Information-Constrained Optima with Retrading: An Externality and Its Market-Based Solution

Area of Science:

• Economics
• Game Theory
• Market Design

Background:

• Moral hazard and unobserved states create inefficiencies in competitive equilibria.
• Retrading in ex post spot markets exacerbates externalities due to private information.

Purpose of the Study:

• To analyze the efficiency of competitive equilibria with moral hazard and retrading.
• To investigate mechanisms for internalizing externalities arising from private information and retrading.
• To establish conditions for equivalence between competitive equilibria and constrained Pareto optimality.

Main Methods:

• Theoretical modeling of agent interactions in environments with moral hazard and unobserved states.
• Analysis of ex ante contracting on market fundamentals (spot prices, interest rates).
• Examination of the role of preferences and their impact on externality internalization.

Main Results:

• The interaction of private information and retrading creates externalities unless preferences are highly restrictive.
• Allowing ex ante contracts on market fundamentals internalizes these externalities.
• Competitive equilibria become equivalent to constrained Pareto optimality under these contracting conditions.
• Examples demonstrate the potential for multiple endogenous market fundamentals or 'price-islands' in equilibrium.

Conclusions:

• Efficient competitive equilibria can be achieved by enabling ex ante contracts on market fundamentals.
• This approach resolves externalities stemming from moral hazard and retrading in spot markets.
• The model highlights the endogenous emergence of multiple equilibria structures, termed 'price-islands'.