Incomplete Markets
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In economics, incomplete markets are markets in which there does not exist an Arrow–Debreu security for every possible state of nature. In contrast with
complete market In economics, a complete market (aka Arrow-Debreu market or complete system of markets) is a market with two conditions: # Negligible transaction costs and therefore also perfect information, # there is a price for every asset in every possible st ...
s, this shortage of securities will likely restrict individuals from transferring the desired level of wealth among states. An Arrow security purchased or sold at date ''t'' is a contract promising to deliver one unit of income in one of the possible contingencies which can occur at date ''t'' + 1. If at each date-event there exists a complete set of such contracts, one for each contingency that can occur at the following date, individuals will trade these contracts in order to insure against future risks, targeting a desirable and budget feasible level of consumption in each state (i.e.
consumption smoothing Consumption smoothing is an economic concept for the practice of optimizing a person's standard of living through an appropriate balance between savings and consumption over time. An optimal consumption rate should be relatively similar at each stag ...
). In most set ups when these contracts are not available, optimal risk sharing between agents will not be possible. For this scenario, agents (homeowners, workers, firms, investors, etc.) will lack the instruments to insure against future risks such as employment status, health, labor income, prices, among others.


Markets, securities and market incompleteness

In a
competitive market In economics, competition is a scenario where different economic firmsThis article follows the general economic convention of referring to all actors as firms; examples in include individuals and brands or divisions within the same (legal) firm ...
, each agent makes
intertemporal choice Intertemporal choice is the process by which people make decisions about what and how much to do at various points in time, when choices at one time influence the possibilities available at other points in time. These choices are influenced by the r ...
s in a stochastic environment. Their attitudes toward risk, the production possibility set, and the set of available trades determine the equilibrium quantities and prices of assets that are traded. In an "idealized" representation agents are assumed to have costless contractual enforcement and perfect knowledge of future states and their likelihood. With a complete set of state contingent claims (also known as Arrow–Debreu securities) agents can trade these securities to hedge against undesirable or bad outcomes. When a market is incomplete, it typically fails to make the optimal allocation of assets. That is, the
First Welfare Theorem There are two fundamental theorems of welfare economics. The first states that in economic equilibrium, a set of complete markets, with complete information, and in perfect competition, will be Pareto optimal (in the sense that no further exchang ...
no longer holds. The competitive equilibrium in an Incomplete Market is generally constrained suboptimal. The notion of constrained suboptimality was formalized by Geanakoplos and Polemarchakis (1986).


Possible reasons for market incompleteness

Despite the latest ongoing innovation in
financial Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fina ...
and
insurance Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...
markets, markets remain incomplete. While several contingent claims are traded routinely against many states such as insurance policies,
futures Futures may mean: Finance *Futures contract, a tradable financial derivatives contract *Futures exchange, a financial market where futures contracts are traded * ''Futures'' (magazine), an American finance magazine Music * ''Futures'' (album), a ...
, financial options, among others, the set of outcomes is far greater than the set of claims. In practice the idea of a state contingent security for every possible realization of nature seems unrealistic. For example, if the economy lacks the institutions to guarantee that the contracts are enforced, it is unlikely that agents will either sell or buy these securities. Another common way to motivate the absence of state contingent securities is asymmetric information between agents. For example, the realization of labor income for a given individual is private information and it cannot be known without cost by anyone else. If an insurance company cannot verify the individual's labor income, the former would always have the incentive to claim a low realization of income and the market would collapse.


Failure of the standard complete markets model

Many authors have argued that modeling incomplete markets and other sorts of financial frictions is crucial to explain the counterfactual predictions of the standard Complete Market models. The most notable example is the
equity premium puzzle The equity premium puzzle refers to the inability of an important class of economic models to explain the average equity risk premium (ERP) provided by a diversified portfolio of U.S. equities over that of U.S. Treasury Bills, which has been obser ...
Mehra and Prescott (1985), where the Complete Market model failed to explain the historical high equity premium and low risk-free rate. Along with the Equity premium puzzle other counterfactual implications of the Complete Market model are related to the empirical observations concerning individuals’ consumption, wealth and market transactions. For example, in a Complete Market framework, given that agents can fully insure against idiosyncratic risks, each individual's consumption must fluctuate as much as anyone else's, and the relative position in terms wealth distribution of an individual should not vary much over time. The empirical evidence suggests otherwise. Further, the individual consumptions are not highly correlated with each other and wealth holdings are very volatile.


Modeling market incompleteness

In the economic and financial literature, a significant effort has been made in recent years to part from the setting of Complete Markets. Market incompleteness is modeled as an exogenous institutional structure or as an endogenous process. In the first approach, the economic models take as given the institutions and arrangements observed in actual economies. This approach has two advantages. First the structure of the model is similar to that of the
Arrow–Debreu model In mathematical economics, the Arrow–Debreu model suggests that under certain economic assumptions (convex preferences, perfect competition, and demand independence) there must be a set of prices such that aggregate supplies will equal aggregat ...
to make it amenable to the powerful techniques of analysis developed for that framework. Second it is easy to compare model allocations with their empirical counterpart. Among the first papers using this approach, Diamond (1967) focused directly on the “realistic” market structure consisting of the stock and bond markets. The other set of models explicitly account for the frictions that could prevent full insurance, but derive the optimal risk-sharing endogenously. This literature has focused on information frictions. Risk sharing in private information models with asset accumulation and enforcement frictions. The advantage of this approach is that market incompleteness and the available state contingent claims respond to the economic environment, which makes the model appealing for policy experiments since it is less vulnerable to the
Lucas critique The Lucas critique, named for American economist Robert Lucas's work on macroeconomic policymaking, argues that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historic ...
.


Example of complete vs. incomplete markets

Suppose there is an economy with two agents (Robinson and Jane) with identical
log utility In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more ce ...
functions. There are two equally likely states of nature. If state 1 is realized, Robinson is endowed with 1 unit of wealth and Jane with 0. In state 2, Robinson gets 0 while Jane receives 1 unit of wealth. With Complete Markets there are two state contingent claims: * q_1 pays 1 unit in state 1 and 0 otherwise. * q_2 pays 1 unit in state 2 and 0 in state 1. Before the realization of the uncertainty, the two agents can trade the state contingent securities. In equilibrium, the two Arrow-Debreu securities have the same price and the allocation is as follows: * Robinson buys 0.5 of q_2 and sells 0.5 of q_1 . * Jane buys 0.5 of q_1 and sells 0.5 of q_2 . The main outcome in this economy is that both Robinson and Jane will end up with 0.5 units of wealth independently of the state of nature that is realized. If the market is incomplete, meaning one or both of the securities are not available for trade, the two agents can't trade to hedge against a bad realization of nature and thus remain exposed to the possibility of the undesirable outcome of having zero wealth. In fact, with certainty, one of the agents will be 'rich' and the other 'poor'. This example is an extreme case of market incompleteness. In practice, agents do have some type of savings or insurance instrument. The main point here is to illustrate the potential welfare losses that can arise if markets are incomplete.


See also

*
Complete market In economics, a complete market (aka Arrow-Debreu market or complete system of markets) is a market with two conditions: # Negligible transaction costs and therefore also perfect information, # there is a price for every asset in every possible st ...
*
Financial innovation Financial innovation is the act of creating new financial instruments as well as new financial technologies, institutions, and markets. Recent financial innovations include hedge funds, private equity, weather derivatives, retail-structured pro ...


References


Literature

*{{Citation , last = Magill , first = Michael J.P. , last2 = Quinzii , first2 = Martine, author2-link= Martine Quinzii , title = Theory of Incomplete Markets , place = Cambridge (Massachusetts), London (England) , publisher =
The MIT Press The MIT Press is a university press affiliated with the Massachusetts Institute of Technology (MIT) in Cambridge, Massachusetts (United States). It was established in 1962. History The MIT Press traces its origins back to 1926 when MIT publish ...
, volume = I , year = 1996 , isbn = 0-262-13324-5 Mathematical finance