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By Root 989 0

of general equilibrium theory with the theory of supply and demand of capital to the attention of economists. He recognized that goods to be supplied in the future were different from those supplied now, even if physically equivalent. If a market were created for each dated good, then, for example, a steel firm would buy a blast furnace today and simultaneously sell steel for delivery in many subsequent years. It would thus know today its stream of future profits and choose today its inputs and outputs in the present and future so as to maximize total profits. (The price today of a future delivery is what would ordinarily be interpreted as a discounted price.)

Of course, if all these markets existed, all the previous analysis of the static market would be applicable. Prices that would clear all markets would exist, and the resulting allocations would be optimal.

Unfortunately, this conceptual description of the economy fails to conform with everyday observation. Markets for future delivery (“futures markets”) exist only to a very limited extent, and only for a specialized range of commodities. We do have futures markets in agricultural commodities (wheat, cotton, and a few others) and in some minerals, but not in manufactured goods. We also, and more importantly, have markets that trade not ordinary goods but various forms of money at different points in time—that is, the whole panoply of credit instruments.

Hicks was perfectly aware of this failure. He suggested that individuals form expectations of future prices and then prepare plans today based on current prices and expected future prices.2 Only the current markets are active and equilibrate (so-called temporary equilibrium). Provision for the future can take the forms of durable goods and of credit instruments (loans and bonds).

It is important to note here that there is no intrinsic reason so far addressed that ensures that different economic agents have the same expectations of the future prices. But the efficiency characteristics of markets depend on the assumption that all individuals face the same tradeoffs (i.e., the same relative prices). Hence, there is no guarantee of efficiency in this broader approach to general equilibrium over time.

There is one assumption, mentioned by Hicks and given much greater emphasis in the work Gérard Debreu and I published in 1954, under which expectations do yield efficiency. This is the assumption of perfect foresight; individuals predict future prices correctly. In this case, of course, all individuals’ expectations are the same. This assumption is consistent, as was demonstrated, but it ascribes an econometric ability to economic agents much beyond that of academics. In principle, it requires that all agents know the utility functions and production possibility sets of all other agents. This condition is not only empirically false; it is also inconsistent with one of the chief claims of economists, that efficiency can be achieved by trading among individuals who know only about their own tastes and productive capabilities.3 I return to this point in the third section below.

Once it is recognized that a great deal of allocation takes place on the basis not of markets but of expectations about future markets, two questions emerge: Why don’t the missing markets come into being, and what are the implications of expectations-driven allocations? I here intend only to broach these questions and make a few preliminary remarks towards an analysis.

GENERAL EQUILIBRIUM UNDER UNCERTAINTY

One obvious explanation for the nonexistence of futures markets is the uncertainty about the future. There are many causes for uncertainty, but one of great importance is surely uncertainty about technological developments. To make a contract now for future delivery at a given price bears a risk because technological change in the coming years may make the cost different from that expected. Another risk may be the future emergence of new products whose qualities are random variables from today’s viewpoint.

That the uncertainty about the future