A large body of evidence shows that informal insurance is an important risk-smoothing mechanism in developing countries but that this risk sharing is incomplete. Models of limited commitment, moral hazard, and hidden income have been proposed to explain the incomplete nature of informal insurance. Using the first-order conditions characterizing optimal insurance subject to each type of constraint, I show that the way history matters in forecasting consumption can be used to distinguish hidden income from limited commitment and moral hazard. This implication does not rely on a particular specification of the production technology or utility function. In a seven-year panel from rural Thailand, I show that neither limited commitment nor moral hazard can fully explain the relationship between income and consumption. In contrast, the predictions of the hidden income model are supported by the data.

Rural areas of developing countries often lack effective legal enforcement. However, villagers who know each other well and interact repeatedly may use implicit contracts to minimize crime. I construct a dynamic limited-commitment model, in which a thief cannot credibly commit to forego stealing from his fellow villagers, but may be induced to limit his stealing by the promise of future gifts from his potential victim. Using a unique survey from rural Paraguay which combines traditional data on production with information on theft, gifts, and trust, as well as with experiments measuring risk aversion and trustworthiness, I test whether the data is consistent with predictions from the dynamic model. The results provide evidence that farmers do implicitly contract

The existing literature on sub-game perfect risk-sharing suffers from a basic inconsistency. While a group of size n is able to coordinate on a risk-sharing outcome, it is assumed that devi-ating subgroups cannot. We relax this assumption and characterize the optimal contract among all coalition-proof history-dependent contracts. This alters the predictions of the standard dy-namic limited commitment model. We show that the consumption of constrained agents depends on both the history of shocks and its interaction with the current income of other constrained agents. From this, we derive a formal test for the presence of endogenous group formation under limited commitment.

This paper studies the role of preference and income risk heterogeneity when risk sharing is partial due to limited commitment. I estimate the dynamic contract determining self-enforcing insurance transfers in a structural manner, and allow the coefficient of relative risk aversion and multiplicative income risk to differ across households. I find that the model explains the consumption allocation significantly better than the homogenous version and the benchmarks of perfect risk sharing and autarky, using household survey data from rural Pakistan. Enforcement constraints bind more often with heterogeneous households, implying less risk sharing. The paper then examines how social policies would interact with existing informal insurance arrangements. I simulate the effects of counterfactual transfers targeting the poor on consumption by both eligible and ineligible households. In the case of a one-time transfer, the heterogeneous (homogeneous) model predicts that consumption by ineligible households increases by one fifth (one fourth) of the transfer; if the transfer is permanent, the predicted share of ineligible households is one tenth (one fifth).

We examine how risk-sharing is impacted by asymmetric information on the probability dis-tribution of wealth. We define the optimal incentive compatible agreements in a simple two-agent model with two levels of wealth. When there is complete information on the probability of the dif-ferent outcomes, the resulting allocation satisfies the mutuality principle (which states that every-one’s final wealth depends only upon the aggregate wealth of the economy). This is no longer true when agents have private information regarding their probability distribution of wealth. Asym-metry of information (i) makes ex-post equal sharing unsustainable between two low risk agents and (ii) induces exchanges when agents have the same realization of wealth.

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This paper examines how well models of risk sharing explain the allocation of consumption in a community. The models of perfect risk sharing, autarky, and risk sharing with limited commitment are estimated in a structural manner. We extend the approach of Ligon, Thomas, and Worrall (2002) in several ways. First, we allow households’ preferences to depend on observable household characteristics. Second, this paper allows for unobservable individual effects. Third, measurement error is dealt with explicitly in the structural model by using a simulated maximum likelihood estimator. Finally, Vuong’s (1989) tests are applied to statistically compare the models. We provide evidence that both heterogeneity in preferences and limitations to the enforcement of informal insurance contracts are important in explaining the consumption allocation. Simulations of the effects of redistributive policies are conducted based on the structural estimations, using household survey data from rural Pakistan.

households do to smooth consumption