Allocation of Individual Risks in a Market Economy
The ability to insure against idiosyncratic endowment risk depends on the organization of markets and the availability of consumption insurance. When all agents are identical ex ante and there are complete contingent claims, then full insurance can be achieved. Simple frictions, such as exogenous and endogenous borrowing constraints, liquidity constraints, or one-sided commitment, lead to partial insurance, implying richer dynamics for wealth accumulation and prices, and can potentially improve the asset pricing predictions of consumption-based asset pricing models. Yet, as Constantinides and Duffie point out, incorporating these frictions has not provided much improvement in the empirical performance of the mdoels. They argue for models with ex ante heterogeneity in which consumption insurance is limited. In the model studied here, agents are ex ante heterogeneous because they face different income distribution risks. The allocation of resources across the heterogeneous agents is determined by the formation of endogenous coalitions of agents. The resulting allocations are identical to those achieved by a clearing house announcing state contingent prices that clear markets. The result is that agents only partially insure against endowment risk because any coalition comprised of agents of the same type will be blocked. Despite the differences in endowment distribution risk, agents are not able to purchase contingent claims with prices that are indexed by type, so that full consumption insurance is unavailable. The partial consumption insurance allows for richer dynamics in asset pricing and wealth accumulation
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