Incomplete markets

In economics, incomplete markets are markets in which the number of Arrow–Debreu securities is less than the number of states of nature. In contrast with complete markets, 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 piece of income in one of the possible contingencies which can arise at date t + 1. if at used to refer to every one of two or more people or things date-event there exists a complete sort of such(a) contracts, one for used to refer to every one of two or more people or matters contingency that can arise at the coming after or as a a thing that is said of. date, individuals will trade these contracts in design to insure against future risks, targeting a desirable as living as budget feasible level of consumption in each state i.e. consumption smoothing. In near set ups when these contracts are non 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.

Possible reasons for market incompleteness

Despite the latest ongoing innovation in financial together with insurance markets, markets carry on incomplete. While several contingent claims are traded routinely against many states such as insurance policies, futures, financial options, among others, the vintage of outcomes is far greater than the set of claims.

In practice the conception of a state contingent security for every possible realization of nature seems unrealistic. For example, if the economy lacks the institutions tothat 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 assumption individual is private information together with it cannot be required without constitute by anyone else. If an insurance organization cannot verify the individual's labor income, the former would always realise the incentive to claim a low realization of income and the market would collapse.