Merton, Robert C., "A Simple Model of Capital Market Equilibrium with Incomplete Information", Journal of Finance, Vol. 42, No. 3, (July 1987), pp. 483-510.
Prologue: The sphere of model financial economics encompasses finance, micro investment theory and much of the economics of uncertainty. As is evident from its influence on other branches of economics including public finance, industrial organization and monetary theory, the boundaries of this sphere are both permeable and flexible. The complex interactions of time and uncertainty guarantee intellectual challenge and intrinsic excitement to the study of financial economic. Indeed, the mathematics of this subject contain some of the most interesting applications of probability and optimization theory. But for all its mathematical refinement, the research has nevertheless had a direct and significant influence on practice.
{…Three pages later…}
All of this is not to say that the perfect-market model has not been and will not continue to be a useful abstraction for financial analysis. The model may indeed provide the best description of the financial system in the long run. It does, however, suggest that researchers by cognizant of the insensitivity of this model to institutional complexities and explicitly assess the limits of precision that can be reasonably expected from its predictions about the nature and timing of financial behavior. Moreover, I believe that even modest recognition of institutional structures and information costs can go a long way toward explaining financial behavior that is otherwise seen as anomalous to the standard friction-less-market model. To illustrate this thesis, I now turn to the development of a simple model of capital market equilibrium with incomplete information.
