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Optimal dynamic risk sharing when enforcement is a decision variable

  • Koeppl, Thorsten V.

Societies provide institutions that are costly to set up, but able to enforce long-run relationships. We study the optimal decision problem of using self-governance for risk sharing or governance through enforcement provided by these institutions. Third-party enforcement is modelled as a costly technology that consumes resources, but permits the punishment of agents who deviate from ex-ante specified allocations. We show that it is optimal to employ the technology whenever commitment problems prevent first-best risk sharing, but never optimal to provide incentives exclusively via this technology. Commitment problems then persist and the optimal incentive structure changes dynamically over time with third-party enforcement monotonically increasing in the relative inequality between agents.

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Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 134 (2007)
Issue (Month): 1 (May)
Pages: 34-60

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Handle: RePEc:eee:jetheo:v:134:y:2007:i:1:p:34-60
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622869

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