Optimal contracts and competitive markets with costly state verification
BibTeX
@article{townsend1979optimal,
title={Optimal contracts and competitive markets with costly state verification},
author={Townsend, Robert M},
journal={Journal of Economic theory},
volume={21},
number={2},
pages={265--293},
year={1979},
publisher={Elsevier}
}
Abstract
This paper focuses on avoidable moral hazard and offers one explanation for limited insurance markets, for closely held firms, and for seemingly simple as opposed to contingent forms of debt. Agents have random endowments of a consumption good which are such that there are gains to trading contingent claims. But any realization of an endowment is known only by its owner unless a verification cost is borne. Contracts in such a setting are said to be consistent if agents submit to verification and honor claims in accordance with prior agreements. The Pareto optimal consistent contracts which emerge are shown to have familiar characteristics.
My Notes
- Author
- Robert M. Townsend
- Summary
- Builds a model to explain why perfect insurance doesn’t exist.
In the model, agent 2 (the insuree) gets stochastic endowment and knows how much they get. To prove their endowment to agent 1 (the insurer) costs resources. Agent two can choose whether to obtain this proof. Consistent contracts require that the transfer is the same whenever proof is not given. Optimal consistent contracts are composed of:
- a constant payment from agent 2 (no verification) when times are good;
- and a variable benefit (with verification) when times are bad (meaning agent 2’s endowment is below some threshold).
The model tells a story reminiscent of insurance deductibles.
Extensions are provided with multiple agents, and with the ability to stochastically decide whether verification occurs. The latter extension gives higher utility than the baseline, and if penalties for lying can give unbounded disutility, then very low inspection probability combined with very high penalty can bring the agents arbitrarily close to optimal contracts. This is similar to the “Becker Rule” but arising from a different context.