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Efficient Allocations with Moral Hazard and Hidden Borrowing and Lending: A Recursive Formulation


  • Arpad Abraham

    (University of Rochester)

  • Nicola Pavoni

    (University College London)


We propose a tractable recursive framework to study the optimal allocation of consumption and effort in a dynamic setting with moral hazard where agents have secret access to the credit market or to storage. The recursive structure is based on a generalized first order approach, whose validity must be verified ex-post. Thanks to the recursive formulation of the optimal contract, the verification procedure turns out to be numerically parsimonious as it can be performed using standard dynamic programming techniques with only one endogenous state variable: The agent's level of assets. We study the performance of our ex-post verification test in practice by solving numerically three representative infinite horizon examples. (Copyright: Elsevier)

Suggested Citation

  • 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.
  • Handle: RePEc:red:issued:06-26
    DOI: 10.1016/

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    References listed on IDEAS

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    More about this item


    Moral hazard; Hidden savings; Efficiency; Recursive contracts; First-order approach; Ex post verification;

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation


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