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Dynamic Optimal Insurance and Lack of Commitment

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Abstract

We analyze the role of commitment in a dynamic principal-agent model of optimal insurance with hidden effort and observable but non-contractible savings. We argue that the optimal contract under full commitment is time-inconsistent. Consequently, we analyze the optimal time-consistent Markov-perfect insurance contract when both the agent and the principal cannot commit for longer than one period and contrast our results with the full commitment case from the existing literature. We find that the optimal contract under lack of commitment provides additional insurance relative to the autarky allocation and features non-degenerate long-run asset and consumption distributions. Furthermore, the no-commitment contract differs significantly from the commitment contract in the time profiles of consumption, savings, and welfare. We solve for the optimal insurance contracts in several environments featuring different degrees of market incompleteness and find that the welfare loss due to lack of commitment can be very high relative to the welfare costs of moral hazard or savings non-contractibility.

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Bibliographic Info

Paper provided by Department of Economics, Simon Fraser University in its series Discussion Papers with number dp07-22.

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Length: 37
Date of creation: Oct 2007
Date of revision:
Handle: RePEc:sfu:sfudps:dp07-22

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Postal: Department of Economics, Simon Fraser University, 8888 University Drive, Burnaby, BC, V5A 1S6, Canada
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Keywords: optimal insurance; time consistency; moral hazard;

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References

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  1. 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.
  2. Helmut Bester & Roland Strausz, . "Imperfect Commitment and the Revelation Principle," Papers 004, Departmental Working Papers.
  3. repec:fth:starer:8415 is not listed on IDEAS
  4. Abraham, Arpad & Pavoni, Nicola, 2004. "Efficient Allocations with Moral Hazard and Hidden Borrowing and Lending," Working Papers 04-05, Duke University, Department of Economics.
  5. Fernando M. Martin, 2004. "A Positive Theory of Government Debt," Macroeconomics 0408013, EconWPA, revised 12 Oct 2004.
  6. Daron Acemoglu & Michael Golosov & Oleg Tsyvinski, 2006. "Markets Versus Governments: Political Economy of Mechanisms," 2006 Meeting Papers 348, Society for Economic Dynamics.
  7. 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.
  8. Daron Acemoglu & Michael Golosov & Aleh Tsyvinski, 2007. "Political Economy of Mechanisms," Working Papers CAS_RN_2007_2, Laboratory for Macroeconomic Analysis.
  9. Thomas, Jonathan & Worrall, Tim, 1988. "Self-enforcing Wage Contracts," Review of Economic Studies, Wiley Blackwell, vol. 55(4), pages 541-54, October.
  10. 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.
  11. 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.
  12. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  13. Karaivanov, Alexander, 2012. "Financial constraints and occupational choice in Thai villages," Journal of Development Economics, Elsevier, vol. 97(2), pages 201-220.
  14. 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.
  15. 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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