MARKET FAILURE WITH MORAL HAZARD AND SIDE TRADING

This paper compares full-information insurance markets (a) with market s where accident-reducing effort levels are unverifiable but trades be tween every pair of agents are verifiable and (b) with markets where n either effort nor trades are verifiable. Markets are represented by a contracting game, with a solution concept allowing coordination among coalitions through information-constrained contracts. Each information al setting yields a correspondence between market outcomes and the app ropriate notion of constrained efficiency in a social planner's proble m. Although incentive externalities do not cause market outcomes to be constrained inefficient, they do imply a welfare gain from public ver ifiability of trades.