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idiosyncratic risks, each individual's consumption must fluctuate as much as anyone else's, and the relative position in terms wealth distribution of an individual should not vary much over time. The empirical evidence suggests otherwise. Further, the individual consumptions are not highly correlated with each other and wealth holdings are very volatile.
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between agents. For example, the realization of labor income for a given individual is private information and it cannot be known without cost by anyone else. If an insurance company cannot verify the individual's labor income, the former would always have the incentive to claim a low realization of
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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
54:+ 1. If at each date-event there exists a complete set of such contracts, one for each contingency that can occur at the following date, individuals will trade these contracts in order to insure against future risks, targeting a desirable and budget feasible level of consumption in each state (i.e.
150:
Along with the Equity premium puzzle other counterfactual implications of the
Complete Market model are related to the empirical observations concerning individuals’ consumption, wealth and market transactions. For example, in a Complete Market framework, given that agents can fully insure against
83:
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
172:
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
376:
If the market is incomplete, meaning one or both of the securities are not available for trade, the two agents can't trade to hedge against a bad realization of nature and thus remain exposed to the possibility of the undesirable outcome of having zero wealth. In fact, with certainty, one of the
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In practice the idea of a state contingent security for every possible realization of nature seems unrealistic. For example, if the economy lacks the institutions to guarantee that the contracts are enforced, it is unlikely that agents will either sell or buy these securities.
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functions. There are two equally likely states of nature. If state 1 is realized, Robinson is endowed with 1 unit of wealth and Jane with 0. In state 2, Robinson gets 0 while Jane receives 1 unit of wealth. With
Complete Markets there are two state contingent claims:
159:
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.
380:
This example is an extreme case of market incompleteness. In practice, agents do have some type of savings or insurance instrument. The main point here is to illustrate the potential welfare losses that can arise if markets are incomplete.
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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
62:
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.
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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
84:
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.
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Before the realization of the uncertainty, the two agents can trade the state contingent securities. In equilibrium, the two Arrow-Debreu securities have the same price and the allocation is as follows:
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no longer holds. The competitive equilibrium in an
Incomplete Market is generally constrained suboptimal. The notion of constrained suboptimality was formalized by
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The main outcome in this economy is that both
Robinson and Jane will end up with 0.5 units of wealth independently of the state of nature that is realized.
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markets, markets remain incomplete. While several contingent claims are traded routinely against many states such as insurance policies,
147:
Mehra and
Prescott (1985), where the Complete Market model failed to explain the historical high equity premium and low risk-free rate.
647:
473:
143:
is crucial to explain the counterfactual predictions of the standard
Complete Market models. The most notable example is the
43:, this shortage of securities will likely restrict individuals from transferring the desired level of wealth among states.
665:
459:"Existence, regularity and constrained suboptimality of competitive allocations when the asset structure is incomplete"
50:
is a contract promising to deliver one unit of income in one of the possible contingencies which can occur at date
36:
600:
Diamond, P.A. (1967). "The Role of a Stock Market in a
General Equilibrium Model with Technological Uncertainty".
458:
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32:
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When a market is incomplete, it typically fails to make the optimal allocation of assets. That is, the
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58:). In most set ups when these contracts are not available, optimal risk sharing between
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Many authors have argued that modeling incomplete markets and other sorts of financial
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Arrow, K. (1964). "The Role of
Securities in the Optimal Allocation of Risk Bearing".
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Suppose there is an economy with two agents (Robinson and Jane) with identical
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Another common way to motivate the absence of state contingent securities is
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119:, among others, the set of outcomes is far greater than the set of claims.
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Uncertainty, information and communication: Essays in honor of K.J. Arrow
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435:
518:"Buffer-stock saving and the Life Cycle/Permanent Income Hypothesis"
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489:
Mehra, R.; Prescott, E.C. (1985). "The Equity
Premium: A Puzzle".
638:, vol. I, Cambridge (Massachusetts), London (England):
560:"Quantitative Macroeconomics with Heterogeneous Households"
468:. Vol. 3. Cambridge University Press. pp. 65–95.
464:. In Hell, W.P.; Starr, R.M.; Starrett, D.A. (eds.).
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457:Geanakoplos, J.D.; Polemarchakis, H.M. (1986).
135:Failure of the standard complete markets model
67:Markets, securities and market incompleteness
31:are markets in which there does not exist an
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377:agents will be 'rich' and the other 'poor'.
46:An Arrow security purchased or sold at date
558:Heathcote; Storessletten; Violante (2009).
181:Example of complete vs. incomplete markets
99:Possible reasons for market incompleteness
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220:pays 1 unit in state 1 and 0 otherwise.
131:income and the market would collapse.
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525:Quarterly Journal of Economics
155:Modeling market incompleteness
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516:Carroll, Christopher (1997).
636:Theory of Incomplete Markets
503:10.1016/0304-3932(85)90061-3
35:security for every possible
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567:Annual Review of Economics
416:Review of Economic Studies
95:and Polemarchakis (1986).
602:American Economic Review
169:stock and bond markets.
537:10.1162/003355397555109
630:Magill, Michael J.P.;
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128:asymmetric information
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362:{\displaystyle q_{2}}
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305:{\displaystyle q_{1}}
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278:{\displaystyle q_{2}}
258:Robinson buys 0.5 of
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242:{\displaystyle q_{2}}
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213:{\displaystyle q_{1}}
145:equity premium puzzle
89:First Welfare Theorem
77:intertemporal choices
56:consumption smoothing
666:Mathematical finance
396:Financial innovation
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39:. In contrast with
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166:Arrow–Debreu model
73:competitive market
29:incomplete markets
342:and sells 0.5 of
315:Jane buys 0.5 of
285:and sells 0.5 of
18:Incomplete market
16:(Redirected from
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573:: 319–354.
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187:log utility
93:Geanakoplos
624:Literature
402:References
81:stochastic
444:154606108
141:frictions
109:insurance
105:financial
660:Category
634:(1996),
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545:14047708
385:See also
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436:2296188
117:options
113:futures
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60:agents
610:JSTOR
583:S2CID
563:(PDF)
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521:(PDF)
462:(PDF)
440:S2CID
432:JSTOR
79:in a
71:In a
644:ISBN
470:ISBN
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