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Incentives and the stock market in general equilibrium

The objective of general equilibrium theory is to understand how the complex structure of contractual markets, characteristic of a modern economy, provides a mechanism for agents (consumers, firms and government) to coordinate their decisions, share their risks and create appropriate incentives, in an evolving intertemporal setting with uncertainty. The basic skeleton on which the theory is constructed is the classical theory, first envisioned as the felicitous “invisible hand” of Adam Smith (1776), enriched by the theoretical fabric contributed by Walras (1874) and Pareto (1909), and elegantly transformed into a mathematical framework some two hundred years later in the Arrow-Debreu theory (Debreu (1959)). This theory provides a highly idealized, abstract model of markets working at their best: the nature of the markets and the underlying contracts envisioned is austere and idealized in the extreme. For the Arrow-Debreu theory conceives a fictitious initial moment of time where all agents that are to live for the indefinite future assemble together to exchange contractual commitments, fully aware of all possible future scenarios, and fully confident that all the contractual commitments will be delivered in the future. The agents look up into the future—expressed as an immense date-event tree of possible scenarios, spelled out with meticulous detail and agreed upon by all agents—and in truly Olympian fashion, trade a complete set of Arrow-Debreu contracts, that rich family of promissory notes, each committing to deliver a good of carefully defined quality and characteristics at some future date-event: a truly grandiose thought experiment of uniquely ambitious proportions in the Social Sciences. The model maps all goods at all future date-events into the present, and assembles all future and present generations of agents onto a grand theatrical stage: it is clear that the model can not be taken literally as a description of reality—indeed some would argue that the whole problem with the model is that it is pure theater—this in essence is the argument of Gintis in this volume. This is unfortunate for a fundamental insight of the Arrow-Debreu theory is that the co-