What is Radner’s equilibrium?
Radner’s equilibrium is an extension of Arrow-Debreu general equilibrium that explores the competitive equilibrium condition under uncertainty to explain the actual existence of financial institutions and markets, such as money and stock exchanges .
Radner Equilibrium was first introduced by American economist Roy Radner in a 1968 paper and further explained in a chapter, “Equilibrium Under Uncertainty”, in the textbook of mathematical economics.
Key points to remember
Key points to remember
- Radner’s equilibrium extends Arrow-Debreu equilibrium theory to include uncertainty and incomplete information about the future.
- This suggests that even with limited uncertainty and information, people could still achieve optimal resource allocation in general equilibrium with unlimited computational resources.
- Because real people always have a limited ability to calculate and account for all possible economic outcomes, Radner’s equilibrium helps explain the demand for cash, the use of money and tradable stocks, and a continuous process of repeated cycle of exchanges in the market.
Understanding Radner’s Equilibrium
Radner’s equilibrium starts with the standard general Arrow-Debreu equilibrium and adds additional conditions intended to more closely reflect the real economy, in which people make decisions with incomplete information about the outcome of their own decisions. and on the decisions that others make simultaneously. In Radner’s equilibrium, producers make production plans and consumers make consumption plans in an initial period with partial and imperfect information about others’ plans and about external conditions that can help determine the outcomes of their plans and preferences for these outcomes in a second (future) period.
Radner argued that if economic decision makers have unlimited computational capacity to choose among strategies, then even in the face of uncertainty in the economic environment, optimal allocation of resources based on competitive equilibrium can be achieved. In this equilibrium, each consumer would maximize his preferences in his possible set of consumption choices, subject to his wealth constraint; each producer would maximize his profits within the framework of his possible production choices; and the total demand for each good would equal the total supply, at each period of time and in each state of given external conditions. In such a world, there would be no role for money and liquidity.
However, the introduction of information, generated by the spot markets during the second period, on the behavior of other decision makers and the computational limitation of the ability of economic actors to actually plan for all possible contingencies generates a demand for cash. This demand for liquidity manifests itself in the use of money, the exchange of ownership shares in production plans, and in continuous successive cycles of market exchanges as people update their beliefs and plans based on newly generated information.
Radner further argued that it is the market participants’ computational limits that matter most, because even in the absence of uncertainty about external conditions, they would produce a similar demand for liquidity.
Because his argument showed that the demand for liquidity (and therefore the existence of money and equity exchanges) in general equilibrium arises from imperfect computational and information limits—that violate basic assumptions used in neoclassical competitive models and theorems of welfare economics—Radner concluded that real-world markets that exhibit the demand for liquidity and the use of money do not lend themselves to analysis using these theories.
