Incomplete Markets - Modeling Market Incompleteness

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 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.