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Solomonic Separation: Risk Decisions as Productivity Indicators

  • Miller, Nolan

    (University of IL)

  • Wagner, Alexander F.

    (University of Zurich)

  • Zeckhauser, Richard J.

    (Harvard University)

A principal provides budgets to agents (e.g., divisions of a firm or the principal's children) whose expenditures provide her benefits, either materially or because of altruism. Only agents know their potential to generate benefits. We prove that if the more "productive" agents are also more risk-tolerant (as holds in the sample of individuals we surveyed), the principal can screen agents and bolster target efficiency by offering a choice between a nonrandom budget and a two-outcome risky budget. When, at very low allocations, the ratio of the more risk-averse type's marginal utility to that of the other type is unbounded above (e.g., as with CRRA), the first-best is approached.--A biblical opening enlivens the analysis.

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Paper provided by Harvard University, John F. Kennedy School of Government in its series Working Paper Series with number rwp12-057.

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Date of creation: Nov 2012
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Handle: RePEc:ecl:harjfk:rwp12-057
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