Coordination failure under complete markets with applications to effective demand

Abstract

Introduction Arrow (1969) refined the idea [implicit in Meade (1952), for example] that missing markets were at the foundation of market failure in perfectly competitive economies. He also advanced the notion that nonexistence of complementary markets could explain why economic agents might have no incentive to open missing markets. Heller and Starrett (1976) developed the idea that the nonexistence of complementary markets could be mutually reinforcing, thereby providing a more complete explanation for the nonexistence of markets. Hart (1980) and Makowski (1980) give fairly general treatments of these ideas in the context of product innovation. In this essay, I show that even when all markets exist, there can be a coordination failure of a type similar to that which occurs with missing markets. There is no missing market here, nor is there any element of uncertainty or time. Instead, there are multiple, Pareto-ranked equilibria in a simple general equilibrium model with a noncompetitive sector. There is, of course, a Pareto inefficiency that results from imperfect competition, but there are additional inefficiencies of the same type that arise in a modified Prisoners' Dilemma game: There is no incentive for any player to unilaterally change his strategy to that associated with a Pareto-superior equilibrium, but coordination among agents could move the economy to the superior equilibrium. Strictly because of noncompetitive behavior, there is also incentive for the players to move away from a Pareto-efficient allocation (viz., the Walrasian allocation).

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