A Welfare Criterion with Endogenous Welfare Weights for Belief Disagreement Models

Belief disagreement generates a fundamental tension between two desirable features of a resource allocation: Pareto optimality and risk sharing. While Pareto optimality generally opposes restrictions to trade, a growing literature rejects it in the presence of heterogeneous beliefs and proposes welfare criteria that instead assume risk sharing as fundamentally desirable. We propose a welfare criterion that balances out these two desirable features by endogenously determining sensible welfare weights based on competitive equilibrium allocation as a benchmark. Applying our method to several belief disagreement models, we show how lax financial regulations can lead to welfare improvements over no regulation (as per Pareto optimality) and over tight regulation (as per other existing approaches)