SFB 303 Discussion Paper No. A - 296

Author: Magill, Michael, and Wayne Shafer
Title: Incomplete Markets
Abstract: Most of the theory on General Equilibrium with Incomplete Markets (GEI) is very recent, having its origins in the classical papers of Arrow (1953), Diamond (1967), Radner (1972), Drčze (1974) and Hart (1975). An extensive array of new results has been obtained in the last five years which seems to call for a re- examination of the status of the theory. What are the central issues which emerge? In this survey we focus principally on the consequences as opposed to the causes of incomplete markets: from this perspective three basic messages stand out.
  1. The non-neutrality of financial instruments and the role of money
  2. The conflicting objectives of firms
  3. The potential inadequacy of a decentralised system of markets.
These three topics motivate the basic layout of the paper. Thus in sections 2 and 3 which analyse the GEI model of an exchange economy we find that when markets are incomplete changing the financial instruments, or when nominal assets are present, changing the money supply leads to a change in the equilibrium allocation: in short financial instruments and money are non-neutral.
Section 4 presents an analysis of the GEI model of a production economy: it is here that the theory still encounters great difficulties. When markets are incomplete each firm faces a public goods problem with respect to its constituency of shareholders (and employees) for which there is no evident solution. We try to bring together the different theories under a common framework, but cannot claim to have advanced the theory much beyond the contribution of Grossman-Hart (1979). When markets are incomplete it should hardly be surprising that equilibrium allocations are inefficient. What is interesting is to understand the cause of the inefficiency: this is the subject of section 5. We have attempted to present a reasonably coherent view of the current status of the theory of incomplete markets. In emphasising conceptual continuity we have had to sacrifice a number of important ideas which are dealt with in only a cursory way in section 6.
Creation-Date: May 1990
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