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Dynamic Optimal Insurance and Lack of Commitment

We analyze the role of commitment in a dynamic principal-agent model of optimal insurance with hidden effort and observable but non-contractible savings. We argue that the optimal contract under full commitment is time-inconsistent. Consequently, we analyze the optimal time-consistent Markov-perfect insurance contract when both the agent and the principal cannot commit for longer than one period and contrast our results with the full commitment case from the existing literature. We find that the optimal contract under lack of commitment provides additional insurance relative to the autarky allocation and features non-degenerate long-run asset and consumption distributions. Furthermore, the no-commitment contract differs significantly from the commitment contract in the time profiles of consumption, savings, and welfare. We solve for the optimal insurance contracts in several environments featuring different degrees of market incompleteness and find that the welfare loss due to lack of commitment can be very high relative to the welfare costs of moral hazard or savings non-contractibility.

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Paper provided by Department of Economics, Simon Fraser University in its series Discussion Papers with number dp07-22.

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Length: 37
Date of creation: Oct 2007
Date of revision:
Handle: RePEc:sfu:sfudps:dp07-22
Contact details of provider: Postal: Department of Economics, Simon Fraser University, 8888 University Drive, Burnaby, BC, V5A 1S6, Canada
Phone: (778)782-3508
Fax: (778)782-5944
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  1. Narayana Kocherlakota, 2010. "Implications of Efficient Risk Sharing Without Commitment," Levine's Working Paper Archive 2053, David K. Levine.
  2. Thomas, Jonathan & Worrall, Tim, 1988. "Self-enforcing Wage Contracts," Review of Economic Studies, Wiley Blackwell, vol. 55(4), pages 541-54, October.
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  4. Liebhafsky, H H, 1969. "New Thoughts About Inferior Goods," American Economic Review, American Economic Association, vol. 59(5), pages 931-34, December.
  5. Eric Maskin & Jean Tirole, 1997. "Markov Perfect Equilibrium, I: Observable Actions," Harvard Institute of Economic Research Working Papers 1799, Harvard - Institute of Economic Research.
  6. Adriano Rampini & Alberto Bisin, 2005. "Markets as Beneficial Constraints on the Government," 2005 Meeting Papers 325, Society for Economic Dynamics.
  7. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
  8. Thomas, J. & Worral, T., 1991. "Foreign Direcyt Investment and the Risk of Expropriation," Papers 9126, Tilburg - Center for Economic Research.
  9. Natalia Kovrijnykh, 2013. "Debt Contracts with Partial Commitment," American Economic Review, American Economic Association, vol. 103(7), pages 2848-74, December.
  10. Alexander K. Karaivanov & Fernando M. Martin, 2011. "Moral hazard and lack of commitment in dynamic economies," Working Papers 2011-030, Federal Reserve Bank of St. Louis.
  11. Krueger, Dirk & Uhlig, Harald, 2004. "Competitive Risk Sharing Contracts with One-Sided Commitment," CEPR Discussion Papers 4208, C.E.P.R. Discussion Papers.
  12. Daron Acemoglu & Mikhail Golosov & Aleh Tsyvinski, 2007. "Political Economy of Mechanisms," Levine's Bibliography 321307000000000886, UCLA Department of Economics.
  13. Daron Acemoglu & Michael Golosov & Aleh Tsyvinski, 2006. "Markets Versus Governments: Political Economy of Mechanisms," Levine's Bibliography 321307000000000032, UCLA Department of Economics.
  14. Fernando Martin, 2009. "A Positive Theory of Government Debt," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 608-631, October.
  15. Kalai, Ehud, 1977. "Proportional Solutions to Bargaining Situations: Interpersonal Utility Comparisons," Econometrica, Econometric Society, vol. 45(7), pages 1623-30, October.
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  17. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  18. repec:fth:starer:8415 is not listed on IDEAS
  19. Abraham Arpad & Nicola Pavoni, 2004. "Efficient Allocations, with Moral Hazard and Hidden Borrowing and Lending," Levine's Bibliography 122247000000000138, UCLA Department of Economics.
  20. Matthias Doepke & Robert M. Townsend, 2002. "Dynamic Mechanism Design With Hidden Income and Hidden Actions," UCLA Economics Working Papers 818, UCLA Department of Economics.
  21. Phelan Christopher, 1995. "Repeated Moral Hazard and One-Sided Commitment," Journal of Economic Theory, Elsevier, vol. 66(2), pages 488-506, August.
  22. Gary Chamberlain & Charles A. Wilson, 2000. "Optimal Intertemporal Consumption Under Uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(3), pages 365-395, July.
  23. Helmut Bester & Roland Strausz, . "Imperfect Commitment and the Revelation Principle," Papers 004, Departmental Working Papers.
  24. Harold L Cole & Narayana Kocherlakota, 2010. "Efficient Allocations with Hidden Income and Hidden Storage," Levine's Working Paper Archive 1909, David K. Levine.
  25. Sleet, Christopher & Yeltekin, Sevin, 2008. "Politically credible social insurance," Journal of Monetary Economics, Elsevier, vol. 55(1), pages 129-151, January.
  26. Ligon, Ethan & Thomas, Jonathan P & Worrall, Tim, 2002. "Informal Insurance Arrangements with Limited Commitment: Theory and Evidence from Village Economies," Review of Economic Studies, Wiley Blackwell, vol. 69(1), pages 209-44, January.
  27. Bester, Helmut & Strausz, Roland, 2001. "Contracting with Imperfect Commitment and the Revelation Principle: The Single Agent Case," Econometrica, Econometric Society, vol. 69(4), pages 1077-98, July.
  28. Karaivanov, Alexander, 2012. "Financial constraints and occupational choice in Thai villages," Journal of Development Economics, Elsevier, vol. 97(2), pages 201-220.
  29. Christopher Sleet & Sevin Yeltekin, 2006. "Credibility and endogenous societal discounting," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(3), pages 410-437, July.
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