What Is Market Segmentation Theory In Economics?

In the market segmentation theory it is assumed that short term and long term rates are determined in separate or segmented markets. Some investors prefer short term securities. They invest in short term bonds. Again, there are some investors who prefer long term bonds. As a result bonds having different maturity periods are not perfect substitutes for one another. Such an argument implies that lenders and borrowers are interested in bonds of only one maturity and even if the return on a sequence of shorter bonds were considerably higher than the return on those bonds, they would not attempt to switch into shorter bonds. Therefore, expectation concerning short rates would have no role in determining long rates. Thus even if short term rate increases in any period of time this theory implies that investors will not shift from long term bonds to short term bonds in order to enjoy higher rate in the short run. Thus even if the short run rate of interest increases it will not influence the long term rate of interest.

This theory is based on institutional practices followed by the commercial banks and insurance companies and investment trusts. While the commercial banks mostly deal in short term securities, insurance companies and investment trusts mostly deal in long term securities. This theory is however not free from defect as it overlooks the fact that there is considerable degree of overlapping between different markets. Same institutions operate in different markets dealing in securities of different maturities.