In this study, we consider a state dependent utility under moral hazard focusing on the loss reduction effort. We assume a two state model: loss occurrence state and no loss occurrence state. According to the marginal utility of income on the states, we analyze the optimal insurance coverage. If the marginal utility of income is equal between the two states, the optimal indemnity and effort level are identical with the state independent utility case. Optimal insurance involves full insurance up to a limit and coinsurance above the limit. If the marginal utility of income in the loss state is larger than that of income in no loss state, then the optimal insurance include full insurance. On the contrary, if the relation is the reverse between the marginal utilities, then the optimal insurance includes the deductible up to a limit and coinsurance above the limit. In this case, full insurance can be also involved. This paper investigates whether the moral hazard is more or less severe under a state dependent utility as well. As a result, if the indemnity level is equal to the indemnity under state independent utility, the effort is higher than that of state independent utility when the marginal utility of income in the loss state is larger than that of the income in no loss state. That is, the moral hazard problem may be less severe. In contrary to this, moral hazard can be more severe when the marginal utility of the income in the loss state is lower than that of the income in no loss state. We apply the state dependent model to the debt contract model. The cost function is state dependent, the interest rate can be lower and the moral hazard problem may not be significant. The reverse case can be also possible depending on the marginal cost.
II. Model description
III. No Moral Hazard Case
IV. Moral Hazard Case
V. Extension – Two Period and Moral Hazard Case