Working Paper: CEPR ID: DP11143
Authors: Tessa Bold; Tobias Broer
Abstract: The limited commitment model is popular for the analysis of village risk-sharing as it captures both the observed partial character of insurance and the presumption that incomes are well observed but formal contracts absent in rural communities. We study dynamic limited commitment when individuals can form new, smaller coalitions after reneging in a larger group, which makes group size an endogenous outcome of the model. This is important for theoretical consistency, but also because we show that enforcement constraints, which typically bind only in case of positive income shocks, counterfactually imply a stronger response of consumption to income increases than to income losses in village-size insurance groups. In small groups, in contrast, the response of consumption to income increases and declines is symmetric. The results show how equilibrium group sizes are much smaller than the typical village, bringing the predicted consumption process in line with the data. We thus argue that allowing for endogenous group formation in the dynamic limited commitment model strongly improves its predictive power for analyzing risk-sharing in village economies.
Keywords: risk-sharing; village economies; informal insurance; dynamic limited commitment; renegotiation-proofness
JEL Codes: D11; D12; D52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| income changes (D31) | consumption responses (D12) |
| endogenous group formation (C92) | predictive power of model (C52) |
| size of insurance groups (G22) | consumption response symmetry (D11) |
| positive income shocks (E25) | stronger response of consumption (E21) |
| standard models (C20) | asymmetrical consumption responses (D11) |
| coalitional deviations (D70) | risk-sharing dynamics (D16) |