Efficiency Costs of Incomplete Markets

This paper quantifies misallocation caused by limited risk-sharing and imperfect consumption-smoothing. We measure these losses in terms of how much of society's resources would be left over if financial markets were complete and each consumer were compensated to maintain their status-quo welfare. Using exact formulas and approximate sufficient statistics, we analyze standard incomplete-market environments—ranging from closed-economy Bewley-Aiyagari models to multi-country settings with input-output linkages. We find that incomplete insurance against household-level idiosyncratic risk is very costly (about 20% of aggregate consumption) based on both structural models and sufficient-statistics computed using household consumption panel data. By contrast, the cost of imperfect international financial markets (abstracting from within-country heterogeneity) is roughly 5%, driven by the inclusion of fast-growing economies such as China and India. Unexploited risk-sharing opportunities among countries at similar levels of development, on the other hand, are fairly limited (less than 1%).