Enforcement of Contracts when Markets are Incomplete

This paper considers a standard general equilibrium model with incomplete markets, which is extended to incorporate durable goods and the possibility of default, following Dubey, Geanakpolos and Shubik (1990) and Geanakoplos and Zame (1998). In such a model asset markets will not be active unless there is some mechanism enforcing the promises made in the contracts. Here we consider two specific institutions; Utility Penalties and Collateral. If markets are complete; using Utility Penalties as the means of enforcement will yield a Pareto optimal allocation of resources, if penalties are set at infinity. Whereas using Collateral is likely to result in an inefficient allocation of resources, independent of how collateral requirements are chosen. If markets are incomplete matters are quite different; we show that using Collateral (Utility Penalties) as the means of enforcing contracts opposed to Utility Penalties (Collateral) may yield a Pareto superior allocation of resources.