Information revelation and market incompleteness

This paper introduces a theory of market incompleteness based on the inform ation transmission role of prices and its adverse impact on the provision o f insurance in financial markets. We analyse a simple security design model in which the number and payoff of securities are endogenous. Agents have r ational expectations and differ in information, endowments, and attitudes t oward risk. When markets are incomplete, equilibrium prices are typically p artially revealing, while full relevation is attained with complete markets . The optimality of complete or incomplete markets depends on whether the a dverse selection effect (the unwillingness of agents to trade risks when th ey are informationally disadvantaged) is stronger or weaker than the Hirshl eifer effect (the impossibility of trading risks that have already been res olved), as new securities are issued and prices reveal more information. Wh en the Hirshleifer effect dominates, an incomplete set of securities is pre ferred by all agents, and generates a higher volume of trade.