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The University of Southampton
Economics Part of Economic, Social and Political Science

1105 Consumer Default with Complete Markets Riskbased Pricing Finite Punishment (X. Mateos-Planas & G. Seccia)


Discussion Paper No. 1105

Consumer Default with Complete Markets: Risk-based Pricing and Finite Punishment

Xavier Mateos-Planas and Giulio Seccia

This paper studies economies with complete markets where there is positive default on consumer debt. Households can default partially, at a finite punishment cost, and competitive intermediaries price household's default risk individually. This environment yields only partial insurance. The risk-based pricing of debt makes it too costly for the borrower to achieve full insurance and there is too little trade in securities. Consumption, as well as debt, are positively correlated with idiosyncratic changes in income. This approach is in contrast with existing literature. Unlike the literature with default, there are no restrictions on the set of state contingent securities that are issued. Unlike the literature on lack of commitment, limited trade arises without debt constraints that rule default out. The approach in this paper implies more consumption inequality.

Keywords: consumer default, complete markets, endogenous incomplete markets,
risk-based pricing, risk sharing

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