Incomplete Markets - Markets, Securities and Market Incompleteness

Markets, Securities and Market Incompleteness

In a competitive market, each agent makes intertemporal choices 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 no longer holds. The competitive equilibrium in an Incomplete Market is generally constrained suboptimal. The notion of constraint suboptimality was formalized by Geanakoplos and Polemarchakis (1986).