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Abstract

Societies provide institutions that are costly to set up, but able to enforce long-run relationships. We study the optimal decision problem of using self-governance for risk sharing or governance through enforcement provided by these institutions. Third-party enforcement is modelled as a costly technology that consumes resources, but permits the punishment of agents who deviate from ex-ante specified allocations. We show that it is optimal to employ the technology whenever commitment problems prevent first-best risk sharing, but never optimal to provide incentives exclusively via this technology. Commitment problems then persist and the optimal incentive structure changes dynamically over time with third-party enforcement monotonically increasing in the relative inequality between agents.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 134 (2007)
Issue (Month): 1 (May)
Pages: 34-60

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Handle: RePEc:eee:jetheo:v:134:y:2007:i:1:p:34-60

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Web page: http://www.elsevier.com/locate/inca/622869

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Find related papers by JEL classification:

• C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
• D60 - Microeconomics - - Welfare Economics - - - General
• D91 - Microeconomics - - Intertemporal Choice and Growth - - - Intertemporal Consumer Choice; Life Cycle Models and Saving
• K49 - Law and Economics - - Legal Procedure, the Legal System, and Illegal Behavior - - - Other

References

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1. Ethan Ligon & Jonathan P. Thomas & Tim Worrall, 2000. "Mutual Insurance, Individual Savings and Limited Commitment," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(2), pages 216-246, April.
   
   • Ethan Ligon & Jonathan P. Thomas & Tim Worrall, 1998. "Mutual Insurance, Individual Savings and Limited Commitment," Keele Department of Economics Discussion Papers (1995-2001) 98/14, Department of Economics, Keele University.
2. Kehoe, Timothy J & Levine, David K, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Wiley Blackwell, vol. 60(4), pages 865-88, October.
   
   • Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers 445, Federal Reserve Bank of Minneapolis.
   • Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
3. Ramey, Garey & Watson, Joel, 1999. "Contractual Intermediaries," University of California at San Diego, Economics Working Paper Series qt49p1c23g, Department of Economics, UC San Diego.
   
   • Garey Ramey & Joel Watson, 2002. "Contractual Intermediaries," Journal of Law, Economics and Organization, Oxford University Press, vol. 18(2), pages 362-384, October.
   • Garey Ramey & Joel Watson, 1999. "Contractual Intermediaries," Cowles Foundation Discussion Papers 1235, Cowles Foundation for Research in Economics, Yale University.
4. Rustichini, Aldo, 1998. "Dynamic Programming Solution of Incentive Constrained Problems," Journal of Economic Theory, Elsevier, vol. 78(2), pages 329-354, February.
5. Avinash Dixit, 2003. "On Modes of Economic Governance," Econometrica, Econometric Society, vol. 71(2), pages 449-481, March.
   
   • Avinash Dixit, 2001. "On Modes of Economic Governance," CESifo Working Paper Series 589, CESifo Group Munich.
6. Gauthier, Celine & Poitevin, Michel & Gonzalez, Patrick, 1997. "Ex Ante Payments in Self-Enforcing Risk-Sharing Contracts," Journal of Economic Theory, Elsevier, vol. 76(1), pages 106-144, September.
7. Garance Genicot & Debraj Ray, 2003. "Group Formation in Risk--Sharing Arrangements," Review of Economic Studies, Wiley Blackwell, vol. 70(1), pages 87-113, January.
   
   • Garance Genicot & Debraj Ray, 2003. "Group Formation in Risk-Sharing Arrangements," Review of Economic Studies, Oxford University Press, vol. 70(1), pages 87-113.
8. Spear, Stephen E & Srivastava, Sanjay, 1987. "On Repeated Moral Hazard with Discounting," Review of Economic Studies, Wiley Blackwell, vol. 54(4), pages 599-617, October.
9. Thomas, Jonathan & Worrall, Tim, 1988. "Self-enforcing Wage Contracts," Review of Economic Studies, Wiley Blackwell, vol. 55(4), pages 541-54, October.
10. Ligon, Ethan & Thomas, Jonathan P & Worrall, Tim, 2002. "Informal Insurance Arrangements with Limited Commitment: Theory and Evidence from Village Economies," Review of Economic Studies, Wiley Blackwell, vol. 69(1), pages 209-44, January.
11. Narayana Kocherlakota, 2010. "Implications of Efficient Risk Sharing Without Commitment," Levine's Working Paper Archive 2053, David K. Levine.
    
    • Kocherlakota, Narayana R, 1996. "Implications of Efficient Risk Sharing without Commitment," Review of Economic Studies, Wiley Blackwell, vol. 63(4), pages 595-609, October.
12. Phelan Christopher, 1995. "Repeated Moral Hazard and One-Sided Commitment," Journal of Economic Theory, Elsevier, vol. 66(2), pages 488-506, August.
13. Stefan Krasa & Anne P. Villamil, 2000. "Optimal Contracts when Enforcement Is a Decision Variable," Econometrica, Econometric Society, vol. 68(1), pages 119-134, January.

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Citations

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Cited by:

1. Thorsten V. Köppl, 2004. "Risk sharing through financial markets with endogenous enforcement of trades," Working Paper Series 319, European Central Bank.
   
   • Koppl, Thorsten V., 2006. "Risk sharing through financial markets with endogenous enforcement of trades," Journal of Economic Dynamics and Control, Elsevier, vol. 30(11), pages 1987-2014, November.
   • Thorsten V. Koeppl, 2004. "Risk Sharing through Financial Markets with Endogenous Enforcement of Trades," Econometric Society 2004 North American Winter Meetings 326, Econometric Society.
   • Thorsten Koeppl, 2004. "Risk Sharing through Financial Markets with Endogenous Enforcement of Trades," Working Papers 1048, Queen's University, Department of Economics.
2. Thor Koeppl & Cyril Monnet & Erwan Quintin, 2007. "The Poor, the Rich and the Enforcer: Institutional Choice and Growth," Working Papers 1150, Queen's University, Department of Economics.
   
   • Erwan Quintin & Cyril Monnet & Thorsten Koeppl, 2008. "The Poor, the Rich and the Enforcer: Institutional Choice and Growth," 2008 Meeting Papers 281, Society for Economic Dynamics.
   • Erwan Quintin & Thorsten Koeppl & Cyril Monnet, 2008. "The poor, the rich and the enforcer: institutional choice and growth," Working Papers 0801, Federal Reserve Bank of Dallas.
3. Guido Ascari & Neil Rankin, 2004. "Perpetual youth and endogenous labour supply: a problem and a possible solution," Working Paper Series 346, European Central Bank.
   
   • Ascari, Guido & Rankin, Neil, 2007. "Perpetual youth and endogenous labor supply: A problem and a possible solution," Journal of Macroeconomics, Elsevier, vol. 29(4), pages 708-723, December.
4. Beth Allen, 2006. "Market games with asymmetric information: the core," Economic Theory, Springer, vol. 29(2), pages 465-487, October.
5. Jonathan Pogach, 2010. "Efficient Auditing and Enforcement in Dynamic Contracts," 2010 Meeting Papers 572, Society for Economic Dynamics.
6. Thorsten Koeppl & Cyril Monnet & Erwan Quintin, 2008. "Efficient institutions," Working Papers 08-33, Federal Reserve Bank of Philadelphia.

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