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Good Donors or Good Recipients? A Repeated Moral Hazard Model of Aid Allocation

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  • Alessia Isopi
  • Fabrizio Mattesini

Abstract

We propose a repeated moral hazard model with full commitment and limited punishment to study the problem of aid allocation in environments characterized by asymmetric information. The donor (principal) finances a three-period development program and the elite of the recipient country (agent), involved in the realization of the project, can affect the final output through adequate policies. The donor has the goal to help the poor of the recipient country, but she may also be conditioned by non altruistic motives. We show that when the moral hazard problem is relevant, under a wide set of parameter values, optimal aid contracts should be conditional on the previous result of the project. We distinguish between weak conditionality, which means that aid depends only on the previous performance of the project and strong conditionality, which means that aid depends on the whole history of the project. Unconditional aid may be an optimal contractual arrangement for the donor if the moral hazard issue is not very important or if the donor gives aid merely for strategic or economic reasons. An entirely altruistic donor will never provide unconditional aid. On the other hand, if she has a strong desire to help the recipient she should never deny aid to it.

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Paper provided by University of Nottingham, CREDIT in its series Discussion Papers with number 09/10.

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Handle: RePEc:not:notcre:09/10

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Keywords: Foreign Aid; Conditionality; Moral Hazard;

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  1. William Easterly & Tobias Pfutze, 2008. "Where Does the Money Go? Best and Worst Practices in Foreign Aid," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 22(2), pages 29-52, Spring.
  2. Alberto Alesina & David Dollar, 1998. "Who Gives Foreign Aid to Whom and Why?," NBER Working Papers 6612, National Bureau of Economic Research, Inc.
  3. Isopi, Alessia & Mavrotas, George, 2006. "Aid Allocation and Aid Effectiveness: An Empirical Analysis," Working Paper Series, World Institute for Development Economic Research (UNU-WIDER) RP2006/07, World Institute for Development Economic Research (UNU-WIDER).
  4. Dollar, David & Levin, Victoria, 2004. "Increasing selectivity of foreign aid, 1984-2002," Policy Research Working Paper Series, The World Bank 3299, The World Bank.
  5. Drew Fudenberg & Jean Tirole, 1988. "Moral Hazard and Renegotiation in Agency Contracts," Working papers, Massachusetts Institute of Technology (MIT), Department of Economics 494, Massachusetts Institute of Technology (MIT), Department of Economics.
  6. Calmette, Marie-Francoise & Kilkenny, Maureen, 2001. "International charity under asymmetric information," Economics Letters, Elsevier, Elsevier, vol. 74(1), pages 107-111, December.
  7. Azam, Jean-Paul & Laffont, Jean-Jacques, 2003. "Contracting for aid," Journal of Development Economics, Elsevier, Elsevier, vol. 70(1), pages 25-58, February.
  8. Henrik Hansen & Finn Tarp, 2000. "Aid effectiveness disputed," Journal of International Development, John Wiley & Sons, Ltd., John Wiley & Sons, Ltd., vol. 12(3), pages 375-398.
  9. Svensson, Jakob, 2000. "Foreign aid and rent-seeking," Journal of International Economics, Elsevier, Elsevier, vol. 51(2), pages 437-461, August.
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