Informal Insurance Arrangements in Village Economies
This paper studies insurance arrangements in village economies when there is complete information but limited commitment. Commitment is limited because only limited penalties can be imposed on households which renege on their promises. Any efficient insurance arrangements must therefore take into account that households will renege if the benefits from doing so outweigh the costs. We study a general model which admits aggregate and idiosyncratic risk as well as serial correlation of incomes. It is shown that in the case of two households and no storage the efficient insurance arrangement is characterized by a simple updating rule. An example illustrates the similarity of the efficient arrangement to a simple debt contract with occasional debt forgiveness. The model is then extended to multiple households in southern India to test the theory against three alternative models: autarky, full insurance, and a static model of limited commitment due to Coate and Ravaillon (1993). Overall, the model we develop does a significantly better job of explaining the data than does any of these alternatives.
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