Question

In: Finance

How are the assumptions in the Arrow-Debreu model inconsistent with reality?

How are the assumptions in the Arrow-Debreu model inconsistent with reality?

Solutions

Expert Solution

Arrow-Debrue model was based on assumption of market equilibrium(i.e., Riskless Society). This equilibrium was used to understand the complex interaction between commodity supply, demand and prices. Derivative industries used this model to determine prices of financial assets that trade in risk but as the economy started growing this model assumption became less efficient because its theory was purely based on mathematical model based on a perfectly competitive market and therefore it doesnot necessarily align with the way that economies are structured and function in real world.

As the economy started growing many factors came into existence in determining commodity supply, demand and prices like

1 Interest Rates

2 Stability

3 Confidence and Expectations

4 Pricing to Earning ratios

5 Emotions

since Arrow-Debrue theory of market equilibrium was strickly based on mathematical model these factors were not considered in that model due to which theory of market equilibrium was not efficient in real world today.

As this model was not efficient in real world lawmakers and administrators implemented many rules and regulations for safety and security of peoples.


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