Econometrica: Jul 1991, Volume 59, Issue 4

Arbitrage, Short Sales, and Financial Innovation<1041:ASSAFI>2.0.CO;2-N
p. 1041-1068

Douglas Gale, Franklin Allen

We describe a model of general equilibrium with incomplete markets in which firms can innovate by issuing arbitrary, costly securities. When short sales are prohibited, firms behave competitively and equilibrium is efficient. When short sales are allowed, these classical properties may fail. If unlimited short sales are allowed, imperfect competition may persist, even when the number of potential innovators is large. If limited short sales are allowed, perfect competition may obtain in the limit but equilibrium can be inefficient because of the presence of an externality: the private benefits of innovation for firms differ from the social benefits.

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