DP9864 Hidden Insurance in a Moral Hazard Economy

Author(s): Giuseppe Bertola, Winfried Koeniger
Publication Date: March 2014
Keyword(s): Constrained efficiency, First-order approach, Hidden action, Principal agent
JEL(s): D81, D82, E21
Programme Areas: Labour Economics, Financial Economics, Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=9864

We consider an economy where individuals privately choose effort and trade competitively priced securities that pay off with effort-determined probability. We show that if insurance against a negative shock is sufficiently incomplete, then standard functional form restrictions ensure that individual objective functions are optimized by an effort and insurance combination that is unique and satisfies first- and second-order conditions. Modeling insurance incompleteness in terms of costly production of private insurance services, we characterize the constrained inefficiency arising in general equilibrium from competitive pricing of non-exclusive financial contracts.