Risk Sharing and Strategic Choice
Abstract: We undertake a decision-theoretic analysis of a model of bilateral risk sharing, conceptualized in two stages: in the first stage agents choose risky endowments (Savage acts), and in the second stage they form a risk-sharing arrangement. Only the first-stage choices are observable to the analyst. We formulate axioms that put joint restrictions on best responses in the first stage and a representation result according to which agents behave as if they are risk averse expected-utility maximizers who anticipate the subsequent sharing arrangement. All the parameters of the model, including the sharing arrangement, can be identified from this first-stage choice data. We generalize our model to allow frictions that impede efficient risk sharing, and we refine our model to feature risk sharing in accordance with prominent bargaining solutions. We compare the inefficiencies those solutions engender in first-stage choices in the context of a stylized example.