Optimal contracts and competitive markets with costly state verification
This paper focuses on avoidable moral hazard and offers one explanation for limited insurance markets, for closely held firms, and for seemingly simple as opposed to contingent forms of debt. Agents have random endowments of a consumption good which are such that there are gains to trading contingent claims. But any realization of an endowment is known only by its owner unless a verification cost is borne. Contracts in such a setting are said to be consistent if agents submit to verification and honor claims in accordance with prior agreements. The Pareto optimal consistent contracts which emerge are shown to have familiar characteristics.
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- Steven Shavell, 1979. "On Moral Hazard and Insurance," The Quarterly Journal of Economics, Oxford University Press, vol. 93(4), pages 541-562.
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- Yaffa Machnes Caspi, 1978. "A Limit Theorem on the Core of an Economy with Individual Risks," Review of Economic Studies, Oxford University Press, vol. 45(2), pages 267-271.
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