TITLE:
On Pareto Efficiency in Asset Markets
AUTHORS:
Kazuhiro Takino
KEYWORDS:
Pareto Efficiency, Utility Possibility Frontier, Default Risk
JOURNAL NAME:
Theoretical Economics Letters,
Vol.9 No.7,
October
11,
2019
ABSTRACT: In this study, we consider Pareto efficiency in
financial markets. In welfare economics, it is sufficient to consider
competitive equilibrium to assure Pareto efficiency. This study, however, focuses
on describing the utility possibility frontier, which explicitly shows Pareto
efficiency for financial markets. To this end, we use the time-additive utility
(functional) with the mean-variance utility. In deriving the utility
possibility frontier, we obtain an asset pricing formula dependent on an agent’s utility. We provide a
characteristic of this formula to ensure Pareto efficiency. Moreover, our study
generalizes the payoff function of the asset. This enables us to analyze
various financial transactions. As an application of our framework, we consider
a simple insurance contract with default. We then show that the likelihood of
default makes the market Pareto inefficient or deteriorates social welfare, as
shown in previous studies.