Essays on Contract Theory and Institution Design

Abstract

This collection of essays uses tools in dynamic contracting theory to address issues in development economics, public finance, and monetary economics. Chapter 1 studies how contractual frictions interact with the amount of risk people choose to bear. Though the framework is general, I use it to examine preventive healthcare expenditure. In particular, I develop a dynamic contracting model in which differences in information and commitment technologies can account for variations in immunization rates over time and across countries. I document four salient facts regarding Diphtheria, Pertussis and Tetanus (DPT) vaccination rates: (i) lower immunization in countries with greater costs of contract enforcement, (ii) higher volatility in immunization in countries with larger informal sectors, (iii) less persistence in immunization relative to aggregate income, and (iv) negative skewness in the distribution of immunization over time. These patterns cannot be explained by efficient immunization in a frictionless economy. However, dynamic contracts subject to ex-post one-sided commitment and hidden income can rationalize these facts. This analysis shows that weak provision of public goods, such as the inefficacy of the judicial system and the degree of informality, can spillover to weak provision of preventive healthcare. A model estimated using U.S. data reveals that a health monitoring technology is welfare enhancing in the long-run, generating an increase of 4.3% in certainty equivalent consumption of the policyholder and 0.6% in the insurer’s surplus. Using the consumption neutrality of the efficient risk choice, I also devise a test to show that the hypothesis of limited commitment cannot be rejected in the data. Chapter 2 explores the rules that governments can impose on themselves to control time-inconsistent preferences. In particular, I show that labor laws can be used to curtail socially suboptimal rates of labor taxation. The standard approach towards a positive theory of labor laws is one in which labor laws are used as a redistributive tool. In Guesnerie and Roberts (1987) or Lee and Seaz (2012), for instance, a single entity can manipulate both instruments–the labor law as well as taxation–to alleviate income inequality in risk-averse populations. Consistent with presidential-congressional type regimes like the U.S. that have more dispersed legislative proposal powers, I develop a model in which a benevolent constitutional planner can restrict the allocation space of a heterogeneously skilled population prior to the stochastic determination of fiscal policy. Elected officials maximize the objective of their constituencies by devising tax systems that favor idiosyncratic gains from redistribution. The equilibrium constitution limits cross-sectional dispersion in hours worked ex-ante to discipline taxation ex-post. A model calibrated to key moments of the U.S. presidential elections and the Lorenz Curve is consistent with two empirical findings from cross-country data: a positive correlation between maximum workweek limits and skill dispersion, and a negative correlation between minimum wage laws and the proportionality of electoral voting systems. Chapter 3 examines the surprise discontinuation of 86% of currency in circulation in India on 8 November 2016. Demonetization, as it was coined, served as a tax on illicit wealth. Traditional models of money assume that the marginal social cost of printing fiat currency is zero, justifying the optimality of the Friedman rule. However, in an environment where the degree of hidden income is alleviated by the dearth of cash, demonetization could be efficient. To implement this policy, the Reserve Bank of India imposed non-discriminatory transfer limits, which I argue are too blunt to insure against idiosyncratic income risk. I propose a set of instruments that provide a better hedge against these shocks–transfer limits dependent on reported household income. I isolate conditions under which state-contingent transfer limits are monotonic in reported endowments and promised values. A model calibrated to the Indian income process reveals that long-run gains in the surplus of the central bank upon switching to a state-contingent monetary policy from a non state-contingent one are 28.5% of aggregate income.