A theory of markets, institutions, and endogenous preferences

The endogeneity of preferences implies that not only individual preferences—along with technologies, government policies, and the organization of society and markets—determine economic outcomes, but also that the economic, social, legal, and cultural structure of society affects preferences. This paper develops a general equilibrium model of incomplete markets in which preferences are endogenously determined. The key feature in the model is the interplay between the extent of the market, competitive endogenous interactions among individuals, and the heterogenous formation of preferences. We develop our model through an example in which individuals’ attitudes toward risk are formed as a function of the exposure to market risks, market incompletenesses, and non-market uncertainties. The model can easily accommodate the consideration of the formation of other preference parameters, and their relationship with other characteristics of the economic, social, and institutional environment. We discuss and present empirical evidence that supports the implication that the degree of risk aversion responds to market arrangements.