Risk, Incentives, and Contracting Relationships

The aim of this paper is to understand the impact of optimal provision of both risk and incentives on the choice of contracting partners. I study a risky setting where heterogeneously risk-averse employers and employees must match to be productive. They face a standard onesided moral hazard problem: mean output increases in the noncontractible input of the employee. Better insurance comes at the cost of weaker incentives, and this tradeo¤ di¤ers across partnerships of di¤erent risk compositions. I show that this heterogeneous tradeo¤ determines the equilibrium matching pattern, and focus on environments in which assortative matching is the unique equilibrium. This endogenous matching framework enables a concrete and rigorous analysis of the interaction between formal and informal insurance. In particular, I show that the introduction of formal insurance crowds out informal insurance, and may leave those individuals acting as informal insurers in the status quo strictly worse o¤. JEL Classi…cation Codes: O1, O13, O16, O17