Journal of Economic Theory 105, 7398 (2002)

doi:10.1006/jeth.2001.2840

On Non-existence of Markov Equilibria in

Competitive-Market Economies 1
Manuel S. Santos
Department of Economics, Arizona State University, Tempe, Arizona 85287
Manuel.Santos@asu.edu
Received July 18, 2000; final version received April 2, 2001;
published online December 4, 2001

This paper presents some examples of regular dynamic economies with externalities and taxes that either lack existence of a Markov equilibrium or such equilibrium is not continuous. These examples pose further challenges for the analysis and
computation of these economies. Journal of Economic Literature Classification
Numbers: C10, C62. 2001 Elsevier Science (USA)
Key Words: competitive equilibrium; Markov equilibrium; externalities; taxes;
money.

1. INTRODUCTION
This paper presents some examples of dynamic competitive-market
economies with taxes and externalities in which either there is no Markov
equilibrium or such equilibrium is not a continuous function of the
underlying state variables. The existence of a continuous Markov (or
recursive) equilibrium has been considered a minimal requirement for the
analysis and simulation of a dynamic model. Indeed, since the early work
of Lucas and Prescott [22] and Prescott and Mehra [31], several papers
have been devoted to study this existence problem. For instance, Lucas and
Stokey [23] and Giovannini and Labadie [15] show the existence of
Markov equilibria for some monetary economies, and Bizer and Judd [5],
1
Paper presented at the meetings of the Society of Economic Dynamics (Sardinia, June
1999), the Society of Economic Theory (Rhodes, July 1999), and the Latin American Meetings
of the Econometric Society (Cancun, August 1999). Comments and suggestions from several
conference participants have been extremely beneficial. The author is especially grateful to
Mordecai Kurz, Ellen McGrattan, Victor Rios-Rull, and Nancy Stokey for some insightful
remarks.

73
0022-0531/01 $35.00
2001 Elsevier Science (USA)
All rights reserved.

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MANUEL S. SANTOS

Coleman [10], and Greenwood and Huffman [16] address this same
existence problem in economies with taxes and externalities. (Danthine and
Donaldson [11] and Stokey et al. [38, Chaps. 1718] offer a detailed
review of analytical methods and specific contributions to this literature.)
All these papers consider simple competitive economies with a representative consumer, and there are no known instances in which a Markov
equilibrium fails to exist. In frictionless economies, continuous Markov
equilibria can be shown to exist under relatively mild assumptions; here,
the most common method of proof hinges upon the contraction property
of the dynamic programming operator. As externalities, taxes, or money is
introduced into the analysis, one may still approach the problem of existence of Markov equilibria using a recursive operator over finite horizons,
but such an operator may fail to possess good convergence properties. The
aforementioned contributions are remarkable in that exploiting monotonicity properties of the solution they substantiate the existence of continuous
Markov equilibria for some important families of unidimensional models.
But it seems sensible to inquire to what extent these analyses may be generalized. Our present results suggest that in certain directions there is not
much scope for further generalizations.
Examples of non-continuous Markov equilibria are often found in gametheoretical settings (e.g., see Peleg and Yaari [30], Bernheim and Ray [4],
and Leininger [21] for analyses of these equilibria in bequest models, and
Fudenberg and Tirole [14] for a general overview of this literature). The
basic sources of these discontinuities are well understood and occur for
reasons outside the scope of perfect competition. In several types of games,
discontinuous choices arise from a loss of concavity of the objective function originated by other players best responses. Similar results are
observed in the literature of dynamic contracts and incentives (e.g., Marcet
and Marimon [24] and Rustichini [33]), where the loss of concavity stems
from the fulfillment of certain rationality conditions.
There is by now a vast literature on the study of the dynamics of competitive equilibrium solutions in economies with externalities, taxes, and
money (see Benhabib and Farmer [2] for a recent update). In a thought
provoking paper, Kehoe et al. [18] illustrate that externalities and taxes
may affect substantially the qualitative dynamics of the system; in particular, there could be a robust continuum of equilibria even in the presence of
a representative consumer. As these authors point out, these equilibria may
be characterized as solutions to a social planning problem with some additional side constraints involving endogenous variables. Although this latter
formulation of the problem may facilitate the analysis and simulation of
the model, the possible effects of these side constraints on the equilibrium
dynamics are not well understood. In some simple cases equilibrium
solutions in economies with distortions may be characterized by standard

NON-EXISTENCE OF MARKOV EQUILIBRIA

75

optimization problems (cf., [1, 11]), but in some other cases these
constraints are non-redundant: No single strictly concave optimization
problem can generate multiple solutions.
Most of the literature on indeterminacy of equilibria has been concerned
with local properties around steady-state solutions. The local behavior of a
certain orbit, however, does not necessarily preclude the existence of other
equilibrium paths comprising a Markov equilibrium. Hence, our paper
goes a step further as a global argument is required to demonstrate that a
Markov equilibrium may fail to exist, or that such equilibrium may not be
described by a continuous function. Our main purpose here is to highlight
some theoretical possibilities that must be faced when analyzing and
simulating a dynamic model. It is our understanding from the work of
Coleman [10] and Greenwood and Huffman [16] that the existence of a
continuous Markov equilibrium is guaranteed for a broad family of unidimensional growth models with taxes and externalities commonly used in
applied work. But as one of our examples illustrates, lack of existence of
these equilibria seems to be a more pervasive phenomenon in multisector
economies.
To provide some intuition for our results, in our economies the representative agent solves a convex optimization problem, and hence the
optimal decision varies continuously with the vector of prices. In equilibrium, however, prices are endogenously determined and may fail to be
expressed globally as continuous functions of the state variables. This lack
of representation of prices as whole functions of state variables seems to
apply to both stochastic and deterministic economies. Further subtle
distinctions will be observed in the separate analyses of discrete- and
continuous-time frameworks. Thus, in our family of continuous-time
models with a single state variable, a Markov equilibrium is made up of a
finite number of equilibrium trajectories or connected arcs. In discrete-time
models, however, an equilibrium trajectory contains a countable number of
points, and hence a continuum of such trajectories is needed to conform a
Markov decision rule. Accordingly, additional types of discontinuities may
arise in a discrete-time setting.
At this informal level of discussion, Table I is meant to elicit the significance of the present findings. For the class of models considered in this
paper, it is relatively easy to establish that every finite-horizon economy
always contains a Markov equilibrium (i.e., see the first column of the
table). But as shown below (viz. Section 3.1), in the presence of an infinite
horizon, existence of this fundamental equilibrium concept is no longer
guaranteed. There could be no fixed-point or stationary equilibrium solution.
Regarding the second column of this table, note that every continuous-time
finite horizon economy has a unique continuous Markov equilibrium. It is
illustrated in Section 2 below that non-continuous Markov equilibria may

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MANUEL S. SANTOS
TABLE I
Existence of Markov Equilibria a

Class of models

Does a Markov equilibrium

always exist?

Is the Markov equilibrium

always continuous?

Continuous-time,
finite-horizon

Yes

Yes

Continuous-time,
infinite-horizon

No

No

Discrete-time,
finite-horizon

Yes

No

Unknown

No

Discrete-time,
infinite-horizon
a

These results apply for the class of regular economies considered in this paper (e.g.,
economies that satisfy assumptions (A.1)(A.3)).

arise in unbounded horizons. Regarding discrete-time models, noncontinuous Markov equilibria may be observed under both bounded and
unbounded horizons. We will see, however, that certain types of discontinuities are characteristic of infinite-horizon economies.
Finally, let us conclude this introduction with some related work on
dynamic social planning problems with non-convexities. 2 Some early, key
contributions in this literature are Skiba [37], and Davidson and Harris
[12]. These analyses are truly unidimensional in that optimal solutions are
characterized from inspection of the phase diagram conformed by the Euler
equations. 3 And, indeed, most results are obtained on a case by case basis.
There is, however, a general result of particular interest to the present
work: Steady states displaying complex eigenvalues are non-optimal and
the policy function may be discontinuous. A similar proposition on the noncontinuity of the equilibrium function will emerge for some competitive
environments, even though the underlying arguments are quite different.
The paper is structured as follows. Section 2 presents a simple economy
with a production externality in which from the equilibrium laws of motion
one cannot construct a continuous Markov equilibrium. Section 3 relates
further developments in two economies with taxes. In the first example
there are two production sectors that are taxed asymmetrically, and a
Markov equilibrium fails to exist. The second example describes a standard
2

There is a parallel line of research on dynamic models with optimal taxation; e.g., see [8].
See Ladron-de-Guevara et al. [20] for a recent attempt at generalization in a model with
multiple controls and state variables.
3

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NON-EXISTENCE OF MARKOV EQUILIBRIA

one-sector growth model with a decreasing tax rate on capital returns; in

this example every Markov equilibrium must be non-continuous. Further
issues on the computation of these equilibria are examined in Section 4.
This discussion is completed in our final section with some concluding
remarks.

2. NON-EXISTENCE OF CONTINUOUS MARKOV EQUILIBRIA

IN AN ECONOMY WITH EXTERNALITIES
This section considers a one-sector growth economy with an externality
in the production of the aggregate good in which there is no continuous
Markov equilibrium. All agents are identical in this economy, and so
without loss of generality we shall focus on the equilibrium problem of a
representative individual. For simplicity of exposition, a competitive equilibrium will be characterized as a solution to a dynamic optimization
problem involving certain consistency conditions.
The representative agent owns an initial stock of capital k0 . The quantity
of output produced, y=f(k, k e), depends on the individuals stock of
capital, k, and on her true perceptions about the average stock of capital in
the economy, k e. Output y is available for consumption, c, or investment, i.
Capital is subject to a constant depreciation rate, d.
Given a path of average stocks {k e(t)}t \ 0 the representative agent
chooses {c(t), i(t)}t \ 0 so as to solve the following optimization problem
.

max F
0

c(t) 1 s rt
e dt
1s

(P)

s.t. c(t)+i(t)=y(t)
y(t)=f(k(t), k e(t))
k(t)=i(t) dk(t)
k(0)=k0
c(t) \ 0,

given,
k(t) \ 0,

s > 0,

r > 0,

d > 0,

t [0, .),

where k(t) denotes the time derivative of k at t.

2
Production function f: R+
0 R+ is assumed to satisfy the following
conditions:
2
(A.1) Function f is bounded and twice continuously differentiable on R++
.

78

MANUEL S. SANTOS

(A.2) For each given k e, the mapping f( , k e) is increasingly monotone

and concave.
(A.3) Let r(k)=f1 (k, k) denote the derivative of f with respect to the
first argument at (k, k). Then limk Q 0 r(k) > r+d.
A competitive equilibrium for this economy is defined as a triple of
(absolutely continuous) functions {c(t), k(t), k e(t)}t \ 0 such that the pair
{c(t), k(t)}t \ 0 solves problem (P) for k e(t)=k(t) for all t \ 0. It follows
that along an equilibrium path the following conditions are always
satisfied:

lim e

rt

c(t)

c(t) 1
= [r(k(t)) r d]
c(t) s

(2.1)

k(t)=f(k(t), k(t)) dk(t) c(t)

(2.2)

k(t)=0.

(2.3)

tQ.

Thus, a competitive equilibrium requires individual optimization, market

clearing, and consistency of beliefs. A steady-state equilibrium (c g, k g) is a
constant pair of positive solutions to Eqs. (2.1)(2.2).
There are several studies on the equilibrium dynamics for growth models
with externalities (e.g., [2, 6], and references therein). Following Benhabib
and Gali [3] we now consider an economy with three steady states. Thus,
as illustrated in Fig. 1, the marginal productivity schedule, r(k), must cross

FIG. 1. Multiplicity of stationary solutions.

NON-EXISTENCE OF MARKOV EQUILIBRIA

79

FIG. 2. Dynamics of consumption and capital in an economy with externalities.

the constant function r+d at three given points, k gL , k gM , k gH . Moreover,

Fig. 2 is intended to represent the phase diagram corresponding to Eqs.
(2.1)(2.2) for this specific economy. Observe that steady states (c gL , k gL )
and (c gH , k gH ) are saddle-path stable, and steady state (c gM , k gM ) is chosen to
be a spiral source. Benhabib and Gali [3] provide a discussion of certain
assumptions generating this dynamic behavior. (These conditions can
additionally be envisaged from linearization of the system of Eqs. (2.1) and
(2.2) at each particular steady state.)
The thick lines in the diagram depict the stable arms W SL and W SH of
steady states (c gL , k gL ) and (c gH , k gH ), which are joined by steady state
(c gM , k gM ). These stable manifolds along with the three non-degenerate
steady states are equilibrium trajectories of our economy. Of course, as is
typical in studies of the global equilibrium dynamics (cf. [37]) to ensure
that these are the only equilibrium solutions of our economy one would
need to rule out the possible existence of some other trajectories satisfying
(2.1)(2.3). A global analysis of the equilibrium solutions, however, will
not be necessary for the present strategy of proof.
If the model economy has a solution in feedback form, then we say that
there exists a Markov equilibrium. That is, a Markov equilibrium is a pair
of decision rules c(k) and k=g(k) such that every trajectory {c(t), k(t)}t \ 0

80

MANUEL S. SANTOS

generated by these feedback controls is a competitive equilibrium. Under

(A.1)(A.3), we now claim that for the economy described in this section
these decision rules cannot be continuous functions.

Proposition 2.1. For the economy described in this section, there does
not exist a continuous Markov equilibrium.
Proof. The proof of this proposition follows from the following steps:
(i) Point k gM cannot be a stationary solution under function g.
Otherwise, given that k gM is a spiral source, continuity requires that the
control variable k=g(k) will circle around point k gM , generating an additional countable number of steady state equilibria. This is not possible,
since points k gL , k gM , k gH are assumed to be the only non-degenerate steady
state equilibria.
(ii) The vector field points inward: g(k) > 0 for k < k gL and g(k) < 0
for k > k gH . Observe that (A.3) implies that g(k) > 0 for k sufficiently small;
hence, by continuity, g(k) > 0 for every k < k gL . Moreover, the asserted
boundedness of f in (A.1) and d > 0 imply that g(k) < 0 for some k large
enough; hence, by continuity, g(k) < 0 for every k > k gH .
(iii) For k < k gH every orbit starting at k under g cannot converge to
point k gH . Let k < k gH . Then consider an equilibrium trajectory starting at a
point (c, k) converging to steady state (c gH , k gH ). One can see from the
phase diagram (Fig. 2) that such a trajectory must belong to the stable arm
joining points (c gM , k gM ) and (c gH , k gH ). (Observe that for each plausible
equilibrium point (c, k), function g would be defined as k=g(k)=
f(k, k) dk c.) But, analogously to (i), the continuity of our feedback
controls implies then that point k1 in Fig. 2 is an additional stationary
point under g. This is therefore a contradiction, which validates this fact.
In the same way, one can show
(iv) For k > k gL , every orbit starting at k under g cannot converge to
point k gL .
(v) Non-existence of a continuous decision rule, k=g(k). If g is a
continuous function, then (i) implies that k gL and k gH are the only (nondegenerate) stationary points under g. As the vector field points toward the
inside (see (ii)) every orbit under g must converge to either k gL or k gH . Then
(iii) entails that every orbit starting a point k < k gL must converge to k gL ,
and (iv) entails that every orbit starting at a point k > k gH must converge to
point k gH . But (iii) and (iv) also imply that every orbit starting at point k in
the open interval (k gL , k gH ) will not converge to any stationary point, and
this stands in contradiction with the postulated continuity of function g. In

NON-EXISTENCE OF MARKOV EQUILIBRIA

81

other words, if g is a continuous function, then (ii)(iv) imply that the

vector field points inward over the interval (k gL , k gH ). Then, the continuity
of g calls now for an additional stationary point in this interval, which is of
course in contradiction with (i).
The present proof of non-existence of a continuous Markov equilibrium
should be distinguished from more familiar results concerning spiralling
trajectories and non-continuous Markov equilibria. More specifically, to
validate the non-existence of a continuous Markov equilibrium it is necessary to consider equilibrium functions over the whole domain; it is not
enough to construct simply a non-continuous Markov equilibrium. Indeed,
as an extension of the present analysis one could concoct instances of
economies that contain both continuous and non-continuous Markov
equilibria. Therefore, the study of the local behavior of an equilibrium
orbit would not be enough for present purposes.
Also, it is relatively easy to prove that a finite-horizon version of
problem (P) would contain a continuous Markov equilibriumalbeit the
corresponding Markov equilibrium functions are non-stationary and must
be parameterized by the time argument. Hence, within the family of models
with a one dimensional state variable the non-existence of a continuous
Markov equilibrium is unique to the infinite-horizon model in that there
may be no single pair of continuous functions that can describe the
equilibrium dynamics for consumption and investment.
It is now readily seen from the phase diagram of Fig. 2 that the economy
contains a multiplicity of non-continuous Markov equilibria. These equilibria can be derived from selecting appropriately portions of the upper
part of the manifold W SL and of the lower part of the manifold W SH so as to
generate an equilibrium function k=g(k). For instance, let k be an arbitrary point in the interval (k1 , k2 ) of Fig. 2. Then consider the following
paths: For k \ k, follow the lower part of W SH , and for k < k follow the
upper part of W SL . This selection gives rise to an equilibrium function as
that depicted in Fig. 3. As a matter of fact, from these arguments one can
see that there is a continuum of these equilibrium functions with a point of
discontinuity k (k1 , k2 ) in which the equilibrium function could be either
continuous from the right or continuous from the left. 4
It should be stressed that in the present example every equilibrium
trajectory can only have one point of discontinuity, for equilibrium
trajectories can solely jump at time t=0 (i.e., at the initial point k) but
not at any other t > 0. In our economy the representative consumer is
4
Of course, if the discontinuity is at point k1 the equilibrium function can only be
continuous from the left, and if the discontinuity is at point k2 the equilibrium function can
only be continuous from the right.

82

MANUEL S. SANTOS

FIG. 3. An equilibrium function with a discontinuity at point k.

solving a strictly concave maximization problem; hence, k must be a continuous function of t for all t > 0 (cf. Fleming and Rishel [13, Chap. 1,
Corollary 3.3]). Therefore, the convexity of the agents optimization
problem precludes any other discontinuity of an equilibrium trajectory
after time t=0. Moreover, as there is a single state variable, a function
describing a Markov equilibrium is conformed by a finite number of equilibrium trajectories or connected arcs. Thus, excepting initial jumps the
equilibrium function is as smooth as the equilibrium trajectories (cf. Santos
and Vila [35]). This is an important difference with respect to multidimensional models, or with respect to discrete-time models. For every
economy satisfying (A.1)(A.3), every Markov equilibrium would generally
have at most a finite number of simple discontinuities (i.e., discontinuities
of the first kind). In a discrete-time formulation of the model, however,
current investment affects the stock of capital in discrete amounts, and so
other types of discontinuities may in principle be observed.
Finally, it may be helpful to call attention to the analogous analysis of
optimal solutions in non-concave social planning problems (cf. [12, 37]).
In these optimization problems, a spiral source such as (c gM , k gM ) is not
optimalit yields less utility than other feasible trajectoriesand neither
are those trajectories starting at points arbitrarily close to (c gM , k gM ). As a
result, the policy function may be discontinuous. Since there is usually a
solution that yields the highest utility, these optimal economies do not
generally possess multiple equilibrium functions. In our decentralized
economy, however, all steady states and every trajectory converging to
a steady state are competitive equilibria. These solutions can be appropriately selected so as to generate a multiplicity of non-continuous
equilibrium functions.

NON-EXISTENCE OF MARKOV EQUILIBRIA

83

3. ECONOMIES WITH TAXES

Under regular assumptions, Bizer and Judd [5], Coleman [10], and
Greenwood and Huffman [16] have shown the existence of continuous
Markov equilibria in standard one-sector growth economies with taxes on
capital returns. This section contains two examples that illustrate the
fragility of this well established result. The first example presents an
economy with two sectors and asymmetric taxation; this economy fails to
possess a Markov equilibrium. The second example reconsiders a onesector economy with a decreasing tax rate on capital returns. Here, every
Markov equilibrium must have one discontinuity point. One main conclusion from this section is that previous results on existence of continuous
Markov equilibria for one-sector economies with taxes appear to be rather
difficult to extend to more complex settings.
3.1. An Economy with Physical and Human Capital and Asymmetric
Taxation
Consider an endogenous growth economy with physical and human
capital and asymmetric taxation across sectors. The available stocks of
physical capital, K, and human capital, H, can be allocated to the production of the physical good or to the production of education. Production in
each sector is determined by a simple CobbDouglas, constant returns to
scale technology. Thus, let
X=AK ax H 1x a ,

A > 0,

0<a<1

(3.1)

be the quantity produced of the aggregate good using the inputs vector
(Kx , Hx ), and let
Y=BK by H 1y b

B > 0,

0<b<1

(3.2)

be the quantity produced of the education good using the inputs vector
(Ky , Hy ).
Let q refer to the price of human capital in terms of the aggregate good.
Then, for given physical capital returns, r, and wage rates, w, profit maximization by firms in each sector implies that
aAK ax 1 H 1x a [ rx ,
(1 a) AK ax H xa [ wx ,

qbBK by 1 H 1y b [ ry
q(1 b) BK by H yb [ wy .

(3.3)
(3.4)

(Here, of course, subscripts refer to the corresponding sector, and equality

must hold for each condition whenever the corresponding vector (Kx , Hx )
or (Ky , Hy ) is positive.)

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MANUEL S. SANTOS

A representative consumer is also present in this economy. This agent is

endowed with k0 units of physical capital and h0 units of human capital.
At each moment in time the agent decides on the amounts to be allocated
for consumption, c, physical capital investment, Ik , and human capital
investment, Ih , and on the fractions of physical capital, v, and of human
capital, u, to be devoted to the production of the physical good. The
remaining fractions of physical and human capital are devoted to the
production of the education good. All physical capital returns are subject
to a single flat-rate tax, yk ; in contrast, wages are taxed in the aggregate
good sector at a rate, yh , and are subsidized in the education sector at a
rate, fh . The proceeds of taxation are rebated to the representative
individual as lump-sum transfers, T.
For given paths for good and factor prices and tax rates {q(t), rx (t),
ry (t), wx (t), wy (t), yk , yh , fh } the agent chooses {Ik (t), Ih (t), c(t), u(t), v(t)}
so as to solve the following optimization problem
.

max F
0

c 1 s rt
e dt
1s

(P )

s.t. c+Ik +qIh [ (vrx +(1 v) ry )(1 yk ) k

+(uwx (1 yh )+(1 u) wy (1+fh )) h+T
k=Ik dk
h=Ih
c \ 0, k \ 0, h \ 0, 0 [ u [ 1, 0 [ v [ 1
k(0)=k0 , h(0)=h0

given, r > 0, s > 0, d > 0, t [0, .).

Here, d > 0 is the depreciation rate of physical capital; for convenience it

is assumed that human capital is not subject to depreciation. Now, the
specification of the government budget constraint and the market clearing
conditions will complete our characterization of a competitive equilibrium.
Revenues from factor taxation in both sectors are simply transferred as
additional income to the representative individual
T=yk rx Kx +yk ry Ky +yh wx Hx fh wy Hy .

(3.5)

Observe that these transfers depend on aggregate variables and not on

the decisions made by the representative agent. Finally, market clearing
requires at all times equilibrium in good and factor markets
c+Ik =X=AK ax H 1x a ,

Ih =Y=BK by H 1y b

k=K=Kx +Ky ,

vk=Kx

h=H=Hx +Hy ,

uh=Hx .

(3.6)
(3.7)

NON-EXISTENCE OF MARKOV EQUILIBRIA

85

That is, aggregate quantities chosen by firms must be consistent with the
agents choices.
Formally, a competitive equilibrium for this economy is a path of prices
and tax rates {q(t), rx (t), ry (t), wx (t), wy (t), yk , yh , fh }t \ 0 , a set of choices
for aggregate production {Kx (t), Ky (t), Hx (t), Hy (t), X(t), Y(t)}t \ 0 , and a
set of choices for the representative agent {Ik (t), Ih (t), c(t), u(t), v(t)}t \ 0
that solve problem (P ), and such that conditions (3.1)(3.7) are always
satisfied. 5
A balanced growth path {k(t), h(t), c(t), u(t), v(t)}t \ 0 is a competitive
equilibrium such that {k(t), h(t), c(t)}t \ 0 grow at a constant rate n, and
{u(t), v(t)}t \ 0 stay constant. If n > 0, then the balanced growth path is said
to be interior.
In the present context, local stability properties of a balanced growth
path have been studied by Bond et al. [7]. The following simple reformulation of one of their results (see their Proposition 5) will be useful for
our purposes.
Proposition 3.1. Assume that the above economy has an interior
balanced growth path. Let ((1 b) a/b(1 a))((1+fh )/(1 yh )) > 1 >
(1 b) a/b(1 a). Then, the balanced growth path is locally unstable.
Raurich [32] and Ortigueira [27] provide extensions of these results to
environments with active government policies.
A Markov equilibrium is a list of functions {Ik , Ih , c, u, v} that depend
on (k, h) such that every trajectory generated by these decision rules is a
competitive equilibrium. Since the utility function follows a power law and
each production sector features constant returns to scale, there is no
restriction of generality to impose that functions Ik , Ih , and c be homogeneous of degree one in (k, h), and that functions u and v be homogeneous
of degree zero. Then our state variable is in fact the ratio m=kh , and our
main objective is to study if there is a Markov equilibrium so that the law
of motion of variable m can be expressed by a function m
=g(m). We have
the following:
Theorem 3.2. Under the conditions of Proposition 3.1, for the economy
described in this section there does not exist a Markov equilibrium.
It should be stressed that the theorem asserts the non-existence of a
(continuous or non-continuous) Markov equilibrium. As discussed in the
preceding section, equilibrium trajectories must be continuous functions of
5
Observe that this definition can encompass non-interior equilibria where at a certain time
either good X or good Y is not produced. For instance, good Y will not be produced if rx \ ry
and wx (1 yh ) \ wy (1+fh ) and one of these inequalities is strict.

86

MANUEL S. SANTOS

t for all t > 0. Then the strategy of proof is to show that this continuity
property of equilibrium trajectories, together with the existence of a
unique, locally unstable steady-state solution, is not compatible with the
existence of a Markov equilibrium.
Proof of Theorem 3.2. It is shown in the Appendix that if there is an
interior balanced growth path, then this is unique and there is not any
other boundary balanced growth path. Now, assume the existence of an
equilibrium function m
=g(m). Under the present assumptions one can
readily establish that the vector field must point inward: g(m) > 0 for m
close to zero and g(m) < 0 for m sufficiently large.
Then pick a point m. As illustrated in the preceding section every equilibrium trajectory starting at m must vary continuously with t for all t > 0.
As the vector field points towards the inside, every initial condition m
under g must converge to a singular point m g. Moreover, one can show
that m g is a steady-state solution for our economy. 6 We have therefore
reached a contradiction, since there is at most one stationary solution m g,
and such a steady state is locally unstable. The proof is complete. L
Within the space of feasible parameter values, one can readily see that
the conditions of Proposition 3.1 will hold for an open set of economies.
Indeed, it should be clear that the results in this paper concerning either
non-existence of a Markov equilibrium or non-existence of a continuous
Markov equilibrium are usually robust to small perturbations of the
primitives. In general, these examples are not isolated, and small changes
in parameter values will not restore existence of a continuous Markov
equilibrium.
The following example is intended to shed light on the preceding analysis.
Example 3.3. Let
X=AK ax H 1x a ,
a=0.3,

Y=BK by H 1y b

b=0.4,

yh =0.4,

fh =0.2.

Then one can check that the parametric condition stated in Proposition 3.1
is satisfied:
(1 b) a 1+fh
(1 b) a
>1>
.
b(1 a) 1 yh
b(1 a)
6
This statement follows from inspection of Eqs. (13a)(14) in [7]. This equations system
has a recursive structure, and the relative price q is constant over the transitional dynamics.

NON-EXISTENCE OF MARKOV EQUILIBRIA

87

Now, following our derivation in the Appendix the existence of an interior

balanced growth path is guaranteed by a selection of appropriate values for
parameters A, B, s, r, and d. These latter parameters, however, do not have
a key role in the qualitative dynamics about a balanced growth path. The
local stability around a balanced growth path is driven by the rankings of
physical factor intensities and factor income shares across sectors. As
explained in Bond et al. [7], taxation may distort the ranking of factor
intensities and income shares. Thus, the present tax rates make sector X
physical capital intensive, even though this capital commands a higher
relative income share in sector Y. As a result of this reversal in the rankings
of factor intensities and income shares, the Rybczynski and Stolper
Samuelson effects work in opposite directions; and the saddle-path stability
of the stationary solution no longer holds. Then under the aforementioned
forward-continuity property of equilibrium trajectories we have established
that there cannot exist a Markov equilibrium.
3.2. A One-Sector Economy with a Decreasing Tax Rate on Capital Returns
It is known from the work of Coleman [10] and Greenwood and
Huffman [16] that for regular one-sector economies with flat or increasing
tax rates on capital returns there always exists a continuous Markov equilibrium. Our purpose now is to show that continuity may be lost if the
average tax rate on capital returns is a decreasing function of the capital
stock.
Time is discrete, t=0, 1, 2, ..., in this economy. There exist but a single
consumer, who is endowed with k0 units of capital, and a unique firm
which operates a one-sector technology described by a function, y=f(k).
The firm is owned by the consumer, who gets all its revenues as either
profits, p, or returns from capital, r. Capital returns are taxed at a rate
y(kt ). The tax rate is allowed to depend on the capital stock of the
economy.
The consumer chooses {ct , xt }t \ 0 in order to solve the following
optimization problem
.

max C c tu(ct )
t=0

s.t. ct +xt [ pt +(1 yt ) rt kt +Tt

kt+1 =xt +(1 d) kt
k0 given,
ct \ 0,

0 < c < 1,
xt \ 0,

0[d[1

t=0, 1, 2, ...

88

MANUEL S. SANTOS

As in our two previous examples, the agent has perfect foresight and
considers that yt , rt , and Tt are exogenously given. These variables are
viewed as functions of aggregate quantities. The firm takes rt as given and
chooses Kt in order to maximize one-period profits, pt =f(Kt ) rt Kt . The
government sets Tt =yt rt Kt . In a competitive equilibrium the good and
factor markets must clear, so that
xt +ct =f(Kt )

and

kt =Kt ,

t=0, 1, 2, ...

(3.8)

At an interior solution, these equilibrium identities and utility maximization conform to the Euler equation
u(ct )+cu(ct+1 )[f(kt+1 )(1 y(kt+1 ))+(1 d)]=0.

(3.9)

Under regular assumptions, if the tax rate y is a non-decreasing function

of k, then (3.9) has at most a unique stationary solution, k g. But if y is a
decreasing function of k, then there could be multiple steady states. We
now consider a simple parameterization in which there are three stationary
solutions. Let
u(c)=log c,

f(k)=k 1/3

c=0.95,

d=1

with the continuous, piecewise linear tax schedule

0.10

y(k)= 0.05 10(k 0.165002)

0

if

k [ 0.160002

if

0.160002 [ k [ 0.170002

if

k \ 0.170002.

Under this parameterization, Euler equation (3.9) has three interior stationary solutions, k gL =0.152148, k gM =0.165002, k gH =0.178198. Observe
that the tax rate is constant around steady states k gL and k gH , and hence
these steady states are saddle-path stable. The slope of the tax schedule at
k gM has been chosen so that this point is a spiral source. In the present
model, this is always possible. 7 The dotted lines in Fig. 4 depict the local
equilibrium dynamics for this economy. Observe from this figure that the
corresponding stable manifolds W SL and W SH are joined by point (k gM , k gM ).
As in our preceding examples, it is now contended that the equilibrium
law of motion of capital cannot be described by a continuous function,
kt+1 =g(kt ). Observe that the qualitative dynamics of this example are like
7
Steady states displaying complex eigenvalues may likewise be generated under alternative
tax schedules. For instance, a variable subsidy on capital returns may give rise to a spiral sink.

NON-EXISTENCE OF MARKOV EQUILIBRIA

89

FIG. 4. PEA and accurate equilibrium solutions.

those of our illustration in Section 2. In a discrete-time model, however, the

dynamics could be more complex (i.e., one-dimensional discrete-time
models may generate periodic orbits or more complicated recurrent paths),
and hence the corresponding arguments for proving non-existence of a
continuous decision rule become more delicate.
Proposition 3.4. For the economy described in this section, there does
not exist a continuous Markov equilibrium.
Proof. (i) The vector field points inward and so k g=g(k g) for some
k > 0. If g is a continuous function, then one can show that g(k) > k for k
near k=0. Also, under our production function f(k)=k 1/3 it follows that
g(k) < k for k large enough. Therefore, there must be some stationary
solution k g=g(k g) for k g > 0.
(ii) Point k gM is not a stationary solution under g. At points near the
steady-state solution k gM , the dynamics are well approximated by the
linearization of (3.9). The eigenvalues of this linear system are the complex
conjugate pair l and l, with l=0.189604+1.03541i. Let r=(0.189604 2+
1.03541 2) 1/2=1.05263 and h=arc cos 0.189604
=1.75191. Then, making an
r
appropriate coordinate change around the point (k gM , k gM ), every nearby
equilibrium point (k, g(k)) undergoes under this linear system a counterclockwise rotation through h=1.75191 radians followed by a stretching
out of the distance to the steady state (k gM , k gM ) by a factor of r (cf. [17,
p. 56]). Thus, for k0 sufficiently close to k gM , every equilibrium orbit {kt } .
t=0
generated by function g will cross a number of times the 45-degree line (i.e.,
g

90

MANUEL S. SANTOS

this orbit will contain several pairs of points kt > k gM and kt > k gM such that
g(kt ) < kt and kt > g(kt )). If k gM =g(k gM ), and g is a continuous function,
then there must be a countable number of steady states arbitrarily close to
k gM . Consequently, k gM ] g(k gM ).
(iii) If k gH =g(k gH ), then there exists a neighborhood U of (k gH , k gH )
such that [graph(g) 5 U] W SH . If k gH =g(k gH ), then the continuity of g
and point (i) above imply that every trajectory under g starting at k > k gH
must converge to k gH . Therefore, the graph of g belongs to W SH for every
min
point k \ k gH . Suppose now that k < k gH . Let l max
H > 1 > l H > 0 be the
g
eigenvalues of the linearization of (3.9) at k H . By the l-Lemma (cf. [29,
p. 84]), there is no loss of generality in assuming that the left-side slope of
or l min
g at k gH is well defined and it is either l max
H
H . If the left-side slope is
max
g
l H , then k > g(k) for k close to k H . In view of (i) and (ii) above, we must
then have convergence to the lower steady state so that k gL =g(k gL ). Moreover, the continuity of g entails that the right-side slope of g at k gL is
l max
> 1, where l max
is the corresponding eigenvalue of the linearization of
L
L
(3.9) at k gL . But this is impossible, since g is a continuous function, and
k > g(k) for k in the open interval (k gL , k gH ). This contradiction then
establishes that the left-side slope of g at k gH is l min
H , and hence the graph of
g belongs to W SH for k < k gH close to k gH . In the same way one can prove
(iv) If k gL =g(k gL ), then there exists a neighborhood U of (k gL , k gL ) such
that [graph(g) 5 U] W SL .
(v) Non-existence of a continuous decision rule kt+1 =g(kt ). It is now
easy to see that (i)(iv) imply that function g must have at least one point
of discontinuity. Thus, (i)(ii) entail that k gL and k gH are the only plausible
stationary solutions under g. Moreover, by (iii) and (iv) both k gH and k gL
should be stationary solutions, since neither W SH nor W SL alone can
encompass graph(g). Then, as in Section 2 we may now conclude from (ii)
that g must have a point of discontinuity in the interval [k1 , k2 ] of Fig. 4.
The result is thus established.
In contrast to the continuous-time framework, it should be observed that
a discrete-time finite-horizon economy may contain a non-continuous
Markov equilibrium. Indeed, even in the case of a finite-horizon for each
initial condition k0 there could be a continuum of solutions to the system
of Euler equations (3.9). Therefore, standard assumptions can only
guarantee the upper-semicontinuity of the equilibrium correspondence,
even if attention is restricted to Markov equilibria. Consequently, several
types of discontinuities may arise for equilibrium decision rules of discretetime models.
Finally, let us mention that we have been unable to establish a discretetime counterpart of the example of the preceding section. That is, an

NON-EXISTENCE OF MARKOV EQUILIBRIA

91

example of an economy which always contains a competitive equilibrium,

but which nevertheless lacks existence of a Markov equilibrium. Again, one
should appreciate here a major difference with respect to the one-dimensional continuous-time framework. In continuous-time economies, the nonexistence of a Markov equilibrium relied on the forward continuity of the
equilibrium trajectories. This argument, however, does not carry through
to a discrete-time framework, since in a discrete-time model every equilibrium orbit is just made of a countable number of points. Thus, an equilibrium function may well display an infinite number of discontinuities.

4. SOME THOUGHTS ON THE SIMULATION OF THESE

ECONOMIES
A model may be simulated even though it may not possess a continuous
Markov equilibrium. Indeed, in our previous examples all equilibria can be
characterized as solutions to systems of Euler equations satisfying certain
transversality conditions, and often these paths can be readily ascertained.
But matters may be more complex in models with several state variables or
in the presence of uncertainty.
Several numerical procedures have been proposed for the computation of
continuous Markov equilibria (cf. [11]). For most algorithms, however, a
solution is not known to exist. Existence of a continuous Markov equilibrium is guaranteed in the iterative schemes considered by Bizer and Judd
[5], Coleman [10], and Greenwood and Huffman [16], provided that a
certain monotonicity condition is satisfied. These methods have not been
extended to models with several endogenous state variables.
Some numerical methods may preserve the continuity of the value and
policy functions at each iteration. But it should be stressed that a key step
in the computation of solutions for infinite-horizon models is to show that
the limiting functions are also continuous and constitute true equilibrium
decision rules. Therefore, typical procedures for stopping the algorithm
(say, whenever two consecutive policy functions gn and gn+1 fall within a
given tolerance bound, ||gn gn+1 || [ E) may lead to the wrong belief that
the true policy function is continuous. The numerical experiment presented
below should warn us against the use of computational methods without
basic knowledge of assumed qualitative properties of solutions including
existence of a Markov equilibrium.
As is well understood, these pitfalls can also be encountered in quadratic
economies. Thus, not every linear Euler equation system has a corresponding continuous equilibrium function. A solution always exists for the
linearization of Eulers equation in regular concave optimization problems
(cf. Scheinkman [36]), but it would not exist for the linearizations of our

92

MANUEL S. SANTOS

previous unidimensional examples at those steady states displaying

complex eigenvalues. For a linear system of Euler equations to be solvable
certain stability conditions need to be satisfied (cf. [25]), and in the
absence of those conditions a finite-iteration approximation scheme may
produce deceptive outcomes.
Our examples in Sections 2 and 3 do not possess a continuous Markov
equilibrium. Hence, it may be inappropriate to compute equilibrium functions using algorithms with continuous solutions. Moreover, application of
these algorithms may not unveil existing discontinuities in the equilibrium
law of motion.
As a simple numerical experiment, a version of the PEA algorithm with
collocation, as described in Christiano and Fisher [9], has been applied to
our parameterized economy in Section 3.2. The algorithm produced stable
outcomes in the sense that successive higher-order interpolants led to
essentially the same solutionno major variations were discerned in the
solution coefficients from changes in the polynomial degree of the interpolant. Again, from this parsimonious behavior one may be led to believe
that this economy contains a continuous Markov equilibrium. Figure 4
displays a representative computed equilibrium function under the PEA
algorithm with collocation. But as shown in the same figure the computed
policy function deviates sensibly from the accurate solution. For the computed PEA solution, we checked the size of the Euler equation residuals (cf.
Santos [34]), and the residuals were fairly large (i.e., of the order of 10 3).
Moreover, the residuals remained of roughly the same size under higherorder interpolations. Thus, evaluation of the residuals may provide a good
indication that the algorithm is not performing well, or that it is inadequate
for the simulation of the model. 8
Further difficulties arise in attempting to compute equilibrium solutions
for the economy of Section 3.1. This is a deterministic model with a unique
stationary solution, but such a steady state is unstable. Numerical solution
of the model seems a more laborious undertaking, since no equilibrium
trajectory converges to a balanced growth path. Furthermore, as shown in
Ortigueira and Santos [28], apart from the stationary solution there is no
equilibrium trajectory that lies in the interior at all times; that is, along any
non-stationary equilibrium orbit the economy is constantly switching from
periods in which both production sectors are active to periods in which

8
Although an evaluation of the residuals may alert us that the algorithm is not performing
well, it is not clear that this criterion may always be effective. Since the model is not concave,
small residuals may be associated with large deviations from the true policy function. What
seems to be true is that the residuals may yield a better indication of accuracy than the previously mentioned check on the stability of the solution coefficients over different interpolation schemes.

NON-EXISTENCE OF MARKOV EQUILIBRIA

93

only one of the sectors is active. 9 The most obvious numerical procedure
for the computation of equilibria in the present economy that comes to
mind is simply to single out those solutions to the system of Euler equations that satisfy feasibility and the transversality condition at infinity. But
this seems to lead to a rather lengthy searching procedure, where sorting
out the desired trajectories involves some kind of trial-and-error method or
what is known as the shooting method.
From a computational standpointand for other purposes as wellit
may be of importance to establish links between the existence of Markov
equilibria and qualitative properties of the model such as existence and
uniqueness of stationary solutions, local stability, and indeterminacy of
solutions. Let us mention that monotonicity together with determinacy of
equilibrium solutions is a key property for validating the existence of a
continuous Markov equilibrium. But most local properties play a much
weaker role, since a multiplicity of continuous and non-continuous Markov
equilibria may coexist in a dynamic model. For instance, in our two previous examples with three steady states there could be other configurations
in which none of the stable arms sprinkles from the middle steady state.
Then there could be two continuous Markov equilibria even if the middle
steady state is a spiral. Therefore, local properties of solutions cannot
usually provide definite clues, since as already pointed out global
arguments are needed to rule out the existence of a continuous Markov
equilibrium.
Our discussion so far has been confined to simple deterministic models.
Here, lack of existence of a continuous Markov equilibrium may not
hamper the analysis and simulation of the model. Sometimes there are
ways to characterize an equilibrium solution which are easily amenable to
computation. Further difficulties, however, may originate in multidimensional models or in stochastic environments, where it may be much harder
to ascertain the limiting behavior of the orbits, the existence of cycles,
limit sets, or invariant distributions, and as to whether or not there is a
continuous Markov equilibrium.

5. CONCLUDING REMARKS
This paper contains three examples of regular dynamic economies which
lack existence of continuous Markov equilibria. In the first example, the
source of non-existence stems from a pronounced production externality.
9
Computation of equilibria in the other two economies will amount to tracing back those
trajectories converging to a steady state, and this task can be accomplished by relatively fast
numerical methods.

94

MANUEL S. SANTOS

Nevertheless, this economy displays a multiplicity of non-continuous

Markov equilibria. The second example describes a two-sector model with
physical and human capital and asymmetric taxation in the labor markets.
It is shown that for a certain range of parameter values there is no Markov
equilibrium. Finally, the third example reconsiders a one-sector model with
a decreasing tax rate on capital returns. As in the first example, every
Markov equilibrium must be non-continuous.
Of course, the most intriguing example is that of Section 3.1 of nonexistence of a Markov equilibrium. It remains to investigate the possible
non-existence of Markov equilibria in discrete-time economies. A major
analytical difficulty in the discrete-time framework is that an equilibrium
orbit is made up of a countable number of points, and so every Markov
equilibrium comprises a continuum of equilibrium orbits. In contrast, in
the continuous-time economies recasted in the first two examples, an
equilibrium orbit varies continuously with time, and so every Markov
equilibrium is conformed by a finite number of equilibrium orbits.
In all these economies, each individual agent is facing a convex optimization problem, and hence the sources of non-existence of a continuous
Markov equilibrium are to be found on the side effects that these distortions
inflict upon the dynamics of the equilibrium system. These results highlight
important differences between optimal and non-optimal economies, and
attest against what appears to be a widely held belief that competitivemarket economies may be suitably respecified as optimization problems. In
the presence of simple tax schemes or externalities an optimization problem
characterizing equilibrium solutions must satisfy certain endogenous consistency conditions, which may preclude the existence of a Markov equilibrium.
These findings should stimulate further advances in the analysis and
simulation of economic models. Thus, there has been extensive work on the
existence of continuous Markov equilibria in competitive economies (cf.
[11, 37]), and the present analysis should help elucidate the conditions
under which these equilibria may exist. Second, our work poses further
challenges to the computation of equilibria in competitive economies. Our
discussion in the preceding section suggests that there is no dominant
numerical method for the analysis and simulation of dynamic economies,
and hence the search for a suitable numerical procedure should begin with
an analysis of the characterization of equilibrium solutions, along with all
other additional theory embedded in the model. Of course, there are situations in which the model is not easily amenable to theoretical analysis, and
where the application of general-purpose, standard numerical methods may
be most valuable. The present paper, however, adds a word of caution to
this basic view, and illustrates that the most powerful numerical techniques
may be inadequate in those situations where paradoxically their use would
be most badly needed.

NON-EXISTENCE OF MARKOV EQUILIBRIA

95

APPENDIX
In this appendix, we show that for the economy described in Section 3.1
there is at most one balanced growth path. Thus, if there is one interior
balanced growth path, there cannot be any further boundary stationary
solutions. There are several related papers (e.g., [7, 19, 26, 32]) in which
one can find a weaker version of this result, namely, that the economy can
possess at most one interior balanced growth path. These papers restrict
the analysis to interior solutions, leaving out the existence of boundary
stationary solutions. For the purposes of our global analysis, however, it is
necessary to consider all possible stationary solutions.
uk
(1 v) k
Let kx =uh
and ky =(1
u) h . Then, following Ladron-de-Guevara et al.
[19] and Stokey and Rebelo [39], an interior balanced growth path
{k gx , k gy , ( kc ) g, u g, n g} must satisfy the conditions
1
r+sn g+d=(1 yk ) aAk ga
x

(A.1)

r+sn g=(1+fh )(1 b) Bk gb

y
g
x

(1+fh )(1 b) k
(1 yh )(1 a) k
=
a
b

g
y

g
(1 u g) Bk gb
y =n

1 kh 2 Ak
g

ug

(A.2)
(A.3)
(A.4)

1 kc 2 .
g

ga
x

=d+n g+

(A.5)

Equations (A.1)(A.3) uniquely determine the growth rate, n g > 0, and

the capital ratios, k gx , k gy . Then, (A.4) yields a unique value for u g, and
considering that kh=ukx +(1 u) ky the consumption capital ratio ( kc ) g is
obtained from (A.5). Observe that the level variables c, k, h grow at the
constant rate n g, and the ratios kc and kh remain constant along the balanced
growth path. Hence, in what follows we fix h=1.
Good and factor prices can now be read off from these quantities. Thus,
h g1 =c g s is the shadow price of the aggregate consumption good, and
h g2 =h g1 q g is the shadow price of human capital, where
1
aAk ga
(1 yh )(1 a) Ak ga
x
x
q g=
=
.
1
bBk gb
(1+fh )(1 b) Bk gb
y
y

(A.6)

These two equalities follow from the required equality of factor returns
across sectors, rx =ry and (1 yh ) wx =(1+fh ) wy . Using these identities,
we can rewrite (A.2) as
h g w g (1 yh )
q g= 2g = x
.
h1
r+sn g

(A.7)

96

MANUEL S. SANTOS

As (A.1)(A.5) imply that there is at most one interior balanced growth

path, it now remains to prove that in such a case there cannot be a noninterior stationary solution.
Observe that it cannot be optimal to specialize in human capital production. Hence, at a non-interior balanced growth path all factors must be
devoted to the production of the physical good, and the human capital
sector will remain inactive. Thus, if {kx , c} is a non-interior stationary
solution, the following restrictions on good and factor prices must be
satisfied
r+d=(1 yk ) aAk ax 1

(A.8)

rh2 =(1 yh ) h1 wx

(A.9)

rx \ ry

(A.10)

(1 yh ) wx \ (1+fh ) wy .

(A.11)

Since b > a and r gx > rx it follows from the StolperSamuelson effect (cf.
(A.6)) that (A.10) and (A.11) are only possible if q < q g. On the other hand,
(A.1) and (A.8) imply that kx > k gx , and so w
x > w gx . Hence, (1 yh ) w gx /
g
(r+sn ) < (1 yh ) wx /r. Then, (A.7) and (A.9) entail that q g=h g2 /h g1
< h2 /h1 =q. But, as already argued, q g < q cannot hold true under r gx > rx
and inequalities (A.10) and (A.11).
This contradiction shows that if there is an interior balanced growth
path, there cannot be a boundary stationary point. As a matter of fact, it is
now easily established that each economy in this class can only have one
stationary solution. Equations (A.1)(A.5) guarantee the uniqueness of an
interior balanced growth path, and Eqs. (A.8)(A.9) guarantee the
uniqueness of a stationary boundary point. Moreover, the preceding
arguments rule out the coexistence of both stationary solutions.

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