The authors study a general-equilibrium economy in which agents have the ability to invest in a risky technology. The investment risk cannot be fully insured with optimal contracts, because shocks are private information. The authors show that the presence of these risks may lead to an underaccumulation of capital relative to an economy where idiosyncratic shocks can be fully insured. They also show that, although the availability of state-contingent (optimal) contracts cannot provide full insurance, it brings the aggregate stock of capital close to the complete markets level. Institutional reforms that make the use of these contracts possible have important welfare consequences.

Also published as:

Endogenous market incompleteness with investment risks
Journal of Economic Dynamics and Control (0165-1889)
November 2006. Vol. 30, Iss. 11, pp. 2143-65