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Insurance and Inequality with Persistent Private Information


Abstract: This paper studies the implications of optimal insurance provision for long-run welfare and inequality in economies with persistent private information. We consider a model in which a principal insures an agent whose privately observed endowment follows an ergodic, finite Markov chain. The optimal contract always induces immiseration: the agent’s consumption and utility decrease without bound. Under positive serial correlation, the optimal contract also features backloaded high-powered incentives: the sensitivity of the agent’s utility with respect to his report increases without bound. These results significantly extend — and elucidate the limits of — the hallmark immiseration results for economies with iid private information. Our analysis utilizes recursive techniques for contracting with persistent states, accounts for the possibility of binding global incentive constraints, extends to other canonical insurance settings (e.g., Mirrleesian economies), and has additional implications for the short-run dynamics of optimal contracts.

Keywords: Immiseration; insurance; inequality; backloaded incentives; recursive contracts; persistent private information;

JEL Classification: C73; D30; D31; D80; D82; E61;

https://doi.org/10.20955/wp.2018.020

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Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2021-12-10

Number: 2018-020

Note: This paper subsumes an earlier working paper circulated as “Misery, Persistence, and Growth” (Bloedel and Krishna 2015).

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