Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

4. Incomplete Market 
Incomplete market occurs when a private market cannot 
supply a good or service even if the consumer is willing to pay more 
than the actual amount required to provide it. Therefore, we can 
say that 
greater demand for a service or good doesn‘t always mean 
greater supply of it, meaning the service or good is limited for 
certain reasons. It could be that the good or service is only offered 
for a limited period of time or number; thus, even if the consumer is 
willing to pay higher cost of the product the manufacturer would not 
supply it still since the primary goal of this private firms is to gain 
big profits, hence they would not risk losing it. 
In capital markets, lenders are solicitous because they are 
afraid that the borrowers would not pay. With this, the lender may 
still find it difficult to distinguish who are the borrowers that are 
willing to pay their loans and who are reluctant to do so. This is the 
specific problem with loans such as a house loan, for if the 
borrower defaults to pay, the problem start to rise and the lender 
find itself in a dilemma. The only consolation for the lender is that 
he or she can vend the house and get back the money that he 
loses. 

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A good example of this kind of problem is the recession 
experienced by the United States of America in the last quarter of 
the year 2007. One of the possible reasons for this recession is the 
borrowers are refusing to pay their house loans. Since a lot of them 
had backed out from paying their loans, the lenders lose their 
potential profit. Thus, they opt for selling the collateral houses with 
the interest rate added so they can get their money back. However, 
no one wanted to buy the houses since it is expensive. With this 
being the case, the lenders has to take the risk of decreasing the 
rate so people could afford the houses. 
This kind of failure may be hard to solve since the lenders 
could not control the borrower, control in a way that they cannot 
guarantee the willingness of the borrower to pay. However, the 
lender can always get the collateral whenever the borrower refuses 
to do his/her financial responsibility. 
Similarly, in insurance market the private firm cannot provide 
insurance for many important risks that individuals face. Suppose 
that an individual wanted to purchase insurance to counter the 
possibility of becoming poor. Would a firm in an efficient market 
ever find it profitable to provide ―poverty insurance‖? Since the one 
who will be interested in this kind of insurance are the ones with 
high probability of being poor, so the consumers would just be 
limited. Also, this kind of insurance requires high rates, so it might 
be hard for the buyers to get the insurance. With this dilemma, the 
firm might not gain enough profit to stay in the market. 
These are the factors why insurance and capital markets are 
imperfect. Three factors are given: (1) innovation, (2) transaction 
costs, and (3) asymmetries of information. Innovation refers to the 
creating of new securities and insurance policies. The introduction 
of these new products has a relation to the second factor: 
transaction cost. It is really expensive to run a market; hence, 
insurance firm maybe reluctant in going into the trouble of 
designing a new insurance policy if it is unsure whether anyone will 
buy it. Thus, there is no effective ―patent protection‖, and as a 
result, there will be under-investment in innovation. Also, 
information asymmetry may arise when the purchaser and the 
producer have different information.