Planner Intervention on the Market Outcome

Abstract

In Chapter 8 we have shown that equilibrium allocations in economies with complete (financial) markets are Pareto optimal . It is also well-known that with incomplete markets, equilibrium allocations typically are not Pareto optimal, as [67] first suggested and as we show for the cases of numeraire, nominal and real assets, and restricted participation in Section 2 ¹. The above result is relatively intuitive: while in the incomplete market framework households face multiple budget constraints, Pareto optimality presumes a planner who has access to the missing markets and therefore has a higher freedom in reallocating goods. It is then quite natural to investigate if equilibria are at least some sort of second best or, as many authors say, if they are constrained optimal. In other words, we want to compare equilibria with allocations that can be implemented by a planner who is constrained to use only existing assets. More precisely, we want to define what the planner may or may not do consistently with presence of incomplete markets and then compare equilibria without and with planner intervention. If equilibria of the latter type are Pareto superior to equilibria of the former type, then we say that equilibria are constrained suboptimal with respect to the chosen type of planner intervention. In that case, we also say that the planner can Pareto improve upon the competitive equilibria. As we are going to show in Section 6, typically in the space of economies the planner can Pareto improve using “few” taxes and subsidies. The intuition for that result is as follows. Even that limited good reallocations have