Perfect Equilibrium with Incomplete Financial Markets: An Elementary Exposition

Abstract

Value and Capital is a real masterpiece, clearly and forcefully demon strating the importance of treating time explicitly, and thus recognis ing that economic plans made today unavoidably depend on beliefs about potential opportunities available tomorrow. Hicks focused his analysis on price uncertainty, starting from the position that, even in the absence of more fundamental sources of uncertainty, there is no convincing rationale for assuming either that individuals’ future price expectations will be identical, or if they were, that individuals’ future plans (based on these expectations) will be coordinated. In other words, self-fulfilling expectations, or perfect foresight, or—in Hicks’s own term—perfect equilibrium is unlikely even under the best of circumstances. But then why not a full range of current markets for trading forward, obviating the need for individuals to guess the potential course of future prices? Because in fact there is also fundamental uncertainty in the economic environment. In Hicks’s own words:

Thirdly, even if price expectations are consistent, still people may foresee their own wants incorrectly, or make wrong estimates of the results of the technical processes of production….Generally, then, it is uncertainty of the future, and the desire to keep one’s hands free to meet that uncertainty, which limit the extent of forward trading under capitalism; the ultimate cause why the first two kinds of disequilibrium cannot be met more efficiently reduces itself to the unavoidable presence of the third and fourth kinds.¹

Research support from the NSF under grant #SES 88–08524 is gratefully acknowledged.