Moral hazard and incentives

This chapter discusses the problem of moral hazard. In the problem of moral hazard, one party to a transaction may undertake certain actions that (a) affect the other party's valuation of the transaction but that (b) the second party cannot monitor/enforce perfectly. A classic example here is fire insurance, where the insuree may or may not exhibit sufficient care while storing flammable materials. The “solution” to a problem of moral hazard is the use of incentives — structuring the transaction so that the party who undertakes the actions will, in their own best interests, take actions that the second party would (relatively) prefer. For example, fire insurance is often only partial insurance so that the insuree has a financial interest in preventing a fire.

Endogenous Partial Insurance and Inequality

In this paper, we propose a model of endogenous partial insurance and we investigate its implications for macroeconomic outcomes, such as wealth inequality, asset accumulation, interest rate, and consumption smoothing. To this end, we include participation costs to state-contingent asset markets into an otherwise standard Aiyagari (1994) model. We highlight the resulting nonmonotonic relationship between wealth and insurance-market participation when insurance is costly. Poor households remain uninsured, middle-class households participate in the insurance market, whereas rich households decide to self-insure by only purchasing risk-free assets. After theoretically characterizing the endogenous partial insurance equilibrium, we quantify its effect, emphasizing the roles of a participation channel and an interest rate channel.

Ambiguity Aversion Decreases the Impact of Partial Insurance: Evidence from African Farmers

Indemnifying smallholder farmers against crop loss is thought to play an important role in encouraging the adoption of new technologies and facilitating productivity growth, but to be infeasible due to information problems. Consequently there is interest in developing alternative, partial, insurance products. Examples include rainfall insurance and the limited liability inherent in credit contracts. I argue that although these products may reduce information asymmetry, ambiguity averse farmers struggle to assess whether the contracts reduce risk. This problem is most pronounced when the production technology is ambiguous, as is likely the case for new technologies. I formalize this argument and test the theory using data from two RCTs, conducted in Malawi and Kenya. Comparative statics from the theory are consistent with both sets of data, and I argue that income losses from ambiguity aversion may be substantial.