Risk sharing contracts with private information and one-sided commitment

Abstract

In a repeated unobserved endowment economy in which agents negotiate long-term contracts with a financial intermediary, we study the risk sharing implications of the interaction between incentive compatibility constraints (due to private information) and participation constraints (due to one-sided commitment). In particular, we assume that after a default episode, agents consume their endowment and remain in autarky forever. We find that once they are away from autarky today, if the probability of drawing the highest possible endowment shock is sufficiently small, the optimal contract prevents agents from reaching autarky tomorrow and, thus, from being “impoverished.” Moreover, an invariant cross-sectional distribution of lifetime utilities (or values) exists. A numerical example shows that the mass of agents living in autarky can be zero in the limit.