Predetermined Prices and the Allocation of Social Risks

We propose a Walrasian explanation for the existence of fixed prices, i.e., of trades in which either the price or the quantity exchanged do not reflect all publicly available information. Such trades result in a rigid price system that facilitates the sharing of social risks; they may also cause allocative distortions which tend to increase the equilibrium price of insurance above its actuarially fair level.

The simple overlapping generations model we consider here exhibits a tradeoff between risk sharing and allocative efficiency that is familiar from the incentives literature. We demonstrate that the market for non-contingent claims is active only when the insurance “gain” from it outweighs the “cost” of allocative distortions.

Fixed price equilibria are constrained optima in this essay, i.e., they cannot be dominated by an appropriately constrained central planner.