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Moral Hazard and Efficiency in General Equilibrium with Anonymous Trading

  • Daron Acemoglu
  • Alp Simsek

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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Paper provided by David K. Levine in its series Levine's Working Paper Archive with number 661465000000000232.

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Date of creation: 08 Oct 2010
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Handle: RePEc:cla:levarc:661465000000000232
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  1. Alberto Bisin & Danilo Guaitoli, 2004. "Moral Hazard and Nonexclusive Contracts," RAND Journal of Economics, The RAND Corporation, vol. 35(2), pages 306-328, Summer.
  2. Alberto Bisin & John Geanakoplos & Piero Gottardi & Enrico Minelli & Herakles Polemarchakis, 2010. "Markets and contracts," Economics Working Papers ECO2010/29, European University Institute.
    • Alberto Bisin & John Geanakoplos & Piero Gottardi & Enrico Minelli & Heracles Polemarchakis, 2009. "Markets and Contracts," Working Papers 0915, University of Brescia, Department of Economics.
  3. Jerez, Belen, 2003. "A dual characterization of incentive efficiency," Journal of Economic Theory, Elsevier, vol. 112(1), pages 1-34, September.
  4. Bisin, Alberto & Gottardi, Piero, 1999. "Competitive Equilibria with Asymmetric Information," Journal of Economic Theory, Elsevier, vol. 87(1), pages 1-48, July.
  5. Mikhail Golosov & Narayana Kocherlakota & Aleh Tsyvinski, 2002. "Optimal Indirect and Capital Taxation," NajEcon Working Paper Reviews 391749000000000449, www.najecon.org.
  6. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
  7. repec:cup:cbooks:9780521629560 is not listed on IDEAS
  8. Doepke, Matthias & Townsend, Robert M., 2006. "Dynamic mechanism design with hidden income and hidden actions," Journal of Economic Theory, Elsevier, vol. 126(1), pages 235-285, January.
  9. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-90, September.
  10. Mikhail Golosov & Aleh Tsyvinski, 2006. "Optimal Taxation with Endogenous Insurance Markets," Levine's Bibliography 784828000000000445, UCLA Department of Economics.
  11. Piero Gottardi & Belén Jerez, 2007. "Comment on "Bertrand and Walras Equilibria under Moral Hazard"," Journal of Political Economy, University of Chicago Press, vol. 115(5), pages 893-900, October.
  12. Alberto Bisin & Piero Gottardi, 2005. "Efficient Competitive Equilibria with Adverse Selection," CESifo Working Paper Series 1504, CESifo Group Munich.
  13. repec:cup:cbooks:9780521335614 is not listed on IDEAS
  14. Citanna, Alessandro & Villanacci, Antonio, 2002. "Competitive equilibrium with moral hazard in economies with multiple commodities," Journal of Mathematical Economics, Elsevier, vol. 38(1-2), pages 117-147, September.
  15. Richard J. Arnott & Joseph E. Stiglitz, 1988. "Randomization with Asymmetric Information," NBER Working Papers 2507, National Bureau of Economic Research, Inc.
  16. Hammond, Peter J, 1987. "Markets as Constraints: Multilateral Incentive Compatibility in Continuum Economies," Review of Economic Studies, Wiley Blackwell, vol. 54(3), pages 399-412, July.
  17. Atsushi Kajii & Antonio Villanacci & Alessandro Citanna, 1998. "Constrained suboptimality in incomplete markets: a general approach and two applications," Economic Theory, Springer, vol. 11(3), pages 495-521.
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