Insuring uninsurable income

TL;DR

This paper introduces a recursive mechanism for dynamic income insurance in a hidden-income economy, achieving efficiency and budget balance under certain conditions, and improving welfare over autarky.

Contribution

It proposes a simple, recursive income insurance mechanism that ensures efficiency and budget balance in a dynamic, private-income setting, extending previous models.

Findings

The mechanism shifts income shocks forward by one period.

Under moderate risk aversion, the mechanism achieves sequential efficiency.

Early cohorts pre-fund transfers, improving overall welfare.

Abstract

We study dynamic mechanism design in a pure-exchange economy with privately observed idiosyncratic income. In the standard infinitely lived hidden-income benchmark of Green (1987) and Thomas-Worrall (1990), constrained-efficient allocations exhibit immiseration. We propose a simple recursive mechanism -- adapted from Marcet-Marimon (1992) -- that shifts each income shock forward by one period, keeps promised utilities in a bounded set, and, under a transparent ``moderate risk-aversion'' condition, delivers sequential efficiency. In a stationary \emph{overlapping-generations} setting, we further show that under additional symmetry and curvature assumptions, a second-order approximation yields a sufficient condition for period-by-period budget balance; early cohorts pre-fund later transfers; for suitable initial promises, all cohorts are better off than under autarky. Our analysis uses a single state (promised utility), closed-form transfers, and a Bellman verification.