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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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File URL: http://www.sfu.ca/econ-research/RePEc/sfu/sfudps/dp07-22.pdf
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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
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  1. 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.
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  8. Natalia Kovrijnykh, 2013. "Debt Contracts with Partial Commitment," American Economic Review, American Economic Association, vol. 103(7), pages 2848-74, December.
  9. Ehud Kalai, 1977. "Proportional Solutions to Bargaining Situations: Interpersonal Utility Comparisons," Discussion Papers 179, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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  13. 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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  16. Abraham, Arpad & Pavoni, Nicola, 2004. "Efficient Allocations with Moral Hazard and Hidden Borrowing and Lending," Working Papers 04-05, Duke University, Department of Economics.
  17. Krueger, Dirk & Uhlig, Harald, 2005. "Competitive risk sharing contracts with one-sided commitment," CFS Working Paper Series 2005/07, Center for Financial Studies (CFS).
  18. Fernandes, Ana & Phelan, Christopher, 2000. "A Recursive Formulation for Repeated Agency with History Dependence," Journal of Economic Theory, Elsevier, vol. 91(2), pages 223-247, April.
  19. Helmut Bester & Roland Strausz, . "Imperfect Commitment and the Revelation Principle," Papers 004, Departmental Working Papers.
  20. Arpad Abraham & Nicola Pavoni, 2008. "Efficient Allocations with Moral Hazard and Hidden Borrowing and Lending: A Recursive Formulation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(4), pages 781-803, October.
  21. Maskin, Eric & Tirole, Jean, 2001. "Markov Perfect Equilibrium: I. Observable Actions," Journal of Economic Theory, Elsevier, vol. 100(2), pages 191-219, October.
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  23. Narayana R. Kocherlakota, 1996. "Implications of Efficient Risk Sharing without Commitment," Review of Economic Studies, Oxford University Press, vol. 63(4), pages 595-609.
  24. Allen, Franklin, 1985. "Repeated principal-agent relationships with lending and borrowing," Economics Letters, Elsevier, vol. 17(1-2), pages 27-31.
  25. Jonathan Thomas & Tim Worrall, 1988. "Self-Enforcing Wage Contracts," Review of Economic Studies, Oxford University Press, vol. 55(4), pages 541-554.
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