Risk Contracts with Private Information and One-Sided Commitment

Eduardo Zilberman and Pedro Hemsley
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Pedro Hemsley: Department of Economics UERJ

No 635, Textos para discussão from Department of Economics PUC-Rio (Brazil)

Abstract: In an endowment economy in which agents negotiate long-term contracts with a financial intermediary, we study the implication of the interaction between incentive compatibility and participation constraints for risk sharing. In particular, we assume that after a default episode, agents consume their endowment and remain in autarky forever. Theoretically, we show that in autarky, the principal cannot spread continuation values to provide incentives except for the agent that draws the highest realization of the endowment. If the probability of such event is small enough then autarky is a persistent state. Numerically, we explore this implication to argue that the optimal contract prevents agents from reaching autarky when the probability of drawing the highest realization of the endowment is small enough.

Pages: 18p
Date: 2015-03
New Economics Papers: this item is included in nep-cta and nep-hrm
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