Optimal dynamic risk sharing when enforcement is a decision variable

Societies provide institutions that are costly to set up, but able to enforce long-run relationships. We study the optimal decision problem of using self-governance for risk sharing or governance through enforcement provided by these institutions. Third-party enforcement is modelled as a costly technology that consumes resources, but permits the punishment of agents who deviate from ex ante specified allocations. We show that it is optimal to employ the technology whenever commitment problems prevent first-best risk sharing and fixed costs are sufficiently low, but never optimal to provide incentives exclusively via this technology. Commitment problems then persist and the optimal incentive structure changes dynamically over time with third-party enforcement monotonically increasing in the relative inequality between agents.