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Dynamic Optimal Insurance and Lack of Commitment

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  • Fernando M. Martin

    (Simon Fraser University)

  • Alexander Karaivanov

    (Simon Fraser University)

Abstract

We analyze the role of commitment in a dynamic principal-agent model of optimal insurance with hidden effort and observable but non-contractible assets. We argue that the optimal contract under full commitment is time-inconsistent. Consequently, we solve for and analyze the optimal insurance contract when both the agent and the principal cannot commit (i.e., each can renege in each period) and contrast our results with the full commitment case studied by the existing literature. We find that the Markov-perfect contract under double-sided lack of commitment provides additional insurance relative to the self-insurance allocation and features a non-degenerate long-run asset and consumption distributions. Furthermore, the no commitment contract differs significantly from the full commitment contract in the time profiles of consumption and savings, insurance, and welfare. We solve numerically for the optimal insurance contract in several environments characterized by different degrees of market imperfections. We find that the welfare loss due to lack of commitment is very high relative to the welfare costs of moral hazard or savings non-contractibility.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2007 Meeting Papers with number 793.

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Date of creation: 2007
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Handle: RePEc:red:sed007:793

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  1. Daron Acemoglu & Michael Golosov & Oleg Tsyvinski, 2006. "Markets Versus Governments: Political Economy of Mechanisms," 2006 Meeting Papers 348, Society for Economic Dynamics.
  2. 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.
  3. Helmut Bester & Roland Strausz, . "Imperfect Commitment and the Revelation Principle," Papers 004, Departmental Working Papers.
  4. 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.
  5. Gary Chamberlain & Charles A. Wilson, 2000. "Optimal Intertemporal Consumption Under Uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(3), pages 365-395, July.
  6. Abraham Arpad & Nicola Pavoni, 2004. "Efficient Allocations, with Moral Hazard and Hidden Borrowing and Lending," Levine's Bibliography 122247000000000138, UCLA Department of Economics.
  7. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  8. Doepke, Matthias & Townsend, Robert M, 2004. "Dynamic Mechanism Design with Hidden Income and Hidden Auctions," CEPR Discussion Papers 4455, C.E.P.R. Discussion Papers.
  9. Karaivanov, Alexander, 2012. "Financial constraints and occupational choice in Thai villages," Journal of Development Economics, Elsevier, vol. 97(2), pages 201-220.
  10. Fernando Martin, 2009. "A Positive Theory of Government Debt," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 608-631, October.
  11. Daron Acemoglu & Michael Golosov & Aleh Tsyvinski, 2007. "Political Economy of Mechanisms," Working Papers CAS_RN_2007_2, Laboratory for Macroeconomic Analysis.
  12. Thomas, Jonathan & Worrall, Tim, 1988. "Self-enforcing Wage Contracts," Review of Economic Studies, Wiley Blackwell, vol. 55(4), pages 541-54, October.
  13. Bisin, Alberto & Rampini, Adriano A., 2006. "Markets as beneficial constraints on the government," Journal of Public Economics, Elsevier, vol. 90(4-5), pages 601-629, May.
  14. Alexander K. Karaivanov & Fernando M. Martin, 2011. "Moral hazard and lack of commitment in dynamic economies," Working Papers 2011-030, Federal Reserve Bank of St. Louis.
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Cited by:
  1. Alexander K. Karaivanov & Fernando M. Martin, 2011. "Moral hazard and lack of commitment in dynamic economies," Working Papers 2011-030, Federal Reserve Bank of St. Louis.

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