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Moral Hazard and Efficiency in General Equilibrium with Anonymous Trading

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  • Daron Acemoglu
  • Alp Simsek

Abstract

A 'folk theorem' originating, among others, in the work of Stiglitz maintains that competitive equilibria are always or 'generically' inefficient (unless contracts directly specify consumption levels as in Prescott and Townsend, thus bypassing trading in anonymous markets). This paper critically reevaluates these claims in the context of a general equilibrium economy with moral hazard. We first formalize this folk theorem. Firms offer contracts to workers who choose an effort level that is private information and that affects worker productivity. To clarify the importance of trading in anonymous markets, we introduce a monitoring partition such that employment contracts can specify expenditures over subsets in the partition, but cannot regulate how this expenditure is subdivided among the commodities within a subset. We say that preferences are nonseparable (or more accurately, not weakly separable) when the marginal rate of substitution across commodities within a subset in the partition depends on the effort level, and that preferences are weakly separable when there exists no such subset. We prove that the equilibrium is always inefficient when a competitive equilibrium allocation involves less than full insurance and preferences are nonseparable. This result appears to support the conclusion of the above mentioned folk theorem. Nevertheless, our main result highlights its limitations. Most common-used preference structures do not satisfy the nonseparability condition. We show that when preferences are weakly separable, competitive equilibria with moral hazard are constrained optimal, in the sense that a social planner who can monitor all consumption levels cannot improve over competitive allocations. Moreover, we establish ε-optimality when there are only small deviations from weak separability. These results suggest that considerable care is necessary in invoking the folk theorem about the inefficiency of competitive equilibria with private information.
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  • Daron Acemoglu & Alp Simsek, 2010. "Moral Hazard and Efficiency in General Equilibrium with Anonymous Trading," Levine's Working Paper Archive 661465000000000232, David K. Levine.
  • Handle: RePEc:cla:levarc:661465000000000232
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    Cited by:

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    3. Sonja Brangewitz & Gaël Giraud, 2012. "Learning by Trading in Infinite Horizon Strategic Market Games with Default," Documents de travail du Centre d'Economie de la Sorbonne 12062r, Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne, revised Oct 2013.
    4. Axelson, Ulf & Bond, Philip, 2011. "Investment banking careers: an equilibrium theory of overpaid jobs," LSE Research Online Documents on Economics 119062, London School of Economics and Political Science, LSE Library.
    5. Scotchmer, Suzanne & Shannon, Chris, 2019. "Verifiability and group formation in markets," Journal of Economic Theory, Elsevier, vol. 183(C), pages 417-477.
    6. Thibaut Mastrolia, 2017. "Moral hazard in welfare economics: on the advantage of Planner's advices to manage employees' actions," Papers 1706.01254, arXiv.org.
    7. Alex Citanna & Paolo Siconolfi, 2020. "Constrained Efficient Markets For Manipulation Economies," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 61(4), pages 1531-1567, November.

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    More about this item

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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