Arrow-Debreu Equilibria for Rank-Dependent Utilities
45 Pages Posted: 15 Sep 2012
Date Written: September 14, 2012
We provide conditions on a one-period-two-date pure exchange economy with rank-dependent utility agents under which Arrow-Debreu equilibria exist. When such an equilibrium exists, we derive the state-price density explicitly, which is a weighted marginal rate of substitution between the initial and the end-of-period consumption of a representative agent, while the weight is expressed through the differential of the probability weighting function. Based on the result we reach several findings, including that asset prices depend upon agents’ subjective beliefs regarding overall consumption growth, that an uncorrelated security’s entire probability distribution and its interdependence with the other part of the economy should be priced, and that there is a direction of thinking about the equity premium and risk-free rate puzzles.
Keywords: Rank-dependent utility, probability weighting, Arrow-Debreu Equilibrium, state-price density
JEL Classification: G11, G12
Suggested Citation: Suggested Citation