What Is Incomplete Market?
An incomplete market is a financial market where there are not enough financial instruments or opportunities to allow economic agents to fully transfer risk or allocate resources across all possible future states of the world. In the realm of financial economics and market theory, a complete market is an idealized concept where a full set of contingent claims exists, enabling participants to perfectly hedge against any conceivable future outcome. Conversely, an incomplete market lacks this full set of securities, meaning some risks cannot be fully diversified or hedged, leaving individuals and firms exposed to undesirable outcomes.
The concept of an incomplete market is central to understanding real-world market imperfections, as virtually all actual securities markets exhibit some degree of incompleteness. This situation often arises due to factors such as information asymmetry, transaction costs, or regulatory restrictions. When markets are incomplete, the optimal allocation of assets is generally not achieved, leading to potential inefficiencies in the economy.
History and Origin
The theoretical foundation for understanding complete and incomplete markets can be traced back to the mid-20th century with the pioneering work of economists Kenneth Arrow and Gérard Debreu. Their development of the general equilibrium theory, which included the concept of "complete markets" with Arrow-Debreu securities, provided a benchmark for ideal market conditions.9 These idealized models assumed that individuals could perfectly insure against all future uncertainties through a comprehensive set of state-contingent contracts.
However, subsequent research recognized that real-world markets rarely meet these stringent criteria. The foundational model for general equilibrium with incomplete markets was notably advanced by Radner in 1972, followed by significant contributions from economists like Oliver Hart in 1975, and later, Michael Magill and Martine Quinzii, who further formalized the theory.7, 8 This body of work shifted focus to understanding the implications of market incompleteness, acknowledging that the absence of a complete set of financial instruments inherently limits agents' abilities to fully share or hedge against risks. As a result, the study of incomplete markets became a crucial area of modern financial economics, providing a more realistic framework for analyzing economic behavior under uncertainty.
Key Takeaways
- An incomplete market lacks sufficient financial instruments to allow economic agents to perfectly hedge against all possible future risks.
- It contrasts with a theoretical "complete market," where all risks can be perfectly managed through existing securities.
- Market incompleteness is a common feature of real-world financial systems, leading to potential inefficiencies and unhedged exposures.
- Factors such as high transaction costs, information asymmetry, and legal or regulatory barriers contribute to market incompleteness.
- The study of incomplete markets helps explain various market phenomena, including the existence of certain financial innovations and observed anomalies in asset pricing.
Interpreting the Incomplete Market
In an incomplete market, the inability to perfectly hedge against all risks means that market participants face uninsurable idiosyncratic shocks. This implies that individuals cannot fully smooth their consumption across different states of the world, even if the aggregate economy is stable. The presence of an incomplete market suggests that the fundamental theorems of welfare economics, which hold under complete market assumptions, may no longer apply, leading to competitive equilibria that are not necessarily Pareto optimal.6
For economists and policymakers, understanding the degree of market incompleteness is vital. It helps in assessing the welfare implications of various policies and the potential for financial innovations to enhance risk-sharing. For investors, it highlights the inherent limitations in achieving full risk management through traditional financial products alone, often necessitating alternative strategies or acceptance of certain unmitigable risks.
Hypothetical Example
Consider a simplified economy with two individuals, Alice and Bob, and two possible future states of the world: "Sunny" and "Rainy," each with equal probability. Suppose Alice's income is high if it's Sunny and low if it's Rainy, while Bob's income is low if it's Sunny and high if it's Rainy.
In a complete market, Alice and Bob could purchase or sell "Arrow-Debreu securities"—contracts that pay out only in one specific state of the world. For instance, Alice could buy a "Rainy" security to boost her income if it rains, and Bob could buy a "Sunny" security. This allows them to perfectly smooth their income, ensuring they have the same consumption level regardless of the weather, effectively eliminating their individual weather-related income risk.
Now, imagine an incomplete market where only a single, simple bond exists. This bond pays a fixed amount regardless of the weather. While Alice and Bob can use this bond to transfer wealth across time, they cannot specifically transfer wealth from the "Sunny" state to the "Rainy" state or vice-versa to fully offset their unique income fluctuations. They cannot create a security that specifically hedges against their personal weather-dependent income risk. Therefore, despite wanting to, they remain exposed to the income volatility caused by the weather, illustrating the core concept of an incomplete market.
Practical Applications
The concept of an incomplete market has profound implications across various areas of finance and economics. One key area is the development of derivative securities, such as options and futures, which often emerge to "complete" markets by allowing for the hedging of specific risks that traditional assets cannot address. F5or example, the creation of weather derivatives allows entities like farmers or energy companies to mitigate financial exposure to adverse weather conditions, a risk that was historically uninsurable.
Furthermore, incomplete markets are crucial in explaining observed financial phenomena that deviate from predictions made by complete market models. For instance, the "equity premium puzzle," which refers to the historically high returns of stocks over risk-free assets, can be partially attributed to the inability of individuals to fully insure against aggregate consumption risks in incomplete markets. T4his necessitates a higher premium for holding risky assets. The limitations in risk sharing due to incomplete markets also influence individual savings behavior, often leading to higher precautionary savings. Regulatory frameworks, too, grapple with market incompleteness, as they aim to foster new markets where needed while managing the risks associated with financial innovation.
Limitations and Criticisms
While the theory of incomplete markets provides a more realistic framework than its complete market counterpart, it also faces certain limitations and criticisms. A primary critique is that despite ongoing financial innovation, markets remain incomplete, suggesting that perfect arbitrage opportunities or full risk transfer are elusive. This inherent incompleteness often leads to economic inefficiencies and can result in significant "welfare losses" for individuals who cannot fully hedge against specific risks.
3Another challenge stems from the fact that in an incomplete market, equilibria are not always unique, and small changes in economic parameters can lead to disproportionately large shifts in outcomes. Furthermore, the absence of specific financial instruments can lead to situations where "Ponzi schemes" become theoretically possible in infinite-horizon models if not adequately constrained, highlighting potential vulnerabilities in such markets. T2he very definition of what constitutes an "incomplete market" can also be complex, as it hinges on the concept of "states of the world" and whether instruments exist to provide payoffs in each unique state. C1ritics also point out that modeling incomplete markets, while more realistic, introduces significant mathematical complexity, making it harder to derive clean analytical solutions compared to complete market models.
Incomplete Market vs. Perfect Market
The terms "incomplete market" and "perfect market" describe two contrasting economic theoretical constructs, with the former representing a more realistic depiction of financial reality.
| Feature | Incomplete Market | Perfect Market |
|---|---|---|
| Definition | Lacks sufficient financial instruments to allow full risk transfer or resource allocation across all possible future states. | Possesses a complete set of contingent claims, allowing perfect risk hedging. |
| Risk Hedging | Not all risks can be fully hedged or diversified. | All risks can be perfectly hedged. |
| Information | Often characterized by information asymmetry and imperfect information. | Perfect information for all supply and demand participants. |
| Transaction Costs | Transaction costs can be present and significant. | Negligible or zero transaction costs. |
| Realism | Reflects real-world market conditions more closely. | A theoretical ideal; does not exist in reality. |
| Efficiency | Competitive equilibria may be suboptimal. | Competitive equilibria are Pareto optimal. |
Confusion often arises because a perfect market is a hypothetical benchmark against which real-world, incomplete markets are often analyzed. The "perfect market" assumes ideal conditions (perfect information, no transaction costs, numerous buyers and sellers, homogeneous products, and complete tradability of all contingent claims) that rarely, if ever, exist. An "incomplete market," conversely, acknowledges the absence of these ideal conditions, particularly the ability to perfectly insure against all future contingencies, making it a more practical framework for market efficiency analysis.
FAQs
Why are markets incomplete in the real world?
Markets are incomplete in the real world due to various factors, including high transaction costs for creating and trading complex securities, issues with information asymmetry (where one party has more or better information than another), legal or regulatory restrictions on certain types of contracts, and the inherent difficulty in foreseeing and writing contracts for every conceivable future "state of the world."
Can an incomplete market become a complete market?
While financial innovation, such as the creation of new derivative securities, can help to "complete" markets by providing instruments to hedge previously uninsurable risks, it is highly unlikely that any real-world market will ever achieve full completeness. The dynamic nature of uncertainty and the persistent presence of frictions prevent a perfect set of contingent claims from being continuously available.
What are the consequences of an incomplete market for investors?
For investors, the primary consequence of an incomplete market is the inability to perfectly hedge against all sources of risk. This means investors may face irreducible exposure to certain market or idiosyncratic shocks. It also implies that optimal risk management strategies may involve a combination of financial instruments and non-market-based solutions, and that achieving a perfectly diversified portfolio is often a theoretical rather than practical goal.