What Are Incomplete Markets?
Incomplete markets refer to a situation within Financial Economics where the available financial instruments do not allow economic agents to fully transfer or hedge all possible future risks. This means there isn't an adequate set of financial contracts, such as contingent claims, to perfectly insure against every conceivable future state of the world. Consequently, individuals and firms cannot achieve an optimal allocation of risk, leading to potential inefficiencies in the economy. Unlike a theoretical complete market where every possible future outcome has a corresponding asset to trade, incomplete markets leave some risks uninsurable.
History and Origin
The concept of incomplete markets emerged as a critical extension to the pioneering work on general equilibrium theory, particularly the Arrow-Debreu model. While the Arrow-Debreu framework demonstrated that a competitive equilibrium could lead to a Pareto-optimal allocation of resources under conditions of market completeness, economists soon recognized that real-world markets rarely, if ever, meet these stringent conditions. Key contributions by economists like Kenneth Arrow, Gérard Debreu, and later, more specifically, by Robert Radner and Oliver Hart, highlighted the implications of an absence of a full set of contingent claims.
The recognition that many risks are not tradable through existing financial instruments spurred further research into the causes and consequences of market incompleteness. The development of derivative markets, for example, can be seen as an ongoing effort to address some aspects of market incompleteness by creating new ways to manage risk.11 Early forms of derivatives, such as future delivery contracts for agricultural goods, date back to ancient Mesopotamia, demonstrating a long-standing human desire to mitigate uncertainty.10 The continuous innovation in derivatives, including options contracts and futures contracts, reflects the persistent need for additional tools for risk management in real-world incomplete markets.
Key Takeaways
- Incomplete markets are characterized by the absence of specific financial instruments needed to perfectly hedge against all future uncertain outcomes.
- This market structure prevents economic agents from achieving an optimal allocation of risk.
- The concept highlights a deviation from the theoretical ideal of complete markets, influencing how economists model and understand real-world financial systems.
- Market incompleteness can lead to suboptimal outcomes, such as constrained inefficiency, where the market fails to achieve a Pareto optimal allocation of resources.
- The study of incomplete markets is crucial for understanding asset pricing anomalies and the role of financial innovation.
Interpreting Incomplete Markets
Incomplete markets are interpreted as a fundamental characteristic of real-world economies, contrasting sharply with theoretical constructs like the Arrow-Debreu model which assume perfect market completeness. The existence of incomplete markets implies that individuals and institutions face risks that cannot be fully diversified away or insured against using existing financial instruments. This inability to fully hedge impacts investment decisions, consumption smoothing, and asset pricing. For instance, in an incomplete market, agents might hold precautionary savings or engage in less-than-optimal portfolio diversification because they lack the necessary tools to transfer specific risks. The presence of incomplete markets suggests that equilibrium outcomes may not be Pareto efficient, meaning there might be ways to make some individuals better off without making others worse off, if only the appropriate markets existed.9
Hypothetical Example
Consider an agricultural economy where farmers face unpredictable weather conditions—either a bountiful harvest (good state) or a drought (bad state). In a theoretical complete market, a farmer could buy an "insurance contract" for the drought state, which pays out if a drought occurs, allowing them to maintain stable income regardless of the weather.
In an incomplete market, such a specific drought insurance contract might not exist. Farmers can only buy general crop insurance that covers some, but not all, weather-related losses, or they can invest in irrigation systems. If a severe drought hits that isn't fully covered by the general insurance, the farmers suffer significant losses, and their consumption is severely impacted. They cannot fully smooth their income across states of nature because the specific contingent claims needed to cover all weather risks are absent. This forces them to bear a portion of the weather risk themselves, leading to less efficient risk management for the economy as a whole.
Practical Applications
The theory of incomplete markets has significant practical applications across finance and economics, influencing how we understand and design financial systems, regulatory frameworks, and risk management strategies.
- Financial Product Development: The existence of incomplete markets provides an incentive for financial innovation. The creation of new derivatives, such as credit default swaps or weather futures contracts, often aims to fill gaps in existing markets, allowing for the hedging of previously untradable risks.
*8 Asset Pricing: In incomplete markets, traditional asset pricing models based on complete markets may not fully capture observed asset returns or risk premia. Researchers and practitioners adapt models to account for uninsurable idiosyncratic risks, which can lead to different predictions for supply and demand and ultimately asset prices. F7or instance, certain asset pricing anomalies can be partially explained by the inability of investors to fully diversify away specific risks due to market incompleteness.
*6 Regulatory Policy: Regulators consider market incompleteness when designing policies to enhance market stability and efficiency. Understanding which risks are uninsurable can inform interventions aimed at facilitating better risk sharing or ensuring adequate capital buffers against systemic shocks. - Macroeconomic Modeling: Macroeconomists increasingly incorporate incomplete markets into their models to better explain phenomena like consumption volatility, wealth inequality, and the impact of financial crises. The National Bureau of Economic Research, for example, publishes research exploring how incomplete markets and heterogeneity among agents affect macroeconomic dynamics.
5## Limitations and Criticisms
While the concept of incomplete markets offers a more realistic portrayal of financial systems compared to complete market models, it comes with its own set of limitations and criticisms.
One primary criticism is the difficulty in precisely defining and measuring the "degree" of market incompleteness. It is challenging to identify every possible "state of the world" and determine whether a corresponding financial instrument truly exists or is merely conceptually missing. M4oreover, the absence of a market for a specific risk might be due to factors like high transaction costs, information asymmetry, or regulatory hurdles, rather than a fundamental theoretical incompleteness.
Some theoretical implications of incomplete markets can be problematic for analysis. For instance, in incomplete markets, equilibrium prices may not be unique, making it difficult to predict market behavior or the impact of policy changes. F3urthermore, even if markets are incomplete, financial innovation continually attempts to fill these gaps, suggesting that the "missing" markets are not static. While new derivatives can help address specific unhedged risks, they can also introduce new complexities and interconnectedness, potentially leading to new forms of market fragility. C2ritiques of the theoretical assumptions underpinning complete markets often emphasize the inherent unrealism of perfect knowledge and foresight, arguing that markets are likely to be inherently incomplete regardless of frictions.
1## Incomplete Markets vs. Perfect Markets
The distinction between incomplete markets and perfect markets is fundamental in Financial Economics. A perfect market is a theoretical construct characterized by several ideal conditions, including perfect information, zero transaction costs, homogeneous products, many buyers and sellers, and, crucially, market completeness. In such a market, all participants are price takers, and no single entity can influence prices. The core implication is that prices accurately reflect all available information, leading to market efficiency and the impossibility of arbitrage.
In contrast, incomplete markets are a more realistic description of actual financial systems. They specifically deviate from the perfect market ideal by lacking the full set of financial instruments required to hedge against every conceivable future state of the world. This incompleteness means that some risks are uninsurable, and agents may not be able to achieve their desired level of risk transfer. While perfect markets imply Pareto efficiency, incomplete markets generally do not, often resulting in constrained suboptimal allocations. The existence of incomplete markets provides the impetus for financial innovation and highlights the limitations of theoretical models that assume perfect conditions.
FAQs
Why are markets incomplete?
Markets can be incomplete for several reasons, including the cost of creating and trading every possible financial contract, information asymmetry among market participants, legal or regulatory restrictions on certain types of trades, and the sheer complexity of defining and pricing instruments for every unique future contingency. It's often impractical or impossible to create a market for every idiosyncratic risk.
What is the impact of incomplete markets on investors?
For investors, incomplete markets mean that certain risks cannot be fully diversified or hedged. This can lead to suboptimal portfolio diversification, where investors might hold less-than-ideal asset allocations or demand higher risk premia for certain exposures because they cannot perfectly offload those risks. It also creates opportunities for financial innovation to develop new derivatives or other instruments to address these unhedged risks.
Can incomplete markets ever become complete?
While a truly complete market is a theoretical ideal unlikely to be achieved in practice, financial innovation constantly works towards "completing" markets by introducing new financial instruments that allow for the transfer of previously unhedged risks. For example, the growth of derivatives markets has significantly expanded the range of risks that can be managed. However, new risks and uncertainties continuously emerge, making absolute completeness an elusive goal.