European Economic Review 34 (1990) 1247-1264.

North-Holland

THE STATE PREFERENCE APPROACH TO GENERAL

EQUILIBRIUM IN CORPORATE FINANCE

Hans WIESMETH*
University of Bonn, D-5300 Bonn. FRG

Received February 1988; tinal version received September 1989

This paper attempts to implement the state preference approach in a multiperiod exchange
economy. The procedure is relevant for a further investigation of various important issues in
corporate tinance, such as the results of Modigliani and Miller, and the integration of the state
preference and the mean-variance approach to asset pricing.

1. Introduction
The state preference approach to general equilibrium in an economy as
developed by Arrow (1964) and Debreu (1959) is one of the most general
frameworks available for the theory of finance under uncertainty. However,
prior to the work of Breeden and Litzenberger (1978), there was little
thought or hope of an application of this model to practical problems in
finance, such as capital budgeting: ‘. . . the absence of a natural, agreed upon,
and manageably small set of state dejkitions puts severe obstacles in the way of
examining data about observable security behavior in terms of underlying
choices for sequences of time state claims’ [Hirshleifer (1970, p. 277); cp. also
the critical remarks of Hakansson (1978)]. On the other hand, the difficulty
of giving empirical content to the state preference approach, in spite of its
importance for investigating theoretical issues, explains the success of the
capital asset pricing model (CAPM), brought forward by Sharpe (1964) and
Lintner (1965). The hegemony of the mean-variance approach is due to its
apparent ease of applicability and to properties, such as efficiency of
equilibrium outcomes, at least for certain classes of utility functions [Mossin
(1973)-J
The rigorous development of the arbitrage pricing theory of contingent
claims, however, opened new possibilities for an application of the state
preference approach to corporate finance. This theory, originally advanced

*I would like to thank the editor, A. Sandmo, and the referees for various useful comments. I
am especially grateful to one of the referees for drawing my attention to the issue of robustness,
addressed in the final section. Financial support of the Faculty of Arts, York University, is
gratefully acknowledged.

0014-2921/90/1603.50 0 1990-Elsevier Science Publishers B.V. (North-Holland)

1248 H. Wiesmeth, The state preference approach

by Black and Scholes (1973), and Merton (1973), is based on the observation
that the ability to trade financial securities frequently enough can enable a
few multiperiod securities to span many states of nature such that the system
of markets becomes effectively complete [see Kreps (1982). Miiller (1985)].
The behavior of asset prices and their stochastic properties in such a general
framework is examined by Cox, Ingersoll and Ross (1985). Breeden and
Litzenberger (1978) are among the first with their attempt to implement the
state preference model in a multiperiod economy, to make the Arrow-
Debreu model operational, by deriving the prices of primitive securities from
the prices of European call options on aggregate consumption expenditures
at each date. From this derivation, a valuation equation is then obtained for
all existing securities and capital budgeting projects [cp. also Banz and
Miller (1978) for an empirical application]. Other contributions by Harris
(1980), and Dybvig and Ingersoll (1982) investigate the link between the state
preference and the mean-variance approach to asset pricing. An integration
of both paradigms should yield a model with both the applicability of the
CAPM and the theoretical attractions of the Arrow-Debreu model. And the
recent development is characterized by the application of the state preference
approach to an investigation of various critical issues in corporate finance.
Important contributions in this area refer to the irrelevance results of
Modigliani and Miller [Benninga (1979), Senbet and Taggart (1984)], and to
equilibrium models of asset pricing under a progressive personal tax
structure [Lai (1989)]. Altogether, the arbitrage pricing theory and the
possibility of completing an otherwise incomplete market system made the
Arrow-Debreu model indispensable for corporate finance.
This paper attempts also to implement the state preference approach in a
multiperiod exchange economy. We thereby proceed in the following way: we
are given a set of commodity securities. As in the model of Breeden and
Litzenberger (1978), the focus is on deriving equilibrium prices for the
primitive Arrow-Debreu securities from the asset prices. In contrast to their
approach, however, we concentrate on the investigation of necessary and
sufficient conditions, which allow a valuation of all securities. One of these
conditions, which is especially interesting for empirical and practical appli-
cations, provides the economic background of their model. This condition
refers to equilibrium patterns of asset prices in a multiperiod framework. It
allows a conclusion, whether a unique valuation of the Arrow-Debreu
securities, and therefore of all capital budgeting projects, is possible, whether
the system of markets is complete, given equilibrium asset prices. In general,
the approach chosen in this paper should open the way for further
applications of the state preference approach to corporate finance. The above
mentioned papers by Breeden and Litzenberger (1978), Benninga (1979),
Harris (1980), and Dybvig and Ingersoll (1982) provide good examples of
such applications at both a theoretical and an empirical level.
 H. Wiesmeth, The state preference approach 1249

Formally, this paper then considers a unified approach to complete

markets in the following sense. Various concepts of completeness will be
introduced, motivated by specific problems and aspects discussed in the
literature. One class of practically releoant concepts relates completeness to
structural properties of the actual market system, the set of securities. This is
the idea underlying the arbitrage pricing theory [Miiller (1985)]. The other
class of theoretically relevant concepts links completeness to existence and
efficiency properties of competitive equilibria, hence to properties of an
Arrow-Debreu model associated with the original market system in a natural
way. This procedure provides the background for various examples of
complete markets given by Guesnerie and Jaffray (1974), Benninga (1979),
Nermuth (1987). Kreps (1982), who also considers a relationship of a given
economy to a corresponding ‘Debreu-style’ economy, introduces the problem
of approximately complete markets, which is important for the robustness of
arbitrage pricing models.
The theoretical background of the paper is then a modified version of
Radner’s original model of equilibrium of plans, prices and price expectations
in a sequence of markets [Radner (1972), (1982)]. Given the tree structure of
the uncertainty, it is then immediately possible to associate an Arrow-
Debreu model with this Radner model in a natural way. One just has to
replace the original set of commodity securities by a complete set of Arrow-
Debreu securities. Concepts of completeness can then be introduced by
referring to relevant properties of the Radner model and the associated
Arrow-Debreu model. The main theorem reveals all inclusions among the
alternative completeness definitions and provides thereby a link between the
theoretically and the practically relevant concepts. The implications of these
results include an interesting comparison between the arbitrage price of a
contingent claim and a preference-free, risk-neutral valuation of a contingent
claim. The concept of a preference-free valuation is extensively discussed in
the literature and refers to a valuation relationship, which depends only upon
potentially observable parameters [cp. Smith (1976), Brennan (1979)]. In the
case of a preference-free valuation of contingent claims, these observable
parameters are the market prices of the underlying securities. As no
assumptions involving risk are employed, such a valuation relationship is
consistent with risk-neutral preferences with respect to the payoff structure of
the contingent claims [cp. again Brennan (1979)]. The general concept of a
preference-free valuation through efficiency prices applies especially to
models based on the mean-variance approach, hence to special versions of
the CAPM, thus providing another link between the state preference and the
mean-variance approach. Also, arbitrage pricing of contingent claims is often
related to the existence of a unique probability measure on the set of
elementary events, such that all security price processes are martingales
[Miiller (1985)]. A similar characterization can be obtained in this frame-
1250 H. Wiesmeth, The state preference approach

work with arbitrary commodity securities. A joint product is the result that
the minimum number of assets, necessary to complete a market system, is
independent of the number of commodities. This result dates back to Arrow
(1964) and appears similarly in other related papers [see Kreps (1982)]. It is
also related to the issue of an optimal number of commodity markets,
addressed by Williams (1986).
The remainder of the paper is organized as follows. The next section
contains a brief review of Radner’s equilibrium model, suitably adjusted to
allow for general commodity securities. The various completeness concepts
are then introduced and motivated, followed by the main theorem and
several implications of these investigations. Final remarks, referring especially
to the robustness of these results, conclude the paper.

2. The model
As the following model is both a natural extension of the Arrow-Debreu
model with uncertainty [Debreu (1959)] and a slightly modified version of
Radner’s model [Radner (1982)], only its main features will be outlined in
this section.
The model takes into account a temporal exchange economy extending
over three periods of time, t =O, 1,2, with an uncertain environment, des-
cribed by an event tree, M, is the finite set of elementary events in period t.
It is assumed that everybody can observe the elementary events m,oM,, and
has complete information with respect to M,. M denotes the set of all
elementary events, or the set of all branching points of the event tree.
There is a finite set H of commodities, described by their physical
characteristics. Spot markets for these commodities open in each elementary
event ME M. Furthermore, there are commodity securities, e.g., commodity
futures, characterized by their state-contingent payoffs. We also assume that
there is a finite set J of real securities, which, for simplicity, can be traded in
any event ME M, before a possible payoff is realized in m. For j EJ and
m E M, aj,E a”, denotes payoff of security j in m.’ Of course, security j E J
will only then be traded in M EM, if there exists nE M with nzm, i.e., the
future event n is attainable from event m, such that aj,#O. This set of
securities is exogenously given; we therefore do not attempt to answer the
question, why markets for exactly these securities exist [cp. Williams (1986)].
By G, we then denote the set of all securities including the spot market
transactions in rno M, which can be considered as trade in simple commodity
securities.
There is a finite set I of agents, with agent i described by the intertemporal
utility function ui: 9”;” -9. The utility functions are assumed to be strictly

‘For notational simplicity, we denote sets and the number of their elements identically.
 H. Wiesmeth. The state preference approach 1251

monotone and continuously differentiable with strictly convex indifference

hypersurfaces, which do not intersect the boundary of WY”. Agents are
further characterized by their endowments WimEWI:, m E M, ie I.
The equilibrium concept is based on the notion of attainable consumption
bundles, given prices for the commodity securities. For this let Zi,mEW for
iEl, jEG,, and rnE M be the number of units of security j that agent i is
willing to offer in event m E M, Zim: = (z,&,, j E G,, denotes the then resulting
transaction vector. Assume furthermore that II, = (n,,),, j E G,, is the price
vector for all securities in m E M. We then arrive at the following definition
[cp. Radner (1982)].

Definition I. A pair (xi, zi) =(xr,,,, zi,,JmCM,consisting of a consumption bun-

dle x,ER~” and a transaction vector Zi=(Zim)neM is attainable for agent iE I
at prices 7c=(z~)~~~, if the following two conditions hold:
(1) C~m:nLm)G~G~~ijrn~jn+~in=Oin forallnEMt

(2) Icmzim =Cj.sG. njJijn =O for all n E M.

The definition of a Radner equilibrium is now an immediate consequence of

the above concept of attainability [cp. again Radner (1982)]:

Definition 2. Let f,(z) be the set of all pairs (x,,zi), which are attainable for
agent iE I at security prices II. Denote by Yi(A) the set of all (x,,z~)E~~(x),
which are optimal for agent i with respect to the utility function ui.
[(x,,z~)~,K] is a Radner equilibrium, if:
(1) (Xi, Zi) E vi(lr) for all i E I,
t2) Cielzijnzo for all j E G, and all n E M.

A Radner equilibrium exists, if lower bounds are imposed on the transaction

vectors Zim, ie I, mE M, hence, if short sales of securities are bounded
[Radner (1982)]. In general, however, existence of competitive equilibria in
an economy with an incomplete system of markets is not guaranteed. The
basic reference here is the paper by Hart (1975); on an advanced level the
existence problem is also discussed in more recent papers: Duffre and Shafer
(1985) prove generic existence of Radner equilibria with respect to small
perturbations in initial endowments and in the payoff structure of the
securities. A different approach for any economy with real assets but with
payoffs denominated in a single numeraire commodity, is considered by
Geanakoplos and Polemarchakis (1985). The existence of equilibrium can be
demonstrated in this model without any restriction on short sales, as it can
in equilibrium models with pure financial assets [see Werner (1987)J.
A Radner equilibrium, an equilibrium of plans, prices and price expectations,
1252 H. Wiesmeth, The state preference approach

is quite a specific equilibrium concept. In the formulation given here,

individuals have correct point expectations with respect to future prices in
the various states of the world. This assumption of perfect foresight does,
however, not extend to the subjective probability distribution over the
elementary events, implicitly contained in the individual utility functions. It is
only required that the set of events, which are expected to occur with
positive probability, is the same for all agents. This is a consequence of the
monotonicity assumption. Empirical applications to option pricing, e.g.,
usually take the probabilistic structure of the security-price process as given
and associate different prices with different states of the world [cp. Black and
Scholes (1973), Mi.iller (1985), Sondermann (1987), Bailey and Stulz (1989)].

3. Complete market systems

Various definitions of completeness of a market system will be introduced
and motivated in this section. Special attention will be given to ideas and
concepts of completeness, which are relevant for practical considerations.
The introductory remarks point to two ways of defining completeness of a
market system. Both ways, however, relate the given Radner economy, a
description of an actual exchange economy, to an abstract Arrow-Debreu
economy. With respect to this point, this paper extends a procedure applied
by Kreps (1982) to an investigation of necessary and sufficient conditions for
a set of securities to span all states of nature.
The first definition of completeness of the market system, given by
(M,(u~,,,),(u~),(o~,,,)) as outlined in the preceding section, refers directly to the
structure of the set of commodity securities, and is therefore relevant for
practical applications. Basically, a market system is called complete accord-
ing to this first definition, if it induces implicit markets for all primitive
Arrow-Debreu securities [cp. Breeden and Litzenberger (1978)], or, more
formally, if the set of Arrow-Debreu securities can be generated by means of
self-financing portfolio strategies.
The term self-financing portfolio strategy is applied in its usual meaning. A
certain event 6~ M and a certain commodity hi H are fixed. An initial
portfolio is then, at given Radner equilibrium prices, adjusted in a self-
financing way in each nE M. Selfifinancing means that there are no net
positive or negative payoffs in any no M with n ffi, and with n #O, the
origin of the event tree. The idea is then to choose the initial portfolio in
such a way that its value is zero in each n with fi$n, and equal to the spot
price of one unit of commodity h in ti. Thus, the final outcome of such a
portfolio strategy is equivalent to the payoff of the Arrow-Debreu security
given event ti and commodity h. The exact definition reads as follows:

Definition 3. Assume that Radner equilibrium asset prices (nj,)j.,, i EJ,

 H. Wiesmeth, The state prefirence approach 1253

m E M, and spot prices (p,,,),,,,m E M, are given. The portfolio strategy (ej,)j,,
generates the Arrow-Debreu security bh, given hi H and rii~ M, and is
self-financing with respect to (7tjm)j.mand (p,),, if the following conditions
are satisfied:
(1) Assume for simplicity that 6~ M, and consider the uniquely determined
EE M, with ~Ezii.
l For kEMz with klii:

pk fork=fi,
0 fork#m.

l For kEM2, k#rii, and for kEM,, k#ii: 0,,=0 for alljEJ.
(2) Consider then the origin 0 of the event tree:
l For kEM,:

l ao(I&) = zE J njOOjO-_P,,~~~ J Ojioajo is then the arbitrage price of the primi-

tive security b: in the origin 0 of the event tree.

This definition contains implicitly the assumption that the asset are traded in
a certain event me M before their payoff in this event is realized. This payoff
can then be traded in on the spot markets. Altogether, this definition is an
appropriate modification of the corresponding concept used in models with
pure financial assets [cp. again Kreps (1982), Miiller (1985)].
We can now introduce the first practically relevant completeness concept.

Definition 4. The market system (M,(aj,),(ui).(~im)) is C,-complete, if a

Radner equilibrium exists, and if for each Radner equilibrium all Arrow-
Debreu securities can be generated by means of self-financing portfolio
strategies.

This definition seems to be comparatively close to the requirement that all

Arrow-Debreu securities are contained in the given set of commodity
securities [see Radner (1982)]. One has to observe, however, that this specific
requirement is completely independent of any equilibrium situation, in
contrast to the definition given here. Also, in view of the generic existence
results of Duffre and Shafer (1985) mentioned earlier, existence of a Radner
equilibrium is not as strong a condition as it might seem.
The following theoretically relevant definitions introduce completeness by
1254 H. Wiesmeth, The state preference approach

comparing the performance of the market mechanism in the given Radner

economy and an associated Arrow-Debreu system. This associated or
underlying Arrow-Debreu system differs from the original model only with
respect to the system of commodity securities. The set of real securities is
replaced by a complete set of Arrow-Debreu securities. All other things,
especially the event tree and the agents’ characteristics, remain unchanged.
More specifically, the next definition postulates an equivalence of equili-
brium allocations in both systems. A comparable procedure in special cases
can be found in Guesnerie and Jaffray (1974), and in Nermuth (1987). The
model of Benninga (1979) shows implicitly that this completeness concept
plays a role in corporate finance, too.

Definition 5. The market system (M, (aj,),(~i),(~im)) is C,-complete, if a

Radner equilibrium exists, and if each equilibrium allocation of this model is
also one of the associated Arrow-Debreu model.

From an allocational viewpoint, a C,-complete market system is equivalent

to the associated Arrow-Debreu model, without, however, requiring a
complete set of primitive securities. This allocational aspect is further
emphasized in the next definition, which refers directly to efficiency of
equilibrium allocations.

Definition 6. The market system (M,(aj,),(Ui),(Oim)) is C,-complete, if a

Radner equilibrium exists, and if all the Radner equilibria are efficient.

The efficiency problem for Radner equilibria is discussed in various papers.

Hart (1975) gives examples of non-efficient equilibrium allocations. In a more
recent paper, Geanakoplos and Polemarchakis (1985) prove generic subopti-
mality of Radner equilibria. Werner (1987) addresses the same problem for
markets with financial assets. The above definition is, thus, well motivated by
these results, and by the observation that the classical CAPM, where agents
are characterized by identical utility functions belonging to the HARA-class,
is C3- complete [cp. Mossin (1973)].
The last completeness concept is again important for practical consider-
ations. It is related to the theory of arbitrage pricing of contingent claims, or,
more specifically, to the theory of option pricing [cp. Miiller (1985)]. For this
theory it is essential that one can associate an Arrow-Debreu equilibrium
price system with a given Radner equilibrium price system in a unique and
quite specific way. Then, prices of contingent claims are completely deter-
mined by the equilibrium prices of the given securities. As mentioned in the
introductory remarks, the term preference-free pricing of contingent claims is
applied to characterize this particular situation, although investors’ prefer-
ences clearly affect equilibrium prices of the underlying securities.
 H. Wiesmeth, The state preference approach I255

For a formulation of this definition we have to introduce a function,

mapping Arrow-Debreu price systems to Radner price systems. Suppose that
(Phgln)ln.h*rn~ M, hell, is a price system for the associated ,Arrow-Debreu
model. Thus, pi,,, is the price of one unit of commodity h to be delivered if
event m occurs. According to the usual convention, this price has to be paid
now, i.e., in event 0, the origin of the event tree. Consider j E J and m E M; a
price xi,,, for this security is then defined by: ll,m=C~n:nLm,C~EH~mp~.a~”with
p,,,> 0, as we can only determine relative prices in m E M. For an explanation
of this definition assume for a moment that we introduce security j into an
Arrow-Debreu model. Its price in event m should then be given by the above
formula. In this sense lCjmis the arbitrage price of security j in event m.
Altogether, we obtain a function l(l:(~,,p~m)m.h~(ajm)j.~, mapping Arrow-
Debreu price systems to Radner Price systems. It is applied in the following
definition:

Definition 7. The market system (M, (Uj,),(ui),(Oin)) is C,-complete, if a

Radner equilibrium exists, and if the above defined mapping $ satisfies the
following condition: for each Radner equilibrium price system (nj,)j.m,
~-‘((nj,)j,,) contains an equilibrium price system ((p,,,,pt,),.h) of the
associated Arrow-Debreu economy.

A motivation for this definition has to be seen in the fact that it allows a
valuation of Arrow-Debreu securities. Similar to the procedure in Breeden
and Litzenberger (197Q equilibrium asset prices implicitly contain the prices
of the state-contingent claims with possible implications for capital budget-
ing. The problem, however, is that this valuation is not necessarily unique,
indicating arbitrage possibilities. The exact relationship to the
C,-completeness concept will be established in the following section.

4. The main theorem

The following theorem reveals all inclusions among the various complete-
ness definitions for the Radner equilibrium model. As an immediate conse-
quence we thereby obtain the exact relationship between the practically and
the theoretically relevant completeness concepts. Other implications refer to a
link between the Arrow-Debreu model and the CAPM, to different notions
of preference-free valuations, and to a martingale property of equilibrium
asset prices. A thorough discussion of these implications will be given in the
next section.

Theorem 1. Let the market system (M,(aj,),(ui),(Wim)) be given. Then the

following inclusions are true for the completeness definitions C,, C1, C3, and
c,: c, =c2-c+-c,.
1256 H. Wiesmeth, The state preference approach

Proof of the Theorem. C,*CJ: Assume that [(Xi,Zi)i,X] is a non-efficient

Radner equilibrium for the economy (M,(Uj,)l(Ui),(Wim)). By C1- comptete-
ness it is possible to generate all Arrow-Debreu securities by means of self-
financing portfolio strategies, given equilibrium prices TI. Clearly, the equili-
brium prices for the Arrow-Debreu securities correspond then to the initial
investments into these self-financing portfolio strategies. Uniqueness of these
prices is an immediate consequence of arbitrage considerations in an
equilibrium. Denote this price system by QJ&&,,,~, ~EH, REM. We then
obtain: ni,t =~L,C1,:,Z.nr)CheHP*nffj” h ’ for all M EM and all jeJ with appropria-
tely chosen positive scalars pm, ME M. But then it is easy to check that
(Xt,),EBt((phOm)m,h), the budget set of agent i with respect to prices (&$,,),,,h.
Non-eficiency of (x~,.z~)~yields then an immediate contradiction to utility
maximization. (Compare also the proof of Lemma 1).
C2=+CJ: Follows immediately from the definitions and the fact that
equilibrium allocations in the Arrow-Debreu economy are Pareto-efficient.
C3=C2: The proof of this inclusion is based on the following lemma, which
will also be used in the next step. Differentiability assumptions on the utility
functions simplify the proof of this statement, but are probably not necessary,
given the standard convexity assumptions on preferences.

Lemma 1. Under the assumption of C,-completeness,

each Radner equilibrium
is also an equilibrium of the associated Arrow-Debreu economy in the folfoGtg
sense. ~quifibrium aflocat~ons are identicul, and eq~~ifibrium price systems are
refated to each other by the earlier introduced mapping $.

Proof of the Lemma. Consider an efficient Radner equilibrium [(Xi, Zi),, ~3

for (Wim)i.mtthe distribution of initial endowments. Combining efficiency and
equilibrium properties of [(x, Zi)irn], there CXkt &iCiCnCy PriCCS @tm),,,h,
~EH, rnE M, such that the variables (x~)~,(Zi)i, (njm)i,m provide a solution to
the following system of equations:

~ui/ax~~ = Ant
(1) for i~~m,n~~h,k~H.
~dWn An

(2) c ,n:mhn)CjEonzijna~~+x~~=o~~ foriEI;hEH;mEM.

t3) Cj.& 7Tj&ijm=O foriEI;mEM.

(4) 7Ljm=Cm:nrm)ChsHI(rnP~na~~ forjEG,; mEM.

t5) &alZijmzo forjEG,;mEM.
Eqs. (1) follow from utility maximization and efficiency, eqs. (2), (3) and (5)
describe the remaining characteristics of the Radner equilibrium as given by
Definitions 1 and 2, and eq. (4) describes a relationship between Radner
equilibrium prices and efficiency prices. These last equations follow from the
 H. Wiesmeth, The state preference approach 1257

first order conditions of utility maximization by taking into account the

existence of efficiency prices. Observe that these efficiency prices are uniquely
determined by the differentiability and boundary assumption on agents’
preferences.
We prove now that xi~Bi((p!&,,),,,,,,), the budget set in the Arrow-Debreu
economy:

given
Thus, XiE Bi((&m),.h), (XivZi) E fi(n)*
Moreover, eqs. (1) show that Xi maximizes utility in the budget set; it
follows then immediately from eqs. (2) and (5) that [(&,),.h,(Xi)i] is an
equilibrium for the associated Arrow-Debreu economy ((Ui),(Wim)).
So far the proof of this lemma, completing also the proof of C,*C,, and
ca*c4.

Counterexamples to the statements C,=X, and C3=C4 will now complete

the proof of the theorem:

C3+C,: Consider the classical CAPM with agents’ preferences depending on

expected return and variance of portfolios, consisting of units of a bond and
one regular asset in the simplest case. It is well-known that all equilibrium
allocations of such a model are Pareto-efftcient, as the utility functions are
quadratic and belong thus to the HARA-class [compare Mossin (1973)]. On
the other hand, it is immediately clear that the duplication of all Arrow-
Debreu securities is not possible, if there are more than two states of the
world in the future period of time.
C,+C,: We consider an exchange economy extending over two periods of
time with two traders and two commodities [Hart (1975) gives a similar
example]. There is only one relevant state of the world in each period.
Furthermore, there are no real securities, and thus only spot markets for
both commodities open each period of time. Agents’ utility functions and
initial endowments are given by:
1258 H. Wiesmeth, The state preference approach

+0.1x:,x:,, (%I) =((5,0),(5, O)),

+0.9x:,x:,, (%I) = ((0,5), (0>5)).

Both Radner equilibrium prices and equilibrium prices in the associated

Arrow-Debreu model are then given by pt = p: = pi0 = ptI = (1,l). However,
the allocations are different for the two models: the equilibrium allocation
in the Radner model is (x;R,x~):=[((2.5,2.5),(2.5,2.5));((2.5,2.5),(2.5,2.5))],
whereas the equilibrium allocation in the Arrow-Debreu model is given
by: (XT,xr): = [((5,5),(0,0)); ((O,O),(5,5))]. Of course, the utility functions can
slightly be perturbed, so that the competitive equilibrium is contained in the
interior of the consumption set, without changing the equilibrium prices.
Clearly, this example satisfies the requirements of completeness definition C.+,
but the equilibrium allocation is not ehicient. This completes the proof of the
theorem.

Observe that C,-completeness does not require a complete equivalence of

Radner and Arrow-Debreu equilibrium allocations, and this equivalence will
not be a consequence of Cz- completeness either. There might exist examples
of economies with the set of Radner equilibrium allocations being a proper
subset of the Arrow-Debreu equilibrium allocations. Again, there is this
problem of a unique valuation of the primitive securities, given Radner
equilibrium prices. The possibility of duplicating any contingent claim in a
C,-complete market system, however, leads to identical equilibrium allo-
cations in the Radner model and the associated Arrow-Debreu model. This
is an important result for practical applications. It shows that a C,- complete
Radner system is in all aspects equivalent to an Arrow-Debreu system.
Hence, a model of actual asset markets can be equivalent to a model ‘. . . with
a somewhat strained relation to reality’ [Koopmans (1974)]. This result
indicates a relationship between a stronger version of C,-completeness and
C,-completeness to be investigated, among other things, in the following
section.

5. Implications of the main theorem

The aim of this section is to investigate the consequences of the main

theorem for both general equilibrium theory and corporate finance. We start
with the problem of a preference-free valuation of contingent claims, a
valuation relationship depending only on potentially observable parameters,
as explained earlier. Preference free, in the above sense risk-neutral valua-
tions have a long history in the theory of finance [cp. Smith (1976)]. First
 H. Wiesmech, The state prefirence approach 1259

attempts already involving the Principle of Mathematical Expectation go back

to Bacheiier (1900), and the latest development is clearly characterized by the
arbitrage pricing theory of contingent claims [cp. Miiller (1985)] with many
specific applications to the theory of finance [cp Merton (1977), Sondermann
(1987), Bailey and Stulz (1989)]. However, continuous time models allow
only for rather restrictive assumptions about the statistical process generating
the stock price process. This is one of the reasons, why Brennan (1979)
argues in favor of a discrete time approach to risk-neutral valuation
relationships [cp. also Stapleton and Subrahmanyam (1984)].
In the discrete time framework of this model, the key to arbitrage pricing
of a contingent claim, a special form of a preference-free valuation, is
C, -completeness. Consider the market system (M, (a& (ui), (q,,,)) and assume
that it is C,-complete. Then any contingent claim, any asset X with payoff
vector X, E RH, me M, can be duplicated by means of a self-financing
portfolio strategy, and the price of X in any event me M is given by the
value of a self-financing portfolio generating X, for all n E M such that n 2 m.
Clearly, all such portfolios must have the same value in equilibrium by
arbitrage considerations. Another method of deriving the price of a con-
tingent claim from the Radner equilibrium prices computes the arbitrage
prices of all Arrow-Debreu securities; these prices must then correspond to
the given equilibrium prices of the assets via mapping $, introduced for
C,-completeness. Intuitively, if there were more than one Arrow-Debreu
price system associated with a given Radner equilibrium price system via this
mapping, the self-financing duplication of some Arrow-Debreu securities
would be ruled out by arbitrage considerations. This is the economic
background of the following theorem.

Theorem 2. The market system (M,(ai,,,),(uJ,(Wi,,,)) is C,-complete if and only

if a Radner equilibrium exists, and if there exists exactly one Arrow-Debreu
price system (II,,,,P!,,,),,,~ for each Radner equilibrium price system (R,,,,),_, such
that ~((~,,~~~),.h)=(~~j,)j.m.

The main theorem guarantees that all the associated Arrow-Debreu price
systems are also equilibrium price systems. A consequence is that a
C,-complete system allows a unique transformation of equilibrium security
prices into equilibrium Arrow-Debreu prices, which in turn allow a
preference-free valuation of any contingent claim. The formal discussion of
this remark will be continued following the proof:

Proof of the Theorem. In the proof we construct a self-financing portfolio

strategy for a fixed but arbitrary contingent claim X with payoff vector
X, oWH for me M. Given are Radner equilibrium prices (7~~,,,)~,~for the
assets and (P:),,,~ for the spot market transactions.
1260 H. Wiesmeth, The state preference approach

l Consider n E M, and define M,(n):= {ME M,: mzn). The value of X in

mo M,(n) is then p,,,X,. We therefore have to find (Bj,)j,,, a solution of the
following system of linear equations: 1j.J nj,ej, = p,,,X, for m E M,(n). For an
arbitrary contingent claim X this system can be solved if and only if the rank
of the coeficient matrix ((nj,,Jj.,,) with ME M,(n) and joJ corresponds to the
number of elements in M,(n).
* The associated system of linear equations for the Arrow-Debreu prices
(p,,,), shows first of all that p,,,,, is determined by p,,, up to a factor p,,,:
pn=~mpom for all m E M, an immediate consequence of the existence of spot
markets. In addition we obtain 71jm =~(,,,p,,,,,u~~ for j E J.

l For n E M, the relevant system of equations reads as follows:

=&POnajn
711” + Pcn 1 POdjm
maMAn)

a system with J equations in the unknowns (l/p,,,), mE M,(n). This system

has a unique solution for any positive parameter p. if and only if the rank of
the coefficient matrix ((nj,,,)& with mEM,(n) and jE J is equal to the
number of elements in M,(n).
l Consider now the origin 0 of the event tree. We must find (ejo)j,, such
that:

1 C zjnejn-
njnejo= C flj.P.aj.+PJ,, nEM1.
jsJ jsJ jeJ

The first and the second term refer to the condition of a self-tinancing
strategy, whereas the third term refers to the payoff of the contingent claim
in event n. This system of equations can be solved for an arbitrary X if and
only if the rank of the coefftcient matrix ((7tjn)j.n) with no MI and jo J is
equal to the number of elements in M r .
l The associated system for the determination of Arrow-Debreu prices reads
as follows:

7cjO=POPOOuj0 +PO C PO@jn +clO 1 PO&jm

ll5Mt meM2

=POPOOajO +POnExM, i njn.

Again, this system has a unique solution in the variables (I/K), n E Ml, for
each positive po, if and only if the rank of the coeflicient matrix ((nj,)j,,) with
n E M,, je J is equal to the number of elements in M 1.
 H. Wiesmeth, The state preference approach 1261

l The proof of the theorem is complete, if we choose pO= 1, and the volume
of the transactions on the spot markets in the origin of the event tree equal
to x,.

This completes the proof of the theorem. Returning now to the issue of a
preference-free valuation, assume that a contingent claim X is given. In a
C,-complete market system the price n;f of X in m E M is:

Of course, (p,), are spot market equilibrium prices in the Radner system,
whereas (~(,,,,p~,,,),,, is the associated Arrow-Debreu equilibrium price system.
Hence, we obtain a preference-free valuation of X in the sense that rrf
depends only on (expected) spot market prices. n”, is usually denoted as the
arbitrage price of X in rnE M.
Consider now a system, which is C,-complete. The efficiency prices of an
efficient allocation are then related to the Radner prices via mapping $.
Clearly, evaluating a contingent claim at these efficiency prices yields
equilibrium prices for this contingent claim. This is then a second example of
a preference-free valuation of a contingent claim. Of course, it can happen in
this case that additional Radner equilibria appear with the introduction of
another asset into a C,-complete, but C,-incomplete market system. As
C,-completeness is a weaker requirement than C,-completeness, this second
method of a preference-free valuation is more general.
This method can especially be applied to the case of the classical CAPM.
Assume that all agents have identical utility functions of the HARA-type.
Then equilibrium allocations are efficient [cp. Mossin (1973)] and the above
results hold. What is the consequence? Dybvig and Ingersoll (1982) investi-
gate the link between the state preference and the mean-variance approach.
They show that the requirements of mean-variance pricing of the Arrow-
Debreu securities typically permit arbitrage opportunities to arise. They
point out that the introduction of a financial asset into an incomplete market
system at an (inefficient) CAPM equilibrium will destroy that equilibrium.
Clearly, somewhat stronger versions of these results are an immediate
consequence of the above considerations. Dybvig and Ingersoll (1982) then
demonstrate conditions under which the CAPM equilibrium will hold for a
subset of assets. Again, the results obtained in this paper should allow further
investigations in this area.
Another remark refers to the problem of an optimal number of commodity
markets [cp. Williams (1986)]. The proof of the above theorem shows that
what really matters is the construction of a self-financing portfolio with the
appropriate financial return in each relevant event me M. This fact together
1262 H. Wiesmeth, The state preference approach

with the existence of all spot markets is then responsible for the observation
that the number of real assets, necessary for a complete market system, is
independent of the number of the commodities. This shows a certain parallel
to Arrow’s model with financial securities [Arrow (1964)], but also has
implications for an optimal number of security markets, if one interprets
‘optimal’ accordingly. Actually, it turns out that the optimal number in this
sense is equal to the maximal number of branches of the event tree [see also
Kreps (1982)].
A final consideration refers to a measure theoretic property of the scalars
(PI& ME M. Assume that (p,,,,pom),,, with ,u~= 1 is the unique Arrow-Debreu
equilibrium price system, associated with the Radner equilibrium price
system ((nj,)j,p,), via mapping $. We then obtain for no M, and
Mom,+,:

njn - Pnajn=

This means that the price of an asset j in event n, net of the value of its
payoff in event n, can be written as the integral of the random variable (rrj,,,),
on M,+,(n) with respect to the measure (,u,,/p,), ME M,+,(n). This is then a
generalization of the martingale property, which is a cornerstone of expec-
tations models of asset prices [cp. LeRoy (1982)], playing especially a role in
the theory of efficient markets [cp. Fama (1970)]. Clearly, this measure on
M,+,(n) is uniquely determined so that we obtain the following corollary,
which has a counterpart in models with financial assets [see Miiller (1985)].
Corollary I. The market system (M,(a,,),(ui),(Oi,,,)) is C,-complete if and
only tf there exist uniquely determined positive numbers pm, m E M, PO= 1, for
each Radner equilibrium price system, such that the price of an asset j in an
event nE M,, t 22, net of the value of its payoff in event n, can be written as the
integral of the price variable on M,, , (n) with respect to the measure (p,,/p,) on
M, + 1(n).
Observe that this martingale property refers to the economy as a whole. If
individual agents are not risk-neutral, then security prices will not follow
exact martingales from the individual viewpoint [cp. Lucas (1978), LeRoy
(1982)].

6. Final remarks

The preceding sections emphasize the relevance of the state preference

approach for corporate finance. In principle, the results refer to the
implementation of the Arrow-Debreu model in a multiperiod economy, but
can also be profitably applied to more specific issues of corporate finance.
Important examples imply a further investigation of the irrelevance results of
 H. Wiesmeth, The state preference approach 1263

Modigliani and Miller, and a thorough study of the relationship between the
state preference and the mean-variance approach to asset pricing.
Both practically and theoretically relevant completeness concepts are
introduced for a Radner equilibrium model with perfect foresight. These
completeness definitions are obtained by comparing the performance of the
competitive mechanism in the Radner model and an associated Arrow-
Debreu model. The main theorem lists then all inclusions among the various
concepts.
How robust are the results? Consider first economies, which are
C,-complete, but not C,-complete. These are economies where preferences
are such that portfolio separation theorems apply. The classical CAPM
provides a typical example. Clearly, any perturbation of preferences or
endowments, which maintains C,-completeness, can never yield
C,-completeness, as the latter depends upon structural properties of the set
of securities. Consider then economies, which are C,-complete, but not
C,-complete. These are economies where the Radner equilibrium prices are
the same as those, which would be generated from the implementation of an
Arrow-Debreu equilibrium as a Radner equilibrium, but do not support the
same allocation. This appears to be a fragile constellation in the sense that
an arbitrarily small perturbation of preferences or endowments can render
C,-incomplete economies also C,-incomplete. This result and its conse-
quences for corporate finance should, however, be studied more carefully.
From the viewpoint of general equilibrium theory, a generalization of the
above considerations could attempt to replace the comparatively strong and
unnatural assumption of perfect foresight by an assumption of differential
information. A dynamic model with rational expectations would result, if
prices reveal additional information to the agents from period to period.

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