Moral Hazard and Entrepreneurial Failure in a Two-sector Model of Productive Matching - with an Application to the Natural Resource Curse

We analyze a two-sector, general-equilibrium model of productive matching and sorting, where risky production is carried out by pairs of individuals both exerting effort. Risk-neutral (entrepreneurial) individuals can match either with other risk-neutral individuals, or – acting as employers/ insurers – with risk-averse (nonentrepreneurial) individuals. Although the latter option has the potential to generate more surplus, when effort is unobservable and risk is high, the moral hazard problem in mixed matches may be too severe for mixing to be attractive to both risk aversion types, leading to a segregated equilibrium in which risk-averse individuals select low-risk, low-yielding activities. An increase in the return associated with the riskier sector can then trigger a switch from a mixed to a segregated equilibrium, causing aggregate output to fall.