2170
us into a second non-standard extension * ( * ~ ) , creating more problems than

we solve. Hence, the argument must proceed without invoking the nonstandard characterization of continuity presented in Proposition 2.5.1.
Definition 2.5.7. Suppose (X, 3 ) is a topological space and (Y, d) is a metric
space. A function f : X - - > Y is bounded if SUPx.y~xd(f(x), f ( y ) ) < w .
(C(X, Y), d) denotes the metric space of bounded continuous functions from
X to Y, where d ( f , g) = supx~x d(f(x), g(x)).
Theorem 2.5.8 (non-standard Ascoli's theorem). Suppose (X, 3-) & a compact topological space and ( Y , d ) is a metric space. If f is an S-continuous
function from *X to * Y, then *d(f, of)= O, i.e. f is nearstandard as an element
of *(C(X, Y), d) and of is its standard part.
Proof. By Proposition 2.5.5, of is a continuous function from (X, ~-) to
(Y, d). Let g = of. Given z E *X, z E/x(x) for some x E X. Transferring the
triangle inequality,
*d(*g(z), f(z)) <~*d(*g(z), g(x)) + *d(g(x), f(x)) + *d(f(x), f(z)) .
(39)
The first term is infinitesimal by Propositions 2.5.1 and 2.5.5; the second by the
definition of g = of; and the third becaus_e f is S-continuous. Therefore * d(g(z),
f(z)) = 0 for every z E *X. Therefore, *d(f, g) < for every E R + + , and thus
d ( L g) = o.
Corollary 2.5.9 (Ascoli). Suppose A C C([0, 1], R) is closed, bounded and

equicontinuous. Then A is compact.
Proof.
tence
Given @R++, there exists ~ E R + ~ and M ~ R such that the sen-
VfEAVx, yE[O, 1] [[If(x)l < M]
(40)
A [lY -- xl < 6 ~ Iflx) --f(Y)l < ll

holds in ~. By Transfer, the sentence
Vf@*AVx, y*[O, 1] [[If(x)l<M]

/x [lY - xl < a ~
I*f(x)
(41)
*f(Y)l < 11
holds in *~f. Suppose f E * A . f(x) is finite for all x ~ * [ 0 , 1]. Moreover, if

y ~ / z ( x ) , then If(y) -f(x)l < E; since is arbitrary, [f(y) -f(x)l = 0 . There-
2171
fore, *f is S-continuous, so f E / z ( f ) . Since A is closed, of E A by Proposition

2.2.2. Thus, every element f E * A is nearstandard, so A is compact by
T h e o r e m 2.3.2.
2.6. Differentiation
Definition 2.6.1. Suppose x, y ~ *R. We write y = o(x) if there is some 6 = 0
such that [y[ ~< 6 [x[ and y = O(x) if there is some m E N such that [y[ ~< Mix[.
Proposition 2.6.2. Suppose f : R m --> R" and x E R m. Then f is differentiable at
x if and only if there exists a linear function J:Rm--> R" such that * f ( y ) =
f ( x ) + * J( y - x) + o( y - x) for all y = x.
Proof. Let L be the set of all linear maps from R m t o R n. Suppose f is
differentiable at x. T h e n there exists J E L such that for each e E R++, there
exists 6 E R++ such that the sentence
VyER m [[y-x[<6~lf(y)-f(x)-J(y-x)[<~e]y-x[]
(42)
holds in ~ ; by Transfer, the sentence

Vy ~ *R"
[ly-x[<6~[f(y)-f(x)-*J(y-x)l<~ely-x[]
(43)
holds in *W. Therefore, if y - ~ x , then ] f ( y ) - f ( x ) * J ( y - x)[ ~< e l y - x[.

Since e is an arbitrary element of R++, I f ( y ) - f ( x ) * J ( y - x)[ = o ( [ y - x[)
for all y--~ x.
Conversely, suppose that there exists J E L such that y = x implies [f ( y ) f(x) - *J(y - x)[ = o([y - x[). Fix e E R + + . Then the sentence
36E*R++[[y-xl<6~lf(y)-f(x)-*J(y-x)l<~ely-x[]
(44)
holds in *~. By Transfer, the sentence

36 E R + + [ l y -
x I< 6 ~[f(y)-f(x)-
J ( y - x)l <~ e l y - x[]
(45)
holds in W. Since e is an arbitrary element of R++, f is differentiable at x.
2. 7. Riemann integration
Theorem 2.7.1.
n E *N\N,
Suppose [a, b] C R and f : [a, b]--~R is continuous. Given
R . M . Anderson
2172
fb f(t)dt=O(1 ~ * f ( a + k(bn-a) )) .
(46)
k=l
Proof. Let In=(1/n)E~=if(a+[k(b-a)/n])

for n E N . By Transfer,
I n =(1/n)E~= l * f ( a + [ k ( b - a ) / n ] )
for n E * N . Since f is continuous,
in ~ .fb f(t) dt. By Proposition 2.1.10, *In = S~=, f(t) dt for all n E *NkN.
2.8. Ordinary differential equations

Non-standard analysis permits the construction of solutions of ordinary differential equations by means of a hyperfinite polygonal approximation; the
standard part of the polygonal approximation is a solution of the differential
equation.
2.8.1. Suppose F : R k [0, 1]-->R ~ is continuous, there exists
m E N such that IF(x, t)] ~< M for all (x, t) @ R k x [0, 1], and Y0 E R k. Choose
n @ *N\N. By the Transfer Principle, we can define inductively
Construction
=Y0,
k+l)
1 .F(z(k),
k)
(47,
and then extend z to a function with domain *[0, 1] by linear interpolation
z(t) = ([nt] + l - nt)z ( [~-~ ) + (nt - [nt])z ( [ n t ] + 1)

where
Let
(48)
[nt] denotes the greatest (non-standard) integer less than or equal to nt.
y(t) = (z(t)) for z E [0, 1].

Theorem 2.8.2. With the notation in Construction 2.8.1,
y is a solution of the ordinary differential equation
(49)
z
is S-continuous and
y(O) = Yo,
y'(t) =
F(y(t), t).
(50)
Proof. Given r, sE*[0,1] with r=s, Iz(r)-z(s)l~Mlr-s[=O, s o z is

S-continuous. By Theorem 2.5.8, y is continuous and there exists 6 = 0 such
that [z(t) - *y(t)l ~< 6 for all t E *[0, 1]. Then
y(t) - Yo = z(t) - z(O) = ~,
2173
z \----~/-
k=0
I.'l- 1
= E -I*F
k=0 n
~- f[ F(y(s), s) ds
N-'
Z -*F
k=o n
,y
(51)
by Theorem 2.7.1. Since y(t) - Yo and J'0 F(y(s), s) ds are both standard, they
are equal. By the Fundamental Theorem of Calculus, y'(t) = F(y(t), t) for all
t E [0, 1], so y is a solution of the ordinary differential equation (50).
3. L o e b m e a s u r e
The Loeb measure, originally developed by Peter Loeb (1975) to solve a

problem in potential theory, is a construction which allows one to convert
non-standard summations on hyperfinite spaces to measures in the usual
standard sense. It has been used very widely in probability theory, and is an
important tool in non-standard mathematical economics.
3.1. Existence of Loeb measure

An internal probability space is a triple (A, d , v) where
(1) A is an internal set,
(2) M C ( * ~ ) ( A ) is an internal o--algebra, i.e.
(a) A E ~ ;
(b) B E ~ implies A \ B ~ M; and
(c) If { B , , : n E * N } is an internal sequence with B . ~ M ,
then
n . e . N B. ~ ~ and U . e . N B. E M; and
(3) t,: M---> *[0, l] is an internal *-countably additive probability measure,
i.e.
(a) ~(A) = 1 and
(b) if {Bn: n E *N} is an internal sequence and B,, n B,, = i~ whenever
n # m, then /2(nn~. N Bn) ---- ~n@*N v(Bn)"
Definition 3.1.1.
Remark 3.1.2. The Loeb measure construction works equally well if we

merely assume that ~ is closed under finite unions and v is finitely additive. We
shall be primarily interested in hyperfinite spaces, in which integration is just
summation.
R.M. Anderson
2174
An internal probability space is hyperfinite if A is a hyperfinite set, zd -- ( * ~ ) ( A ) (i.e. ~d is the class of all internal subsets of A), and
there is an internal set of probability weights {Aa: a E A} such that v(B) =
EaE z A a for all B E a.
Definition 3.1.3.
Example 3.1.4. The canonical example of a hyperfinite probability space is

(A,~Cu), where A = { 1 . . . . . n} for some n E * N \ N , ~ / = ( * ~ ) ( A ) and
u(B) = tBI/n for all n EN.
Construction 3.1.5 (Loeb measure).
Suppose (A, ~1, v) is an internal prob-
ability space. Define

~ / = {B C A:VE ER++ 3 C E a EIDEag
[C C B C D, v ( D \ C ) < e]}
(52)
and
~(B) =inf{v(D): B C D @ ~ } = sup{u(C): C C B, C E ~/}
(53)
for B E ~ , v is called the Loeb measure generated by v.

Theorem 3.1.6 (Loeb). Suppose (A, ag, v) is an internal probability space.
Then
(1) ~/is a a-algebra, fg D a;
(2) 17is a countably additive probability measure;
(3) ~ is complete with respect to ~;
(4) g(B) = u(B) for every B E a; and
(5) for each B E ag, there exists A E a such that
~ ( ( A \ B ) U ( B \ A ) ) = O.
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Proof. If B@~/, then for each n E N , we may find C , , D , , E M with C l C

C2 C - - - C B C - - - C D 2 C D 1 and u ( D n \ C n ) < l \ n . By Theorem 1.11.3, we
can extend C, and Dn to internal sequences in ~/. { n ~ * N :
[ C m C C m + I C D m + 1 C D m A v ( D m \ C , , ) < I / m ] (l~<m~<n)} is internal and
contains N, so it contains some n E *N\N by Proposition 2.1.6. C n E ~/. If
mEN,
g((Cn\B) U ( B \ C , ) ) < ~ g ( ( C n \ C m ) U ( D m \ C , ) ) < ~ g ( D m \ C m ) < l / m .
Since m is an arbitrary element of R++, g((Cn\B ) U ( B \ C , ) ) = O.
Suppose B , B ' E a g . Fix e E N , and find C C B C D ,
C'CB'CD'
with B,
B', D, D' E a and u ( D \ C ) < e/2, u ( D ' \ C ' ) < e/2. C~D' C B \ B ' C D \ C ' and
((D\C')\(C\D')) C ((D\C) O (D'\C')),
so
v ( ( D \ C ' ) \ ( C \ D ' ) ) < E/2 + e~
2 = e. Thus, B \ B ' E ,ft.
2175
Now suppose B 1, O2,... E ~ and let B = U . c N B n. By considering B~ =

B , ,1v[il\="- 1 Bi, we may assume without loss of generality that the Bi are disjoint.
Given @ R + + , we may find C, C B , C D , with B,, D , E ~ / satisfying
v ( D , \ C , ) < E/2 "+1. Extend C, and D , to internal sequences with C,, D n E ~1
by T h e o r e m 1.11.3. If we let otn = (v(U~'_ 1 Ci) ), then a n is a non-decreasing
sequence in [0, 1], so it converges to some a @R. By Proposition 2.1.9, we
may find some n 0 E * N \ N such that v(U~'= 1 C i ) = a for n C * N \ N , n<-n o.
M o r e o v e r , {n: v(UT=l D , ) ~< v(U~'=l C,) + e/2} is an internal set which contains N, so by Proposition 2.1.6, it contains all n ~< n~ for some n~ C *N\N.
Taking n = min{n 0, nl}, we see there exists n @ *N\N such that v(Ui"_ 1 C,) =
o~ and v(UT=l D.)<-v(UT=~C.)+/2. Moreover, we can find m E N such
that a m > a - e / 2 .
Let c = U i m ~ c ~ and D = U i ~ _ I D ~ . Then C, D ~ / ,
CCBCD
and ( v ( D \ C ) ) < E , so v ( D \ C ) < e . T h e r e f o r e , B @ ~ / . a /2 < (v(C)) <~ E(B) <~(v(D)) <~ol + e/2.
< E/2"+1, so
IEncy ff(B,) - ozI < e/2. Since is arbitrary, if(B) = oz = EnC N ff(B,), so ~ is
countably additive.
Suppose B C B' with B ~ ~ and E(B) = 0. Then given E ~ R + + , there exists
D E ~ such that B ' C D and v ( D ) < E. Then 0 C B C D, so B @ ~ , so ~ / i s
complete with respect to ~.
-
3.2. Construction of Lebesgue measure

In this section, we present a construction of Lebesgue measure in terms of the
Loeb measure on a natural hyperfinite probability space.
Construction 3.2.1 (Anderson). Fix n ~ *N\N, and let A = {k/n: k ~ * N ,
l<~k<~n}. Let s = ( * ~ ) ( A ) , the set of all internal subsets of A, and
u(B) = [B[/n for B E ~ . Let (A, ~ , if) be the Loeb probability space generated by ( A , ~l, v). Let st denote the restriction of the standard part map to A,
i.e. s t ( a ) = a for a E A , and let st -1 denote the inverse image of st, i.e.
s t - l ( B ) = {a E A: a E B} for B C [0, 1]. Let ~ = {B C [0, 1]: s t - l ( B ) E ~/}
and ~ ( B ) = ff(st-l(B)) for all B E ~ .
Theorem 3.2.2 (Anderson, Henson).

space on [0, 1].
([0, 1], ~ , / ~ ) is the Lebesgue measure
Proof. Since ~/ is a o--algebra, so is c~; since ff is countably additive,

so is tz. Consider the closed interval [a, b ] C [ 0 , 1]. Then s t - l ( [ a , b ] ) =
nmcN*(a--(1/m), b+(1/m))nA.
by
the
Internal
Definition
Principle,
*(a-(1/m),
b+(_l/m))nAE,~l
so s t - l ( [ a , b ] ) E ~ L
I.~([a,b]) =
R.M. Anderson
2176
ff(st-~([a, b]) = limm_,= l*(a - 1/m, b + 1/m) 71Al/n = limm__,= b - a + ( 2 / m )

=b-a.
Let ~ be the class of Borel sets. Since ~ is the smallest o--algebra containing
the closed intervals, c D ~ . Since /z and Lebesgue measure are countably
additive, and agree on closed intervals, they agree on ~ . qg is complete with
respect t o / z because ~ is complete with respect to 12 Therefore, q contains all
Lebesgue measurable sites a n d / z agrees with Lebesgue measure.
Finally, we show that qg is contained in the Lebesgue or algebra. 6 Suppose
B E q . Given ~ @ R + + , there exist C, D E ~
with C C s t - I ( B ) C D
and
u(O)-u(C)<e.
Let C = { c : c ~ C } , b = [ 0 , 1 ] \ { a : a E A - D } .
Then
C C B C / 9 . (~ and [0, 1]\D are closed by Proposition 2.2.3, so D is open; thus,
(~, b E 93. /z(/9) - / z ( C ) = i(st-l(/~)) - i ( s t - l ( ( ? ) ) < ~(D) - if(C) (since
st-l((~) D C and st-l(/5) C D) = v(D) - v(C) < E. Since ~ is complete with
respect to tz, B E ~ , so c = ~ .
3.3. Representation of Radon measures

Definition 3.3.1. A Radon probability space is a probability space (X, ~ , / x )
where (X, J-) is a Hausdorff space, ~ is the o--algebra of Borel sets (i.e. the
smallest o--algebra containing 3-), and
/z(B) = sup{/z(C): C C B, C compact}
= inf{/z(T): B C T, T E 0-}
(55)
for every B E ~.
Example 3.3.2.
Let (X, d) be any complete separable metric space, ~ the

or-algebra of Borel sets. Then any probability measure/z on ~ is Radon [see
Billingsley (1968)].
Theorem 3.3.3 (Anderson). Let (X, ~ , / x ) be a Radon probability space,

the completion of ~ with respect to tz. Then there is a hyperfinite probability
space (A, ~1, u) and a function S : A ~ X such that B E ~ if and only if
S - I ( B ) E ft. For every B @ ~ , ~ ( B ) = ~(S-I(B)).
Proof. The proof is similar to the proof of Theorem 3.2.2; for details, see
Anderson (1982).
6The proof of this part given here is due to Edward Fisher.
2177
3.4. Lifting theorems

In this section, we state a number of "Lifting Theorems" relating integration
theory in Loeb probability spaces to the internal integration theory in internal
measure spaces. Note that, in the case of a hyperfinite measure space, the
internal integration theory reduces to finite summations. In particular, feasibility conditions in hyperfinite exchange economies can be formulated as conditions on summations, in exactly the same way as they are formulated in finite
exchange economies. However, the Loeb measure construction can be used to
convert a hyperfinite exchange economy to an economy with a measure space
of agents in the sense introduced by Aumann. The lifting theorems provide the
link between the two constructions. The proofs are not difficult, but are
omitted in the interests of saving space.
Definition 3.4.1. Suppose (A, ~ , v) is an internal probability space and
(X,~-) is a topological space. A function f:A---~*R is said to be a vmeasurable if it is internal and f - l ( T ) E ~ for every T E *3.
Theorem 3.4.2 (Loeb, Moore, Anderson). Suppose (A, ~l, v) is an internal
probability space.
(1) I f (X, 3-) is a regular topological space, f : A---~ * X is v-measurable, and
f(a) is nearstandard for r-almost all A E A, then of : A ~ X is r-measurable.
(2) I f ( X , 3-) is a Hausdorff topological space with a countable base of open
sets, and F : A--~ X is r-measurable, then there exists a v-measurable function
f : A ~ X such that f(a) = F(a) r-almost surely.
Proof.
See Anderson (1982).
Definition 3.4.3. Suppose (A, ~ , v) is an internal probability space and

f : A---~ *R is v-measurable. Suppose A E *~,. Let I be the function which
assigns to every pair ((B, ~ , / z ) , g), where (B, ~ , / Z ) is a standard probability
space and B E ~n and g is a/z-measurable real-valued function, the integral
I((B, ~ , / z ) , g) = fB g d/z. The internal integral of f, denoted f a f dr, is
defined by ~a f dv = (*I)((A, M, v), f).
Example 3.4.4. Let (A, d , v) be as in the construction of Lebesgue measure
(Construction 3.2.1). If f:A---~*R is any internal function, then f is vmeasurable by the Internal Definition Principle. Moreover,
fA f d v = 1 ~
n
aEA
f(a)
by the Transfer Principle.
(56)
R.M. Anderson
2178
Definition 3.4.5. Suppose (A, ~, v) is an internal probability space and

f : A ~ *R. We say f is S-integrable if
(1) f is a v-measurable function;
(2) fA Ill dv < oo;
(3) B E d , v ( B ) = O ~ f B l f l d v = O .
Theorem 3.4.6 (Loeb, Moore, Anderson). Suppose (A, d , v) is an internal
probability space.
(1) I f f : A--~ *R is v-measurable and f A If(a)] dv is finite, then f is integrable with respect to ~ and f A 171 d ~ IA Ift d v
(2) I f f : A--~ *R is S-integrable, then of is integrable with respect to ~ and
f A f d v = I A of dr.
(3) I f F : A-->R is integrable with respect to v, then there exists an Sintegrable function f : A---> *R such that of = F ~-almost surely. Moreover,
f A f dv = IA of du.
Proof. Items (2) and (3) are proved in Anderson (1976). To see item (1),
suppose m E N, and define fro(a) = min{lf(a)l, m}. fm is obviously S-integrable,
so by (2), fro is integrable and f z fm dv = f z fro dff. By the definition of the
standard integral, J'a [fl dff = limm_= fA Ln d f f = limm__, f a f m d r ; note that
this last sequence is increasing and bounded above by fA Ifl d v < ~. Therefore f i s integrable and IA 171 d ~ f a
Ifl dr.
Definition 3.4.7. Suppose A n is a sequence of finite sets. A sequence of
functions fn :An ~ Rk+ is said to be uniformly integrable if, for every sequence
of sets E n C Z,, satisfying [E,, ]/]A n [~ 0,
1 ~] f ~ ( a ) ~ 0
[A,[ ocE,
(57)
Proposition 3.4.8. Suppose {A,,: n ~ N } is a sequence of finite sets and

f~ : A , ~ Rk+. Then { f~ : n @ N} is uniformly integrable if and only if for all
n E *N, f, is S-integrable with respect to the normalized counting measure
vn(B) = I B I / I z , I for each internal B C Z,,.
Proof.
See Anderson (1982, Theorem 6.5).
3.5. Weak convergence
Definition 3.5.1. A sequence of probability measures /zn on a complete

separable metric space (X, d) is said to converge weakly to a probability
measure/z (written/x n ~ / z ) if
fx F dix. ~ f x F dix
2179
(58)
for every bounded continuous function F : X--* R. The standard theory of weak
convergence of probability measures is developed in Billingsley (1968). Because the theory is widely used in the large economies literature [Hildenbrand
(1974, 1982), Mas-Colell (1985)], it is useful to have the following nonstandard characterization in terms of the Loeb measure.
Theorem 3.5.2 (Anderson, Rashid). 7 Suppose v, ( n ~ N) is a sequence of

Borel probability measures on a complete separable metric space (X, d). Let
].lbn ( O ) -~. , u,(st
- 1 (B)) for each Borel set B C X define a Borel measure on X for
each n E *N. Then u, converges weakly if and only if
(1) *vn(ns(*X)) : 1 for all n @ *N\N; and
(2) IX, = Ixm for all n, m @ *N\N.
In this case, the weak limit is the common value tx,, for n E *N\N.
Proof.
See Anderson (1990) or Anderson and Rashid (1978).
4. Large economies
The subject of large economies was introduced in Section 1.2. We are
interested in studying properties of sequences of exchange economies
X,, : A , ~ P x Rk+, where A,, is a set of agents, Rk+ the commodity space, and P
the space of preference relations on Rk+. In this section, we examine price
decentralization issues for the core, bargaining set, the value and the set of
Pareto optima, as well as the question of existence of approximate Walrasian
equilibria. Rashid (1987) provides a more extensive survey of the applications
of non-standard analysis in the large economies literature.
We begin by studying the properties of hyperfinite exchange economies. The
Transfer Principle then gives a very simple derivation of analogous properties
of sequences of finite economies.
Much of the work on large economies using non-standard analysis concerns
the core. For this reason, we have chosen to devote considerable attention to
the core, in order to illustrate the use of the non-standard methodology, and to
contrast that methodology to measure-theoretic methods. In Section 4.5, we
focus on the following issues:
(1) The properties of the cores of hyperfinite exchange economies, in
T h e o r e m 4.5.2.
7The result holds for spaces much more general than the complete separable metric spaces
considered here. See Anderson and Rashid (1978) for details.
R.M. Anderson
2180
(2) The use of the Transfer Principle to give very simple derivations of
asymptotic results about the cores of large finite economies from results about
hyperfinite economies, in Theorem 4.5.10.
(3) The close relationship between hyperfinite economies and Aumann
continuum economies, which are linked using the Loeb measure construction,
in Proposition 4.5.6.
(4) The ability of the non-standard methodology to capture behavior of
large finite economies which is not captured in Aumann continuum economies,
in Remark 4.5.3 and Examples 4.5.5, 4.5.7, 4.5.8 and 4.5.9.
4.1. Preferences
Given x, y E Rk+, x i denotes the ith component of x; x > y means x i i> y' for all
i and x y ; x>>y m e a n s x i > y i for all i. If l<~p~<oo, IIXHp = (y,/k=, Ixilp)l/p;
IIxll
= max(Ixl':
i= 1 , . . . , k}.
Definition 4.1.1. A preference is a binary relation on R k . Let P denote the set

of preferences. A preference >
(1) is transitive if Vx y, z ERk+ [ x > y , y > Z ~ x > z];
(2) is continuous if {(x, y) ~ Rk+ Rk+ : x > y} is relatively open;
(3) is (a) monotonic if Vx, y ~ Rk+ [x >>y ~ x > y];
(b) strongly monotonic if Vx, y E Rk+ [x > y ~ x > y];
(4) is irreflexive if Vx @ Rk+ [x~'x];
(5) is (a) convex ifVxERg+, {y: y > x } is convex;
(b) strongly convex if Vx, y E Rk+ [x y ~ [(x + y ) / 2 > x v (x + y) /
2>y]];
(6) satisfies free disposal if Vx, y, z C R k [[x > y] A [y > Z] ~ X > Z].
Let Pc denote the space of continuous preferences.
Definition 4.1.2.
We define a metric on Pc as follows. Let d 1 be the one-point

compactification metric on R ~ U {~}. Given any compact metric space (X, d),
the Hausdorff metric d H is defined on the space of closed sets of X by
dn(B, C) =inf{6: [VxE B 3y E C d(x, y) < 6]

A [Vy E C 3 x E B d(x, y) < 6]}.
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Let d 2 be the Hausdorff metric (dl) H. Given > E Pc, define C> = {(x, y) @ R ~ :
x ~ y } U {~}. Then define
d ( > , > ' ) = d2(C >, C>,).
(60)

Proposition 4.1.3 (Brown, Robinson, Rashid).
2181
For any > E Pc,
/z(>) = {~' ~ *Pc: Vx, y ~ Rk+ [x > y :>/x(x) > ' / z ( y ) ] }
(61)
where Ix(x), Ix(y) are taken with respect to the Euclidean metric on Rk+. (Pc, d)
is compact.
Proof. (1) Recall that the one-point compactification metric induces the usual
Euclidean topology on Rk+, so that if x ER~+, the dl-monad of x, tZd,(X)
coincides with the Euclidean monad/z(x). Suppose > E P~. We will show that
equation (61) holds.
(a) Suppose > ' @ *Pc, ~ ' E / z ( > ) . Fix x, y E Rk+. We show x ~ y if and only
if/z(x) > '~(y).
(i) Suppose x > y . If there exist u E / x ( x ) , v ~ / z ( y ) with u J ' v ,
then
( u , v ) E * C > , , so there exist ( w , z ) E * C > with *dl((u,v), (w,z))<~
*d2(>-' , ) = 0 . *dl((W , z), (x, y)) ~< *d,((w, z), (u, v)) + *d,((u, v), (x, y)) =
O, so w E tz(x), z @ tz(y). Since (w, z) E *C>, w * ~ z . Since x > y and > E Pc,
~(x)* > / x ( y ) , so w > z, a contradiction which shows/x(x) > ' > ( y ) .
(ii) If x ~ y , then (x, y) E C>, so there exists (u, v) E * C > , such that
*dl((U, v), (x, y)) - 0 . Therefore u E/x(x) and v E / z ( y ) , so t~(x)~>(y).
(b) Conversely, suppose for every x, y E Rk+, x > y :> ~(x) > ' / z ( y ) . We will
show that every w C * C>, is infinitely close to some z E * C>, and vice versa.
(i) Suppose w E *C>,. We will show there exists z E *C> with *dl(w , z) = 0 .
We consider two cases:
-Suppose w E/Zdl(OO). In this case o: E *C>, and *dl(w , o~) ~--0.
. W = ( U ; V ) EI~dI(X,y) for some x, yERk+. In this case, u J ' v ,
so
tz(x)U" tz(y), so x ; / y , so (x, y) E C>.
,
t
Accordingly, for every w in C>, there exists z E *C> such that *d~(w, z ) = O.
(ii) Suppose w @ *C>. We will show there exists z ~ *C>, with *d~(w, z) =
0. Again there are two cases.
The case w E/Zdl(~ ) is handled as above.
~ Suppose w = (u, v ) E IXd~(X, y) for s o m e x, y ~Rk+. In this case, u * J v , so
Ix(x)*;/lz(y), so x J y (since > is continuous), so (x, y ) E C>.
Therefore,
{n ~ * N : [Vx E B 3y E Cd(x, y) < 1/n]
A [Vy E C 3 x 3 B d(x, y) < l/n]}
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contains N. The set is internal by the Internal Definition Principle. Hence,

it includes some infinite n by Proposition 2.1.6, so * d ( > , > ' ) =
*d2(*C>, *C>,) = 0 . Therefore, > ' E / z ( > ) .
We have thus verified equation (61).
R.M. Anderson
2182
(2) It remains to show that (Pc, d) is compact. Given > ' ~ *Pc, define > by
x > y :>/z(x) > ' / z ( y ) . If x > y, then/z(x) > ' / z ( y ) . Let B = {(u, v): u > ' v}. B
is internal and contains p.(x, y), so it contains *T for some open set T with
(x, y) E T. If (w, z) ~ T, then/x(w, z) C * T, so/x(w) > ' / x ( z ) , so w > z. Thus,
> ~ P~. By equation (61), >-' E / z ( > ) . By Theorem 2.3.2, (Pc, d) is compact.
4.2. Hyperfinite exchange economies

Definition 4.2.1. A hyperfinite exchange economy is an internal function
X" A--* *(P x R~+), where A is a hyperfinite set. We define the endowment e(a)
and preference > , of a by ( > , , e(a)) = x(a).
4.3. Loeb measure economies

Let (A, ~3,/z) be a standard probability space. An Aumann
continuum economy is a function X : A ~ Pc x Rk+ such that
(1) X is measurable;
(2) e(a) is integrable.
Definition 4.3.1.
Suppose X : A---~*(Pc x Rk+) is a hyperfinite exchange

economy. Let ~4 denote the set of all internal subsets of A, and u(B)= IBI/IAI
for B ~ M. Let (A, M, if) be the Loeb measure space generated by (A, s, u).
D e f i n e x : A ~ P c x R k + b y x ( a ) = ( o ~ a, o e(a)).
Construction 4.3.2.
Theorem 4.3.3 (Rashid). If X : A--~ *(Pc x Rk+) is a hyperfinite exchange
economy with n = ]AI infinite and (1/n)~ae z e(a) is finite, then X as defined in
Construction 4.3.2 is an Aumann continuum economy, fAe(a) d~<~
((1/n)ZacA e(a)), with equality ire is S-integrable.
Proof.
Since Pc is compact by Proposition 4.1.3, > , is nearstandard for all
aEA.
~,({a: Ile(a)l[ ~>M}) ~<(~-Ile(a)ll~

\
Mn
~<o
so 15({a: e(a) is fnite}) = 1. Thus, x(a) is defined for ~-almost all a E A; it is

measurable by Theorem 3.4.2. fA e(a)d~<~((1/n)Z,EA e(a)) (with equality
in case e is S-integrable) by Theorem 3.4.6.
2183
4.4. Budget, support and demand gaps
Definition 4.4.1. Let
R k + "
Definition 4.4.2.
A={pER*: ]]P]]z =1),
a+ :anIU+ and a++ = a n
Define D, Q zl x P x R k+--> ~(Rk+) by
D ( p , >, e) = {xER~+: p . x < ~ p ' e , y > x ~ p . y > p . e} ,
(63)
Q ( p , >, e) = (x ER~" p . x < ~ p . e ,
(64)
y > x~ p. y~p.e}
D and Q are called the demand set and the quasidemand set, respectively.
Definition 4.4.3. Define 6 , " rk+ x A x R~ --~ r + , ~bs. R~ x A x P--~ r + , and
~b-Rk+ x A x P x R ~ - - ~ R +
by
6B(x, p, e) = I p - ( x - e)l,
(65)
Os(X, p, > ) = sup{p" ( x - y): y > x } ,
(66)
dp(x, p, >, e) = c~B(x, p, e) + 6s(X, p, > ) .
(67)
~bB, ~bs and 4, are referred to as the budget gap, the support gap and the
demand gap, respectively.
Proposition 4.4.4. Suppose x, e E *Rk+ are finite, > ~ *Pc and p E *A.
(1) I f * ~bs(X, p, > ) - - 0 , then x ~ Q(p, >, x). If in addition 12 ~ A++ and
0 ~ 0 , then x ~ D(p, >, x).
(2) I f *~b(x, p, >, e ) = 0 , then x ~ Q ( p , > , e ) . If in addition p E A + ,
then x @ D(p, >, e).
Proof. (1) Suppose the hypothesis of (1) are satisfied. If y E R~ and yO> x,
then y>/.~(x) by Proposition 4.1.3, so y > x . Therefore, p . y = p . y > ~
p - x - ~bs(p, x, > ) --- p - x = p- x, so p. y >I Op. x, hence x E Q(p, >, x).
If p E A++, we show that x ~ D(p, >, x) by considering two cases:
(a) If p- x = 0, then x = 0 and D(p, >, x) = {0}. Since 0 ~ 0, 0 ff 0, so
ox ~. D(Op, o>, Ox)"
(b) If p.x > 0 , suppose y ERk+, y > x and p. y = p.x. Since o> is
continuous, we may find w ~ Rk+ with Op. ow < Op . y = Op. x with w o > o x. By
Proposition 4.1.3, w > x , so ks(X, p, > ) ~ 0 , a contradiction. Hence x ~
0 ( % >, x).
2184
R.M. Anderson
(2) If the hypotheses of (2) are satisfied, then (1) holds and in addition
Op. x = (p" x) = ( p . e) = p. e, so the conclusions of (2) follow from those
of (1).
4.5. Core
Definition 4.5.1. Suppose X : A--~ P Rk+ is a finite exchange economy or an
Aumann continuum economy. The Core, the set of Walrasian allocations, and
the set of quasi-Walrasian allocations, of X, denoted cO(X), 7T'(X) and ~(X),
respectively, are as defined in Hildenbrand (1982). In case X is a finite
exchange economy, Cg(X), ~ ( X ) , and ~(X) are defined by the following
sentences:
C~(X)={fEof(A,Rk+): ~ f(a) = ~ e(a)

aEA
aEA
VS @ ~ ( Z ) V g E ~(S, Rk+)[a~es g(a)= E e(a)

a~S
~[S=,v
3aES
g(a)~ af(a)]]},
(68)
7 U ( X ) = { f ~ ( A , R ~ + ) : E f ( a ) = ~ e(a)
aEA
aCA
A 3p E A Va E A f(a) E D(p, >a, e(a))}
(69)
and
S t ( X ) = { f e , ~ ( A , Rk+): ~ f(a) = ~ e(a)

aEA
aEA
A 3p E AVa E A f(a)~ Q(p, > , , e(a))}.
(70)
Given ~ ~ R + + , define
(X)=
f E f ( A ' R ~ + ) : ] ~1
E f ( a ) - e(a) <
aEA
A 3p E A Va C A f(a) E D(p, >a, e(a))}.
(71)
Because cg, ~ and W are defined by sentences, if X is a hyperfinite exchange

economy, we can form *~g(X), *?~/'(X) and *~(X); each is internal by the
2185
Internal Definition Principle. Define

W=o(X)=
1") */~(X).
(72)
6~R++
Theorem 4.5.2 (Brown,

Robinson, Khan, Rashid,
X : A---~ *(Pc x Rk+) be a hyperfinite exchange economy.
(1) I f
(a) n E aN\N;
(b) for each a E A, >.
(i) is *-monotonic;
(ii) satisfies *-free disposal;
(C) ((1/ n)~aEA e(a)) E Rk++;
(d) e(a)/n ~--0 for all a E A;
Anderson).
Let
then for every f E *qC(X), there exists p E * A+ such that f(a) E

Q(P, >a, e(a)) for if-almost all a E A. If Op E A++ and for each a, 0 ~ , O,
then f(a) E D(p, o > , e(a)) for if-almost all a @ A.
(2) I f the assumptions in (1) hold and in addition for each commodity i,
if({a E A: o > is strongly monotonic, e( a)i > 0}) > 0, then Op E A+ + and hence
f(a) E D(p, >a, e(a)) for if-almost all a.
(3) I f the assumptions in (1) and (2) hold and in addition e is S-integrable,
then f is S-integrable and (Op, of) ~ ~(X).
(4) I f the assumptions in (1) hold and in addition
(a) >, is strongly convex for if-almost all a E A;
(b) for each commodity i, if({a: e(a) i > 0}) > 0;
(c) >, is *-irreflexive, *-convex and *-strongly convex for all a E A;
then f(a) = * D ( p , >a, e(a)) for if-almost all a C A.
(5) I f the assumptions in (1) and (4) hold and, in addition, e is S-integrable,
then there exists g @ 74f=0(X) such that
1 ~ lf(a)_g(a)[~_O.
n aGA
(73)
Proof. (1) Suppose X satisfies the assumptions in part (1) of the Theorem. By
Anderson (1978) [see also Dierker (1975)] and the Transfer Principle, there
exists p @ *A+ such that
1 ~ *dp(f(a), p, e(a)) <- 6k max,c A Ile(a)ll~ = 0
n aEA
n
(74)
since max,e A [e(a)l/n =0. (l/n) ~aEAf(a) = (l/n) f"aEA e(a) is finite, so f(a)
and e(a) are finite for if-almost all a E .A. f(a) ~ Mt P,

,, e(a)) by Proposition 4.4.4. If Op ~ A++, then f(a) E D(p, o > , e(a)) by Proposition 4.4.4.
R.M. Anderson
2186
(2) Suppose in addition that for each commodity i, ff({a E A: >, is strongly
monotonic, e ( a ) ~ > 0 } ) > 0 . We will show that p E A + + by deriving a contradiction. If p j~'A+ +, we may assume without loss of generality that p~ = 0,
Op2> 0. By assumption (1)(c), ]e(a)l is finite for if-almost all a E A. Let
S = {a E A: >a is strongly monotonic,
e(a) ~ > O, f(a) E Q(Op, o > , Oe(a))} "
(75)
P(S) > 0 by the conclusion of (1) and the additional assumption in (2), so in
particular S 0 . Suppose a E S. Then Op. e(a) >i Op2. Oe(a)2 > 0. Let x =
f(a) + (1, 0, 0 , . . . ,0). Since >a is strongly monotonic, x > a f(a). p . x =
p ' f ( a ) <-p.e(a). There are two eases to consider.
(a) p . x a ' Oe(a)), a contradiction.
(b) p ' x = p . e ( a ) > 0. Since >a is continuous, there exists 6 E R++ such
that y E Rk+, lY - xl < 6 implies y > a f(a). We may find y E R~+ such that
lY - x[ < 6 and Op . y < o19 . x = 19 .e(a), so f(a) ~ Q(p, >a, e(a)), again a
contradiction.
Consequently, p E zl++, so f(a) E D(p, > , , e(a)) by the conclusion of (1).
(3) We show first that f is S-integrable. Suppose S C A is internal and
4 s ) --o.
1
,,~cs f(a) ~ ~
--
<~
1
p
i E
n min i p aCS
"
f(a)
i ~, p ' e ( a ) + *4~B(f(a), p, e(a))

n min i p aEs
1
, ~ p.e(a)=O
n min i p acs
(76)
since e is S-integrable. Thus, f is S-integrable. By Theorem 3.4.6,
Of d ~ = I
CA
l'l
~] f(a)
aEA
)o(1
=
E
aCA
e(a) =
ed~5
EA
(77)
'
and so (Op, of) ~ o#/(OX)"

(4) (a) Suppose >a is strongly convex. We show first that >a is strongly
monotonic. Suppose x, y E Rk+ and x > y. Let z = 2x - y. Then (z + y ) / 2 = x.
Since z C y , either X>a x or X > a y . If X>aX, then x > ~ x by Proposition
4.1.3, which contradicts irreflexivity. Therefore, we must have x >,, y, so > a
is strongly monotonic. Consequently, the assumptions in (4) imply the assumptions in (2), so p E A++ and f ( a ) E D(p, o > , Oe(a)) for ~-almost all a.
2187
(b) Suppose a E A .
Transferring Theorem 1 of Anderson (1981),
*D(p, >a, e(a)) contains exactly one element. Define g(a) = *D(p, >~, e(a)).
For J-almost all a ~ A, we have p . f(a) = p . e(a) -- i n f ( p x: x >a f(a)} and
e(a) is finite; consider any such a E A. We will show that f ( a ) = g(a). We
consider two cases:
(i) If e(a) = 0, then p . f(a) = 0 = p . g(a). Since p ~>O, f(a) ~- 0 = g(a), so
f(a) = g(a).
(ii) If e(a) yZO, then p . e(a) yZO. If f(a) yZ g(a), then either
f(a) + g(a) >'a of(a)

2
(78)
f(a) + g(a) o> g(a)

2
a
(79)
or
If equation (78) holds, then since o > is continuous and p e ( a ) ~ 0 , we can

find w ~Rk+ with p . w af(a). By
Proposition 4.1.3, w > , f(a), which contradicts inf{ p -x: x >a f(a)} = p - e(a).
If equation (79) holds, we may find w @Rk+ with p - w ,g(a). By Proposition 4.1.3, w >a g(a), which contradicts g(a) = * D ( p , >~, e(a)).
Accordingly, f(a) = g(a).
Therefore, we have f ( a ) = g(a) for ~7-almost all a E A.
(5) Suppose the assumptions in (1) and (4) hold and in addition e is
S-integrable. The assumptions in (4) have been shown to imply the assumptions in (2), so f is S-integrable by (3). As in (4), let g(a) = *D(p, >a, e(a)).
An easier version of the argument in (3) proves that g is S-integrable.
Therefore
1
tI
g(a)[=fA
~ If(a) -
a~- A
If(a)
--
g(a)l d15 =
(80)
by Theorem 3.4.6. Therefore

1
-
g(a)
t'1
e(a)
.
1
g(a)
.
f(a)
<~.
~
Fl
g(a)
f(a) = 0 ,
a~ A
(81)
so g E 74~=0(X).
Remark 4.5.3. Theorem 4.5.2 reveals some significant differences between
the hyperfinite and continuum formulations of large economies.
2188
R.M. Anderson
(1) One can introduce atoms into both the hyperfinite and continuum [as in
Shitovitz (1973, 1974)] formulations. However, as noted by Hildenbrand
(1982, p. 846), this leads to problems in interpreting the preferences in the
continuum formulation. In essence, the consumption set of a trader represented by an atom cannot be R~+; it must allow consumptions infinitely large
compared to those of other traders. In asymptotic analogues of the theorems,
key assumptions 8 are required to hold under rescalings of preferences; the
economic content is then unclear, except in the special case of homothetic
preferences. In the non-standard formulation, this problem does not arise.
Preferences over the non-standard orthant *Rk+ are rich enough to deal with
atoms, although we do not cover this case in Theorem 4.5.2.
(2) Now, let us compare how the non-standard and continuum formulations
treat the atomless case. In the continuum formulation, the endowment map is
required to be integrable with respect to the underlying population measure.
One could of course consider an endowment measure which is singular with
respect to the underlying population measure. In this case, however, the
representation of preferences becomes problematic. Specifically, if one considers a consumption measure/z which is singular with respect to the population
measure, then /z has no R a d o n - N i k o d y m derivative with respect to the
population measure, so one cannot identify the consumption of individual
agents as elements of Rk+. Moreover, an allocation m e a s u r e / z ' may allocate a
coalition consumption which is infinitely large compared to the consumption
allocated that coalition by another measure/z". As in the case with atoms, the
consumption space over which preferences need be defined must be larger than
Rk+. Asymptotic formulations require assumptions about rescaled preferences
which are hard to interpret except in the case of homothetic preferences. In the
non-standard framework, replacing the assumption that e is S-integrable with
the much weaker assumption that e(a)/IA]= 0 for all a E A poses no technical
problems. Part (1) of Theorem 4.5.2 analyses precisely what happens in that
case, while part (3) indicates how the result is strengthened if we assume that e
is S-integrable and >a is strongly monotonic for a set of agents of positive
if-measure. Example 4.5.4 provides an example of a hyperfinite economy
satisfying the hypotheses of part (1), but not those of part (3).
(3) Suppose that the endowment map e is S-integrable, which corresponds
to the integrability of endowment inherent in the definition of the continuum
economy. In a continuum economy, allocations (including core allocations) are
by definition required to be integrable. In the hyperfinite context, allocations
may fail to be S-integrable. If f E * q~(X) is not S-integrable, then
8For example, strong monotonicity,in conjunction wth compactness conditions inherent in the
measure-theoretic formulation of convergence for sequences of economies, becomes a uniform
monotonicity condition.
fA f d g < l
~.
f(a)
n a~A
ol ~ e(a) fa ed~'
n a~A
2189
(82)
so of does not correspond to an allocation of the associated Loeb measure

economy. In Example 4.5.5, we present an example due to Manelli of a
hyperfinite economy X with a (non-S-integrable) core allocation f such that
(1/n)~ae m *4~8(f(a), p, e(a))yLO. However, core equivalence holds in the
associated continuum economy X, in the sense that q E ~(X) implies g E
.~(X). Indeed, Proposition 4.5.6 shows that, in the absence of monotonicity
assumptions, any S-integrable core allocation f is close to an element of the
core of X. In other words, the integrability condition in the definition of the
continuum core is revealed by the hyperfinite formulation to be a strong
endogenous assumption.
(4) In Example 4.5.8, we present an example due to Manelli of an economy
X with endowment e and core allocation f, both of which are S-integrable, such
that ( l / n ) ~'aEA *qbB(f(a), P, e(a)) = 0 for some p E *A but there is no p E *A
such that (l/n)~aEA * ~ o ( f ( a ) , p , ~'a' e(a)) = 0 . Core equivalence holds in the
associated continuum economy X, in the sense that g E ~(X) implies g E
2~(X). Indeed, f ~ ~(X) , so f E ~(X). In the example, the commodity
bundles which show p is not an approximate supporting price for f are infinite;
they thus pose no barrier to the verification of the support condition in the
continuum economy.
(5) The condition
*4~(fla), p,
>,,, e ) = 0
(83)
in the hyperfinite formulation implies the condition
~b(Of(a),Op, o>a ' e) = 0
(84)
in the Loeb continuum economy which in turn implies
f(a)EQ(p,>a,e(a)).
(85)
In the presence of strong convexity, equation (83) implies that
f(a) =
*Q(p, >a, e(a)) ;
(86)
without strong convexity, equation (86) may fail, as shown by Example 4.5.9.
The formulas (83) and (86) are nearly internal; using the Transfer Principle,
we show in Theorem 4.5.10 that the form of convergence is stronger for
sequences of finite economies with strongly convex preferences than it is in the
2190
R.M. Anderson
absence of convexity. However, the strong convexity is not needed to deduce

formula (85) (which corresponds to the conclusion of Aumann's Equivalence
Theorem) from (84). Thus, in the continuum economy, convexity plays no role
in the theorem. Since formula (85) is far from internal, it is not amenable to
application of the Transfer Principle. Thus, the conclusion of Aumann's
Theorem does not reflect the behavior of sequences of finite economies, in the
sense that it does not capture the implications of convexity for the form of
convergence
Example 4.5.4 (Tenant farmers). In this example, we construct a hyperfinite
economy in which the endowments are not S-integrable. Core convergence of
the associated sequence of finite economies follows from Theorem 4.5.10;
however, the sequence does not satisfy the hypotheses of Hildenbrand (1974)
or Trockel (1976).
(1) We consider a hyperfinite economy X A - - ~ * ( P x R+),
k
where A =
{ 1 , . . . , n 2} for some n E *N\N. For all a E A, the preference of a is given by a
utility function u(x, y ) = 2 V ~ x l / 2 + y. The endowment is given by
Think of the first commodity as land, while the second commodity is food The
holdings of land are heavily concentrated among the agents 1 . . . . , n + 1, a
small fraction of the total population Land is useful as an input to the
production of food; however, the marginal product of land diminishes rapidly
as the size of the plot worked by a given individual increases.
(2) There is a unique Walrasian equilibrium, with p = (~, ) and allocation
Thus, the "tenant farmers" n + 1 . . . . . n 2 purchase the right to use land with
their endowment of food; they then feed themselves from the food they are
able to produce on their rented plot of land.
(3) By part (4) of Theorem 4.5.2, g E ( * ~ ) ( 1 ' ) ~ g(a)= (2, 0) for ~-almost
all a E A, so that almost all of the tenant farmers receive allocations infnitely
close to their Walrasian consumption A slight refinement of Theorem 4.5.2 in
Anderson (1981) shows that
2191
T-~ a=.+lZg(a)=(2,0)
(89)
(,2
and
o(1
T-~.=,
~ g(a) = ( 0 , 1 ) .
(90)
Thus, the per capita consumption allocated to the two classes (landowners and
tenant farmers) is infinitely close to the Walrasian consumptions of those
classes.
(4) If one forms the associated sequence of finite economies in the obvious
way, and considers g,, E ~(X,,), one concludes by transfer that
n 2
and
( 1 ~ gn(a))--~(0,1)
(92)
(5) If one forms the associated continuum economy X via the Loeb measure
construction, one gets
L e(a) d~ = (1, 1 ) / ( 2 , 1) = ~ 1 o~A

~ e(a).
(93)
In other words, the measure-theoretic economy X has less aggregate endowment than the hyperfinite economy X. In X, the unique Walrasian equilibrium
has price (V~/(1 + V~), 1/(1 + V~)) and consumption (1, 1) almost surely.
Thus, the continuum economy does not capture the behavior of the sequence
X, of finite economies. Trockel (1976) proposed a solution involving rescaling
the weight assigned to the agents in the sequence of finite economies.
However, the example violates Trockel's hypotheses, since the preferences do
not converge under Trockel's rescaling to a strongly monotone preference as
he requires. We conclude that the assumption that endowments are integrable
in the continuum model represents a serious restriction on the ability of the
continuum to capture the behavior of large finite economies.
2192
R.M. Anderson
Example 4.5.5 (Manelli, 1991) 9 (1) We consider a hyperfinite exchange

economy X : A---~ *(~c x Re+). A = { 1 , . . . , n + 2} with n E *N\N. The endowment map is e(1) = e(2) = 0, e(a) = (1, 1) (a = 3 , . . . , n + 2). Let V denote the
cone {0} U {x E RZ++: 0.5 < xl/x 2 < 2}. Consider the allocation
, f(a) = O,
f(1) = (n, 0), f(2) = 0,
(a = 3 , . . . , n ) .
(94)
The preferences have the property that
x >. f(a) => x - f(a) E *V.
(95)
It is not hard to see that there are internal complete, transitive preferences that
satisfy equation (95). Moreover, we can choose > so that >,, is locally
non-satiated for each a E A.
(2) It is not hard to verify that f E *C(X). However, f i s not approximable
by a core allocation of X. Indeed,
fA
( ~)
O f d f f = 0,
fA
#(1,1)=
edff,
(96)
so of is not even an allocation of X.

(3) Given p E *A+,
1
~ ~be(f(a ), p, e(a))
n + 2 aeA
11
nlpll + ~ Ip21 + n
n +2
/> 2(n + 2-----)7 0 .
(97)
(4) X is an Aumann continuum economy with locally non-satiated preferences. As Hildenbrand (1982, p. 85), notes a careful examination of the
original proof of Aumann's Equivalence Theorem shows that %(X) C ~(X).
In particular,
g ~ q~(X) ~ 3 p E A
Sa dP(g(a)' P'>"'e(a))d~=O"
(98)
Comparing equations (97) and (98), one sees that the decentralization properties of *~(X) are totally different from those of c(X). By the Transfer
9Examples 4.5.5, 4.5.8 and 4.5.9 were originally given in the context of a sequence of finite
exchange economies.
2193
Principle, one can construct a sequence of finite economies whose cores have
the decentralization properties exhibited by * ~(X) rather than those exhibited
by the A u m a n n continuum economy ~(X).
(5) In Proposition 4.5.6, we show that if h is S-integrable and h E *~(X),
then h E qg(X); hence
h E qC(X) ~
3p ~ A fA th(h(a), p, o> a, Oe(a)) dff = 0
(99)
by item (4). Consequently, the properties of the internal core are significantly
different from those of the set of S-integrable core allocations. By the Transfer
Principle, one can construct a sequence of finite economies whose core
allocations have the decentralization properties exhibited by *~(X)- Consequently, the restriction to integrable allocations inherent in the definition of the
core in the A u m a n n economy is thus a strong endogenous assumption which
prevents the A u m a n n economy from capturing the properties of certain
sequences of finite economies.
Proposition 4.5.6 (Brown, Robinson, Rashid). Suppose X : A--> *(Pc x R k)

is a hyperfinite exchange economy. If e and f are S-integrable and f E *q~(X),
then of @ ~(X).
Proof. fA of dff = ((l/n) ~"aEAf(a)) = ((1/n) ~a~A e(a)) = YA e dr7 by Theorem 3.4.6. Thus, of is an allocation of X
Suppose of ~/~(X). Then there exists S E ~/with if(S) > 0 and an integrable
function g: S--->Rk+ such that fs g d f f = fs e dff and g(a) > , f(a) for ~-almost
all a E S . By Theorem 3.1.6, there exists T ' E ~ / such that ff((S\T')U
(T'\S)) = 0 . Define g(a)= 0 for a E T'\S. By Theorem 3.4.6, there is an
S-integrable function G:T'--->*Rg+ such that G(a)---g(a) for if-almost all
a E T ' . Let J = { j E { 1 , . . . , k } :
fs ejdff=O}. We can choose G such that
G(a)J = 0 for all a E T', j E J . Let T = { a E T': G(a)>af(a)}. T E ~ 4 by the
Internal Definition Principle; moreover, u ( T ' \ T ) = 0 . Given m @ N, let T m =
{a @ T: y @ *R k, [y - G(a)[ < 1/m ~ y > , f(a)}. Then T m ~ ~ by the Internal Definition Principle and ~( U r n ~ N Tm) = ~(T) by Propositions 2.1.5 and
4.1.3, and the fact that g(a)>af(a) for if-almost all a E S . Since G is
S-integrable, there exists m E N such that
- ~ G(a) j>~
n ,~r,,
1
- E.~ T G(a) j
n
for j E {1 . . . . . k}\J. Let H(a) = G(a) if a E T\T,,. For a E Tin, define
(100)
R.M. Anderson
2194
E e(a) j
H(a)j _ ,,~r
if j E J
(101)
H(a) j = (1 - bET G(b)J - e(b)j

-G--(~7 / G(a) j i f j ~ E ' J .
(102)
Irml
and
aET\T,~. For a ~ T m, H(a) E*Rk+, and

Thus, H(Q) ~'a f(a) for all a E T. An easy
calculation shows that E,E T H(a)= ~aeT e(a), so f~*cC(X ), a contradiction
Then
H(a)=G(a)>af(a)
for
IH(a) - G(a)[ = O, so H(a) ~'a f(a).
which completes the proof.

Example 4.5.7. In this example, we show that the converse to Proposition
4.5.6 does not hold. Specifically, we construct an S-integrable allocation f such
that r E cg(X) but f~*c~(X). In a sense, this example is merely a failure of
lower hemicontinuity on the part of the core, a well-known phenomenon. Its
importance lies in showing that the topology on ~c is inappropriate for the
study of economies where large consumptions could matter. We consider a
hyperfinite exchange economy X" A---~ *(~c R2) A = { 1 , . . . , n + 1} with
n E *N\N. The endowment map is e(a) = (1, 1) for all a ~ A. Let p = (1 - (1 /
n), 1/n). The preferences have the property that
x>,(1,1) ~ [[x~>(1,1)]v[x~ (0, 2 ) ] l ;

x>,(1,1)
<=>
p.x>p.(1,1)
(103)
(a=2,...,n+l).
Consider the allocation f = e. f is Pareto dominated in X by the allocation

g(1)=
n ' ~
'
g(a)=
1-]-
/,/
2,~-n
(a+2 ..... n+l).

(104)
Note however that of (which equals f ) is a Walrasian allocation of X with price

vector (1, 0). One cannot block of by Og precisely because g is not S-integrable.
Accordingly, the restriction to integrable blocking allocations inherent in the
defnition of the core in the A u m a n n continuum economy is a significant
endogenous assumption.
Example 4.5.8 (Manelli, 1991). (1) We consider a hyperfinite exchange
economy X : A--~ *(~c R2) A = ( 1 , . . . ,2n} with n E *N\N. The endowment
2195
2
map is e ( a ) = ( 1 , 1) for all a E A . Let V denote the cone {0}U { x E R + + .

0.5 < x~/x 2 < 2}. Consider the allocation
f(a)=
O,
f(a)=(2'3)
(1 = 1 . . . .
,n),
(105)
(a = n + 1 . . . . . 2 n ) .
The preferences have the property that
x > a f ( a ) Or> x - f ( a ) E * V
f(1)
[Ix-f(1) e
(a=2,...,2n),
v Ix
(106)
0)]].
It is not hard to see that there are internal complete, transitive preferences that
satisfy equation (106). Moreover, we can choose >a SO that >a is locally
non-satiated for each a E A.
(2) It is not hard to verify that f E * ~ ( X ) . Moreover, e and f are Sintegrable, so f ~(X) by Proposition 4.5.6. As in item (4) of Example
4.5.5, there exists p @ A such that
fa 4,(f( a ) , p , o> ,,, e(a)) dff = 0
(107)
Indeed, it is easy to see that p - -+(~, - 2 ). Consequently,

1
IZ[
*qSB(f(a), p,e(a))~-- fA qbB(f( a ), P, e(a)) dff = 0
(108)
aEA
by T h e o r e m 3.4.6) 0 However, with p = - ( ,
E *6s(f(a), p, > a ) = - ~ .
(109)
]a[ ~cA
Comparing equations (109) and (107), one sees that the decentralization
properties of f are quite different from those of of. By the Transfer Principle,
one can construct a sequence of finite economies whose cores have the
decentralization properties exhibited by f rather than those exhibited by of.
Example 4.5.9 (Anderson, Mas-Colell). We consider a hyperfinite exchange
economy X : A---~ *(~,, R2+). A = { 1 , . . . , n} with n E *N\N. Fix a transtIt is also easy to verify equation (108) by direct reference to the hyperfinite economy X.
2196
R.M. Anderson
cendental number ~ E [0, 1]. The endowment map is e(a) = (1 + so")(1, 1) for
all a E A. Let 6 = min{IEae A ha(1 + ~")1: h internal, h, E { - 1 , 0, 1}, h, not all
0}. Since ~: is transcendental, 6 E ' R + + . One can construct a homothetic
preference > E * ~ c such that (, 3 ) > ( 1 , 1) and ( 3 )>(1, 1), but such that
f = e @ * c~(X); the idea is to make the region around (, 3) and (3,) which is
preferred to (1, 1) very small [see Anderson and Mas-Colell (1988) for details].
For any price q ~ *A, If(a) -- * D ( q , >a, e(a))l/> 1/v~ for all a E A. However, of ~ oW(ox)' in fact of E D((1, ), o > , Oe(a)) for all a E A. As a consequence, the Aumann continuum economy fails to distinguish between the
equivalence conditions in equations (83) (which says that the demand gap of
the core allocation is small) and (86) (which says that the core allocation is
close to the demand set). In particular, convexity plays no role in Aumann's
equivalence theorem, while it significantly alters the form of the equivalence
theorem for hyperfinite economies; by the Transfer Principle, convexity significantly alters the form of core convergence for sequences of large finite
economies.
T h e o r e m 4.5.10 (Brown, Robinson, Khan, Rashid, Anderson). Let

X, : A , ~ (Pc Rk+) be a sequence o f finite exchange economies.
(1) I f
(a) IZnl--~ m;
(b) for each n E N and a E A , , >a
(i) is monotonic;
(ii) satisfies free disposal;
(c) (i) lim(1/n) ~aEA e(a) < ~;
(ii) lim(1/n) ~'aEZ e(a) >>0;
(d) max,Ez, ' [e(a)l/lA,[--+O;
then for every sequence fn E C~(X,), there exists a sequence p , E A+ such that
1
IA.I
4a(f,,(a), p . , >., e(a))--->O
(lm)
aEA n
(2) I f the assumptions in (1) hold and in addition there is a compact set K o"
strongly monotonic preferences and 8 @ R+ + such that for each commodity i and
each n E N,
[{a E A . : >a E K, e(a)' > 6}1
IAI
>6,
(111)
then there is a compact set D Q a++ and n o @ N such that p. E D for all n >i n o.
(3) I f the assumptions in (1) and (2) hold and in addition the endowment
2197
sequence {e,,: n E N} is uniformly integrable, then the sequence {f,: n E N} is

uniformly integrable.
(4) I f the assumptions in (1) hold and in addition
(a) for all 3' @ R++, there is a compact set K of strongly convex preferences
such that for all n E N,
I{a~A,,:>.EK}I
IA,,I
> 1- y ;
(112)
(b) there is a 6 E R + + such that, for each commodity i,
l{a
A,,: e(a)'
a}l
1.4,,I
a ;
(113)
(c) >,, is irreflexive, convex and strongly convex for all n C N and all a E A . ;
then for each ~ E R + + ,
]{a E A,,:
],(a)
- D ( p , , >u, e(a))[ > E}[
Ial
--+0.
(114)
(5) I f the assumptions in (1) and (4) hold and, in addition, e is S-integrable,
then there exists a sequence ~,,--+0 and g,, E ~#~,,(X,) such that
IA.t o A,,
]f,,,(a) - g.(a)]-->0
(115)
Proof. (1) This follows immediately from Anderson (1978); see also Dierker
(1975). The proof given in Anderson (1978) was originally discovered by
translating non-standard proofs of part (1) of Theorem 4.5.2 and a weaker
version of part (1) of Theorem 4.5.10. Note that if n ~ *N\N, then Xn satisfies
the hypotheses of part (1) of Theorem 4.5.2.
(2) Suppose the additional assumption in (2) holds. By Transfer, for all
n E * N , v ( { a E A , , : > , , ~ * K , e(a) i>16})I>6. If > a E * K , then > , C K by
Theorem 2.3.2, so >a is strongly monotonic. Hence, for n E *N\N, X, satisfies
the assumptions of part (2) of Theorem 4.5.2. Hence, Op, E A++. Hence, for
n ~ *N\N, p, E zl++. Let M = {n E N: p,, 5E'A++}. If M is infinite, then there
exists n E * M A ( * N \ N ) , a contradiction. Hence M is finite; let no=
(max M) + 1. Let D = {p,,: n E *N, n >I no}. D is compact by Proposition
2.3.7, D C A++, and p,, E D for all n~>0, n E N .
(3) Suppose that the sequence e, is uniformly integrable. Then for n E
*N\N, e n is S-integrable by Proposition 3.4.8. By part (3) of Theorem 4.5.2, f,
is S-integrable for n ~ *N. Then the sequence {fn: n E N} is uniformly integrable by Proposition 3.4.8.
R.M. Anderson
2198
(4) Fix ~ ER++. It is easy to see that the assumptions in (4) imply that the
assumptions of part (4) of Theorem 4.5.2 hold for n E*N\N. Thus, for
n E *N - N,
v,({a ~ A,,: ]f~(a) - *D(p,, >,,, e(a))l > e}) = 0 .
(116)
By Proposition 2.1.9, for n E N,
v~( {a E A~: f,,(a) - D(p,,, >a, e(a)) > ~ } ) - * 0 .
(117)
(5) For n E N , choose p,, and g, E D ( p , , >,, e(a)) to minimize 1~]Ant ZaEa,'
[L(a)- g,(a)l. If n E *N\N, then X,, satisfies the hypotheses of part (5) of
Theorem 4.5.2, so (1/]a,,])E~a, ' I f , ( a ) - g , ( a ) l - 0 . By Proposition 2.1.10,
%- IA,,I
If,,,(a)-g,,(a)]~O
(118)
Then g. E ~,,(X.), which completes the proof.
4.6. Other work in large economies

There has been much other research on large economies using non-standard
analysis. Regrettably, space constraints limit us to listing the following references:
(1) Approximate Equilibria: Khan (1975), Khan and Rashid (1982), and
Anderson, Khan and Rashid (1982),
(2) Pareto Optima: Khan and Rashid (1975), Anderson (1988);
(3) Value: Brown and Loeb (1976);
(4) Bargaining Set: Geanakoplos (1978); and
(5) "Strong" Core Theorems: Anderson (1985), Hoover (1989).
5. Continuum of random variables
5.1. The problem

In modelling a variety of economic situations, it is desirable to have a
continuum of independent identically distributed random variables, and to be
able to assert that, with probability one, the distribution of outcomes of those
random variables equals the theoretical distribution; in other words, there is
individual uncertainty but no aggregate uncertainty. Some applications include
2199
Lucas and Prescott (1974), Diamond and Dybvig (1983), Bewley (1986) and
Faust (1988); see Feldman and Gilles (1985) for other references.
There is no difficulty in defining a continuum of independent, identically
distributed random variables. Suppose (O0, ~0, P0) is a probability space, and
X : O0---~R a random variable with distribution function F. Let (O, ~ , p ) =
H~10.11(O0, G0, P0), and define X,(to) = X ( w t ) . Then the family {X,: t E [0, 1]}
is a continuum of independent random variables with distribution F.
The problem arises in the attempt to formulate the statement that there is no
aggregate uncertainty. Let ([0, 1], ~ , / x ) denote the Lebesgue measure space.
Given to E g2, the empirical distribution function should be defined as Fo~(r) =
/x({t E [0, 1]: X,(to) ~< r}. Unfortunately, {t @ [0, 1]: X,(to) <~ r} need not be
measurable, so the empirical distribution function need not be defined.
Judd (1985) considered a slightly different construction of (O, ~,/.~) due to
Kolmogorov. In it, he shows that {to: F~, is defined} is a non-measurable set
with outer measure 1 and inner measure 0. Thus, one can find an extension/z'
of the Kolmogorov measure /z such that t7,o is defined for /x'-almost all to.
However, {to: F~ = F} is not measurable with respect t o / z ' ; in fact, it has ~ '
outer measure 1 a n d / x ' inner measure 0. Thus, one can find an extension/x" of
~ ' with the property that/x"({to: Fo~ = F}) = 1. However, the extensions o f / z '
and /z" are arbitrary, leaving the status of economic predictions from such
models unclear.
A variety of standard constructions have been proposed to alleviate the
problem [Feldman and Gilles (1985), Uhlig (1988) and Green (1989)]. Much
earlier, Keisler gave a broad generalization of the Law of Large Numbers for
hyperfinite collections of random variables on Loeb measure spaces [Theorem
4.11 of Keisler (1977)]. Since Loeb measure spaces are standard probability
spaces in the usual sense, this provides a solution of the continuum of random
variables problem. In Section 5.2, we provide a simplified version of Keisler's
result. In Section 5.3, we describe a non-tatonnement price adjustment model
due to Keisler (1979, 1986, 1990); in Keisler's model, individual uncertainty
over trading times in a hyperfinite exchange economy results in no aggregate
uncertainty.
5.2. A c o n t i n u u m o f r a n d o m variables on a L o e b space
Loeb probability spaces are standard probability spaces in the usual sense, but
they have many special properties. In the following construction, the internal
algebra is guaranteed to be rich enough to ensure that the measurability
problems outlined in Section 5.1 never arise. The construction also satisfies an
additional uniformity condition highlighted in Green (1989), since the conclu-
2200
R.M. Anderson
sion holds on every subinterval of the set of traders (conclusion (2b) of

Theorem 5.2.2).
Construction 5.2.1.
Let (A, M, u) be as in the construction of Lebesgue

measure (Construction 3.2.1). Suppose Y : A - + * R is v-measurable, and
lY(a)l<oo for if-almost all a ~ A . Define $ ' 2 = I l a e a A , ~ = ( * ~ ) ( O ) ,
p ( B ) = IBt/IOI for B E ~ , Y,(w) = ]((%) and X,(o~) = Y(%).
Theorem 5.2.2 (Keisler). Consider Construction 5.2.1. Let F be the distribution function for Y, i.e. F(r) = ff({a E A: Y(a) <~r}).
(1) X~ is ~-measurable, and has distribution function F, for all a E A;
(2) for fi-almost all oJ E g2, for all r ~ R, for all s, t E [0, 1] satisfying s < t
(a) {a E A O *[s, t]: X, <<-r} E ~ and
(b) ~({a E A n *Is, t]: X, ~ r}) = (t - s)F(r).
Proof. (1) S a is ~-measurable by Theorem 3.4.2. For all a E A, the distribution function of X, equals F, the distribution function of Y.
(2) If r E R ,
let C r = { a E A :
Y(a)<~r}. Since c r = n m = l { a E A :
Y(a) <~r + ( l / m ) } , v({a E A: Y(a) <~r + (I/m)})--* ff(Cr) as m---> oo. Therefore, there exists m E *N\N such that v({a ~ A: Y(a) <~r + ( l / m ) } ) = ff(Cr) ,
by Proposition 2.1.9; let D r = {a G A: Y(a) <~r + ( l / m ) } . Let W = {(r, s, t) E
R [0, 1] [0, 1]: s > t } . By Theorem 1.14.4, we may find an internal set
T C *W such that W C T and I TI < n 1'4 where n = Izl. Let T, = {r E *R: 3s, t
(r, s, t ) E T}. Given a finite set V C R, let G v denote the set of internal
functions g : T 1~ ~ such that r E R ~ g(r) = D r. G v is non-empty for all V by
the Internal Definition Principle; by saturation, n v e ~ ( m G v # O .
Choose
g E n w ~ ( m G v and define D r = g ( r ) for all r E T~. For (r,s, t) E T, let k be
the greatest element of *N less than or equal to n(t - s). Let A,, = A N *[s, t].
n v ( Y - ~ ( D r ) n A~,) has a *-binomial distribution B(k, v(Dr)), so it has mean
ku(Dr) and standard deviation ~ / [ k u ( D ~ ) ( 1 - u(Dr))] < ~
by Feller (1957)
and the Transfer Principle. Thus, u ( y - I ( D r ) n A,t ) has mean k u ( D r ) / n and
standard deviation less than V'-k/n ~< 1/x/~. Therefore,
p
( {w:[
v(Y
-, (D~) n A,,)
ku(Dr)
n
] })1
> n -~
<~--
(119)
by Chebycheff's Inequality [Feller (1957)]. Therefore
p({o,. 3(r, s, t)E r, u(Y-'(Dr) n As,)
kv(D~)
})
1/4 1
> n -~ -<n
n
~
=0.
(120)
2201
Therefore
/~({to: V(r, s, t) E W u(Y-I(Dr) 71Ast ) = (t - s ) F ( r ) } ) = 1 ,
(121)
/~({to: V(r, s, t) E W ff({a @ As,: Y ( a ) <<-r) ) >1 (t - s ) F ( r ) } ) = 1.
(122)
so
Similarly,
~({to: V(r, s, t) @ W ~({a E As,: Y ( a ) <~ r}) <~ (t - s ) F ( r ) } ) = 1,
(123)
/~({to: V(r, s, t) @ W ~({a @ As,: Y ( a ) <~ r}) = (t - s ) F ( r ) } ) = 1.
(124)
so
Remark 5.2.3. Suppose G is an arbitrary distribution function. There exists a

random variable Z defined on the Lebesgue measure space [0, 1] with distribution function F. Define Z ' : A - - ~ R
by Z ' ( a ) = Z ( a ) . Z ' has distribution
function G by Theorem 3.2.2. There exists a u-measurable function Y : A--~ *R
such that Y ( a ) = Z'(a) almost surely by Theorem 3.4.2; the distribution
function of Y is G. Thus, Construction 5.2.1 allows us to produce a continuum
of independent random variables with any desired distribution.
5.3. Keisler's p r i c e a d j u s t m e n t m o d e l
In the tatonnement story of the determination of equilibrium prices, it is

assumed that a fictitious Walrasian auctioneer announces a price vector,
determines the market excess demand at the price, and then adjusts the price
in a way which hopefully leads eventually to equilibrium. No trade is allowed
until the equilibrium price is reached. This story has two critical flaws:
(1) If no trade is allowed at the non-equilibrium prices called out by the
auctioneer, why should individual agents bother to communicate their excess
demands to the auctioneer? If they do not convey their excess demands, how
does the auctioneer determine what the social excess demand is? The more we
require the auctioneer to know, the less the tatonnement story fills the role of
providing foundations for a theory of decentralization by prices.
(2) Convergence to the equilibrium price requires a countable number "of
steps. Since there is presumably a technological lower bound on the length of
time needed for the auctioneer to elicit the excess demand information,
equilibrium cannot be reached in finite time. Thus, no trade occurs in finite
time.
R.M. Anderson
2202
Thus, it is highly desirable to replace the tatonnement story with a model

which allows trade out of equilibrium, and in which the information required to
adjust prices is kept to a minimum.
Keisler has developed such a model using a hyperfinite exchange economy in
which agents are chosen to trade randomly. In the remainder of this section,
we sketch Keisler's result, listing the principal assumptions and conclusions in a
special case. For a complete statement, see Keisler (1979, 1986, 1990). The set
of agents is A = { 1 , . . . ,n} and the time line is T = {j/n: jE *N, j ~ n 2) for
n E *N\N. There are k E N commodities. T h e r e is a central market. At each
time t E T, one agent is chosen at random to go to the market trade. Thus, the
underlying probability space is (S'2, 93, u), as described below.
(1) O = A v. Thus, an element co E J2 is an internal function from T to A. If
co(t) = a, then agent a is chosen to go to market at time t.
(2) 93 is the set of all internal subsets of 2.
(3) u(B)=IBJ/JA j for B E G .
D ( p , I, a) denotes the demand of agent a with income I and price vector p.
The prevailing price in the market is set initially at an arbitrary price p ( 1 / n ) .
The market has an initial inventory I ( 1 / n ) = (nE,..., nE). Each agent begins
with an endowment f(a, 0). The prevailing price at time t, denoted p(t), the
market inventory at time t, denoted I(t) and the commodity bundle of agent a
at time t, denoted f(a, t) are determined inductively by the formula
f
f ( a , t) =
a,t-
if c o ( t ) ~ a
[(D p(t),p(t)'f
(1)
a,t-n
p t+ n =P(t)+A f(co(t),t)-f
'a
ift>O&co(t)=a;
co(t),t-
1)1
(125)
I(t + 1)__ I(t) + If(co(t), t)- f (w(t), t - 1 ) ] .

In other words, in each time period, the agent who trades purchases his/her
demand given the prevailing price and his/her holding from previous trades,
the net trade of these agents is taken from the market inventory, and the price
is adjusted proportionately to the net trade of this agent.
The parameters A and n are chosen so that A = n c for some c E (0, 1), so
(An) = ~ ,
A log(An) -----0
(126)
(in particular A = 0). The inventory parameter e = 0, but e is not too small.
The demand functions of the agents are assumed to be parametrizable in a
2203
certain fashion. This parametrization assumption appears to be a form of

compactness condition on the demand functions. An economy with a finite (in
the standard sense) number of types of agents with C l demands satisfying a
global Lipschitz condition will satisfy the parametrization assumption. It is also
assumed that the initial endowment f(a, 0) is uniformly bounded by some
M ~ N and that p(0) is finite.
The evolution of the economy is a random process, depending on the
realization of the random variable w which determines which agents trade at
each time. We can associate a deterministic price adjustment process defined
by the differential equation
q(0) = p(0)
o(1
q'(t) =
(127)
n ~-' [D(p(t), p(t). f(a, 0), a ) - f ( a , 0)] .

a~A
We assume that the solution of equation (127) is exponentially stable, with

limit p, a Walrasian equilibrium price, for every initial value in a neighborhood
of p(0).
Keisler shows that for ~-almost all o E ~ , the following properties hold.
(1) p(t) = *q(Ant) for all t C T with t < ~. Note that since q(t)----> p as t---->
and An is infinite, p(t)-----p for finite t E T satisfying (Ant) = 0o. Thus,
(a) the path followed by the price is, up to an infinitesimal, deterministic;
and
(b) the price becomes infinitely close to the Walrasian equilibrium price p in
infinitesimal time and stays infinitely close to p for all finite times.
(2) I(t) >>0 for all t E T. Thus, an initial market inventory which is infinitesimal compared to the number of agents suffices to ensure that the trades desired
by the agents are feasible when the agents come to market.
(3) For almost all agents a, there exists t(a)E T with t(a)< ~ such that
f(a, t)~--D(p, p. f(a, 0), a) for all t > t(a). Thus, almost all agents trade at a
price infinitely close to the Walrasian price p, and they consume their demands
at p. An infinitesimal proportion of the trade takes place at prices outside the
monad of the Walrasian price p.
6. Translation of non-standard proofs
Because hyperfinite economies possess both the continuous properties of

measure-theoretic economies (via the Loeb measure construction) and the
discrete properties of large finite economies (via the Transfer Principle), they
provide a tool for converting measure-theoretic proofs into elementary ones.
The strategy for doing this involves taking a measure-based argument, and
2204
R.M. Anderson
interpreting it for Loeb measure economies; the interpretation typically involves the use of formulas with iterated applications of external constructs. One
can then proceed on a step-by-step basis to replace the external constructs with
internal ones; each time one does this, the conclusion of the theorem is
typically strengthened. In most cases, the process terminates with one or more
external constructs still present, and no tractable internal arguments to replace
them. However, it is occasionally possible to replace all the external constructs;
if one succeeds in doing this, the internal proof is (with * deleted) a valid
standard proof which is elementary in the sense that measure theory is not
used.
An extended discussion of translation techniques is given in Rashid (1987).
We will limit outselves to listing a few examples.
(1) The elementary proof of a core convergence result in Anderson (1978)
was obtained by applying the translation process to a non-standard version of
the Kannai-Bewley-Grodal-Hildenbrand weak convergence approach to core
limit theorems detailed in Hildenbrand (1974). Much of the groundwork for
the translation was laid in Brown and Robinson (1974, 1975) who first
developed non-standard exchange economies, and in Khan (1974b) and Rashid
(1979). A critical phase in the translation was carried out by Khan and Rashid
(1976), who showed that one can dispense with the assumption that almost all
agents in the hyperfinite economy have preferences which are nearstandard in
the space of monotone preferences.
(2) Anderson, Khan and Rashid (1982) presents an elementary proof of the
existence of approximate Walrasian equilibria (in the sense that per capita
market excess demand is small) in which the bound on the excess demand is
independent of compactness conditions on preferences such as uniform monotonicity. The proof is a translation of the non-standard proof in Khan and
Rashid (1982). As in item 1, a key to the successful completion of the
translation was the discovery that preferences in the hyperfinite economy need
not be nearstandard in the space of monotone preferences.
(3) Anderson (1985, 1988) proved that "strong" versions of core convergence theorems and the second welfare theorems hold with probability one in
sequences of economies obtained by sampling agents' characteristics from a
probability distribution, even with non-convex preferences; here, "strong"
means that agent's consumptions are close to their demand sets. The proofs are
highly external, and so would appear poor candidates for translation. However, they require checking certain conditions for standard prices only; since
the set of standard prices can be embedded in a hyperfinite set by Theorem
1.14.4, this suggested strongly that the key was to consider only finitely many
prices at a time. Hoover (1989) recently succeeded in giving a standard proof
by carrying out the translation. Hoover's proof is elementary in the sense that
it uses little measure theory beyond that necessary to define sequences of
economies obtained by sampling from a probability distribution.
2205
7. Further reading
This chapter is a condensation of Anderson (1990); further details, particularly
proofs which are omitted here, may be found there.
There are a number of other applications of non-standard analysis in
economics which space does not permit us to discuss here. We refer the
interested reader to the list of references, and in particular to the work of
(1) Richter (1971) and Blume, Brandenburger and Dekel (1991a, b) on the
representation of preferences;
(2) various authors on other solution concepts for large economies, as listed
in Section 4.6;
(3) Lewis (1977), Brown and Lewis (1981) and Stroyan (1983) on infinite
time horizon models;
(4) Geanakoplos and Brown (1982) on overlapping generations models;
(5) Muench and Walker (1979) and Emmons (1984) on public goods
economies; and
(6) Simon and Stinchcombe (1989) on equilibrium refinements in noncooperative games.
There are a number of approachable books given an introduction to nonstandard analysis. We particularly recommend Hurd and Loeb (1985), which
gives a thorough non-standard development of the principal elements of real
analysis. Keisler (1976), an instructor's manual to accompany a calculus text
based on infinitesimals, is very useful for those who find mathematical logic
intimidating. An entirely different approach to non-standard analysis is given
in Nelson (1977).
Rashid (1987) provides a broader survey of the applications of non-standard
analysis to the large economies literature, and gives an extended discussion of
techniques for translating non-standard proofs into elementary standard
proofs.
There is an extensive literature on stochastic processes, including Brownian
motion and stochastic integration, based on the Loeb measure. Since stochastic
processes play an important role in finance, this is a potentially fertile area for
future applications of non-standard analysis to economics. See Anderson
(1976), Keisler (1984) and Albeverio, Fenstad, H0egh-Krohn and Lindstr0m
(1986).
References
Albeverio, S., J.E. Fenstad, R. H0egh-Krohnand T. LinstrOm(1986) Nonstandard methods in
stochastic analysis and mathematical physics. Orlando: AcademicPress.
Anderson, R.M. (1976) 'A non-standardrepresentationfor Brownianmotionand It6 integration',
Israel Journal of Mathematics, 25: 15-46.
2206
R.M. Anderson
Anderson, R.M. (1978) 'An elementary core equivalence theorem', Econometrica, 46: 1483-1487.
Anderson, R.M. (1981) 'Core theory with strongly convex preferences', Econometrica, 49:
1457-1468.
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379-381.
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Chapter 40
NON-LINEAR DYNAMICAL
INSTABILITY AND CHAOS
SYSTEMS:
IN E C O N O M I C S
WILLIAM A. B R O C K a* and W. DAVIS D E C H E R T b'**
aDepartment of Economics, University of Wisconsin and bDepartment of Economics,

University of Houston
Contents
1. Introduction
2. The mathematics of chaos and the emergence of chaos in dynamical
systems
2.1.
2.2.
2.3.
2.4.
2.5.
2.6.
Period doubling route to chaos

Liapunov exponents
Chaotic dynamics
Examples of chaotic dynamics and attractors
Period three implies chaos
Structural stability
3. Chaotic equilibrium dynamics

3.1. Chaos in overlapping generations models
3.2. Chaos in growth models
4. Detection of chaos in dynamic time series

4.1. Reconstruction of the dynamics
4.2. Fractal dimension
5. Statistical inference theory for chaotic and non-linear dynamics

5.1. BDS test
5.2. Model misspecification tests
5.3. Testing for deterministic versus stochastic data
References
2210
2211
2211
2212
2213
2215
2217
2218
2219
2221
2223
2224
2224
2226
2228
2228
2230
2231
2233
*I wish to thank the NSF for support under grant 144-AHO1, and the University of Wisconsin
Graduate School.
**Support from Deutsche Forschungsgemeinschaft, Gottfried-Wilhelm-Leibniz-F6rderpreis,
during BoWo'89 is gratefully acknowledged.

ElsevierScience Publishers B.V., 1991
2210
W.A. Brock and W.D. Dechert
1. Introduction
The purpose of this chapter is to: (i) set out enough of the mathematics of
dynamical systems from the perspective of chaos theory so that the endogenous
emergence of chaotic dynamics and other highly complex dynamics may be
understood; (ii) explain measures of instability and complexity; (iii) explain
how one tests for the presence of chaos and other complex non-linear dynamics
in time series data; and (iv) explain how these concepts have been applied in
economics. There is a detailed review from the point of view of natural science
and mathematics of many of the topics treated here in Eckmann and Ruelle
(1985). In addition there are two reviews in economics: Baumol and Benhabib
(1989) and Boldrin and Woodford (1988). Furthermore Grandmont (1985) and
the Journal o f Economic Theory 1986 symposium volume edited by Grandmont have extended discussions of chaos. Other symposium volumes are edited
by Anderson, Arrow and Pines (1988), Barnett, Berndt and White (1988) and
Barnett, Geweke and Shell (1989). Also, in the papers by Brock (1988) and
Brock and Sayers (1988) there is an extensive discussion of testing for chaos
and complex dynamics in time series data.
We have made the chapter as self-contained as possible. In cases of strong
overlap with readily available published material, we have been brief. Emphasis is placed on discussing the fabric and unity of this subject from the point
of view of economic theory and econometrics. We have developed enough
basic mathematics so that ideas and the notion of chaotic dynamics may be
defined precisely.
What is the role of chaos in theory, and what are its applications to the way
we think about our world? One answer is that it is a phenomenon that can
occur in economic models, physical models, biological models, etc., and we
should at least pause to consider if it in any way affects our theoretical or
empirical analyses. Another answer is to give examples of its use and then
judge the merits of the applications. In the physical sciences there has been a
renewed interest in the theory of turbulent fluid flow which has been brought
about by testing for chaotic dynamics. This in turn has led to a re-examination
of the modelling of fluid flow (and in particular the simplifying assumptions in
the modelling) which has led to a seemingly better understanding of turbulent
phenomena. In computer science there is a great deal of interest in the
properties of random number generators. Measures which are designed to
detect chaos can also be used to test random number generators. It raises the
issue of what criteria should be used in judging whether or not finite length
sequences are "random." In statistical hypothesis testing, certain measures
which are used to detect chaotic dynamics have been used to test for stochastic
Ch. 40: Instability and Chaos in Economics
2211
stationarity and i n d e p e n d e n c e . Curiously, these tests have high p o w e r against a

b r o a d class of statistical alternatives.
In m o d e l s of e c o n o m i c dynamics, the two principal results have b e e n that
chaos can occur in overlapping generations models and in m o d e l s of optimal
e c o n o m i c growth. M a n y e c o n o m i c theorists seem to express a " S o w h a t ? "
attitude, which stems in part f r o m the fact that f u r t h e r d e v e l o p m e n t s are
n e e d e d before o n e can judge the merits of analysing d y n a m i c e c o n o m i c
p h e n o m e n a f r o m a chaos theoretic point of view. Equilibrium m o d e l s of
e c o n o m i c d y n a m i c s could well be a fertile area for research into the effects of
chaos o n the e c o n o m y .
2. The mathematics of chaos and the emergence of chaos in dynamical systems
2.1. Period doubling route to chaos

C o n s i d e r the following dynamical system in discrete time
Xt+ 1 = F ( x t ,
a),
t ----0, 1 , . . .
(2.1)
where F : R n x R m---->R", 0/is an m - v e c t o r of p a r a m e t e r s , and x 0 is an n - v e c t o r

o f initial conditions. T h e iterates o f F are defined by
F(x, 0/) = x ,
F'+I(x, 0/)= F(F'(x, 0/),0/),
t=O, 1 , . . . .
In cases w h e r e o~ does not play an essential role, we will simply use x,+ 1 =
F(x,) = F'+l(x0). In o r d e r to d e m o n s t r a t e s o m e of the properties of chaos,
consider a special case of (2.1),
x,+~ = o/x,(1 - x,)
(2.2)
w h e r e 0/ and x are scalars, which has b e e n studied by F e i g e n b a u m (1983).

L o o k at the long run b e h a v i o r of (2.2) as a function o f the p a r a m e t e r 0/. F o r
0 ~< 0/~< 4, F m a p s the interval [0, 1] to itself. F o r 0 ~< 0/~< 1, x* = 0 is the limit
of F'(x o, 0/) for all x 0 E [0, 1]. F o r 1 ~< 0 / < 3 = 0/1 there is a unique positive
fixed point, x*, such that for all x0 C (0, 1), F'(xo, 0/)---~x* as t--> ~. T h e r e is
0/9/2> 0/1 such that for 0/, < 0 / < 0/2 there is a unique two cycle that attracts
almost all initial conditions x 0 E (0, 1). T h e r e is o~3 such that for 0/2 < 0/ "~ 0/3
there is a unique f o u r cycle that attracts almost all initial conditions x 0 E (0, 1).
P r o c e e d i n g sequentially therefore are o/n, 0/n+i such that for 0/n < 0 / < 0 / n + 1
2212
there is a unique 2" cycle that attracts almost all initial conditions x 0 E (0, 1).
The sequence { a, } increases to a limit a~, called the "Feigenbaum point" such
that U(x o, a=) is aperiodic for almost all initial conditions x0; i.e. the trajectory
looks "chaotic." This cascade is called "the period doubling route to chaos."
What is striking about Feigenbaum's results is that the period doubling route to
chaos holds for a broad class, c~, of maps (2.1) and
a.+ 1 - a.
~n+2 -- ~n+l
-->4.6692016...
(2.3)
independently of the form of the map F E ~. Given some broad regularity

conditions one only has to assume F is hump shaped with a unique maximum
that increases in the "'tuning" parameter a to obtain Feigenbaum's results.
Similar behavior is present in some classes of multidimensional maps [Feigenbaum (1983)].
The demonstration of this period doubling route to chaos, the observation of
its universality even in some multidimensional situations, the universality of the
constant 4.6692016..., and the confirmation in nature of this rather intricate
behavior in experimental fluids transcending to turbulence by Libchaber,
Swinney, and others discussed by Gleick (1987) has led to widespread interest
in chaos theory.
2.2. Liapunov exponents

The Ruelle-Takens scenario [see, e.g. Eckmann and Ruelle (1985)] envisages
systems of the form (2.1) where the parameter vector a changes adiabatically
(i.e. slowly) relative to the speed of the dynamics of {x,) as a central
description of the emergence of apparently random behavior in applications
ranging from transition to turbulence in fluids to emergence of erratic dynamics
in populations. First, in order to precisely define chaotic dynamics we need a
generalization of the notion of eigenvalue and eigenvector to non-linear
dynamical systems.
Definition 2.1. Let 0 = V T C V 7 -1 C . . . C V ]
be subspaces of R" in the
tangent space at F'(x0), and let/z, ~</~,_~ ~< ~< ~t1 be such that
(i) D~oF(VI) = V~+,,
(ii) d i m V i = n + l - i ,
(iii) lim,_.= t -1 ln[[(DxoFt)v[[ -~- P~i, Vv E _voi ,\_voi + l with [[v 1[ = 1.
T h e / x i are called the Liapunov exponents of F at x o.
2213
The subspace V ] \ V 2 consists of those vectors that grow at the fastest

(average) rate, V2~\V~ consists of those vectors that grow at the next most rapid
rate, and so forth. A simple example from G u c k e n h e i m e r and H o l m e s (1983)
and Brock (1986) is the following.
Example 2.1. If x 0 is a fixed point, then the subspaces V I = V i are independent of the index t, and are the eigenspaces associated with the eigenvalues of
DxoF. Suppose that F : R 2 ~ R 2 is such that
where A1 > A2. T h e n Vo~ : span{J1 01, [0 1]} and V~ = span{[0 1]}. For this
example,
~LL1
lim,+~
/*2 = l i m , ~
l ln(la;v,
t -I ln(la'?l
+ A'2v2l ) : l n l a , I ,
for 0 ~ V~\V ~
+ a'2v2l ) = lnla2[ ,
for v E V 2 .
2.3. Chaotic dynamics

The forward orbit of x 0 is the set of iterates, {F'(x0) I t = 0, 1 , . . . } . Chaos
theory deals with the case that the forward orbits of the dynamics lie in (or are
convergent to) a b o u n d e d region of R n. T h e following defines some of the
terminology of chaotic dynamics.
Definition 2.2. For a given dynamical system, F : X---~ X with X C R n,
(a) A C X is invariant if F(A) = A.
(b) A closed invariant set A is indecomposable if (Vx, y ~ A) and (VE > 0)
there are x = x0, x 1. . . . . xn_ 1, xn = y and t l , . . . , t n with IF"(xi_l) - xil < E.
(c) F is topologically transitive on an invariant set, A, if for all U, V open
relative to A, (3 0, U ( U ) f3 V ~ O.
(d) A n indecomposable invariant set, A, is an attractor if there is an open set
U with A C U and
A : f') U(U).
t-O
The largest such o p e n set is called the basin of attraction. Alternatively, if F is

topologically transitive on an invariant set, A, and the above holds then A is
also called an attractor.
w.A. Brock and IV.D. Dechert
2214
(e) The dynamical system exhibits sensitive dependence on initial conditions

if (Vx E A ) ( 3 6 > 0)(VE > 0)(3y E a ) ( 3 t >>-1)
Ix-yl <e
and
IF'(x)-U(y)ll>6.
(f) A measure p on an invariant set A is an invariant measure if for all

measurable A C A, p ( F I(A)) = p(A). It is ergodic if for all continuous functions g : A--~ R
lim T - ' ~ g(F'(x)) =

T~
gdp
(2.4)
t=l
A
for p almost all x ~ A.

(g) An invariant set, A, is hyperbolic if F is a diffeomorphism and (Vx ~ A)
there is a direct sum decomposition, R " = Ex~ E~', and constants C > 0 ,
0 < A < 1 such that:
(i) if v E E~", then ](DxF ')v] ~ CA'Iv I,
(ii) if v E E~, then I(DxF')v] <- CA'Iv[,
(iii) there are bases for E~ and E~ which vary continuously with x.
The above definitions are from Guckenheimer and Holmes (1983) and
Devaney (1989). The following provides a sufficient condition for a mapping F
to have an ergodic measure.
Theorem 2.1 [Sinai (1972), Bowen and Ruelle (1975)]. If F is C 2 with a
hyperbolic attractor, then there is a unique ergodic measure for F on A.
Furthermore, the ergodic property (2.4) holds for almost all x E U (with respect
to Lebesgue measure).
For the existence of Liapunov exponents, we have the following.
Theorem 2.2 [Oseledec (1968), Ruelle (1979)]. Let F be C 2, and let it have an
attractor A with an ergodic measure p on it. Then for p almost all x E A,
Liapunov exponents exist.
It is worth noting that the subset of p measure 1 in Theorem 2.1 is not

necessarily large with respect to Lebesgue measure. For example, when A
consists of a stable fixed point, , the theorem only asserts that Liapunov
exponents exist for F at the single point, .
Periodic points play a central role in the description and analysis of chaos
theory. A point x is periodic if there is an integer k such that Fk(x) = x. If k is
2215
the least such integer, it is called the prime period of x. A point x is eventually
periodic if for some l, Ft(x) is periodic.
There is not a universal agreement on the definition of chaos. Following
Eckmann and Ruelle (1985, p. 625), define an attractor A to be strange if the
dynamics on the attractor exhibits sensitive dependence on initial conditions.
Following Wolf et al. (1985), refer to the system as chaotic if the largest
Liapunov exponent is positive. We shall say that a dynamical system with an
attractor A admits complex dynamics if there are orbits which are dense on A,
and which are not eventually periodic.
Since the notion of sensitive dependence on initial conditions is so closely
related to the largest Liapunov exponent being positive that we shall use the
term chaotic dynamics for both situations interchangeably. Notice that in
Definition 2.1 each of the subspaces V I have Lebesgue measure zero for i > 1.
This leads to the following.
Corollary 2.3.
For p-almost all x ~ A and for Lebesgue almost all unit vectors
v E R ~,
t-' lnll(D~F')ol].
gL = l i m
When the system dynamics are one-dimensional, an appeal to the Birkhoff

ergodic theorem gives the following.
Corollary 2.4.
]"1 =
For p-almost all x @ A and for Lebesgue almost all v E R 1,
lim t - ' Inl(D~F')vl
l----~ z c
= lim t -t
ln[(DFs ,(x)F)ol
s 1
= f In[(D~F)I do(x) .
A
2.4. Examples of chaotic dynamics and attractors

Here are some examples of chaotic maps and their attractors.
Example 2.2 (tent maps).
For 0 < a < 1 and x ~ R let
[ X/Ol
F(x,
= L (1 - x)/(1
X ~ ot
-
x/>
W . A . Brock and W.D. Dechert
2216
Sakai and Tokumaru (1980) show that for this map, A = (0, 1) and the
invariant measure is Lebesgue measure on (0, 1). They also demonstrate an
additional feature of this mapping. For almost all x E (0, 1), the sequence
{F'(x, a)} has the same autocorrelation coefficients as the first-order autoregressive process,
(2a
Xt+ 1 =
1)x, + ,,,.,,
{v,} IID.
(2.5)
This fact was exploited by Brock and Dechert (1988a) to show that the set of
linear processes driven by tent map orbits is isometrically isomorphic to a
dense subset of linear processes driven by white noise. This in turn implies that
linear techniques applied to deterministic data can not be successfully used to
distinguish them from stochastic processes.
As an application of Corollary 2.4 to the tent map,
Liapunov exponent is
F(x) = 1 - I1 - 2x l, the
tz, = f Inl2l dx
= In 2.
This follows from the fact that p ( d x ) = dx on [0, 1] for this map, and that
IF'(x)l = 2 for x E (0, ) U (,1).
Example 2.3 (quadratic maps). The maps in equation (2.2) for a ~ ( 0 , 4 ]
have attracting periodic orbits of period 2 n with n tending to infinity as a
increases to 3 . 5 7 . . . [Eckmann and Ruelle (1985, p. 625)]. For the limiting
value as = 3 . 5 7 . . . there is a special attractor A, called the Feigenbaum
attractor, which is not chaotic by the above definition yet the dynamics are
"complex."
Example
2.4
[H~non (1976) attractor]. For (x, y ) E
R2
define
y [l+yx2]
0.3x
"
It can be shown [Devaney (1989, p. 214)] that there is a quadrilateral Q such

that F(Q) c Q. Thus the set n , ~ 1 F ' ( Q ) is invariant and is called the H6non
attractor.
The above are examples of fairly simple (in the sense that the descriptive
equations are not very complicated) systems that have highly complex
2217
dynamics in a discrete time framework. Although we emphasize discrete time

analysis in this chapter, for the sake of completeness, here are some examples
of chaos in continuous time.
Example 2.5 [ L o r e n z (1963) attractor].
equations,
:
The following system of differential
(2.6)
Jc2 : - x 2 + ( R - x 3 ) x 1
ff3 : XlX2 -- bx3
was studied by Grassberger and Procaccia (1983a) for values of the parameters
of o- = 10, R = 28 and b = 8/3. They found that this system is "low dimensional" and exhibits chaotic dynamics for these parameter values.
Example 2.6 [ M a c k e y - G l a s s (1977) attractor]. Mackey and Glass modelled

the regeneration of blood cells by the delay differential equation,
:f(t) =
ax(t - "c)
1 + x(t-
z) 1
bx(t).
(2.7)
Notice that a 1- or 2-dimensional differential equation cannot lead to complex

dynamics. This example does generate chaos for certain values of the delay
parameter, z, as shown by Grassberger and Procaccia (1983a).
2.5. Period three implies chaos
It is not easy to show the existence of a "robust chaos." One of the earliest
theorems was that of Li and Yorke (1975) and a generalization by Diamond
(1976), which were used by Benhabib and Day (1981) to prove the existence of
erratic equilibrium dynamics in overlapping generations models.
Theorem 2.5 [Li and Yorke (1975), Diamond (1976)]. Let F : [0, 1]---~[0, 1]
be continuous, a n d suppose that there is a point, x ~ [0, 1] with
F3(x) ~<x < F(x) < F2(x) ,
then:
(1) there is a periodic point o f p r i m e p e r i o d n f o r all n = 1, 2 , . . . ;
2218
(2) there is an uncountable set C C [0, 1] which contains no periodic points
and which satisfies the following:
(i) (VxCyEC)
lim sup [F'(x) - F'(y)[ > 0 = lim inf [F'(x) - F ' ( y ) I ,
(ii) (Vx @ C) and for each periodic point y E [0, 1],
lira sup [F'(x) - F'(y)[ > 0.
Notice that part (2) of this theorem is a characterization of sensitive dependence on initial conditions. The tent map, F(x) = 1 - [1 - 2 x [ , has for x = 1/4,
F(1/4) = 1/2, F2(1/4) = 1, F3(1/4) = 0, and so satisfies the hypotheses of this
theorem. In fact, it can be shown that the tent map has exactly 2 n periodic
points of period n.
A stronger theorem used to establish the possibility of chaotic dynamics in
an overlapping generations model by Grandmont (1985) is the theorem of
Sarkovskii.
Order the integers as follows:
3>5>7>...
>2-3>2-5>.--
>23.3>23.5>
......
>22 - 3 > 2 2 - 5 > . . -
>23>22>2>1.
Then, we have the following.

Theorem 2.6 [Sarkovskii (1964)]. Let F : R--~ R be continuous, and suppose
that F has a periodic point of prime period n. Then F has a periodic point of
prime period k for every k with n > k.
The fact that 3 is the first number in the Sarkovskii ordering implies that if F
has a periodic point of period 3, then it has periodic points of all orders.
Hence, "period three implies chaos." The disappointing aspect about this
theorem is that it does not generalize to multidimensional maps.
2.6. Structural stability

In studying the dynamics of certain maps, it is useful to generalize the study of
a single map to an equivalence class of maps. This allows us to study the
properties of one map by studying the properties of other maps in the same
equivalence class. The appropriate notion of equivalence for dynamical systems
is as follows.
2219
Definition 2.3. A map F : A--> A is topologically conjugate to G : M--> M if

there is a homeomorphism, h : A--> M such that
hoF=
Goh.
(2.8)
Maps which are topologically conjugate have the same dynamics. For
example, if for x @ A the set {F'(x)} is dense in A, then the set {Gt(y)} is
dense in M, where y = h(x). Similarly, if p E A is a periodic point of prime
period n, then h ( p ) ~ M is a periodic point of G, also of prime period n.
Liapunov exponents are an invariant of a dynamical system: if ~ is a Liapunov
exponent of F, then it is also a Liapunov exponent of G. An example [see
Devaney (1989)] of two maps that are topologically conjugate are the tent
map, F(x) = 1 - l1 - 2x[, and the quadratic map, G ( y ) = 4y(1 - y), both maps
being restricted to the interval [0, 1].
From the point of view of empirical work as well as theory, it is important to
know when small parametric changes alter the nature of the dynamics of a
system. Systems whose dynamical properties are unaffected by such changes
exhibit a structural stability which can be characterized as follows.
Definition 2.4.
[[FII r =
sup
Define a norm on the set of C r functions on R n by
{IF(x)[, IF'(x)l, [F"(x)l,..., IF(r)(x)l}.
(2.9)
A map, F, is said to be Cr-structurally stable if 3 e > 0 such that [IF implies that F and G are topologically conjugate.
GI[ r <
As an example, Devaney (1989, p. 57) shows that the quadratic map,

F(x, a) = ax(1 - x), is C2-structurally stable for a > 2 + X/5.
3. Chaotic equilibrium dynamics

First, in this section we give a brief description of the Benhabib and Day
(1981), and G r a n d m o n t (1985) type of results which show how chaotic rational
expectations equilibria can be produced in overlapping generations models.
Second, since there have been objections that two period overlapping
generations models generate results that are driven by parameter values that
conflict with existing empirical studies, we present the Boldrin and Montrucchio (1986) result which shows that any dynamics, including chaotic dynamics,
can be generated as the optimal solution of an infinite horizon growth model.
Hence when the model is turned into a rational expectations model [Sargent
(1987)] we can get chaotic rational expectations equilibrium dynamics in an
infinite horizon model.
2220
Third, since many economists of a more applied bent complain that model
building in pure theory is too loosely disciplined by data we discuss the
possibility of chaos in models where parameter choice is disciplined in the style
of the Real Business Cycle School (RBC) [King, Plosser and Rebelo (1989)].
Indeed, since the Boldrin-Montrucchio result may be viewed as the analogue
for dynamic recursive economics of the Sonnenschein-Mantel-Debreu result
for general equilibrium theory, discipline on parameter choice must be imposed in order to generate persuasive examples of chaotic equilibria. While the
RBC approach can be criticized for not doing econometrics within the context
of the model under scrutiny, we believe that it is a useful intermediate step that
avoids paying the price of model specific development of econometric theory.
Fourth, in intertemporal general equilibrium models with recursive preferences and technology the turnpike theorem of optimal growth theory puts
limits on the possibility of complex dynamics in complete market models. See
Epstein (1987) and Marimon (1989), as well as their references, for the most
recent work on turnpike theorems applied to general equilibrium theory in
both deterministic and stochastic models. The bottom line is that the combined
discipline of parameter choice for preferences and technology constrained by
empirical studies in the manner of the RBC approach, recursive preferences
and recursive technology, and complete markets makes it hard to construct
examples of chaotic competitive equilibrium dynamics. There are too many
markets present to hedge against risks, there are too many devices to use to
smooth intertemporal consumption and production, and the desire to do so on
both the production and consumption side is too strong to be consistent with
complex dynamics. Therefore we suggest the following channels by which
complex equilibrium dynamics might appear. Some of these are taken from
Arthur (1988), Boldrin (1988) and Brock (1988).
(1) Introduce households that heavily discount the future and make their
mass large enough relative to the rest of the economy.
(2) Introduce increasing returns and externalities. Many economists feel the
growth and decay of cities must be explained by self-catalysing external effects.
(3) Abandon the assumptions of complete markets. For example, we believe
that Bewley (1983) is the first to show how liquidity constraints can generate
instability in recursive intertemporal general equilibrium models. Bewley
(1983) shows how the dynamics induced by shutting down borrowing and
lending markets can look like overlapping generations dynamics.
(4) Allow agents to be price setters, not price takers.
(5) Impose complex or chaotic dynamics directly in preferences and technology.
(6) Abandon the equilibrium assumption. This would allow learning
dynamics as in Anderson, Arrow and Pines (1988).
(7) Allow direct effects of some agents' actions upon the tastes or tech-
2221
nologies of others. To put it another way, allow externalities as defined in

Arrow and Hahn (1971, Chapter 6). This would allow complex dynamics of
fashion or technological diffusion to be transmitted to prices and quantities
through the equilibration process.
(8) Introduce exogenous forcing functions.
(9) Introduce lagged effects in consumption and technology. Although it is
well known that lags are connected with instability and chaos the main problem
with lags of the "time to build" type in macroeconomics is that micro entities
may have an incentive not to initiate projects when everyone else is initiating
them. This causes a smoothing effect across project initiation dates which leads
to a smoothing effect on project completions which in turn leads to a
smoothing effect on the resulting aggregative macroeconomic measures of
investment activity.
3.1. C h a o s in o v e r l a p p i n g g e n e r a t i o n s m o d e l s
The simplified version of the standard overlapping generations model presented below will allow us to quickly outline the highlights of the Benhabib and
Day (1981) results as treated by Grandmont (1985).
Consider the following overlapping generations model:
(1) Young at date t: maximize U ( c y, c~) subject to,
e
0
e
0
(2) p t cy + M y = p t t o y, p t + l c t = M y +Pt+xto ;
(3) ptct = ptto 0 -t- M ty- l ,
(4) P~+I = Pt+l (rational expectations);
(5) p~+ 1 = P,-1 (backward expectations);
(6) M y = M , c y + c 0t 1 ~ t o y _[_ t o O .
where U is the utility of consumption, c y is the consumption of an agent born
in date t when young, c o is the consumption of an agent born in date t when
old, Pt is the price level at date t, pe~+a is a point expectation formed at date t of
price level at date t + 1, M y is the nominal money balances demanded by
young at date t, M is the (constant) money supply, and toY and too are the
endowments of the young and the old. The budget sets in (2) are the same as
e
p t c y -t- P t + lCt = P t t o y -~- P t + l to "
Dynamic equilibria are easy to depict in this model using either the young's
offer curve or writing the equilibrium dynamics in terms of real balances
M
x, = --.
(3.1)
P~
Let the utility function be of the special form, U(C y, C0) = l~l(Cy) -1- u(cO), with
u', v' > 0 , u", v " < 0 and u ' ( 0 ) = v ' ( 0 ) = o~. From the first order necessary
2222
conditions for optimum of the young we obtain the rational expectations

dynamics, in terms of x,,
A(xt)
= u t ( o ) y - x t ) x ` -7_ o r ( o ) 0 + X t + l ) X t + 1 .
(3.2)
Denote this last function by B(x,+ 1, a), where a represents a one-dimensional

arc in the space of parameters defining the tastes and endowments of the old.
This one-dimensional arc will be chosen to play the role of the shift parameter
in the Ruelle-Takens scenario and will be used to generate a Feigenbaum
period doubling route to chaos as in Grandmont (1985, Figure 4, p. 1030).
Now observe that concavity of u implies A' > 0 and ooy > 0 implies A(0) = 0.
Invert A to write (3.2) in the form
(3.3)
x, = F(x,+,, a)
where F = A 1o B. The "forward perfect foresight dynamics" are generated

from (3.3) by putting
Xt+l--
Pt+l
M
(3.4)
Forward perfect foresight dynamics correspond to rational point expectations

equilibrium dynamics. The "backward perfect foresight dynamics" are generated by putting x,+ 1 = x~+ ~ = p~+ 1/M = p,_ ]/M = x,_ 1, which leads, from (3.4)
to
x, = F(x,_l,
(3.5)
Backward perfect foresight dynamics correspond to the equilibrium dynamics

of a sequence of "Hicksian" temporary equilibria where expectations are
P~+1 =P, 1. Note that (3.5) is in the form treated in Section 1 where we
exhibited the period doubling route to chaos. Recall that one must assume
F(x, a) has a unique maximum, x , , that M~ = F(x~, a) increases, and that F is
C 2 with non-trivial curvature at x~.
To obtain the above conditions on F(x, a) necessary to obtain a period
doubling route to chaos all one needs, since A' > 0 , is to impose similar
conditions on B(x) = v'(co + x)x. That is, we need B to be hump shaped with
the size of the hump increasing along an arc in the space {,0 , v ( y , / 3 ) ) . Here
v ( y , / 3 ) will denote a family of concave, increasing functions v(.,/3) parameterized by the vector/3. For example, look at the class
B(x, a)=[~o(a) + x] d(~) Ix,
- o o < d <_ l .
2223
One can easily find an arc (w(a), d(a)) such that the above conditions for a
Feigenbaum cascade are satisfied.
We have shown above that one can easily generate chaotic backward
dynamics. To generate an example of chaotic rational expectations dynamics
all one needs to do is pick the above backwards dynamic path out of the
multiplicity of forward dynamic paths consistent with the rational expectations
dynamics (3.3). There will be a multiplicity of forward dynamic paths because
given an x,, in many cases, there will be at least two xt+ 1 consistent with (3.3)
due to the humped shape of F.
Objections have been made [e.g. Boldrin (1988)] to using overlapping
generations models to generate realistic examples of chaotic dynamics in
economics. The criticism is that one would like to obtain dynamics whose
fluctuations are commensurate with fluctuations observed at business cycle
frequencies and overlapping generations models realistically parameterized
cannot do the job [Sims (1983)]. Turn now to another class of models that may
be used to generate chaotic dynamics. We shall consider a class of infinite
horizon, recursive, growth models with concave one period payoff functions.
3.2. Chaos in growth models
Boldrin and Montrucchio (1986) showed that in a general class of growth

models the optimal policy could be such that the dynamics of the system would
be chaotic. Earlier results by Majumdar and Mitra (1982) and Dechert and
Nishimura (1983) had shown that by weakening the hypothesis that the
technology set is convex the global asymptotic stability property of one sector
growth did not hold. However, the sequence of capital stocks was shown to be
monotonic and so chaos could not emerge from such models. In a more general
growth model (similar to the one below), Benhabib and Nishimura (1985) and
Deneckere and Pelikan (1986) showed that periodic behavior was consistent
with optimal growth. The surprising part of the Boldrin and Montrucchio result
is that they showed that chaos is possible in optimal growth models with a
convex technology and convex preferences.
A typical optimal growth model is:
maximize ~ 6'U(k,, k,+l)
t--0
subject to (k,, k,+l) E T

given k 0 E K
with the following assumptions on preferences and technology:
2224
(A1) K C R n+, and T C K x K are convex, compact and have non-empty

interior;
(A2) U : K x K--> R is continuous and concave and strictly concave in the
second argument;
(A3) U(k, k') is strictly increasing in k and strictly decreasing in k'.
The result is the following.
Theorem 3.1 [Boldrin and Montrucchio (1986)]. Let F : K--> K be C 2 and
such that (Vk E K), (k, F(k)) E T. Then (30 < 6 < 1)(3 U satisfying A2 and
A3) such that (Vk E K)
{F'(k), t : 0 ,
1,...}
is an optimal solution to the growth problem.

The p r o o f of this theorem is essentially by construction. Also included in the
proof is an estimate on the size of 6 for which the theorem holds. As an
example of their techniques, they show that the quadratic map, 4x(1 - x) can
be the policy function for a one sector growth model when the discount
parameter does not exceed 0.01263. One area for further research is to
examine the properties of the optimal dynamics as 6 varies from close to 1
(when we get global asymptotic stability) to close to zero (when we can get
chaos). Neither the onset of chaotic behavior nor its nature are well understood
at this time.
4. Detection of chaos in dynamic time series
4.1. Reconstruction of the dynamics

Eckmann and Ruelle (1985) review methods of detecting the presence of
chaotic dynamics in time series data. Since economic time series data are noisy
and much less stationary than data in most areas of natural science these
methods will have to be modified to apply to economics. We need some
definitions. Some of what follows is taken from Takens via Brock (1986).
Definition 4.1. A time series of scalars {at} has a smooth deterministic
explanation if there are smooth functions h, F, and an initial condition x 0 such
that
(i) the solution to ~ = F(x) is hounded,
(ii) a t = 4,(t, Xo), where 4, is a flow for the differential equation with
4,(0, x0) = x0.
Ch. 40." Instability and Chaos in Economics
2225
That this conforms in part to one's intuition about the differences between
deterministic and stochastic data is supported by the following.
Theorem 4.1 [Takens (1983)].
L e t the sequence {at} be l i D u n i f o r m r a n d o m

variables. Then the probability that a sequence admits a s m o o t h deterministic
explanation is zero.
The central idea is this: given a time series {at} of real numbers, we will say
it has a deterministic explanation if there is a measurement apparatus, h ( x ) ,
through which one views the underlying dynamics which are not observable. If
such a construction is possible, then at least it is plausible that the data may
have been generated by a deterministic process. T h e o r e m 4.1 in part substantiates the definition, since with probability one, no sequence that is
generated by a continuous IID stochastic process admits a smooth deterministic
explanation. Given that the data does admit a smooth deterministic explanation, the basic issue is to discover ways of "reconstructing" the unobservable
dynamical system, F, from the observations {at}. The reconstruction theorem
of Takens is as follows.
Theorem 4.2 [Takens (1981)].
L e t M be a c o m p a c t m a n i f o l d o f dimension n,
F : M---~ M , a C 2 d i f f e o m o r p h i s m and h : M---~ R , a C 2 function. Then (Vm 1>
2n + 1)
Jm(X) = (h(x), h o F ( x ) , . . . , h o F m - l ( X ) ) .
Then Jm is generically a 1-to-1 m a p o f M onto J m ( M ) . The n u m b e r m is referred
to as the embedding dimension.
Notice that the conclusion of this theorem is that if h is an open mapping,

then generically M and J m ( M ) are homeomorphic and that G = Jm F j ~ l and
F are topologically conjugate. This theorem is a cornerstone in the support of
empirical research into chaotic dynamics. Essentially most interesting systems
are not directly observable by the experimenter, but rather observations are
made which are functions of the underlying state variables. For example,
temperature and heart rate are observations of the complex dynamics of the
body, while price and volume are observations of the complex dynamics of the
economy. From such distilled data, how can we ever hope to understand the
nature of the unobserved dynamics?
T h e o r e m 4.2 suggests the following: from the observations, {at} , c o n s t r u c t
m-histories of the data a'~ = (a,, at+l, . . . , a t + m _ l ) . Then a t = Jm(X,), and for
m i> 2n + 1 these m-histories will (generically) have the same dynamical properties as the sequence of state variables, ( x t ) . Most experimental results are
m
2226
calculated for an increasing sequence of embedding dimensions until a degree

of constancy is observed.
4.2. Fractal dimension

One of the often used measures of chaos is the correlation dimension of
Grassberger and Procaccia (1983a,b). It provides a lower bound for some of
the c o m m o n fractal measures used to explore data for chaotic behavior. The
correlation integral Cm(E ) of a data set A = {at} at embedding dimension m is
E E H(e - d(a m, aT)),
Cm,n(E_) -- ( ~ ) l<<-i<j<<-n
Cm(E )
(4.1)
n--->~ C m ,n (E),
lim
where d(a m, a) = max(la i Heavyside function,
aj[,...,
[ai+m-1 - aj+m-,I),
and
H(-)
is the
0 if x~<O,
H(x)=
ifx>O.
The correlation dimension is then defined in terms of the correlation integral:

o%(A) = lira sup
e~O
In Cm(~_ )
In 6
(4.2)
The correlation dimension o/m is a topological invariant: every metric on R m

which is equivalent to d yields the same value of a m.
The correlation dimension can be used as a basis for distinguishing deterministic data from certain random data. This property of the correlation
integral and dimension has been exploited in a large number of experiments,
and it is the essential property in the statistical estimation theory presented in
Section 5. The behavior of the correlation dimension is given by the following.
Theorem 4.3 [Takens (1983)]. (1) Under the hypotheses o f Theorem 4.2, a m is
constant for m >~2n + 1.
(2) I f the {a,} are HD continuous random variables then (Vm) a,n = m wpl.
The classical measure of fractal dimension is the Hausdorff dimension. It is
derived from the Hausdorff measure on R n.
Definition 4.2.
The Hausdorff s-measure of a set A C R n is
2227
~S(A) = lim inf ~] d i a m ( U i f ,

E---~O o//~
where U, is the set of countable e-covers of A, and {Ui} E ~ , .

See Falconer (1985) for the properties of Hausdorff s-measure. The Hausdorff dimension of A is then H(A) = inf{s > 0 [ ~S(A) = 0}. A comparison of
the Hausdorff s-measure with the correlation integral quickly reveals that the
former is quite difficult to compute in general, while the latter is straightforward to calculate. Takens (1981) introduced the notion of limit capacity which
is simpler to compute than the Hausdorff dimension. Define r(e) and s(e) as
follows:
r(e) =
inf{IsI I s c A , A c [..J N , ( x ) } ,
x~S
s(e) = sup(IsI I s c A , (Vx : y E S) Ix - yl
~>
"}.
The limit capacity of A is
L(A) = lim inf

~o
In r(e)
In s(e)
= lim inf - -In e
,~0 - I n e
where the equality of the two inferior limits comes from the fact that
r(e) ~< s(e) ~< r(e/2) .
Grassberger and Procaccia (1983a) argue that am(A ) ~ H(A), while Takens
(1981) shows that H(A)<~L(A). In Brock and Dechert (1988a) it was shown
directly that if the ergodic measure satisfies certain regularity conditions, then
am(A ) <~L(A). Because of the simple form of the correlation integral, it is the
only fractal measure whose statistical properties have been developed.
The theory laid out above motivates several diagnostics to detect chaotic
dynamics in a time series: (i) estimate correlation dimension and see if it is
small; (ii) estimate the largest Liapunov exponent and see if it is positive; (iii)
graph phase portraits and see if they "look like chaos;" (iv) reconstruct the
dynamics by Poincar6 sections or by some other method. Swinney (1985)
reports successful execution of this procedure in natural science. The key step
in our view is the fourth step. This is so because previous studies (e.g. Brock
(1986), Brock and Sayers (1988), Ramsey and Yuan (1989), and Ramsey,
Sayers and Rothman (1990)) have shown that it is difficult to distinguish the
presence of low dimensional chaos from highly persistent stochastic processes
by steps (i)-(iii). Since reconstruction is essentially impossible unless the chaos
is of a very low dimension, one approach would be to substitute a fourth step
2228
in the above procedure that captures the spirit of reconstruction. If the data is
chaotic rather than stochastic, then we should be able to make short term
predictions more accurately than we can for the stochastic models. (Because of
sensitive dependence on initial conditions, long run forecasting of chaotic
dynamics is not possible.) This could provide a testing ground for deterministic
versus stochastic methods.
5. Statistical inference theory for chaotic and non-linear dynamics

This section develops statistical inference theory that is capable of detecting
low dimensional chaotic dynamics as well as the presence of other non-linear
and non-stationary effects. The test statistic that is discussed in this section has
been applied to a variety of economic and financial time series in Brock and
Sayers (1988), Frank, Gencay and Stengos (1988), Hsieh (1989) and Scheinkman and LeBaron (1987, 1989).
5.1. B D S test
We need to briefly describe the BDS test [Brock, Dechert, Scheinkman and
LeBaron (1988)] for IID data that will be used as a building block in what
follows. The statistic in equation (5.1) can be used to formulate a nonparametric test of the null hypothesis of IID against a wide class of dependent
alternatives:
S m n = C m , n -
(5.1)
C m1 ,it
where
C ...... = ( n)-i
~
~ ~
hm(uT,
u m)
l~s'<t~n
Our notation here is

m
U! ~
(l~t, . . . , Ut+m_l)
m
m
hm(u, , Us )=- I I h(u,+,, us+k) ,
k=0
and h : R ~--->R is a symmetric kernel which for the BDS statistic was taken to
be h(x, y) = H(E - [x - y[). U n d e r the hypotheses of liD and E l h I < 0% it can
be shown that S m,~-~O, almost surely as n-->oo. If E h 2<o~ and
2229
Var[h(ul,
U2)IU2]>0, then N/-nSm, n converges in distribution to a normal

random variable with mean zero and finite variance.
Astute choices of the kernel function h(x, y) improves the ability of this test
to detect temporal dependence. The choice h(x, y) = H(E - Ix - y]) works well
[Hsieh and LeBaron (1988)] in Monte Carlo studies for size and power
performance when E is chosen between one half to one and one half times the
standard deviation of the data set which is being tested. This range of the
values of ~ works well for data sets with 500-1000 observations.
For the case h(x, y) = H ( e - Ix - Yl), the formula for the variance V is
m-I
m 2 g C 2(m-l)
(5.2)
C = E[H(e - l u , - u,I)] = f [F(x + ~) - F(x - e)] d F ( x ) ,
(5.3)
V/4 = 2 ~
K m - J c 2j +
g m + (m -
1 ) 2 C 2m -
j=l
where
and
t"
K = E[H(E
]Ur -- u~I)H(E
- lus - u , ] ) ] =
[ F ( x + ~) - F ( x
E)] 2 dF(x).
(5.4)
The form in equation (5.2) for the variance is valid for all kernels h. The forms
in equations (5.3) and (5.4) for C and K can be easily modified for other
kernels. Consistent estimators for K and C are
C.(e) = n-2l{(s, t)I 1 ~<s, t<~n, lu,- u,I < ~}1,

K.(E)=n-31{(r,s,t)ll<~r, s,t<~n,
lUr--Usl<~, lUs- u,l<~}l,
where I{'" "}] denotes the cardinality of the set.

Theorem 5.1 [Brock, Dechert and Scheinkman (1987)]. Let h(x, y) = H ( e ] x - y ] ) and K ( c ) - C ( E ) 2 > 0 . Then if {u,) is H D with mean zero and finite
variance then
x/B
Sin,.(.)
- --~ N(0, 1)
V~(~)
(5.5)
in distribution. Here V n ( ~) denotes the formula in equation (5.2) evaluated at the

consistent estimators, Cn(E ) and K , ( c ) .
2230
W.A.
Brock
and
W.D.
Dechert
5.2. M o d e l misspecification tests
As an.application of the BDS statistic, consider the data generator

(5.6)
y, = f ( Y , _ , , I~_,) + tru,
where I, is information available at time t, I1,_ ~ are lagged dependent variables

and {u,} is liD with mean zero and unit variance. The basic idea is to estimate
f and or with x/-~-consistent estimators (if possible) and to test
y,-f~
Ut,n --
for liD, where f , and tr, denote the estimates o f f and or. Under the null model
Ut, n ~
U t . Note that
f +cru,-L
Ul, n
tr
_ f- - -L
--
~ -- ~ .
-t- -
o-,
tr,
U t q- U t
dr, n + u I .
Theorem 5.2 [Brock and Dechert (1988b)]. L e t {u,} be l i D with a s y m m e t r i c

distribution function F, and let F, be the o'-algebra generated by u,, u,_ ~. . . . .
L e t {ut.,}, {~t} a n d {~b,} satisfy the following:
( A 1 ) u,..~- u, = qJ.~, + o(q,.),
(A2)
P
d
(A3) x/-~b, --~ Z , with E[Z 2] < ~,

(A4) ~:~ is F t_ 1 measurable,
(A5) s u p , O / n ) E,~=I E[~ 2] < ~.
L e t dp be an even C 1 function which satisfies
(A6) 0~<+~<1,
and let
(A7) U. =
(AS) /.),, =
and define A ,
n -2 r.~=1 Zt= 1 ~i)(u t

. 2 ' .= 1 ~ ) ( U t , n
n -2^~'s=l
= U, - U,. Then
Us) ,
--
Us,n),
v ~ A ~ 0.
This is an example of a "nuisance parameter" theorem which can be used to
2231
prove more general theorems that the asymptotic distribution of the BDS
statistic does not depend on the estimation of any parameters, as long as they
can be estimated x/-~-consistently. Other nuisance parameter theorems for
more general time-series models (including the popular G A R C H - M model
[e.g. Bollerslev (1986) and Engle (1987)] can be found in Brock (1991).
5.3.
Testing f o r deterministic versus stochastic data
Dechert (1989) uses a variant of the correlation integral to test for independence in time series. Define the lagged correlation integral by
Om..(E,, E2) -
( ~1)
Z E H(Et - I x ~ - - x,I)H(E2-IX~+m -- x,+ml)

,~<,~<.
(5.7)
for m/> 1, and

DIn(El, ez) = lira D m . , ( e , , a2)-
The main result on independence is as follows.

Theorem 5.3 [Dechert (1989)]. I f {ut} is a stationary Gaussian process then
(Vm ~> 1) Dm(E1,I E 2 ) = C I ( I E I ) C I ( E 2 )
/ f and only if the {ut} are independent.
This characterization of independence in terms of a fractal measure from the
theory of deterministic processes extends to some other processes as well. The
statistic
Sm,,(a,, e2) = Dm,,(E,, ~2) - C(~I)C(E2)
(5.8)
has limn__.= S.... = 0 almost surely. Furthermore, if K(ei) - C(EI) 2 > 0, then
Sm.,(~,, ~2)
tr(e,, ez) ~'N(0, 1).
(5.9)
where or2= 4 [ K ( e l ) - C(E1)2][K(E2)-C(E2)2]. When the data are deterministic, this statistic behaves quite differently.
Theorem 5.4 [Dechert (1989)].
condition:
l_l+ot+"'+ot
A s s u m e that F : R--+ R satisfies a Lipschitz

( 3 k ) ( 3 a > O)(Vx, y E A )
I F ( x ) - F ( y ) l ~< k l x - yl .
I f E2 >!
m - I otm - ~
t"
r/
\
E 1
m e n f o r x,+~ = r ~ x , ) ,
2232
Om,n(~.l, ~2) = C l , n ( ~ l )
and
D,,(~t, e2) = C,(e~).
W h e n the conditions for this theorem hold,
liI-il -v~Sm,n(e , k l+a+'"+am-IE Tm)
= ~.
(5.10)
This statistic can be used to test a m o d e l with measurement noise:

x,+, = F ( x , ) ,
(5.11)
Yt = Xt + -wt ,
where { % } are IID with Ew, -- 0 and Ew~ = 1. In Figure 40.1 there are plots
for data which are generated by a tent map with IID Gaussian measurement
a F / a = 10
log(x/-nSm,n)
~vl~ = 1
10 2
1103
Figure 40.1
P-
10 4
log n
2233
n o i s e . S i g n a l to n o i s e r a t i o s o f 1 a n d 10 a n d d a t a s e t s o f l e n g t h n = 100 to
n = 7500 w e r e u s e d . N o t i c e t h a t t h e s l o p e o f t h e u p p e r g r a p h (~rf/cr = 10) is 1 / 2
f o r all v a l u e s o f n, s h o w i n g t h a t f o r t e n t m a p d a t a w i t h a s m a l l a m o u n t o f n o i s e
t h e s t a t i s t i c c o n v e r g e s r a p i d l y t o a c o n s t a n t t i m e s w/-~. E v e n f o r a l o w s i g n a l t o
n o i s e r a t i o (crf/cr = 1) t h e statistic p i c k s u p t h e p r e s e n c e o f n o n - l i n e a r s t r u c t u r e
f o r n / > 4000.
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INDEX
Aarts, EHL 2078

abstract exchange economy 1909, 1910-12,
t917, 1920
revenue in 1938-9
accumulation
bubbles in 1685
capital accumulation 1753
activity analysis
static economies with taxes 2128
static production economy 2079, 2081, 2082,
2086, 2088
adaptive learning rules 1749-50
s e e a l s o sunspot equilibria, learning
Admati, A 1667
aggregate excess demand function 1541, 1543
OGM 2113
static exchange economy 2051, 2052, 2055
static production economy 2083, 2085
Aiyagari, SR 1758
Alaoglu's theorem 1840-1, 1842, 1859, 1880
Albeverio, S 2205
Aliprantis, CD 1842, 1872, 1873, 1881, 1882,
1888, 1890
all-solutions algorithm (Drexler) 2061, 2064,
2065
Allais, MA 1768, 1771, 1796, 1900, 1946
Allais paradox 1826
Allen, B 1784, 2013
Allen, F 1609
Allen-Hicks elasticity of substitution 2011
allocation 1883
complete contingent-commodity equilibrium
consumption 1633
contingent market equilibrium allocations
1540
financial market equilibrium allocations
1540
intertemporal allocation problems 1836-7
OGM 1907
abstract exchange economy 1910
feasible allocation 1907-8, 1921, 1930
optimality of equilibrium allocations
1926-37
production economy (GEl) 1578
quasi-Walrasian allocation 2184
under uncertainty 1837
Walrasian allocation 2184

alternative, theorem of 1626
Anderson, PW 2210, 2220
Anderson, RM 2145-2205
Anderson, SP 2024
Anderson-Dierker theorem 2197-8, 2204
Anderson-Rashid theorem 2179
Anger, B 1805
Anscombe, FJ 1796-7
Anscombe-Aumann preference 1796-8
anticipated utility theory 1778-9
Antonelli, GB 2077, 2085
APT model (asset pricing) 1667
Araujo, A 1639, 1640, 1844, 1872, 1873,
1874, 1875, 1889, 2102
arbitrage
approximate solution of PDE 1664-5
arbitrage pricing functional 1649, 1653
arbitrage-free s e e no-arbitrage
meaning of 1648
no-arbitrage equilibrium 1534-6
stochastic exchange economies 1559-62
no-arbitrage pricing 1607, 1617
capital asset pricing model (CAPM) 1623
pricing 1625-7
redundant securities 1655-6
self-financing strategies and 1648-9
Archibald, GC 2024, 2040
Archimedean point 1901
Archimedean axiom 1769, 1770, 1797, 1800,
1801, 1805-6
Arnold, L 1669
Arrow, KJ 1539, 1573, 1617, 1666, 1809,
1811, 1813, 1814, 1822, 1854, 1855, 1900,
1903, 1917, 1923, 1929, 1946, 1964, 1984,
1997, 2031, 2052, 2068, 2069, 2071, 2099,
2210, 2220, 2221
'Role of Securities' paper 1618-20
Arrow model 1625-6, 1635
Arrow securities 1539
Arrow-Debreu model 1524, 1525, 1560, 1684,
1798, 1900, 1901, 1964, 1970, 1981
Arrow-Hahn monopolistic competition 1984
Arrow-Pratt theory s e e risk aversion
Arthur, WB 2220
ascending bit auctions 1773
2237
2238
Ascoli's theorem 1850, 1851, 2170-1
asset pricing
A P T model 1667
arbitrage pricing 1625-7
CAPM see capital asset pricing model
(CAPM)
continuous-time derivative 1646-65
American put option 1659, 1665
arbitrage PDE 1664-5
arbitrage pricing 1648-9, 1655-6
Brownian case 1656-9
equivalent martigale measure 1650-2
alternative sufficient conditions for
1653-4
state price process and 1654-5
viability 1653
free lunch 1653-4
numeraire-invariance 1650
PDE method
extensions of 1665
Krylov's theorem 1663, 1665
Marklov case 1659-64
reading sources 1669
short-term rate 1647
spanning and Girsanov's theorem 1656-9
equilibrium asset pricing models 1668
extended recursive preference models
t631-2
frictions 1668
reading sources
asymmetric information 1667
derivative asset pricing 1669
equilibrium models 1668
frictions 1668
mutual funds and 1667
recursive models 1670
recursive models 1629 31, 1670
representative-agent pricing 1625, 1627-31,
1639-42
risk 1632
security markets 1617, 1625-32
state-pricing 1626
stochastic Euler equation 1629-31
time consistency 1631-2
assets
endogenous asset formation in GEl model
1608-9
financial 1530
goods delivery assets 1593
income delivery assets 1593
nominal 1530
see also incomplete markets, nominal
assets
numeraire 1532-3, 1594
secondary or derivative 1530, 1607-8
social and private consequences 1548-9
Index
asymmetric information 1667

attraction, basin of 2213
attractors
Feigenbaum attractor 2216
H6non attractor 2216-17
Lorenz attractor 2217
Mackey-Glass attractor 2217
strange 2215
Auerbach, AJ 2122, 2123-5, 2126
Auerbach and Kotlikoff model 2122, 2123-5,
2126
Aumann, RJ 1796-7, 2177
Aumann continuum economy 2180, 2182,
2184, 2192-3, 2194, 2195, 2203
hyperfinite exchange economy compared
2187-90
Aumann equivalence theorem 1888, 2190,
2192
autarky, OGM 1920-1, 1942
average cost pricing 1967, 1972, 1974, 1976,
1981, 1984
Azariadis, C 1689-90, 1696, 1715, 1726, 1728,
1733, 1734, 1738, 1740, 1758
Azema's martingale 1639
Bachelier, L 1669
Back, K 1668, 1868, 1888
Balasko, Y 1551, 1685, 1688, 1692, 1758,
1914, 1922, 1932, 2112, 2114-15
Banach lattice 1841, 1847, 1850, 1851, 1864,
1870
bankruptcy
costs in Modigliani and Miller model 1620
G E l model 1579, 1609
EI-Barkuki, RA 1860, 1882
Barnett, WA 2210
Barone-Adesi, G 1669
basin of attraction 2213
Baumol, W 2210
Beato, P 1968-9, 1971, 1974, 1976, 1977, 1989
Beato and Mas-Colell model 1977-80, 1981,
1983, 1984
Becket, RA 1890, 2136
belief generation 1745
Bellman, R 2094
Bellman equation 1643
Benassy, J-P 1997-2045
Benhabib, J 1943, 2110, 2116, 2210, 2217,
2219, 2221 2223
Benveniste, LM 1932, 1936, 2094, 2102
Bercovici, H 1890
Bergman, Y 1668
Berndt, ER 2210
Bernoulli's hypothesis 1777-8
Bertrand-Edgeworth model 2001-3, 2011-13,
2015
Index
Bertrand's rule 2000, 2002

Bertsekas, D 2105, 2107, 2109
beta pricing formula 1607
betweenness property 1773-6
behavioural implications of 1773
very weak substitution 1776
weighted utility theory 1774-6
Bewley, TF 1836, 1837, 1844, 1845, 1849,
1854, 1858, 1860, 1861, 1863, 1864,
1879-81, 1880, 1883, 1884, 1905, 2075,
2090, 2199, 2204, 2220
Bhattacharya, S 1667
bifurcation theory 1722-3, 1725
in space of economies 1741-3
subcritical Flip bifurcation 1742
supercritical Flip bifurcation 1742
Billingsley, P 2176, 2179
Binmore, K 1748
Birkhoff ergodic theorem 2215
Black, F 1622, 1651, 1665, 1669
Black-Scholes call option pricing model 1660
Black-Scholes formula 1647
Black-Scholes model 1562, 1565, 1660
Black-Scholes option pricing formula 1658-9,
1660, 1664
Blackwell, D 2094
Blanchard, OJ 1717, 1752
Blaschke, W 1800
Block, HD 2069
Blume, L 2103, 2205
Blume's theorem 1709
Boiteux, M 1971-2
Bojan, P 1860, 1882
Boldrin, M 2102, 2111, 2210, 2219, 2220,
2223, 2224
Boldrin and Montrucchio theorem 2224
Bollerslev, T 2231
Bolzano-Weierstrass theorem 2166
Bona, JL 1945, 2122
Bonnisseau, JM 1969, 1977-8
Bonnisseau and Cornet theorem 1969, 1971,
1972, 1977-8, 1981-3, 1984
Borel measure 1659, 1837, 1845, 1846
Borel probability 1790
Borel sets 1845, 2176, 2179
Borsuk-Ulam theorem 1551
bounded functions 2170
bounded quantifiers 2157
bounded rationality 1667
Bowen, R 2214
Boyd, JH 1888
/
Boyle, P 1669
Brandenburger, A 2205
Braun, RA 2137
Bray, M 1667
Breeden, D 1643, 1646, 1668, 1669, 1670
2239
Brock, WA 1670, 2099, 2209-34
Brouwer's fixed-point theorem 1550, 1551,
1964, 1971, 1977, 1979, 1985, 2053-4,
2055, 2057, 2115
Brown, D 1668, 1670, 1844
Brown, DJ 1842, 1872, 1873, 1881, 1882,
1888, 1930, 1940, 1945, 1963-95, 2122,
2181, 2196-7, 2198, 2204, 2205
Brown-Robinson theorem 2185, 2196-7
Brownian motion 1647, 1669, 1671
dynamic spanning 1636, 1638, 1656-9
Girsanov's theorem 1656-9
standard filtration 1671
bubbles 1685
budget gap 2183
Bulirsch, R 2063
Bulirsch-Stoer method 2063
bundles
cartesian product bundle 1555, 1557
commodity bundles 1574, 1590, 1687, 1798,
1836, 1847, 1871
not present in market 1871
OGM 1901, 1902, 1903-4, 1905-6, 1913
pricing 1847
consumption bundles 1528, 1540, 1852
mod 2 Euler number of 1555-7
'present in the market' 1847, 1871
tangent bundle 1555
vector bundles 1553-5, 1564
Burke, JL 1906, 1916, 1919, 1920, 1922, 2112,
2114
Burkinshaw, O 1842, 1872, 1873, 1881, 1888,
1890
Burmeister, E 2108
Bushaw, DW 2026
capital accumulation 1753
capital asset pricing model (CAPM) 1607,
1622-5, 1642-6
consumption-based (CCAPM) 1642-6, 1667
Ito's endowments 1644-5
Ito's lemma 1643-4
endowment spanning 1622
market portfolio 1624
no-arbitrage pricing 1623
non-triviality assumption 1624
utility function 1622
variance aversion 1622
Caplin, A 2005
CAPM see capital asset pricing model
(CAPM)
cardinal coordinate independence 1799
comonotonicity 1809-10
Carino, D 1667
Carr, P 1669
2240
cartesian product bundle 1555, 1557
cash-in-advance constraints 1668, 1757
Cass, D 1539, 1667, 1686, 1688, 1690, 1691,
1692, 1903, 1914, 1922, 1932, 1936, 1940,
2112, 2114-15
Cauchy sequency 2103
CCAPM (consumption-based CAPM) 1642-6,
1667
Cellina's theorem 1979
certainty equivalent 1778-9
Chamberlain, G 1622, 1623, 1667
Chamberlin, EH 1997
Chamberlin model 2003-5
Edgeworth non-existence problem 2005-7
entry, with 2007-8
numbers of competitors 2011
reviewed of 2013-14
substitutability and 2010-11
Chang, LJ 2137
chaos 2209-34
attractors
Hrnon attractor 2216-17
strange 2215
chaotic dynamics 2213-15
basin of attraction 2213
ergodic measure 2214
eventually periodic 2215
forward orbit 2213
prime period 2215
quadratic maps 2216-17, 2219
tent maps 2215-16, 2219
chaotic equilibrium dynamics 2219-24
detection in dynamic time series 2224-8
fractal dimension 2226-8
reconstruction of dynamics 2224-6
smooth deterministic explanation 2224
Takens' theorem 2224, 2225, 2226
Feigenbaum and 2216, 2222
growth theory 2220, 2223-4
Li-Yorke theorem 2217-18
Liapunov exponents 2212-13, 2214-15,
2216, 2219, 2227
OGM 2217-18, 2219, 2221-3
perfect foresight dynamics
backward 2222
forward 2222
Ruelle-Takens scenario 2222
period doubling route to 2211-12, 2222,
2223
period three 2217-18
rational expectations 2219, 2222, 2223
robust chaos 2217
Index
role in theory 2210-11

Ruelle-Takens scenario 2212, 2222
statistical inference theory 2228-33
BDS test 2228-9
detection of temporal dependence 2228,
2229
deterministic and stochastic data 2231-2
model misspecification tests 2230-3
nuisance parameter theorem 2230-1
structural stability 2218-19
turnpike theorem 2220
Chateauneuf, A 1807
Chebycheff's inequality 2200
Cheng, HHC 1856
Cheng, S 1669
Chew, SH 1632, 1774, 1775, 1776, 1781, 1784,
1785-6, 1791-2, 1824, 1825
Chiappori, PA 1683-1762
Chichilnisky, G 1864, 1888-9
Chipman, JS 2077, 2085
Choquet, G 1805
Choquet integral 1805
Choquet theorem 1651
Christiano, LJ 2105
Chung, KL 1659, 1669
Clark, S 1668
Clarke, F 1968
Clarke normal a n d tangent cones see cones
Clower, R 2026
Coase, RH 1973
Cobb-Douglas production function 2079,
2088-9
Coles, JL 2099
commodities
contingent commodities 1528-9, 1532, 1798
contingent-commodity market equilibrium
1619, 1620, 1633, 1637
marginal rate of substitution of 1931
commodity bundles 1574, 1590, 1687, 1798,
1836
not present in market 1871
OGM 1901, 1902, 1903-4, 1905-6, 1913
pricing 1847
commodity spaces 1527, 1558, 1842, 1850,
1859, 1885
allocation of problems under uncertainty
1837
commodity differentiation models 1837
infinite dimensional spaces 1836, 1850,
1859, 1876, 1885
common ratio effect 1772
comonotonicity 1779, 1780, 1808, 1809-10
comonotonic independence 1804-5, 1806
utility theory 1779, 1780
Index
compactness
Euclidian, metric and topological spaces
2165-7
infinite dimensional spaces 1849-52
compensated equilibrium 1915, 1921-2, 1929
competition, monopolistic s e e monopolistic
competition
competitive equilibrium 1687, 1964
OGM 1902, 1908, 1910, 1915-26, 1923
optimality 1926-37
1633, 1637
computable GE models 1965
cones
Clarke normal cone 1968, 1970, 1978, 1983,
1984, 1988, 1991
Clarke tangent cone 1968, 1969, 1983, 1990,
1991
Dubovickii and Miljutin cones 1968
of interior displacements 1968, 1991
tangent cones 1968
Connor, G 1667
consequentialism 1788, 1789
Constantinides, G 1629, 1667, 1668
consumers, representative consumer approach
2015-17
consumption bundles 1528, 1540, 1852
OGM 1929
consumption plan (Arrow model) 1618
contingent commodities 1528-9, 1532, 1798
contingent markets 1528-9, 1558
production economy (GEl) 1578-9
contingent-commodity market equilibrium
compensated 1619, 1620
complete 1619, 1633, 1637
continuity 2168-71
S-continuity 2169, 2170, 2172
continuous-time equilibrium
consumption-based CAPM 1642-6
Ito's lemma 1643-4
dynamic spanning assumption 1636
GE in continuous-time 1633-7
representative-agent asset pricing formula
1638-42
value in security markets 1633-46
continuum of random variables 2149,
2190-203
Keisler's price adjustment model 2199,
2201-3
Loeb space, on 2199-201
contraction mapping theorem 2103-5
contracts
2241
equity contracts 1533
futures contracts 1533, 1579
core convergence theorem 1888
Cornet, B 1969, 1971, 1973, 1977-8, 1984
Bonnisseau and Cornet theorem 1969, 1971,
1972, 1977-8, 1981-3, 1984
Cournot equilibrium 2000-1, 2009-10
Cournot-Nash equilibrium 2028
Cournot-Walras equilibrium 2026-8
Cox, J 1642, 1645, 1664, 1665, 1669, 1776
credit constraints 1668
Cuny, C 1609
cycles 1940-3
Dana, RA 1639, 1876, 2099
Danthine, JP 2136
Dasgupta, P 2009
D'Aspremont, C 2039
date-event 1684
Davidson, C 2015
Davis, MH 1668
Day, RH 1943, 2116, 2217, 2219, 2221
De Palma, A 2024
Debreu, G 1528, 1541, 1546, 1617, 1618,
1666, 1773, 1800, 1818, 1836, 1842, 1860,
1864, 1900, 1901, 1903, 1906, 1917, 1923,
1929, 1946, 1964, 1965, 1983, 1991, 1997,
2054, 2059, 2069, 2072, 2099, 2102
Debreu-Scarf theorem 1881, 1888
Debreu's regular economies 1551-2
debt finance 1581
Dechert, WD 2209-34
decision making s e e utility theory
default 1579, 1609
degree 1552
mod 2 degree of map 1552-3
mod 2 Euler number 1555-7
oriented degree 1553
degree theory 1965, 1966
Dehez, P 2039
Dekel, E 1632, 1776, 1824, 1825, 2205
Dellacherie, C 1805
demand curves
objective 2031, 2033-4
Cournot 2026-8
with price makers 2028-30
perceived inverse 2025
subjective 2025-6, 2031
demand functions
aggregate excess 1541, 1543
OGM 2113
static exchange economy 2051, 2052, 2055
consumer's excess 2119, 2120
2242
demand gap 2183
demand set 2183
DeMarzo, P 1589, 1610, 1621, 1666
Dem'yanov, VF 1984
Deneckere, R 2015, 2024, 2223
density process 1641
derivative assets 1530, 1607-8
deterministic exchange economy 2089-92
Devaney, RL 2216, 2219
Diamond, DW 2199
Diamond, P 1539, 1589, 1602, 1607, 1666,
1685, 1813, 1819, 2090, 2099, 2217
Dierker, E 1541, 1965, 1970, 1971, 1972,
1973, 1983, 1985, 2005, 2059, 2060, 2185,
2197
Dierker, H 2005, 2028, 2031, 2059
Dierker's index theorem 1553, 1965, 1971,
1985
Diewert, WE 2082
differential topology 1528
dividends 1559
dynammic spanning condition and
real dividend process 1640, 1642
well defined (nominal) dividend process
1640-1
Dixit, AK 2016, 2022
Dixon, H 2003, 2013, 2039
dominance, stochastic 1778, 1781
Donaldson, J 1632
Donaldson, JB 1790, 2136
Dothan, M 1667
Dow, J 1807
Drexler, FJ, all-solutions algorithm 2061,
2064, 2065
Drbze, J 1587, 1589, 1602, 1607, 1610, 1666,
1667, 1802
Dr~ze equilibrium 1587-8, 1604
Dubey, P 2031
Duffle, D 1552, 1553, 1557, 1589, 1609,
1615-82, 1708, 1837, 1872, 1889, 1903,
2127
Durrett, R 1669
Dutta, J 1903
Dybvig, P 1648, 1668, 2199
dynamic consistency s e e utility theory,
dynamic consistency
dynamic economy with taxes and externalities
2131-4
multiplicity of equilibria 2134
dynamic production economy
differentiability and regularity 2102-3
dynamic programming framework 2092-9
endowments 2094, 2099
Euler equations 2096, 2097, 2098
Index
optimality 2093-4
policy function 2097, 2098
return function 2096, 2097
transversality conditions 2096, 2097, 2098
value function 2094, 2095, 2096, 2097, 2098,
2102
dynamic programming 2108, 2110, 2112
computational methods 2103, 2104
deterministic exchange economy 2090
dynamic production economies 2092-9
stochastic economy 2101
dynamic spanning s e e spanning
dynamical systems, chaos in s e e chaos
Dynkin, E 1663, 1665
E-stability 1751
Easley, D 2103
Eaton, BC 2023, 2024, 2040
Eaves, BC 1966, 1985, 2056, 2059, 2063, 2088
Eckmann, J 2210, 2212, 2215, 2216, 2224
Economides, N 2019
economies
2184, 2192-3, 2194, 2195, 2203
exchange economy s e e exchange economy
large s e e large economies
production s e e production economy
stochastic s e e stochastic economies
tenant farmer economy 2190-2
theory of regular economies 1541
Edge-worth equilibrium 1881-2
Edgeworth analysis 2001-3
Edgeworth box diagram 2067
Edwards, W 1778
efficiency of markets
GEI system 1590-1607
constraints
constrained efficient plan 1593-4, 1597,
1601, 1602
constrained feasible plan 15J3, 1595,
1601
weakly constrained efficiency 1591,
1592
exchange economy 1590-1601
feasible allocations 1592-3
fictitional planner 1592, 1598
portfolio efficiency condition 1604
production economy 1601-7
stock market equilibrium 1605-6
production efficiency condition 1604
virtual endowments 1593, 1596, 1602
Eilenberg-Montgomery fixed point theorem
1551
Eisenberg, B 2077, 2085
Ekeland, I 2097
Index
Ekern, S 1589, 1666

elasticity of substitution, Allen-Hicks 2011
Elliott, R 1669
Ellsberg, D 1796, 1803
van den Elzen, A 2086
Emmons, DW 2205
Encaoua, D 2024
endowment space 1540
endowment vector 1842
endowments 1871
dynamic production economy 2094, 2099
Ito endowments 1644-5
OGM 1906-7, 1913
virtual 1596, 1602
Engle, R 2231
entry placed in different batch
equilibriumequilibriumequilibrium
Epstein, L 1632, 1668, 1670
Epstein, LG 1781, 1784, 1785-6, 1791-2,
1792, 1816, 2102, 2220
Epstein-Zin utility model 1632
equilibrium
compensated equilibrium 1915
contingent-commodity 1619, 1620
OGM 1915, 1921-2, 1929
competitive equilibrium 1687, 1908, 1910,
1964
OGM 1902, 1915-26, 1926-37
1619, 1633, 1637
contingent market equilibrium 1558
continuous-time equilibrium s e e continuoustime equilibrium
Cournot equilibrium 2000, 2009-10
Cournot-Walras equilibrium 2026-8
Edgeworth equilibrium 1881-2
existence of s e e existence of equilibrium
extended price equilibrium 1965, 1966
financial market equilibrium 1559
free-disposal equilibrium 1978-9
GEl equilibria existence theorem 1542-3
Hicksian temporary equiilibria 2222
marginal cost pricing equilibrium 1969-70
monetary equilibrium 1567
multiplicity of s e e multiplicity of equilibria
Nash equilibrium 2000, 2003, 2009, 2012,
2013, 2014, 2028, 2035
no-arbitrage equilibrium 1534-6, 1559-62
nominal asset equilibrium 1568-9
optimization and s e e optimality
production equilibrium 1982, 1983
pseudo-equilibrium 1547, 1549-50, 1554,
1556, 1561
pure spot market equilibrium 1542
2243
quasi-equilibrium 1855, 1856, 1858, 1864,
1870, 1872, 1880, 1883
rational expectations equilibrium 1527,
1701
real numeraire asset equilibrium 1569
security-spot market equilibrium 1619,
1634-5
spot market equilibrium 1596
temporary equilibrium theory 1526-7
unique backward equilibrium 1739
Walrasian equilibrium 1635
s e e a l s o GE a n d GEl model
equilibrium manifold 1551-2
equity contracts 1533
equivalent martingale measure 1650-2
alternate sufficient conditions for 1653-4
ergodic measure 2214
ergodic theorem (Birkhoff) 2215
Ethier, S 1642, 1669
Euclidean norm 1933
Euler equations
computational methods 2107-8, 2111, 2112
dynamic production economy 2096, 2097,
2098
stochastic 1629-31, 2100, 2101, 2102
E U R D P 1777-81, 1786
comonotonicity 1779, 1780
definition 1777
dual theory 1779-81
first order stochastic dominance 1778
Gateaux differentiable 1825
risk aversion 1825
weak certainty equivalent substitution axiom
1778-9
Evans, G 1751
exchange economy
abstract 1909, 1910-12, 1917, 1920
revenue in 1938-9
deterministic 2089-92
Dierker's index theorem of GE exchange
economy 1553
efficiency 1590-1601
hyperfinite 2179, 2182, 2185, 2187-90, 2192,
2193, 2194, 2195-6, 2202, 2203
numeraire asset 1594
smooth 1576
static s e e static exchange economy
stochastic s e e stochastic exchange economy
two period s e e two period exchange
economy
virtual 1596, 1599
existence of equilibria
GEl equilibrium 1537-9
generally complete markets 1542-3
2244
existence of equilibria ( c o n t i n u e d )
incomplete markets 1547-8
two period exchange economy 1537-9
monopolistic competition 2003-9
Chamberlin model 2003-5, 2007-8
OGM 2112-15
static exchange economy 2052-5
static production economy 2078-82
activity analysis 2079, 2081, 2082
welfare theory and 2072-5
s e e also sunspot equilibria
expectations
expectation formation 1526-7
rational s e e rational expectations
external sets 2152-4, 2156, 2157
externalities, economies with 2131-4
optimization problems 2135-7
Falconer, KJ 2227
Farmer, RA 1706, 1712, 1715, 1753
Faust, J 2199
Feigenbaum, M 2211-12, 2222
Feigenbaum cascade 2212, 2223
Feigenbaum point 2212
Feldman, D 1667
Feldman, M 2199
Fenstad, JE 2205
Feyman-Kac solution 1663
fiat money 2113, 2114, 2115, 2116, 2119, 2120
finance theory, prices see value in security
markets
financial assets 1530
financial market equilibrium 1559
financial structure, invariance of 1546
finite approximations method 1879-81
firms
GEl theory of 1583
see also stock-market (GEl)
objective functions of 1582-4, 1585
profit maximisation 1603
Fischer, S 1539, 1575
Fishburn, P 1771, 1772, 1776, 1795, 1797,
1798, 1802, 1846
fixed-point theorems
Brouwer 1550, 1551, 1964, 1971, 1977,
1979, 1985, 2053-4, 2055, 2057, 2115
homotopy invariance theorem 1966, 1985,
1986, 1987-8
index theorem 1553, 1965, 1971, 1985, 2060
Kakutani 1858, 1882, 1964, 1971, 1984,
1985, 2005, 2054, 2075, 2081
Flannery, BP 2127
Index
Florenzano, M 1882
Foias, C 1890
Foster, E 2130
fractal dimension
chaos in dynamic time series 2226-8
correlation dimension 2226
correlation integral 2226
Frank, M 2228
Fraysse, J 2010
Frechet derivatives 1753
Frechet differentiable preferences 1782, 1784,
1785, 1823
Fredholm operators 1889
free lunch 1653-4
Freedman, D 1669
Freidlin, M 1663
Freixas, X 2068
frequent trading 1562, 1685
Friedman, A 1669
Friedman, JW 2004, 2040
Friesen, P 1608, 1668
Fubini's theorem 1642
futures contracts 1533, 1579
Gabszewicz, JJ 1836, 1837, 2018, 2019, 2023,
2024, 2040
gain process 1633
Gale, D 1609, 1626, 1685, 1728, 1754, 1932,
1936, 1964, 2088, 2115
Gale-Debreu-Nikaido lemma 1882
games, approach to infinite dimensional
spaces 1882
gap
budget gap 2183
demand gap 2183
support gap 2183
GARCH-M model 2231
Garcia, CB 1966, 1988, 2061, 2065
Gary-Bobo, R 2031
Gateaux differentiable 1784, 1785-6, 1824,
1825
Gatto, M 1669
Gauss-Seidel method 2068, 2070, 2075
OGM 2123-5
Gaussian curvature condition, non-vanishing
1932-3, 1937
GE model 1524-5
computable 1965
contingent markets 1528-9
continuous-time 1633-7
monopolistic competition see monopolistic
competition, GE representations
Geanakoplos, JD 1557, 1593, 1594, 1602,
1607, 1630, 1667, 1708, 1889, 1899-1960,
2055, 2122, 2127, 2198, 2205
Index
Gear, CW 2063
GEl model 1526
bankruptcy 1609
efficiency of markets see efficiency of
markets, GEl system
endogenous asset formation 1608-9
existence of GEl equilibrium 1537-9
GEl equilibria existence theorem 1542-3
interface with finance 1607
secondary or derivative assets 1607-8
see also incomplete markets
Gelatt, CD 2077
Gencay, R 2228
general equilibrium analysis see GE model:
GEl model f o r incomplete markets
Gennotte, G 1667
Geoffard, PY 1722, 1736
Geske, R 1669
Geweke, J 2210
Gibbons, M 1670
Gihman, I 1669
Gilboa, I 1781, 1807, 1808-9
Gilles, C 1849, 2199
Ginsburgh, VA 2137
Girsanov, I 1669
Girsanov's theorem 1637-9, 1656-9
Girsanov-Lenglart theorem 1638
Gleick, J 2212
Glicksberg, IL 2009
global analysis method (Smale) 1965-6
global Newton method 1988, 2069, 2070,
2071-2, 2075
static exchange economy 2057-9, 2060-1,
2063
Glosten, L 1667
Goldman, B 1669
Gorman, WM 2077, 2085
government intervention 1692
Grandmont, J-M 1706, 1713-15, 1728, 1734,
1741, 1748-9, 1750, 1773, 1943, 2116,
2210, 2218, 2219, 2221
Grassberger, P 2217, 2226, 2227
Grassmanian manifolds 1550-1, 1561, 1563,
1564
Grauer, F 1668
Green, EJ 2199
Green, JR 1781, 1790
Green, R 1609, 1668
Green, RC 1889
Grodal, B 2028, 2031, 2204
gross substitutability 2067, 2068, 2069
OGM 2125
Grossman, S 1586, 1589, 1591, 1607, 1610,
1667, 1668
Grossman-Hart equilibrium 1587-8
2245
growth theory
chaos and 2220, 2223-4
Guckenheimer, J 2213, 2214
Guesnerie, R 1683-1762, 1967, 1968, 1970,
1971, 1972, 1983, 1988, 1989
den Haan, WJ 2112
Haggerty, K 1667
Hahn, FH 1854, 1855, 1900, 1917, 1923, 1984,
1997, 2031, 2052, 2067, 2071, 2221
Hahn-Banach theorem 1838-9, 1840, 1879-80
Hammond, PJ 1788, 1789
Hammour, M 1758
Handa, J 1778
Hanoch, J 1822
Hansen, L 1667, 1670
Hardy, GH 1813, 1817
Harris, M 1610, 2094
Harrison, JM 1627, 1639, 1647, 1651, 1653,
1669
Hart, OD 1537, 1539, 1586, 1588, 1589, 1592,
1610, 1816, 1903, 2015, 2017, 2028, 2039,
2040
Hartley, R 2078
Hatta, T 2130
Hausdorff topology 1838, 1839, 1842, 1851,
2163-4, 2169, 2176, 2180, 2226-7
Hay, DA 2023
Heal, GM 1969, 1970, 1971, 1983, 1985, 1988,
1989, 2110
Heath, D 1669
Heine-Borel theorem 1850
Heller, WP 1973, 1980, 1981
Hellwig, M 20134
Helpman, E 2040, 2086
Hemler, M 1669
H6non attractor 2216-17
Henry, C 2069
Hens, T 1691-2
Hernandez, A 1889
Herstein, IN 1770, 1781
Hessian matrices 2082
heteroclinic sunspot equilibria 1726, 1729-34,
1747
Hicks, J 1618
Hicks-Kaldor criterion 1585, 1586, 1587, 1595
Hicksian temporary equiilibria 2222
Hilbert space 1623, 1635, 1637, 1672
Hildenbrand, W 1864, 1889, 1976, 2085, 2179,
2184, 2188, 2190, 2204
Hindy, A 1667, 1668
Hirsch, MW 2057-8, 2109
Ho, T 1669
H0egh-Krohn, R 2205
Holmes, P 2213, 2214
2246
homotopy approach see homotopy invariance
theorem: path-following methods
1986, 1987-8
see also path-following methods
Hoover, DN 2198, 2204
Horsley, A 1837, 1850, 1860
Hotelling, H 1967, 2003, 2005, 2019
Hotelling's multiplier 2082
Howitt, P 2134
Hsieh, D 2228, 2229
Huang, CF 1640, 1648, 1650, 1660, 1668,
1669, 1837, 1846
Huber, PJ 1773
Huberman, G 1667
Hull, J 1669
Hurd, AE 2159, 2161, 2205
Hurwicz, L 2068, 2069
hyperfinite exchange economy 2179, 2182,
2185, 2192, 2193, 2194, 2195-6, 2202,
2203
Auman economy and 2187-90
hyperfinite set 2148, 2157, 2160-1, 2162,
2167, 2182, 2184, 2204
hyperplane theorem 1627
Ikeda, N 1669
impatience 1844, 1905, 1914
implicit function theorem 1551, 1644-5,
1726-9
impossibility of the land of Cockaigne 1539
income transfers, subspaces of 1530-1,
1536-7, 1572
efficiency
constraints
constrained efficient plan 1593-4, 1597,
1601, 1602
constrained feasible plan 1593, 1595,
1601
weakly constrained efficiency 1591,
1592
exchange economy 1590-1601
feasible allocations 1592-3
fictitional planner 1592, 1598
properties 1590-1607
generally complete markets 1539-46
comparative statics 1546
equivalence under regularity 1545, 1546
generic existence 1542-3
invariance of financial structure 1546
Pareto optimality 1545
regularity necessity 1546
representation of subspaces 1543-5
Index
nominal assets 1565-76

indeterminancy of GEl equilibrium with
1567-73
monetary equilibrium 1567, 1573-5
money, real effects of 1573-5
Walras' test 1566-7
contingent markets (GE) 1578-9
two-period production economy 1576-8
properties of model 1547-57
Debreu's regular economies 1551-2
existence of generic set 1547-8
Grassmanian manifold 1550-1
mod 2 degree of map 1552-3
mod 2 Euler number of vector bundle
1555-7
oriented degree 1553
pseudo-equilibrium 1547, 1549-50, 1554,
1556
real effects of financial assets 1548-9
vector bundles approach 1553-5
real assets 1527-65
stochastic exchange economies 1557-65
GE and GEl equilibrium 1558-9
generically complete markets 1562-3
information structure 1557-8
stock-market (GEl) 1579-81
firms objective functions 1582-3
generically complete stock market 1583-4
incomplete stock-market 1585-8
market value maximisation 1588-9
partial spanning 1584 5
two period exchange economy 1527-39
contingency markets (GE) 1528-9
dual subspaces 1536 7
non-arbitrage equilibrium 1534-6
real assets 1531-4
spot-financial markets (GEl) 1529-31
see also GEl model
independence axiom
dual independence axiom 1779, 1780
utility theory 1767, 1769, 1771, 1772, 1774,
1800, 1801
independent interest 1751
indeterminancy, OGM 1943-6
index theorem 1553, 1734, 1735, 2082, 2129
Dierker 1553, 1965, 1971, 1985
fixed point 2060
static economies with taxes 2129-30
static exchange economy 2059-61, 2063-4
Index
ineffectivity theorem 1686-9, 1692

failure of 1691-2
infimum (greatest lower bound) 1840
infnite dimensional spaces 1835-98
allocation under uncertainty 1837
Aumann's core equivalence theorem 1888
Banach lattice 1841, 1847, 1850, 1851, 1864,
1870
basic assumptions 1842-3
consumption set 1842
endowment vector 1842
monotonicity 1843
preference relation 1842
basic fixed point argument 1854-9
aggregate endowment 1854
attainable set 1854
Kakutani's theorem 1858
quasi-equilibrium 1855, 1856, 1858, 1864
utility possibilities 1855
utility vectors 1855
Borel measures 1845, 1846
commodity bundles 1871
commodity differentiation models 1837
commodity space 1836, 1850, 1859, 1876,
1885
compactness difficulty 1849-52, 1856, 1883
norm compact (Ascoli's theorem) 1850
order continuous norm 1851
utility possibility set 1851-2
core convergence 1888
core equivalent method 1881
Debreu-Scarf theorem 1881, 1888
determinancy of equilibrium 1888-9
Duffle 1875
finite approximations method 1879-81
fnite point theorem 1882
games approach 1882
general consumption sets with empty
interior 1888
impatience 1844
interior consumption 1859-64
finitely additive measures 1861
joint continuity 1853-4, 1858
lattice structure of price space 1876-9
marginal rates of technological
transformation 1886
mathematical structures 1838-42
Alaoglu's theorem 1840-1, 1842, 1859,
1880
Ascoli's theorem 1850, 1851
Banach lattice 1841
commodity space 1842
Hahn-Banach theorem 1838-9, 1840,
1879-80
2247
Heine-Borel theorem 1850
infimum (greatest lower bound) 1840
Lebesgue measure 1845, 1847
Lebesgue spaces 1841
Lipschitz function 1846, 1848
Minkowski's theorem 1838-9, 1852
Rademacher function 1845, 1853, 1868
Riesz decomposition property 1841-2
Riesz space 1840
separation theorem 1839-40, 1843, 1853,
1860, 1870
supremum (least upper bound) 1840
vector lattice 1840, 1841
monotonicity 1852, 1855, 1857, 1858, 1863,
1876, 1880, 1885
Negishi approach 1854, 1879-81, 1889
one consumer, marginal rates of
substitution 1864
order ideal 1871-4
exchange economy 1872
quasi-interior 1873
preferences and continuity 1842, 1843-6
pricing 1847-9
lattice structure of price space 1876-9
supporting prices 1864
production context 1882-8
allocation 1883
boundedness assumptions 1883
compactness assumptions 1883
data of economy 1883
exclusion assumption 1885
Possibility of Truncation 1884
profit maximization 1885
quasi-equilibrium 1883
recursive treatment 1883
technological transformation rates 1886
utility maximization 1885-6
properness 1864-71
F-properness 1866, 1872, 1875, 1881
one consumer
preferences 1865
supporting prices 1864
several consumers 1867-71
uniform properness 1866, 1886
weak optima 1867, 1869
quasi-equilibrium 1870, 1872, 1880
Riesz decomposition property 1869, 1873
separable utilities and finance model 1874-6
sublattices 1881
supportability 1852-3, 1855-6, 1859, 1861
weak optima 1867, 1889-90
topology 1843-6
Banach lattice 1841, 1847, 1850, 1851,
1864, 1870
compatible topology 1843
2248
infinite dimensional spaces (continued)
Hausdorff 1838, 1839, 1842, 1851, 1876
Mackey topology 1839, 1844-5, 1851,
1854, 1860
weak topology 1839
wealth map 1853
welfare theorems
first 1855
second 1854, 1855-6, 1860
infinite economies see infinite dimensional
spaces: overlapping generations model
(OGM)
infinitesimal 2149-50, 2152
information
asymmetric 1667
Modigliani and Miller model 1620
Ingersoll, J 1642, 1645, 1665, 1669
instantaneous real return 1645
instantaneous regression coefficient 1646
integration
S-integrable 2178, 2182, 2185, 2188, 2189,
2190, 2193, 2194
uniformly integrable 2178, 2197
interest
independent 1751
riskless 1575
internal definition principle 2159-60, 2162,
2165, 2175, 2177, 2181, 2185, 2193
internal sets 2152-4, 2156, 2157
invariance theorem 1547-8
1986, 1987-8
inverse function theorem 1965
invisible hand 1525
Ionescu-Tulcea, C 1882
Ireland, NJ 2024, 2040
Irwin, MC 2116
Ito endowments 1644-5
Ito's lemma 1643-4, 1650, 1658, 1661
Jackson, MO 1609
Jacobian determinant 1735, 1736, 1740
Jacobianmatrix 1986, 2059, 2070
Jacobs, DAH2070
Jacobs, R 1669
Jacobsen, HJ 2039
Jacod, J 1668, 1669, 1673
Jaffray, JY 1685, 1773, 1781
Jamshidian, F 1669
Jarrow, R 1668, 1669
Jerison, Michael 2085, 2089
John, R 2089
Johnsen, T 1632, 1790
Johnson, H 1669
Jones, L 1837, 1846, 1864, 1867, 1889
Index
Jones, LE 2015, 2021, 2099

Jones, R 1669
Judd, KL 2112, 2137, 2199
Jullien, B 1781
Kahn, CM 1717, 1752
Kahn, D 1608
Kahneman, D 1771, 1778
Kakutani fixed-point theorem 1858, 1882,
1964, 1971, 1984, 1985, 2005, 2054, 2075,
2081
Kalman, P 1864, 1888-9
Kamiya, K 1978, 1983
algorithm 1986, 1987
existence theorem 1971, 1972
Kandori, M 1629
Karatzas, I 1639, 1640, 1669, 1876
Karmarkar, US 1778
Karni, Edi 1763-1831
Keenan, D 2072
Kehoe, T 1752, 1889, 1943, 1945, 2049-2144
Keisler, HJ 2199, 2205
Keller, HB 2126
Keynesian economics 1946, 1948, 2039
animal spirits 1946, 1947
Khan, M Ali 1880, 1889, 1890, 1969, 1971,
1983, 2196-7, 2198, 2204
Kihlstrom, RE 1816, 1818, 1819, 2068
Kim, IJ 1669
King, R 2220
Kirkpatrick, S 2077
Kirman, A 1976
Kolmogorov measure 2199
Koopmans, TC 1539, 2072, 2079, 2090, 2099
Kopp, P 1669
Kotlikoff, LJ 2122, 2123-5, 2126
Kranz, DM et al 1800
Krasa, S 1608
Kraus, A 1668
Krein-Rutman theorem 1627
Kreps, D 1565, 1627, 1632, 1639, 1647, 1651,
1653, 1668, 1669, 1685, 1846, 2015
Kreps, DM 1792
Kreweras, G 1776
Krugman, P 2040
Krylov, N 1663, 1669
theorem 1663, 1664, 1665
Ku, B 1608
Kuhn, HW 2056, 2099
Kuhn-Tucker theorem 2036-7, 2072, 2129
Kunita, H 1668
Kurtz, T 1642, 1669
Kydland, FE 2107, 2137
Kyotaki 1758
Index
van der Laan, G 2069, 2086

van Laarhoven, PMJ 2078
Laffont, JJ 1691
lagged correlation integral 2231
Lagrange multiplier 2074, 2076, 2081, 2086,
2090, 2129
laisser-faire 1525
Laitner, J 1726, 2122
Lakner, P 1639, 1640, 1876
Lancaster, KJ 2040
Landsberger, M 1817
van der Lann, G 2056
large economies
Anderson-Dierker theorem 2185, 2197-8
Brown-Robinson theorem 2185, 2193-4,
2196-7
budget, support and demand gaps 2183-4
core convergence 2184-98
hyperfine set 2148, 2160-1, 2162, 2167,
2182, 2184, 2204
Loeb measure construction 2148
Manelli's examples 2189, 2192, 2194-5
non-standard analysis 2148, 2179-98
preferences 2180-2
Laroque, G 1668, 1749, 1750
Larson, S 1771-2
Law of Large Numbers 2199
Le, C Van 2099
learning see sunspot equilibria, learning
LeBaron, B 2228, 2229
Lebesgue integral 1661
Lebesgue measure 1780, 1841, 1845, 1848,
2175-6, 2199, 2215, 2216
Lee, S 1669
Lehoczky, JP 1639, 1640, 1876
Leibniz' formulation of calculus 2149-50
Leland, H 1668
Lenglart, E 1669
Lerner index 2010, 2014, 2038
Lerner's 'degree of monopoly' 2009
LeRoy, SF 1629, 1849
Levine, DK 1752, 1889, 1943, 1945, 2096,
2102, 2115-17, 2119, 2121, 2122, 2125,
2127, 2130, 2134, 2136
Levitan, RE 2040
Lewis, L 1844
Lewis, LM 2205
Li, TY 2217-18
Li-Yorke theorem 2217-18
liability
limited 1970
unlimited 1970
Liapunov exponent 2227
chaos 2212-13, 2214-15, 2216, 2219
2249
Liapunov function 2068, 2071, 2086
Lifting theorems 2177-8
Lindley, VD 1796
LindstrOm, T 2205
linear-quadratic approximation 2103, 2107,
2111-12
Lintner, J 1622
Lipschitz conditions 1660
Lipschitz functions 1846
Lipsey, RG 2023, 2024, 2040
Lipster, R 1669
Lipton, D 2122, 2126
Littlewood, JE 1813, 1817
Litzenberger, R 1668, 1669, 1670
local uniqueness
continuity and 2059
non-convex technologies 1984-8
Loeb, PA 2159, 2161, 2173, 2177, 2178, 2198,
2205
Loeb measure 2173-9, 2182
construction 2148, 2174
construction of Lebesgue measure 2175-6
existence of 2173-5
lifting theorems 2177-8
weak convergence 2178-9
Loeb space 2199-201
Loeb's theorem 2174-5
Long, JB 2099
lotteries see utility theory
Louie, SG 2078
Lucas, R 1629, 1668, 1670, 1730, 1733, 1757,
1836, 1884
Lucas, RE 2051, 2094, 2096, 2099, 2101,
2103, 2104, 2199
Luce, R 1769
Luenberger, DG 2103
Luxemburg, WAJ 2158, 2161
Lyapunov's theorem 2149
MacAfee, RP 2134
MacCrimmon, KR 1771-2, 1775, 1776
McFadden, D 2054-5
Machina, MJ 1632, 1772, 1783, 1784, 1789,
1810, 1816, 1823, 1824, 1825, 1826
McKenzie, LW 1618, 1855, 1887, 1888, 1917,
1964, 2074, 2079, 2086, 2110
Mackey topology 1905-6
infinite dimensional spaces 1839, 1844-5,
1851, 1854, 1860
OGM 1914
Mackey's theorem 1839
Mackinnon, JG 2056, 2063
McKinnon, LW 1971
2250
McLennan, A 1630, 1708, 1889, 1903, 2127
McManus, D 1608
macroeconomics
monopolistic competition and s e e
monopolistic competition
OGM and 1946-7
Magill, M 1523-1614, 1667, 1854, 1860
Majumdar, M 2223
Makowski, L 1666
Malinvaud, E 1770, 1883
Manelli, A 2189, 2192, 2194-5
manifold
with boundary 1555, 1557
equilibrium manifold 1551-2
Grassmanian manifold 1550-1, 1561, 1563,
1564
orientable 1553
Mantel, R 1971, 1984, 2054, 2054-5, 2069
Mantel's model 1987-8
MCP existence proof 1974-5, 1976, 1977
Manuelli, RE 1746, 1758, 1889, 2099
maps
quadratic maps 2216-17, 2219
tent maps 2215-16, 2219
Marcet, A 2112
marginal cost pricing 1966-7, 1969, 1970-2,
1974-6, 1981, 1984, 1985, 1987-8
existence proof 1974-84
inefficiency of 1989-90
two-part (TPMCP) 1973, 1974, 1979, 1980,
1981
marginal rate of substitution 1864, 1931
marginal rate of technological transformation
1886
Margrabe, W 1669
Marimon, R 2220
market clearing 1526, 1543, 1902, 1920
market failure 1524-5
market portfolio
zero-beta portfolio 1624-5
market size, Cournot equilibrium and 2009-10
markets
contingent s e e contingent markets
efficiency of s e e efficiency of markets
incomplete s e e incomplete markets
missing 1525
security, value in s e e value in security
markets
sequential market models s e e sunspot
equilibria
Shubik-type 1692
spot-financial (GEl) 1529-31
Markov chain 1694-5
Markov matrices 1723, 1741
Markov process 1617, 1701-2, 1704
Index
Markov state space setting 1659-64

Marschak, J 1770
Marschak, T 2028
martingales 1730
Azema's martingale 1639
equivalent martingale measure 1627, 1650-2
alternate sufficient conditions for 1653-4
local martingale 1673
martingale difference 1718
martingale generator 1636, 1638, 1639, 1657
martingale multiplicity 1668
semimartingale 1633, 1636, 1638, 1654,
1661, 1673
special semimartinglae 1656
Mas-Colell, A 1595, 1630, 1635, 1691, 1692,
1708, 1835-98, 1903, 1969, 1971, 1973,
1976, 1977, 1989, 2010, 2015, 2018, 2031,
2040, 2054-5, 2059, 2060, 2068, 2082,
2085, 2088, 2089, 2125, 2127, 2179
Mas-Colelt's theorem 1635
Maskin, E 2009
Matsuyama, K 1758
Mayshar, Y 1817
Mehra, R 1670, 1836
Meilijson, I 1817
Memin, J 1669
Merrill, OH 2056, 2063
Mertens, JF 1879-81
Merton, R 1668, 1669
mesh 2057
Michael selection theorem 1976, 1979
Milgrom, P 1667
Miller, M 1620-2, 1666
Miller, MH 1609
Milnor, J 1770, 1781
Miltersen, K 1669
Minkowski-Farkas lemma 1534-5
Minkowski's theorem 1838-9, 1852
Mirman, LJ 1818, 1819, 2099
missing markets 1525
Mitra, T 2223
Mobius band 1556
Modigliani, F 1620-2, 1666
Modigliani and Miller model
irrelevance of corporate finance 1620-2
irrelevance of financial policy 1666
theorem 1581, 1583, 1589
monads 2162-4
monetarism 1947
monetary equilibrium 1567, 1573-5
monetary policy
Keynesian policy 2039
neutrality of 2038-9
s e e a l s o monopolistic competition,
macroeconomic issues and
Index
money
in GEl model with nominal assets 1567,
1573-5
medium of exchange, as 1573
non-neutral 1747
precautionary demands for 1574-5
process 1730
purchasing power 1574
store of value, as 1573
transactions demand for 1574
monopolistic competition 1997-2045
Bertrand-Edgeworth model 2001-3, 2015
market size and 2011-13
undercutting argument 2001, 2002
Bertrand's rule 2000, 2002
Chamberlin model 2003-5
entry, with 2007-8
numbers of competitors 2011
review of 2013-14
substitutability and 2010-11
competitiveness 2009-15, 2020-1
Bertrand-Edgeworth model and market
size 2011-13
Chamberlin model reviewed 2013-14
Chamberlin model and substitutability
2010-11
Cournot equilibrium and market size
2009-10
Lerner's 'degree of monopoly' 2009
Cournot equilibrium 2000, 2009-10
Cournot model 2000-1, 2015, 2026-8
Cournot-Walras equilibrium 2026 8
defined 1997
Edgeworth analysis 2001-3
Edgeworth non-existence problem 2005-7,
2011, 2014
efficiency 2021-2
excess capacity 2022
existence of equilibrium with 2003-9
Chamberlin model 2003-5, 2007-8
GE representations 2024-31
general framework 2024-5
objective demand curve 2031
Cournot 2026-8
with price makers 2028-30
perceived inverse demand curve 2025
subjective demand curves 2025-6, 2031
imperfect competition review 2000-3
Lerner index 2014
macroeconomic issues and 2032-9
equilibrium, definition and characteristics
2035-7
general excess supply 2034
"
2251
inefficiency 2037-8
model 2032-3
neutrality of monetary policy 2038-9
objective demand curves 2033-4
underemployment and underproduction
2037-8
market size
Bertrand-Edgeworth model and 2011-13
Cournot equilibrium and 2009-10
2013, 2014, 2028, 2035
product differentiation 2015-24
closeness or substitutability 2018
competitiveness 2020-1
continuity of preferences 2018
efficiency 2021-2
finiteness property 2018
horizontal differentiation 2019
modelling of 2015-17
preference for diversity 2016
representative consumer approach
2015-17
spatial competition 2019-20
vertical differentiation 2018
zero profits 2022-4
star-shaped production sets 1984
unemployment 2037-8
zero profits 2022-4
monotonicity 1806, 1852, 1863, 2068
Anscombe-Aumann preference 1798
comonotonicity 1779, 1780, 1804-5, 1806,
1808, 1809-10
conditional 1795, 1808
1855, 1857, 1858, 1863, 1876, 1880, 1885,
1976
mixture-monotonicity 1773
OGM 1920, 1921, 1928, 1937
Monte Carlo simulation 1664, 2229
Monteiro, P 1639, 1640, 1846
Monteiro, PK 1872, 1873, 1874, 1875
Montrucchio, L 2102, 2111, 2219, 2220, 2223,
2224
Morton, A 1669
Mostowski collapsing function 2152-3
motivation 1771-2, 1802-3
Muench, T 2205
Miiller, S 1669
Miiller, WJ 2112, 2122
multiple shooting method 2126
multiplicity of equilibria
dynamic economies with taxes and
externalities 2134
non-sunspot equilibria 1687
OGM 2115-22
2252
lndex
multiplicity of equilibria ( c o n t i n u e d )
optimality and 2075-8
static exchange economy 2065-8
weak axiom of revealed preference
2067-8, 2069
sunspot equilibria 1687, 1691-2, 1695,
1695-6, 1696
mutual fund theorem 1625
Myneni, R 1669
Nachman, D 1668
Nakamura, Y 1776
Nalebuff, B 2005
2013, 2014, 2028, 2035
Nataf, A 2077, 2085
Negishi, T 1854, 2025-6, 2027, 2039, 2040,
2074
Negishi method 1854, 1879-81, 1889, 2074-5,
2077, 2090
infinite dimensional spaces 1854, 1879-81,
1889
taxes in economies and 2135
Nelson, E 2205
Neuefeind, W 1971, 1972, 1983
von Neumann-Morgenstern theory see u n d e r
yon
new classicals 1946, 1948

Newton method 2105, 2125-6
global see global Newton method
Nielsen, L 1669
Nieison, LT 1622
Nikaido, H 1917, 1964, 2028
Nishimura, K 2223
Nishimura, S 2110
no-arbitrage equilibrium 1534-6, 1559-62
no-arbitrage pricing 1607, 1617, 1623
nominal asset equilibrium 1568-9
nominal assets 1530
see also incomplete markets, nominal assets
non-convex technologies 1963-95
average cost pricing equilibrium 1967, 1972,
1974, 1976, 1981, 1984
Beato and Mas-Colell model 1977-80, 1981,
1983, 1984
Bonnisseau and Cornet 1977-8, 198l-3,
1984
Bonnisseau-Cornet theorem 1969, 1971,
1972
cones
Clarke normal cone 1968, 1970, 1978,
1983, 1984, 1988, 1991
Clarke tangent cone 1968, 1969, 1983,

1990, 1991
of interior displacements 1968, 1991
tangent cones 1968
Dierker index 1985
free-disposal equilibrium 1978-9
global analysis 1967
Global Newton's method 1988
Guesnerie method 1967-70, 1974
1986, 1987-8
Kamiya 1978, 1985, 1986, 1987-8
local uniqueness and computation 1984-8
Mantel's model 1987-8
marginal cost pricing equilibrium 1966-7,
1969-72, 1974-6, 1981, 1984, 1985,
1987-8
Michael selection theorem 1976, 1979
non-linear prices 1972-3
non-smooth analysis 1967, 1968
optimality 1966, 1969, 1970, 1971-2,
1988-92
path-following method 1985, 1986, 1987-8
pricing rules
bounded losses pricing rules 1981-4, 1985
see also average a n d marginal cost pricing
equilibrium
privately owned public utilities 1966
production 1966
equilibrium 1982, 1983
Scarf algorithm 1964-5, 1966
Scitovsky community indifference curve
1988
second welfare theorem 1988, 1990, 1990-2
Smale's method 1988
star-shaped production sets 1984
survival assumption 1978, 1982
TPMCP 1973, 1974, 1979, 1980, 1981
two part tariff 1967, 1973
willingness to pay 1973, 1980-1
non-linear dynamical systems, chaos in see
chaos
non-standard analysis 2145-2205
Anderson-Dierker theorem 2185, 2204
Anderson-Rashid theorem 2179
2184, 2192-3, 2194, 2195, 2203
hyperfinite exchange economy and
2187-90
Aumann Equivalence theorem 2190, 2192
bounded quantifiers 2157
Brown-Robinson theorem 2185, 2196-7
Index
continuum of random variables 2149,

2190-203
2201-3
on Loeb space 2199-201
elementary proofs 2149
2161-73
Ascoli's theorem 2170-1
closed set 2165
compactness 2165-7
continuity 2168-71
S-continuous 2172
differentiation 2171, 2172-3
monads 2162-4
open set 2164-5
overspill 2162-3
products 2167-8
Riemann integration 2171-2
Tychonoff theorem 2168
finite set 2166
hyperfinite exchange economy 2179, 2182,
2185, 2192, 2193, 2194, 2195-6, 2202,
2203
Auman economy and 2187-90
hyperfinite polygonal approximation 2172
hyperfinite set 2148, 2157, 2160-1, 2162,
2167, 2182, 2184, 2204
ideal elements 2149-50
infinitesimal 2149-50, 2152
infinite set 2152
integration
S-integrable 2178, 2182, 2185, 2188, 2189,
2190, 2193, 2194
uniformly integrable 2178, 2197
internal definition principle 2159-60, 2162,
2165, 2175, 2177, 2181, 2185, 2193
internal and external sets 2152-4, 2156,
2157
large economies 2179-98
Anderson-Dierker theorem 2185, 2197-8
Brown-Robinson theorem 2185, 2193-4,
2196-7
budget, support and demand gaps 2183-4
core convergence 2184-98
Manelli's examples 2189, 2192, 2194-5
preferences 2180-2
Law of Large Numbers 2199
Lebesgue measure space 2175-6, 2199
Leibniz' formulation of calculus 2149-50
Loeb measure 2173-9, 2182
construction 2148, 2174
2253
existence of 2173-5
internal probability space definition 2173
Lebesgue measure 2175-6, 2199
lifting theorems 2177-8
Radon measures representation 2176
Loeb space, continuum of random variables
on 2199-201
Loeb's theorem 2174-5
Mostowski collapsing function 2152-3
non-standard extensions 2160, 2161
notational conventions 2154
probability theory 2149
saturation 2158-9, 2161, 2163, 2164, 2166,
2200
standard models 2154-6
superstructure 2154, 2155
embeddings 2156-7, 2158
Transfer Principle 2148, 2157, 2157-8, 2160,
2172, 2179, 2185, 2189, 2190, 2193,
2195-6, 2203
translation of non-standard proofs 2203-4
ultrafilter 2151
ultraproduct 2160
construction 2150-2, 2157, 2160, 2161
usefulness of 2147-9
weak convergence 2178-9, 2204
non-vanishing Gaussian curvature condition
1932-3, 1937
Novshek, W 2010, 2040
numeraire assets 1532-3, 1569
numeraire-invariance 1650
objective functions of firms 1582-4, 1585
OGM see overlapping generations model
(OGM)
O'Hara, M 2103
Okuno, M 1922, 1940
optimality
dynamic production economy 2093-4
economies with taxes and externalities
2135-7
equilibrium and 2072-8
generally complete markets 1545
multiplicity of equilibria 2075-8
Negishi approach 2074-5, 2077
non-convex technologies 1966, 1969, 1970,
1971-2, 1988-92
welfare theory and existence of equilibrium
2072-5
options
American put options 1659, 1665
Black-Scholes option pricing model 1658-9,
1660, 1664
2254
Ortega, J 2070
Oseledec, VI 2214
Ostroy, J 1837, 1846, 1849, 1864
overlapping generations model (OGM) 1685,
1689, 1690, 1693, 1706, 1754-5,
1899-1960
abstract exchange economy 1909, 1910-12,
1917, 1920
revenue in 1938-9
aggregate endowment of commodity 1906-7
aggregate excess demand functions 2113
aggregate revenue at equilibrium 1937-40
Allais and Samuelson model 1900
allocation 1907
for abstract exchange economy 1910
feasible allocation 1907-8, 1921, 1930
optimality 1926-37
autarky 1920-1, 1942
chaos and 2217-18, 2219, 2221-3
perfect foresight dynamics 2222
commodity bundles 1903-4, 1905-6, 1913
compensated equilibrium 1915, 1921-2,
1929
competitive equilibria 1902, 1908, 1910,
1923
existence of 1915-26
truncations 1917-26
optimality of allocations 1926-37
computational methods 2122-7
consumer's excess demand functions 2119,
2120
consumption bundles 1929
convergences of prices and 1922
consumption periods 1913
countable infinity of individuals and
commodities 1901, 1903
cycles 1940-3
economy 1903-15
endowment periods 1913
existence of equilibria 2112-15
failure of finite valuation 1901-2
fiat money 2113, 2114, 2115, 2116, 2119,
2120
Gauss-Seidel method 2123-5
with government expenditure 1712-13
gross substitutability 2125
immortality of individual 1912
impatience 1905, 1914
indeterminancy and 1943-6, 1947
intragenerational heterogeneity 1941
macroeconomics and 1946-7
market clearing 1902, 1920
monotonicity 1920, 1921, 1928, 1937
n-commodity version 1758
Index
optimality of equilibrium allocations

1926-37
prices, convergences of consumption
bundles and 1922
production and 1903
revenue and 1937-40
Samuelson steady-state 1942
simple demographic structure 1914-15,
1932-3, 1940
bounded curvature condition 1936
non-vanishing Gaussian curvature
condition 1932-3, 1937
social security system 1900
stationary economies and cycles 1940-3
stochastic models 1911, 1912
temporal and demographic structure
1910-15
topology 1904-6
Mackey topology 1905-6, 1914
truncated model 1917-26, 1939, 2114-15,
2122
uncertainty and 1903
value of arbitrary commodity bundles 1901,
1902
well behaved 1942
overspill 2162-3
Pareto, V 2072
Pareto efficiency and optimality s e e optimality
Parkinson, M 1669
Paroush, J 1822
Parthasarathy, KR 1773
partial spanning 1584-5, 1589
path-following method 1985, 1986, 1987-8
static exchange economy 2061-5, 2169, 2175
static production economy 2086
Peck, J 1692, 1707, 1726, 1729, 1746, 1758
Peleg, B 1871, 188i, 2097
Pelikan, S 2223
perfect foresight 1685, 1699-1700
backward dynamics 2222
equilibrium 1699-1700
forward dynamics 2222
s e e a l s o rational expectations
perturbation argument 1564, 1600
s e e a l s o transversality conditions
Pfleiderer, P 1667
Pines, D 2210, 2220
Pliska, S 1651, 1668, 1669
Plosser, C 2099, 2220
plungers 1825
Podczeck, K 1837, 1846, 1849
Poincar6 sections 2227
Poincar6-Hopf index/method 1750
Poincar4-Hopf theorem 1734-41
2255
Index
Poisson process 1639

Polemarchakis, H 1557, 1593, 1594, 1607,
1608, 1691, 1899-1960
policy function
computational methods 2106, 2111, 2112
policy iteration algorithm 2105
Polya, G 1813, 1817
Pontier, M 1639, 1876
Porteus, EL 1632, 1792
portfolio choice 1603, 1813-14, 1816-17
portfolio efficiency condition 1604
Postlewaite, A 2031
Poterba, J 2122, 2126
Prabhakar, ND 1860
Pratt, JW 18tl, 1813, 1814, 1816
Prechac, A 1692
preferences
Anscomb and Aumann 1800
Frechet differentiable 1782, 1784, 1785
functional representation of 1772-3
Gateaux differentiability 1784, 1785-6
irrelevance 1781
large economies 2180-2
monotonicity 1852, 1876, 2068
1858, 1885
non-linear, risk aversion and 1822-6
ordinal independence 1781
smooth 1528, 1784-5
state dependent 1800-2, 1820-1, 1820-2
stochastic dominance 1778, 1781
strong axiom of revealed 2085
weak axiom of revealed
static exchange economy 2067-8, 2069
s e e a l s o utility theory
Prescott, EC 1670, 1836, 1864, 1884, 2023,
2094, 2096, 2099, 2101, 2103, 2104, 2107,
2137, 2199
Press, WH 2127
prices
Arrow-Debreu (GE) prices 1560
Boiteux-Ramsey prices 1972
decentralization by 2201
factor prices, computation in space of
2086-9
infinite dimensional spaces and 1847-9
non-linear prices 1972-3
price deflator 1650
security price process 1559
state prices 1536-7, 1619, 1626, 1654-5

stochastic spot price process 1558-9
stochastic state price process 1559-60
undercutting argument 2001, 2002
s e e a l s o pricing: value in security markets
pricing
arbitrage see arbitrage
assets see asset pricing
average cost pricing 1967, 1972, 1974, 1976,
1981, 1984
beta pricing formula 1607
bounded losses pricing rules 1981-4, 1985
marginal cost pricing 1966-7, 1969, 1970-2,
1974-6, 1981, 1984, 1985, 1987-8
equilibrium 1969-70
optimality 1966
no-arbitrage pricing formula 1607
state pricing 1626, 1654-5
two-part marginal cost pricing 1973, 1974,
1979, 1980, 1981
two-part tariff 1967, 1973
Prisman, E 1668
probability
internal probability space 2173-4
Procaccia, 1 2217, 2226, 2227
product topology 1905-6
production economy
dynamic s e e dynamic production economy
contingent markets (GE) 1578-9
efficiency 1601-7
stochastic 1587-8
two-period production economy 1576-8
s e e also stock-market (GEl)
smooth 1576-7
static see static production economy
s e e a l s o infinite dimensional spaces,
production context
production equilibrium 1982, 1983
properness see infinite dimensional spaces,
properness
Protter, P 1669, 1673
pseudo-equilibrium 1547, 1549-50, 1554, 1556,
1561
purchasing power 1574
nominal asset equilibrium and 1568, 1569
put options, American 1659, 1665
quantifiers, bounded 2157
quantity theory equations 1574
quasi-Walrasian allocation 2184
quasidemand set 2183
2256
Quiggin, J 1777
Quinzii, M 1574, 1589, 1602, 1607, 1667,
1970, 1973, 1988
Rademacher functions 1845, 1853, 1868
Radner, R 1527, 1539, 1589, 1684, 2097
Radner equilibrium 1685
Radon-Nikodym derivatives 1636, 1638, 1651,
1654, 1872, 2188
Raiffa, H 1769
Ramsey, F 1972
Ramsey, FP 1796
Ramsey, J 2227
random number generators 2210
random variables, continuum of 2149,
2190-203
2201-3
random walk 1730
Rashid, S 2179, 2181, 2182, 2196-7, 2198,
2204, 2205
rational expectations 1684
chaos and 2219, 2222, 2223
equilibria 1527, 1701, 1746, 1747
expectation correspondence 1709
rationalisability 1707-8
sunspot equilibria and 1701-5
wandering between fixed points 1733
s e e also sunspot equilibria
rationality, bounded 1667
Raut, LK 1844
Raviv, A 1610
real assets s e e incomplete markets, real assets
Real Business Cycle School 2220
Rebelo, S 2220
reconstruction theorem (Takens) 2225
redistribution 1938
redundant securities, arbitrage pricing of
1655-6
regression coefficient, instantaneous 1646
regular economies, theory of 1541
Reichlin, P 1753
representative consumer approach 2015-17
return function
computational methods 2111
returns, instantaneous real return 1645
revenue see taxes
Rheinboldt, W 2070
Riccati equation 2109
Richard, S 1667, 1669
Richard, SF 1846, 1866, 1867, 1876, 1886,
1887
Index
Richter, MK 2054-5, 2205

Riemann integration 1793, 2171-2
Riesz decomposition property 1841-2, 1869,
1873
Riesz representation theorem 1651
Riesz space 1840
risk aversion 1779, 1811-26
absolute 1813
Arrow-Pratt theory of 1811, 1812-14
absolute risk aversion 1813
definitions 1812
local relative risk aversion 1813
simple mean utility preserving spread
1812
conditional asset demand 1824
decreasing 1815-16
definition of 1811
diversification
conditional 1824
unconditional 1825
dual theory of choice under risk 1825-6
E U R D P theory 1825
Frechet differentiable functionals 1823
local relative 1813
matrix measures 1819-20
mean preserving spread 1823
measurement of 1821
multivariate 1817-22
autocomparability of 1818, 1821
on commodity space 1822
comparative 1817-19
need for measures 1811
with non-linear preferences 1822-6
one risk in presence of others 1814-17
portfolio choice problem 1813-14, 1816-17
risk neutrality 1811
risk premium 1812, 1821
risk proclivity 1811, 1816
simple compensating spread 1823
state-dependent preferences 1820-2
strict risk 1823
yon Neumann-Morgenstern utility and 1783
Roberts, J 2028
Roberts, K 2028
Robertson, B 1776
Robinson, A 2150, 2157, 2161, 2181, 2196-7,
2204
Rockafellar, RT 1968
Roell, A 1781, 1826
Rogerson, R 1691
Romer, D 1816
Romer, PM 1889, 2096, 2099, 2102, 2130,
2134, 2136
Ross, SA 1607, 1626, 1627, 1642, 1645, 1664,
1665, 1667, 1668, 1669, 1815-16
Index
Rothman, P 2227
Rothschild, M 1667, 1817, 1823, 2024
Royden, HL 2147
Rubinov, AM 1984
Rubinstein, M 1629, 1664, 1669
Rudin, W 2147
Ruelle, D 2210, 2212, 2214, 2215, 2216, 2224
Ruelle-Takens scenario 2212, 2222
Ruggles, N 1967, 1969, 1972
Runge-Kutta method 2063
Rust, J 2105
Rutherford, T 1972
Ryder, HE 2097, 2110
S-continuity 2169, 2170, 2172
S-integrable 2182, 2185, 2188, 2189, 2190,
2193, 2194
Saari, DG 2071
Sachs, J 2122, 2126
saddlepoint splitting 2119
Safra, Z 1773, 1777, 1784, 1785, 1786, 1789,
1824, 1825
Sakai, H 2216
Samuelson, PA 1754, 1770, 1900, 1933, 1942,
1946, 1997, 2068, 2087, 2112
Samuelson steady-state 1947
Samuelson's model s e e overlapping
generations model (OLG)
Santos, MS 1945, 2102, 2122
Sard's theorem 1551, 1552, 1570, 1889, 1965,
2058, 2059
Sargent, TJ 1575, 2094, 2107, 2219
Sargent-Wallace neutrality proposition 1575
Sarkovskii's theorem 2218
saturation 2158-9, 2161, 2163, 2164, 2166,
2200
non-standard analysis 2161, 2163, 2164,
2166, 2200
Savage, LJ 1795
Savage's expected utility theory 1767, 1792-3,
1795-6
Savage's axioms 1794-5, 1808
statistics and 1795-6
Savage's Foundations 1796
Sawyer, CN 1844, 1862
Sayers, C 2210, 2227, 2228
Scarf, HE 1964, 1965, 1984, 1985, 2056, 2085
Scarf's algorithm 1964-5, 1966, 1971, 1986,
2075
mesh 2057
simplex 2056
static exchange economy 2055-7, 2060
subsimplex 2056, 2057
Schaefer, HH 1840, 1842
2257
Scheinkman, JA 1668, 1889, 2015, 2097, 2116,
2228, 2229
Schlee, E 1790
Schmeidler, D 1763-1831, 2031
Scholes, M 1669
Schultz, C 2039
Schwartz, E 1669
Scitovsky community indifference curve 1988
secondary assets 1530, 1607-8
security markets
arbitrage pricing of redundant securities
1655-6
pricing see arbitrage: asset pricing: value in
security markets
security-spot market equilibrium 1619, 1634-5
Segal, U 1777, 1781, 1789
Selten, R 2028
separating hyperplane theorem 1627
separation theorem 1839-40, 1843, 1853,
1860, 1870
sequential market models, sunspot equilibria
in s e e sunspot equilibria
Sharer, W 1523-1614, 1666, 1846, 2055
Shaked, A 2018, 2019
Shapiro, C 2040
Shapley, L 2007, 2031
Shapley, LS 2067
Shapley-Folkman theorem 2149
shareholders, extra-market information from
1588
Sharpe, W 1622
Shastri, K 1669
Shell, K 1685, 1686, 1688, 1690, 1691, 1692,
1758, 1914, 1922, 1932, 2112, 2114-15,
2210
Shiryayev, A 1669
Shitovitz, B 2188
Shoven, JB 1965, 2051, 2127
Shreve, SE 1639, 1640, 1669, 1876
Shubik, M 2003, 2007, 2013, 2031, 2040, 2067
Shubik-type markets 1692
Sibley, DS 1966
Sidrauski-Brock model 1758
Silvestre, J 2031, 2039
Simon, C 2071
Simon, LK 2205
simplex 2056, 2128
subsimplex 2056, 2057
Sims, C 2223
simulated annealing algorithm 2077
Sinai, YaG 2214
Singleton, K 1670
skew-symmetric bilinear theories 1776
Skorohod, A 1669
Smale, S 1965-6, 1985, 2057-8, 2109
2258
Smale's infinite dimensional version of Sard
1889
Smale's method 1988
Smith, Adam 1525
Smith, VL 1776
smooth preferences 1528
smoothing 1806
Sneessens, H 2039
Snower, D 2039
social security
no new generation and 1900
OGM and 1900
pay-as-you-go system 1900
social welfare s e e welfare
Sonnenschein, H 2010, 2028, 2040, 2054,
2055, 2068, 2069, 2130
Sonnerschein-Mantel-Debreu theorem 2075
Sosin, H 1669
spanning 1619
dynamic 1633, 1636, 1637-9, 1656-9
Girsanov's theorem and 1637-9, 1656-9
reading sources 1666-7, 1668
shareholder unaninimity and 1622
variance aversion and 1622
Spear, SE 1609, 1734, 1738, 1746-7, 1754,
1889, 2134
Spence, AM 2016, 2022
Sperner's lemma 2056
spot market equilibrium 1542, 1596
spot market multiplicity 1691, 1692
spot price process, stochastic 1558-9
spot-financial markets 1529-31
Sraffa, P 2031
Srivastava, S 1754
SSB s e e skew-symmetric bilinear theories
SSE s e e sunspot equilibria, stationary
Stanton, R 1665, 1669
Starr, RM 1973, 1980, 1981
state dependent preferences 1800-2
state prices 1536-7, 1619, 1626, 1654-5
static economies with taxes s e e taxes
static exchange economy
aggregate excess demand functions 2051,
2052, 2055
computations 2051-72
existence of equilibrium 2052-5
Brouwer's theorem 2053-4, 2055, 2057
Kakutani's theorem 2054
Gauss-Seidel method 2068, 2070, 2075
global Newton method 2057-9, 2060-1,
2063
index theorem 2059-61, 2063-4
Index
weak axiom of revealed preference

2067-8, 2069
Newton's method 2068
path-following methods 2061-5, 2169, 2175
regularity and index theorem 2059-61
Scarf's algorithm 2055-7, 2060
t~tonnement 2068-9, 2070, 2071
static production economy
activity analysis 2086, 2088
aggregate excess demand function 2083,
2085
Cobb-Douglas production functions 2088-9
computation 2078-89
existence of equilibrium 2078-82
activity analysis 2079, 2081, 2082
gross substitutability 2083, 2085
index theorem and multiplicity of equilibria
2082-5
non-substitution theorem 2087-8
path-following method 2086
t~tonnement method 2085-6
weak axiom of revealed preference 2083.
2085
statistical inference theory 2228-33
BDS test 2228-9
detection of temporal dependence 2228,
2229
deterministic and stochastic data 2231-2
model misspecification tests 2230-1
Stefan problem 1665
Stengos, T 2228
Stieltjes integral 1673
Stiglitz, JE 1589, 1593, 1607, 1667, 1813,
1817, 1819, 1822, 1823, 2016, 2022, 2040
Stinchcombe, MB 2205
stochastic economy 2099-102
dynamic programming framework 2101
Euler equations 1629-31, 2100, 2101, 2102
OGMs 1911, 1912
policy function 2102
return function 2101
transversality conditions 2101
value function 2100, 2102
stochastic exchange economy
GEl model with real assets 1557-65
GE and GEl equilibrium 1558-9
generically complete markets 1562-3
information structure 1557-8
stochastic integration 1670-3
Brownian motion 1671
definition of 1672-3
quadratic variation 1671
Index
stock-market (GEl) 1579-81

default 1579
equilibrium with fixed producer plans 1581
firms objective functions 1582-3
generically complete stock market 1583-4
incomplete stock-market 1585-8
market value maximisation 1588-9
matrix of inter-firm shareholdings 1580
matrix of stock-market returns 1580
partial spanning 1584-5
shareholders 1588
Stoer, J 2063
Stokey, N 1668, 1670, 1757, 2094, 2096, 2099,
2101, 2103, 2104
Streufert, PA 2099
Strotz, RH 1789, 1822
Stroyan, KD 2205
subspaces
dual subspaces 1536-7
fixed point theorem 1557
Grassmanian manifold 1550-1
of income transfers 1530-1, 1536-7, 1572
orthoganal complement 1544
of present value vectors 1536-7
representation of 1543-5
substitution 2018
Allen-Hicks elasticity of 2011
Chamberlin model and 2010-11
OGM 2125
marginal rates of 1864, 1931
non-substitution theorem 2087-8
Summers, L 2122, 2126
Sundaresan, S 1668
sunspot equilibria 1683-1762
bifurcation theory 1722-3, 1725, 1741-3
subcritical Flip bifurcation 1742
supercritical Flip bifurcation 1742
concavity of utility function 1691
consistency of derivatives assumption 1705
cycles 1727-8, 1738-9, 1754
degenerate 1704
existence of 1726-34
continuity arguments
implicit function theorem 1726-9
sunspots and cycles 1727-8
two steady states 1728-9
dynamical systems and heteroclinic
equilibria 1729-34
homoclinic solutions 1734
random walk property 1730
invariant compact argument 1754
invariant set arguments 1706-15
applications 1710-15
expectation correspondence 1709
2259
invariant compact set 1708-15
invariant set open 1706-8
rationalisability 1707-8
strong version 1708-15
weak version 1706-8
finite support, with 1702-5
fragility of 1751
GE with rational expectations 1684-6
Arrow-Debreu markets 1684-5
Radner equilibria 1685
heteroclinic 1729-34, 1747
see also dynamical systems and
heteroclinic equilibria
heterodox sunspot equilibria 1726
indeterminacy of stationary state 1715-26
finite SSE 1718-21
linear models 1716-18
ineffective theorem and 1686-9, 1692
infinite horizon sequential models 1693-7
insurability issue 1686-9
intrinsic and extrinsic uncertainty 1744-7
belief generating role 1745
continuity argumenr 1744-6
non-sunspot connected equilibria 1747
rational expectation equilibria 1746, 1747
sunspot connected equilibria 1747
'sunspot like' fluctuations 1746
trembling hand economy 1744
learning
adaptive learning rules 1749-50
convergence 1749
eductive 1748
evolutive 1748-51
expectation dependant on past
realizations 1748-9
Poincar6-Hopf index 1750
literature on 1689-93
local sunspot equilibria 1715-26
Markov chain 1694, 1695
memory models 1751-4
E-stability 1751
Frechet derivatives 1753
general case 1753-4
independent interest (E-stability) 1751
initial conditions 1752
model 1697-1701
continuity assumption 1698-9
convex valuedness of rationalizing
measures 1699
deterministic dynamics and determinacy
1699-1701
regularity of SSE 1699
temporary equilibria 1697, 1698
multiplicity 1687, 1691-2, 1695, 1695-6,
1696
2260
sunspot equilibria (continued)
n-commodity version of OGM model 1758
non-informative sunspot 1739-40
non-neutral money 1747
OGM 1685, 1689, 1690, 1693, 1754-5
with government expenditures 1712-13
n-commodity version 1758
perfect foresight equilibrium 1699-1700
Poincarg-Hopf theorem 1734-41
rational expectations and 1701-5, 1746,
1747
smoothness assumption 1705
standard first best hypothesis 1758
stationary sunspot equilibria (SSE) 1695
finite stationary 1718-21
regularity of 1699
structure of 1734-43
bifurcation theory see bifurcation theory
differential topology and Poincare-Hopf
theorem 1734-41
boundary conditions 1735
cycles in N-dimensional case 1738-8
index theorems 1734, 1735
non-informative sunspots 1739-41
one-dimensional case 1737-8
uniqueness of stationary equilibrium
1735-6, 1737
temporary equilibrium 1697-8
time independent 1701-2
welfare relevant 1691
superstructure 2154, 2155
embeddings 2156-7, 2158
supply
general excess supply 2034
positive net supply 1533
zero net supply 1533
support gap 2183
supremum (least upper bound) 1840
sure thing principle 1767, 1794, 1803
Sutton, J 2018, 2019
Svensson, L 1668, 2039
Swinney, H 2212, 2227
Szu, H 2078
Takens, F 2212, 2224, 2225, 2226, 2227
Takens' theorem 2224, 2225, 2226
Talman, AJJ 2056
Talman, D 2069, 2086
tangent bundle 1555
tangent cones 1968
Clarke's 1968, 1969, 1983, 1990, 1991
tariffs, two part 1967, 1973
tfitonnement 2068-9, 2070, 2071, 2201
Index
taxes
dynamic economies with 2131-4
Negishi approach 2135
OGM and revenue 1937-40
optimization problems 2135-7
static economies with 2127-31
activity analysis matrix 2128
index theorem for 2129-30
technological transformation, marginal rates of
1886
tent maps 2215-16, 2219
Teukolsky, SA 2127
theorem of the alternative 1626
Theory of Value (Debreu) 1617
Thisse, JF 2018, 2019, 2023, 2024, 2040
Thomsen, G 1800
Tiffin, R 2024
timing premium 1791-2
Tirole, J 2040
Tobin, J 1824
Todd, MJ 2056, 2080, 2127
Tokumaru, H 2216
topology
compactness
Ascoli's theorem 2170-1
2165-7
continuity 2168-71
S-continuity 2169, 2170, 2172
Euclidian, metric and topological spaces,
non-standard analysis 2161-73
Hausdorff topology 1838, 1839, 1842, 1851,
1854, 1876, 2163-4, 2169, 2176, 2180,
2226-7
infinite dimensional spaces 1843-6
Banach lattice 1841, 1847, 1850, 1851,
1864, 1870
compatible topology 1843
Hausdorff 1838, 1839, 1842, 1851, 1876
Mackey topology 1839, 1844-5, 1851,
1854, 1860
weak topology 1839
Mackey topology 1839, 1844-5, 1851, 1854,
1860, 1905-6, 1914
rood 2 degree of map 1552-3
OGM 1905-6
product topology 1905-6, 2167-8
vector bundle 1554
Index
weak topology 1839, 1905

Toussaint, S 1889
Townsend, R 1668
trading
continual trading 1633
frequent trading 1562, 1685
strategy 1559, 1634
weighted net trade vector 1598
transaction costs
asset pricing and 1668
Transfer Principle 2148, 2157-8
non-standard analysis 2157, 2160, 2172,
2179, 2185, 2189, 2190, 2193, 2195-6,
2203
transversality conditions 1545
computational methods 2110
2098
see also perturbation argument
Traub, JF 2071
'trembling hand' economy 1744
Trockel, W 2190, 2191
truncation
OGM 1917-26, 1939, 2114-15, 2122
Tversky, A 1771, 1778
two period exchange economy
non-arbitrage equilibrium 1534-6,
1534-9
real assets 1531-4
non-arbitrage equilibrium 1534-6
real assets 1527-39, 1531-4
Uhlig, H 2199
ultraproduct construction 2150-2, 2157, 2160,
2161
ultrafilter 2151
uttraproducts 2160
uncertainty
allocation problems under 1837
OGM and 1903
sunspot equilibria and 1684, 1686, 1688
2261
utility with see utility theory, with
uncertainty
underproduction 2037-8
unemployment 2037-8
uniqueness
local 2059
see also multiplicity of equilibria
utility theory
Anscombe-Aumann approach 1796-8, 1800
monotonicity 1798
Archimedian axiom 1769, 1770, 1797, 1800,
1801, 1806
betweenness property 1773-6
behavioural implications of 1773
very weak substitution 1776
bounded acts 1804, 1805
comonotonicity 1779, 1780, 1804-5, 1806,
1808, 1809-10
decision making under risk and uncertainty
1765-8
analytical framework 1765-7
conceivable acts 1766
consequences 1765
constant acts 1766
definition of problem 1765
feasible acts 1765
state of nature 1766
dynamic consistency 1786-92
atemporal sequential choice
chance nodes 1787
compound lotteries 1787-8
consequentialism 1788, 1789
decision trees 1787
independence 1789
terminal nodes 1787
definition of problem 1786-7
temporal sequential choice 1787, 1790-2
definition 1790
timing premium 1791-2
timing resolution of uncertainty 1791
two period consumption model 1790
EURDP 1777-81, 1786
comonotonicity 1779, 1780
definition 1777
dual theory 1779-81
first order stochastic dominance 1778
Gateaux differentiable 1825
weak certainty equivalent substitution
axiom 1778-9
2262
utility theory ( c o n t i n u e d )
expected utility theory 1772
Archimedian axiom 1769, 1770
independence axiom 1767, 1769, 1771,
1772
intergral representation 1770-1
local 1781-6
mixture continuity 1770
non-additive subjective probabilities
1802-10
bounded acts 1804, 1805
certainty independence 1806
comonotonic independence 1804-5,
1806
motivation 1802-3
prior probabilities 1803
purely subjective probability 1807-9
reduction of uncertainty to risk 1810
uncertainty aversion 1805-6
preliminaries 1768-9
rank-dependent probabilities s e e EURDP
reduction of compound lotteries 1769
Savage, LJ 1767, 1792-3, 1795-6
Savage's axioms 1794-5, 1808
statistics and 1795-6
sure thing principle 1803
subjective probabilities 1792-1802
Anscombe-Aumann approach 1796-8
cardinal coordinated independence 1799
conditional monotonicity 1795
convex range definition 1793
non-additive s e e non-additive subjective
probabilities
non-atomicity 1795
non-degeneracy 1795
notations 1794
qualitative or ordinal probability
1794-5
Savage's axioms 1794-5
state dependent preferences 1800-2
state independence 1794
sure thing principle 1794
topologically connected spaces
1798-1800
von Neumann-Morgenstern 1528, 1628,
1686, 1688, 1767, 1769-70, 1783, 1793,
1795, 1796, 1797, 1817-18
Frechet differentiable preferences 1782,
1784, 1785, 1823
functions 1527
concavity of VNM functions 1691
Gateaux differentiable 1824, 1825
implicit weighted utility 1776
independence axiom 1769, 1771, 1772, 1774,
1800, 1801
Anscombe-Aumann approach 1797
Index
atemporal sequential choice 1789

dual independennce axiom 1779, 1780
weakening of 1802-3
local utility function 1781-6
consistency with evidence 1784
Frechet differentiable preferences 1782,
1784, 1785
global behaviour analysis 1783
uniqueness 1784
mixture-monotonicity 1773
monotonicity 1806
Anscombe-Aumann approach 1798
comonotonicity 1779, 1780, 1804-5, 1806,
1808, 1809-10
conditional 1795, 1808
non-atomicity axiom (Savages) 1808
non-expected utility theory 1771-86
betweenness property s e e betweenness
property
common ratio effect 1772
functional representation of preference
relations 1772-3
local expected utility analysis 1781-6
motivation 1771-2
rank-dependent probabilities s e e EURDP
preferences
Frechet differentiable 1782, 1784, 1785
functional representation 1772-3
Gateaux differentiability 1784, 1785-6
irrelevance 1781
smoothness of preference functionals
1784-5
state-dependent 1800-2
risk aversion and 1820-1, 1820-2
strong consistency axiom 180l-2
risk s e e dynamic consistency: expected
utility theory: non-expected utility theory
a n d risk aversion
Savage s e e expected utility function, Savage
state independence axiom (Savages) 1808
sure thing principle 1767, 1794, 1803
uncertainty, with 1763-1831, 1792-1810
von Neumann and Morgenstern s e e
expected utility theory
consistency with evidence 1775-6
implicit weighted utility 1776
intergral representation of 1775
interpretation of 1775
unique solvability 1774
weak substitution axiom 1774
Uzawa, H 2054-5, 2075
Index
value function
computational methods 2103, 2106, 2111
2096, 2097, 2098, 2102
stochasitc economy 2100, 2102
value in security markets 1615-82
arbitrage-free prices 1617
Arrow model 1617, 1618, 1625-6
Arrow's 'Role of Securities' paper 1618-20
asset pricing s e e asset pricing
capital asset pricing model (CAPM) 1622-5
market portfolio 1624
no-arbitrage pricing 1623
non-triviality assumption 1624
variance aversion 1622
continuous-time derivative asset pricing s e e
asset pricing
continuous-time equilibrium 1633-46
consumption-based CAPM 1642-6
Ito's lemma 1643-4
dynamic spanning assumption 1636
GE in continuous-time 1633-7
representative-agent asset pricing formula
1639-42
convexity 1619, 1620
corporate finance irrelevance 1620-2
financial policy irrelevance 1666
Markov processes 1617
martingalcs s e e martingales
Modigliani and Miller model 1620-2, 1666
monotonicity 1619, 1620, 1632
no-arbitrage prices 1617
reading sources
asset pricing 1667
continuous-time models 1669
finite-dimensional GE 1666
firm behaviour 1666-7
general 1665
infinite horizon recursive models 1670
mutual funds 1667
spanning 1666-7, 1668
spanning 1619, 1622
dynamic 1633, 1636, 1636-7
Girsanov's theorem and 1637-9, 1656-9
reading sources 1666-7, 1668
state price vector 1619
stochastic integration 1670-3
welfare theorem 1619, 1920
van der Heyden, L 2137
van Zandt, T 1882
Vanderbilt, D 2078
Varaiya, P 1668
2263
Varian, H 1669, 2057
Vecchi, MP 2077
vector bundles 1553-5, 1564
Vetterling, WT 2127
Vickrey, W 1773
Vind, K 1800, 1802
virtual endowments 1596, 1602
virtual exchange economy 1596, 1599
Visscher, M 2023
Vives, X 2013, 2015
Vohra, R 1890, 1969, 1971, 1972, 1983, 1992
von Neumann-Morgenstern theory 1528, 1628,
1686, 1688, 1767, 1769-70, 1783, 1793,
1795, 1796, 1797, 1817-18
Wakker, PP 1790, 1799, 1800, 1802, 1807,
1809
Wald, A 2067
Wald, HP 1967
Walker, M 2205
Wallace, N 1575
Walras, L 2059, 2068, 2070
Walras' equilibrium 1635, 1964
Walras' Law 1535, 1554, 1901, 1902, 1975,
1977, 2052, 2054, 2055, 2059, 2068, 2079,
2116, 2117
nominal and real assets 1566-7
Walrasian allocation 2184
Watanabe, S 1668, 1669
weighted utility theory s e e utility theory,
weighted utility theory
Weiss, L 1668
Weitzman, ML 2039, 2097
welfare
Hicks-Kaldor criterion 1595
marginal change in social welfare 1603-4
welfare theorems 1591-2
Arrow model, in 1619, 1920
existence of equilibrium and 2072-5
first 1692, 1855, 1973
second 1854, 1855-6, 1860, 1988, 1990,
1990-2, 2090
Weller, P 1789
Werlang, S 1807
Werner, J 1608
Whalley, J 1965, 2051, 2086, 2127
White, H 2210
Whiteman, CH 2137
Williams, R 1659, 1669
Williams, S 1816
Williamson, RE 2090, 2099
willingness to pay 1973, 1980-1
Wilson, C 1906, 1915, 1920, 1922
Wilson, CA 2114
Wilson, R 1589, 1666
Wolf, A et a l 2215
2264
Wooders, MH 2023
Woodford, M 1706, 1712, 1715, 1721-6, 1734,
1741, 1745, 1749, 1751, 1753, 1754, 1756,
2112, 2122, 2125, 2210
Wozniakowski, H 2071
Wright, R 1691, 1758
Wrobel, A 1837, 1850, 1860
Yaari, ME 1779, 1780, 1790, 1817, 1822,
1826, 1871, 1881, 1912
Yannelis, NC 1849, 1860, 1866, 1870, 1873,
1881, 1882, 1889
Index
Yano, M 2090
Yorke, JA 2217-18
Yosida-Hewitt theorem 1861, 1863, 1884
Young, DM 2070, 2125
Yuan, H-J 2227
Zame, WR 1609, 1639, 1835-98, 2089, 2125
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Arrow Debreu Hahn

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Arrow Debreu Hahn

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INTRODUCTION

The aim of the Handbooks in Economics series is to produce Handbooks for

Contents of the Handbook

Global Analysis and Economics

Duality Approaches to Microeconomic Theory

On the Microeconomic Theory of Investment under Uncertainty

Market Demand and Excess Demand Functions

Part 3 - MATHEMATICAL APPROACHES TO COMPETITIVE

Existence of Competitive Equilibrium

Contents of the Handbook

Temporary General Equilibrium Theory

Equilibrium under Uncertainty

The Computation of Equilibrium Prices: An Exposition

Social Choice Theory

Information and the Market

The Theory of Optimal Taxation

Contents of the Handbook

Positive Second-Best Theory

Optimal Economic Growth, Turnpike Theorems and Comparative

Part 5 - MATHEMATICAL APPROACHES TO ECONOMIC

Incentive Aspects of Decentralization

The Theory of Value in Security Markets

Sunspot Equilibria in Sequential Markets Models

Utility Theory with Uncertainty

Part 7 - INFINITE ECONOMIES

Equilibrium Theory in Infinite Dimensional Spaces

Part 8 - NON-CONVEXITY AND IMPERFECT COMPETITION

Equilibrium Analysis with Non-Convex Technologies

Part 9 - COMPUTATION AND MATHEMATICAL METHODS

Computation and Multiplicity of Equilibria

Non-Standard Analysis with Applications to Economics

Non-Linear Dynamical Systems: Instability and Chaos in Economics

The field of mathematical economics

Preface to the Handbook

University of California, Los Angeles

1. The Organization of topics

Uncertainty and Information

The task of explaining the development of mathematical economics since the

In Chapter 30, "Incomplete Markets," Michael Magill and Wayne Shafer

Infinite dimensional commodity spaces occur naturally in models with an

decision making with uncertainty. In Chapter 34, "Equilibrium Theory in

Part 8 -Non-convexity and imperfect competition

Chapter 36, "Equilibrium Analysis with Non-Convex Technologies," by

Part 9 - Computation and mathematical methods

Many useful applications of general equilibrium analysis require numerical

MICHAEL MAGILL and WAYNE SHAFER*

University of Southern California

Indeterminacy of GEl equilibrium with nominal assets

Production and the stock market

Two period exchange economy

Interface with finance

Handbook of Mathematical Economics, Volume IV, Edited by W. Hildenbrand and H. Sonnenschein

M. Magill and W. Shafer

Ch. 30: Incomplete Markets

investigation the Arrow-Debreu theory provides the idealised framework in

(1) The non-neutrality of financial instruments and the role of money

Ch. 30: lncomp~ Marke~

rational expectations equilibrium.

2.1. Two period exchange economy

Ch. 30: Incomplete Markets

his e n d o w m e n t to i = (to o, ojil . . . . . OJs) at the prices P = (Po, P, . . . . . Ps)

R% I P(x'- o/) = 0}.

Definition I. A contingent market (CM) equilibrium for the economy $ ( u , to)

max{ui(x i) Ix i E B(P, o9i)}