In this chapter, we will discuss economies in which there may exist restrictions of various forms on trading by agents. One of the most common forms of market friction is the presence of a borrowing constraint. However, there may also exist economies in which only a small number of assets is traded. Typically we refer to economies in which the number of assets traded is less than the set of random states as economies with market incompleteness. Such market incompleteness may arise from private information considerations or intergenerational restrictions. We consider the role of intergenerational frictions in Chapter 17. In contrast to environments where individual heterogeneity does not matter in a fundamental way, an important implication of models with market incompleteness is that the cross-sectional distribution of nonhuman wealth will vary over time and help to determine economic outcomes.

In this chapter, we start with a model of idiosyncratic endowment risk, in which aggregate output is constant and there is a countable infinity of agents. This setup was introduced by Bewley [64] as a way of providing general equilibrium foundations for the permanent income hypothesis. In such an environment, agents can trade a variety of assets to eliminate the impact of idiosyncratic income or endowment risk on their consumption profiles. Using this framework, we distinguish between the impact of closing down contingent claims markets and the impact of closing down credit markets. We consider three different market arrangements – complete contingent claims, pure insurance markets, and pure credit markets.