Arrow-Debreu Model

Definition

The Arrow-Debreu Model is a fundamental concept in economic theory that represents a framework for understanding general equilibrium in a complete market. It highlights how consumers and firms interact to reach an efficient allocation of resources where supply equals demand across all markets, while considering uncertainty and risk. This model is crucial for analyzing scenarios involving moral hazard and principal-agent problems, as it provides a structured approach to understand how contracts and incentives can influence decision-making in uncertain environments.

5 Must Know Facts For Your Next Test

1. The Arrow-Debreu Model assumes that all markets exist and are perfectly competitive, allowing for the trading of goods, services, and securities to achieve efficiency.
2. In this model, every possible future state of the world is accounted for, making it a powerful tool for analyzing decisions under uncertainty.
3. It illustrates how agents can use complete contracts to align incentives and mitigate issues related to moral hazard and adverse selection.
4. The existence of a complete set of markets ensures that all risks can be traded away, which is essential in addressing the principal-agent problem effectively.
5. The model relies on the concept of 'Arrow-Debreu securities,' which are contingent claims based on future states of the world, helping agents manage uncertainty.

Review Questions

• How does the Arrow-Debreu Model illustrate the concept of general equilibrium in relation to resource allocation?
  • The Arrow-Debreu Model illustrates general equilibrium by showing how all markets in an economy interact simultaneously to achieve an efficient allocation of resources. When supply equals demand across every market, it demonstrates that resources are allocated optimally. This interplay among consumers and firms ensures that decisions made by one agent can have ripple effects throughout the economy, highlighting the importance of interconnectedness in achieving overall efficiency.
• What role do complete contracts play in addressing moral hazard within the Arrow-Debreu Model framework?
  • Complete contracts are vital in the Arrow-Debreu Model as they define terms that align incentives between parties involved, thus mitigating moral hazard. When contracts specify outcomes based on performance and include contingencies for various states of the world, agents are less likely to engage in risky behavior since their actions are monitored and their interests are aligned with those of the principals. This structure helps create accountability, ensuring that all parties work towards optimal outcomes.
• Evaluate how the Arrow-Debreu Model contributes to understanding the principal-agent problem in economic theory.
  • The Arrow-Debreu Model enhances our understanding of the principal-agent problem by providing a framework where various states of nature and corresponding payoffs can be modeled through complete contracts. It shows how designing contracts that consider potential outcomes can incentivize agents to act in line with principals' interests. By focusing on risk-sharing and contingent claims, this model demonstrates how efficient contracts can reduce information asymmetry and align objectives between principals and agents, ultimately leading to better decision-making and resource allocation.

Related terms

General Equilibrium: A condition where supply and demand are balanced across all markets in an economy, leading to an efficient allocation of resources.

Moral Hazard: A situation where one party takes risks because they do not bear the full consequences of their actions, often due to asymmetric information.

Principal-Agent Problem: A conflict that arises when one party (the principal) delegates decision-making authority to another party (the agent), who may act in their own interests rather than those of the principal.