Working Paper: CEPR ID: DP4208
Authors: Dirk Krueger; Harald Uhlig
Abstract: This Paper analyses dynamic equilibrium risk sharing contracts between profit-maximizing intermediaries and a large pool of ex-ante identical agents that face idiosyncratic income uncertainty that makes them heterogeneous ex-post. In any given period, after having observed their income, the agent can walk away from the contract, while the intermediary cannot, i.e. there is one-sided commitment. We consider the extreme scenario that the agents face no costs to walking away, and can sign up with any competing intermediary without any reputational losses. Contrary to intuition, we demonstrate that not only autarky, but also partial and full insurance can obtain, depending on the relative patience of agents and financial intermediaries. Insurance can be provided because in an equilibrium contract an up-front payment effectively locks in the agent with an intermediary. We then show that our contract economy is equivalent to a consumption-savings economy with one-period Arrow securities and a short-sale constraint, similar to Bulow and Rogo (1989). From this equivalence and our characterization of dynamic contracts it immediately follows that without cost of switching financial intermediaries debt contracts are not sustainable, even though a risk allocation superior to autarky can be achieved.
Keywords: competition; limited commitment; long-term contracts; risk sharing
JEL Codes: D11; D91; E21; G22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| agents and principals discounting the future at the same rate (D15) | full consumption insurance for the agent (G52) |
| principal's patience (Y20) | partial insurance (G52) |
| ability to switch intermediaries (L14) | sustainability of debt contracts (F34) |