Dynamic Allocation and Pricing in Incomplete Markets: A Survey

This paper surveys the recent development of empirical and theoretical researches on incomplete markets, pointing out the following aspects. First, the theoretical study in this field is motivated by empirical findings of both asset pricing anomalies and heterogeneous behavior among economic agents. Second, incomplete insurance combined with either borrowing constraints or transaction costs offers predictions consistent with empirical findings. In addition, the failure of insuring persistent or permanent shocks alone yields empirically reasonable predictions. Third, recent theoretical research has made attempts to endogenize incomplete insurance from first principles. Fourth, incomplete markets may make aggregate shocks distributed disproportionately among agents, thereby having a significant impact on dynamic allocation and pricing. Finally the theoretical research into incomplete markets triggers a reassessment of welfare implications as to business cycles, economic growth, and financial integration.