The Choice of Techniques and the Optimality of Market Equilibrium with Rational Expectations

This paper shows that, in the absence of a complete set of risk markets, prices provide incorrect signals for guiding production decisions. Even if all individuals have rational expectations concerning the distribution of prices which will prevail on the market next period, the market allocation is, in general, not a constrained Pareto optimum. Essentially the only conditions under which, for all technologies, the market equilibrium is a constrained Pareto optimum are those in which risk markets are redundant. We derive the necessary and sufficient conditions for redundancy of risk markets, which turn out to be extremely restrictive. There is another way of looking at these results which may prove instructive. In a world of complete markets, insurance markets allocate risk, and goods markets allocate goods; but in the absence of insurance markets, the remaining goods markets have to serve both functions. For example, if the source of the variability lies on the supply side, and if demand is not too inelastic, the negative correlation between price and output means that the output market transfers some of the risk facing producers to consumers, and producers' income variability will be less than their output variability. In a rational expectations equilibrium, each farmer correctly forecasts the distribution of prices and chooses the level and riskiness of output to maximize his expected utility. Together, these output decisions generate a distribution of total supply which in turn generates the price distribution. No one farmer can influence the price distribution, but each one is affected by it, and, collectively, their actions reproduce it