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Decreasing Relative Risk Aversion and Tests of Risk Sharing

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  • Ogaki, Masao
  • Zhang, Qiang

Abstract

The relative risk aversion (RRA) coefficient of a household whose consumption is close to the subsistence level may be very high. For example, if consumption is exactly at the subsistence level, the household may not be willing to bear any risk. If this is the case, then the RRA coefficient must be a decreasing function of wealth for poor households. Therefore we should allow the possibility of decreasing RRA (DRRA) in testing the full risk sharing hypothesis. However, existing tests in the empirical literature are derived using preferences that exhibit either increasing or constant RRA even when they are applied to data containing low-income households. We therefore use a Hyperbolic Absolute Risk Aversion (HARA) utility, which implies increasing, constant, and decreasing RRA as special cases, to test full risk-sharing hypothesis. Using the International Food Policy Research Institute (IFPRI) and the International Crops Research Institute of the Semi-Arid Tropics (ICRISAT) household level data sets, we find evidence in support of the DRRA hypothesis, along with evidence favoring full risk-sharing hypothesis at the village level, and evidence against the hypothesis at the inter-village level. When RRA is restricted to be constant, we replicate the previous results in the literature: reject the full risk-sharing hypothesis at both levels. Our tests, however, reject this restriction and favor DRRA in almost all cases. These results suggest that it is important to allow for DRRA in testing the full risk-sharing hypothesis when data containing low-income households are investigated.

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Bibliographic Info

Article provided by Econometric Society in its journal Econometrica.

Volume (Year): 69 (2001)
Issue (Month): 2 (March)
Pages: 515-26

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Handle: RePEc:ecm:emetrp:v:69:y:2001:i:2:p:515-26

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  1. Rosenzweig, Mark R. & Binswanger, Hans P., 1992. "Wealth, weather risk, and the composition and profitability of agricultural investments," Policy Research Working Paper Series 1055, The World Bank.
  2. Guiso, Luigi & Jappelli, Tullio & Terlizzese, Daniele, 1996. "Income Risk, Borrowing Constraints, and Portfolio Choice," American Economic Review, American Economic Association, vol. 86(1), pages 158-72, March.
  3. Hayashi, Fumio & Altonji, Joseph & Kotlikoff, Laurence, 1996. "Risk-Sharing between and within Families," Econometrica, Econometric Society, vol. 64(2), pages 261-94, March.
  4. Townsend, Robert M, 1994. "Risk and Insurance in Village India," Econometrica, Econometric Society, vol. 62(3), pages 539-91, May.
  5. Mace, Barbara J, 1991. "Full Insurance in the Presence of Aggregate Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 99(5), pages 928-56, October.
  6. Robert B. Barsky & Miles S. Kimball & F. Thomas Juster & Matthew D. Shapiro, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Survey," NBER Working Papers 5213, National Bureau of Economic Research, Inc.
  7. Sumru Altug & Robert Miller, . "Household Choices in Equilibrium," University of Chicago - Population Research Center 87-8, Chicago - Population Research Center.
  8. Atkeson, Andrew & Ogaki, Masao, 1996. "Wealth-varying intertemporal elasticities of substitution: Evidence from panel and aggregate data," Journal of Monetary Economics, Elsevier, vol. 38(3), pages 507-534, December.
  9. Cochrane, John H, 1991. "A Simple Test of Consumption Insurance," Journal of Political Economy, University of Chicago Press, vol. 99(5), pages 957-76, October.
  10. Barsky, Robert B, et al, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study," The Quarterly Journal of Economics, MIT Press, vol. 112(2), pages 537-79, May.
  11. Kessler, Denis & Wolff, Edward N, 1991. "A Comparative Analysis of Household Wealth Patterns in France and the United States," Review of Income and Wealth, International Association for Research in Income and Wealth, vol. 37(3), pages 249-66, September.
  12. Masao Ogaki & Andrew Atkeson, 1997. "Rate Of Time Preference, Intertemporal Elasticity Of Substitution, And Level Of Wealth," The Review of Economics and Statistics, MIT Press, vol. 79(4), pages 564-572, November.
  13. Robert M. Townsend, 1995. "Consumption Insurance: An Evaluation of Risk-Bearing Systems in Low-Income Economies," Journal of Economic Perspectives, American Economic Association, vol. 9(3), pages 83-102, Summer.
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