Does Inefficient Risk Sharing Increase Public Self-Protection?

This paper studies how the risk of having an unequal distribution of income across the population affects the investment in a public self-protection policy, such as financial regulation or climate change mitigation. Two economies are compared. In the first economy, there is perfect risk sharing, i.e., individuals can credibly commit on a set of transfers that will remove ex-post inequalities in consumption. In the second economy, no risk sharing takes place. By referring to the literature on background risks, I determine some conditions in terms of change in risk aversion and prudence, which guarantee an increase in self-protection under inefficient risk sharing. Generally speaking, if self-protection reduces the risk of inequality, the investment tends to rise when either the probability of a catastrophic event and/or the risk of inequality are sufficiently low. If self-protection increases the risk of inequality, the investment tends to rise when both the probabilities of aggregate loss and the increase in the risk of inequality are sufficiently small.