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Self-insurance vs. self-financing: A welfare analysis of the persistence of shocks

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  • Buera, Francisco J.
  • Shin, Yongseok

Abstract

We study the welfare cost of market incompleteness in a generalized Bewley model where idiosyncratic risk takes the form of entrepreneurial productivity shocks. Market incompleteness in our framework has two dimensions. First, in the Bewley tradition, only a limited set of instruments for consumption smoothing is available. Second, entrepreneurs[modifier letter apostrophe] capital rental is subject to collateral constraints. As is well known, it is harder to self-insure against more persistent shocks, and the welfare cost of missing consumption insurance increases with shock persistence. On the other hand, with collateral constraints, an increase in shock persistence leads to better allocation of production factors through entrepreneurs[modifier letter apostrophe] self-financing, and the welfare cost of imperfect capital rental markets decreases with shock persistence. The overall welfare cost of market incompleteness can be increasing, decreasing, or even non-monotone in shock persistence, depending on the relative strengths of its two components--the cost of missing insurance and the cost of imperfect capital markets.

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Bibliographic Info

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

Volume (Year): 146 (2011)
Issue (Month): 3 (May)
Pages: 845-862

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Handle: RePEc:eee:jetheo:v:146:y:2011:i:3:p:845-862

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

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Keywords: Incomplete market Self-insurance Self-financing Shock persistence;

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Cited by:
  1. Corbae, Dean & Marimon, Ramon, 2011. "Introduction to Incompleteness and Uncertainty in Economics," Journal of Economic Theory, Elsevier, Elsevier, vol. 146(3), pages 775-784, May.
  2. William B. Hawkins & Jose Mustre-del-Rio, 2012. "Financial frictions and occupational mobility," Research Working Paper, Federal Reserve Bank of Kansas City RWP 12-06, Federal Reserve Bank of Kansas City.
  3. Lian Allub & Andres Erosa Etchebehere, 2014. "Financial frictions, occupational choice and economic inequality," Economics Working Papers we1413, Universidad Carlos III, Departamento de Economía.
  4. Modalsli, Jørgen Heibø, 2011. "Polarization, Risk and Welfare in General Equilibrium," Memorandum, Oslo University, Department of Economics 27/2011, Oslo University, Department of Economics.
  5. Benjamin Moll & Robert M. Townsend & Victor Zhorin, 2013. "Financial Obstacles and Inter-Regional Flow of Funds," NBER Working Papers 19618, National Bureau of Economic Research, Inc.

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