Moral Hazard and Lack of Commitment in Dynamic Economies

27 Pages Posted: 13 Apr 2012

See all articles by Alexander Karaivanov

Alexander Karaivanov

Simon Fraser University (SFU) - Department of Economics

Fernando M. Martin

Federal Reserve Banks - Federal Reserve Bank of St. Louis

Date Written: October 2011

Abstract

We revisit the role of limited commitment in a dynamic risk-sharing setting with private information. We show that a Markov-perfect equilibrium, in which agent and insurer cannot commit beyond the current period, and an infinitely-long contract to which only the insurer can commit, implement identical consumption, effort and welfare outcomes. Unlike contracts with full commitment by the insurer, Markov-perfect contracts feature non-trivial and determinate asset dynamics. Numerically, we show that Markov-perfect contracts provide sizable insurance, especially at low asset levels, and are able to explain a significant part of wealth inequality beyond what can be explained by self-insurance. The welfare gains from resolving the commitment friction are larger than those from resolving the moral hazard problem at low asset levels, while the opposite holds for high asset levels.

Keywords: risk-sharing, optimal insurance, lack of commitment, moral hazard, wealth inequality

JEL Classification: D11, E21

Suggested Citation

Karaivanov, Alexander and Martin, Fernando M., Moral Hazard and Lack of Commitment in Dynamic Economies (October 2011). Available at SSRN: https://ssrn.com/abstract=2038950 or http://dx.doi.org/10.2139/ssrn.2038950

Alexander Karaivanov (Contact Author)

Simon Fraser University (SFU) - Department of Economics ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada

Fernando M. Martin

Federal Reserve Banks - Federal Reserve Bank of St. Louis ( email )

411 Locust St
Saint Louis, MO 63011
United States
314-444-7350 (Phone)

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