What is Radner Equilibrium?
The Radner Equilibrium is an extension of Arrow-Debreu general equilibrium that explores the condition of competitive equilibrium under uncertainty to explain the real world 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 as a chapter, "Equilibrium Under Uncertainty," in the Handbook of Mathematical Economics.
- Radner equilibrium extends Arrow-Debreu equilibrium theory to include uncertainty and incomplete information about the future.
- It suggests that even with uncertainty and limited information, people could still achieve an optimal allocation of resources in general equilibrium with unlimited computational resources.
- Because real people always have limited ability to compute and account for all possible economic outcomes, Radner equilibrium helps explain the demand for liquidity, the use of money and tradable shares, and an ongoing process of repeated round of market exchange.
Understanding Radner Equilibrium
Radner equilibrium begins with standard Arrow-Debreu general equilibrium and adds additional conditions that are intended to more closely reflect the real economy, whereby people make decisions with incomplete information about the outcome of their own decisions and about the decisions others are simultaneously making. In Radner equilibrium, producers make production plans and consumers make consumption plans all in an initial time period under partial, imperfect information about each others' plans and about the external conditions that may help determine the outcomes of their plans and the preferences for those outcomes in a second (future) time period.
Radner argued that if economic decision makers have unlimited computational capacity for choice among strategies, then even in the face of uncertainty about the economic environment, an optimal allocation of resources based on competitive equilibrium can be achieved. In this equilibrium, each consumer would maximize their preferences within their possible set of consumption choices, subject to their wealth constraint; each producer would maximize profits within their possible production choices; and total demand for each good would equal total supply, in every time period and in every 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 spot markets in the second time period, about the behavior of other decision makers and computational limitation on the ability of people in the economy to actually plan for all possible contingencies generates a demand for liquidity. This demand for liquidity manifests in the use of money, the trading of ownership share in production plans, and in continuous successive rounds of market exchange as people update their beliefs and plans based on newly generated information.
Radner further argued that it is the computational limitations of market participants that are more important, as 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 thus the existence of money and equity stock trading) in general equilibrium arises from computational limits and imperfect information—which violate the basic assumptions used in neoclassical competitive models and the theorems of welfare economics—Radner concluded that real world markets which do feature the demand for liquidity and use of money are not amenable to analysis using these theories.