A general equilibrium analysis of moral hazard phenomena.

Summary This paper studies the properties of competitive equilibria and second-order allocations in production economies with multiple goods and moral hazard. The analysis focuses on competitive situations where the number of agents in each market is large and information is asymmetrically distributed among agents. We characterize the set of equilibrium allocations, and establish the welfare properties of competitive equilibria under alternative assumptions about the verifiability of trade. Equilibrium allocations are defined by the sets of individual rationality conditions and non-arbitrage conditions. In equilibrium, economic agents maximize their objective functions and exploit all arbitrage opportunities in each market. We show that an equilibrium without arbitrage opportunities always exists, and that non-arbitrage prices can be different from market clearing prices. In this case, rationing phenomena occur at equilibrium. We fully characterize the set of contracts traded in markets with asymmetric information, and clarify the role of contract lotteries and contracts with commitments on future period trades. Finally, we show that the first welfare theorem does not hold in the presence of moral hazard, and characterize the transfer policies that allow for second-best allocations.