Endogenous market incompleteness with investment risks

This paper studies 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. We show that the presence of investment risks lead to under-accumulation of capital relative to an economy where idiosyncratic shocks can be fully insured. We also show that the availability of state-contingent (optimal) contracts - compared to simple debt contracts - brings the aggregate stock of capital close to the complete markets level. Institutional reforms that make possible the use of these contracts have important welfare consequences.