On Pareto Efficiency in Asset Markets

Abstract

In this study, we consider Pareto efficiency in financial markets. In welfare economics, it is sufficient to consider competitive equilibrium to assure Pareto efficiency. This study, however, focuses on describing the utility possibility frontier, which explicitly shows Pareto efficiency for financial markets. To this end, we use the time-additive utility (functional) with the mean-variance utility. In deriving the utility possibility frontier, we obtain an asset pricing formula dependent on an agent ’ s utility. We provide a characteristic of this formula to ensure Pareto efficiency. Moreover, our study generalizes the payoff function of the asset. This enables us to analyze various financial transactions. As an application of our framework, we consider a simple insurance contract with default. We then show that the likelihood of default makes the market Pareto inefficient or deteriorates social welfare, as shown in previous studies.