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Moral hazard and lack of commitment in dynamic economies

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  • Alexander K. Karaivanov
  • Fernando M. Martin

Abstract

We revisit the role of limited commitment in a dynamic risk-sharing setting with private information. We show that a Markov-perfect equilibrium, in which agent and insurer cannot commit beyond the current period, and an infinitely-long contract to which only the insurer can commit, implement identical consumption, effort and welfare outcomes. Unlike contracts with full commitment by the insurer, Markov-perfect contracts feature non-trivial and determinate asset dynamics. Numerically, we show that Markov-perfect contracts provide sizable insurance, especially at low asset levels, and are able to explain a significant part of wealth inequality beyond what can be explained by self-insurance. The welfare gains from resolving the commitment friction are larger than those from resolving the moral hazard problem at low asset levels, while the opposite holds for high asset levels.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2011-030.

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Date of creation: 2011
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Handle: RePEc:fip:fedlwp:2011-030

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Keywords: Moral hazard ; Risk;

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  1. Matthias Doepke & Robert M. Townsend, 2002. "Dynamic Mechanism Design With Hidden Income and Hidden Actions," UCLA Economics Working Papers 818, UCLA Department of Economics.
  2. Abraham, Arpad & Pavoni, Nicola, 2004. "Efficient Allocations with Moral Hazard and Hidden Borrowing and Lending," Working Papers 04-05, Duke University, Department of Economics.
  3. Arpad Abraham & Nicola Pavoni, 2008. "Efficient Allocations with Moral Hazard and Hidden Borrowing and Lending: A Recursive Formulation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(4), pages 781-803, October.
  4. Thomas, J. & Worral, T., 1991. "Foreign Direcyt Investment and the Risk of Expropriation," Papers 9126, Tilburg - Center for Economic Research.
  5. Alexander Karaivanov & Fernando Martin, . "Dynamic Optimal Insurance and Lack of Commitment," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.
  6. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  7. 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.
  8. Ethan Ligon & Jonathan P. Thomas & Tim Worrall, 2002. "Informal Insurance Arrangements with Limited Commitment: Theory and Evidence from Village Economies," Review of Economic Studies, Oxford University Press, vol. 69(1), pages 209-244.
  9. Thomas, Jonathan & Worrall, Tim, 1988. "Self-enforcing Wage Contracts," Review of Economic Studies, Wiley Blackwell, vol. 55(4), pages 541-54, October.
  10. Thomas, Jonathan & Worrall, Tim, 1990. "Income fluctuation and asymmetric information: An example of a repeated principal-agent problem," Journal of Economic Theory, Elsevier, vol. 51(2), pages 367-390, August.
  11. Mikhail Golosov & Aleh Tsyvinski & Ivan Werning, 2007. "New Dynamic Public Finance: A User's Guide," NBER Chapters, in: NBER Macroeconomics Annual 2006, Volume 21, pages 317-388 National Bureau of Economic Research, Inc.
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Cited by:
  1. Alexander K. Karaivanov & Fernando M. Martin, 2007. "Dynamic Optimal Insurance and Lack of Commitment," Discussion Papers dp07-22, Department of Economics, Simon Fraser University.

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