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Insurance and Inequality with Persistent Private Information

Author

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  • Alex Bloedel
  • R. Vijay Krishna
  • Oksana Leukhina

Abstract

This paper studies the implications of optimal insurance provision for long-run welfare and inequality in economies with persistent private information. We consider a model in which a principal insures an agent whose privately observed endowment follows an ergodic, finite Markov chain. The optimal contract always induces immiseration: the agent’s consumption and utility decrease without bound. Under positive serial correlation, the optimal contract also features backloaded high-powered incentives: the sensitivity of the agent’s utility with respect to his report increases without bound. These results significantly extend — and elucidate the limits of — the hallmark immiseration results for economies with iid private information. Our analysis utilizes recursive techniques for contracting with persistent states, accounts for the possibility of binding global incentive constraints, extends to other canonical insurance settings (e.g., Mirrleesian economies), and has additional implications for the short-run dynamics of optimal contracts.

Suggested Citation

  • Alex Bloedel & R. Vijay Krishna & Oksana Leukhina, 2018. "Insurance and Inequality with Persistent Private Information," Working Papers 2018-020, Federal Reserve Bank of St. Louis, revised 12 Dec 2021.
  • Handle: RePEc:fip:fedlwp:2018-020
    DOI: 10.20955/wp.2018.020
    Note: This paper subsumes an earlier working paper circulated as “Misery, Persistence, and Growth” (Bloedel and Krishna 2015).
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    More about this item

    Keywords

    Immiseration; insurance; inequality; backloaded incentives; recursive contracts; persistent private information;
    All these keywords.

    JEL classification:

    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • D30 - Microeconomics - - Distribution - - - General
    • D31 - Microeconomics - - Distribution - - - Personal Income and Wealth Distribution
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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