OVERVIEW

Competitive market equilibrium plays a crucial role in economic analysis. It focuses on the role of competitive markets and competitive prices in resource allocation. One key result obtained in Chapter 11 is the following:

In the presence of complete competitive markets and in the absence of externalities, a market economy can generate a Pareto efficient allocation of resources.

This result has sometimes been used to argue in favor of a market economy and against the involvement of government in economic policy. In this context, in order to justify government policy, it becomes necessary to identify the presence of market failures. Market failures can take many forms (e.g., noncompetitive markets, externalities, the presence of public goods). This section focuses on a particular form of market failure: the fact that risk markets are typically incomplete under uncertainty.

Indeed, under uncertainty and in the absence of externalities, we saw in Chapter 11 that competitive market equilibrium is Pareto efficient if there exists a competitive market for each possible state of nature. This is the assumption of perfect contingent claim markets. The problem is that, although many markets exist in the real world, they clearly do not cover all possible states of nature. For example, there is no market that would trade on whether the growing season will be good for farmers ten years from now. Thus, we are in a typical situation of incomplete risk markets. This suggests that incomplete contingent claim markets can generate inefficient resource...