Pareto improving financial innovation in incomplete markets

David Cass, Alessandro Citanna

Research output: Contribution to journalArticlepeer-review


In this paper we develop a differential technique for investigating the welfare effects of financial innovation in incomplete markets. Utilizing this technique, and after parametrizing the standard competitive, pure-exchange economy by both endowments and utility functions, we establish the following (weakly) generic property: Let S be the number of states, I be the number of assets and H be the number of households, and consider a particular financial equilibrium. Then, provided that the degree of market incompleteness is sufficiently larger than the extent of household heterogeneity, S - I ≥ 2H - 1 [resp. S - I ≥ H + 1], there is an open set of single assets [resp. pairs of assets] whose introduction can make every household better off (and, symmetrically, an open set of single assets [resp. pairs of assets] whose introduction can make them all worse off). We also devise a very simple nonparametric procedure for reducing extensive household heterogeneity to manageable size, a procedure which not only makes our restrictions on market incompleteness more palatable, but could also prove to be quite useful in other applications involving smooth analysis.

Original languageEnglish (US)
Pages (from-to)467-494
Number of pages28
JournalEconomic Theory
Issue number3
StatePublished - May 1998

ASJC Scopus subject areas

  • Economics and Econometrics


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