Implications of Endogenous Group Formation for Efficient Risk-Sharing
This paper models the implications of endogenous group formation for efficient risk-sharing contracts in the dynamic limited commitment model. Endogenising group formation requires that any risk-sharing arrangement is not only stable with respect to individual deviations but also with respect to deviations by sub-groups. This requirement alters the central predictions of the dynamic limited commitment model for efficient bilateral risk-sharing. Firstly, consumption of constrained agents depends on the previous history of shocks and the interaction of the history of shocks with the current income realizations of other constrained agents. As a consequence, the efficient contract does not display amnesia. Secondly, the covariance between current consumption and past income can take on negative values. Based on the first result, we derive a formal test for the presence of endogenous group formation under limited commitment. In addition, we show how this test can be extended to distinguish a limited commitment/perfect information environment from a full commitment/imperfect information environment empirically.
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