MARKETS WITH ENDOGENOUS UNCERTAINTY THEORY AND POLICY

Classic formulations of markets regard uncertainty as originating from acts of nature. I extend this to a formulation of markets which face risks induced by the economy itself, such as the environmental risks o f atmospheric and climate change induced by CFC and CO2 emissions. I f ormulate and prove the existence of a general competitive equilibrium where the state space and the probabilities of events are endogenously determined as part of the equilibrium. Traders take optimal positions with respect to the uncertainty which their own actions induce. The e quilibrium allocations are efficient in a restricted sense. I show tha t scientific uncertainty can be fully hedged. However uncertainty indu ced by the unknown level of output at an equilibrium cannot be hedged fully. I discuss applications for CAT Futures, recently introduced on the Chicago Board of Trade, and to international environmental strateg ies.