Risk-Sharing in Village Economies Revisited

The limited enforcement model is popular for the analysis of village risk-sharing as it captures both the observed degree of insurance and the presumption that incomes are well observed but formal contracts absent in rural communities. Enforcement constraints in insurance contracts, however, typically bind only in case of positive income shocks, when the outside option of leaving the village is attractive. We show how this results in strongly counterfactual asymmetries in the consumption process at usual village sizes. When households can renege on informal contracts together with other villagers, however, the size of insurance groups becomes endogenous, and is usually much smaller than typical villages. This brings the predicted consumption process, which is more symmetric in small groups, in line with observed data. We thus argue that village risk-sharing should be replaced by neighbourhood, or kinship, risk-sharing.