Efficiency Costs of Incomplete Markets

David R. Baqaee and Ariel Burstein

No 34233, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: 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%).

JEL-codes: E0 F0 F1 F30 (search for similar items in EconPapers)
Date: 2025-09
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