Economics serving society

Heterogeneity and the formation of risk-sharing coalitions

Fernando Jaramillo, Hubert Kempf and Fabien Moizeau

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In developing economies where financial markets are lacking, households protect against income risk by forming risk-sharing groups and informal networks. However, social exclusion from participation in community-based arrangements is pervasive, adversely affecting the capacity of society to adequately provide risk sharing to its members.
This paper provides a joint explanation of partial risk sharing and social segmentation based on the capacity of agents to voluntarily form risk-sharing groups. We study how the segmentation of society into a plurality of distinct groups derives from utility-maximization behavior when agents are heterogeneous. As a consequence, individuals do not to benefit from the same opportunities to protect against risk. Our analysis allows us to understand how ex ante heterogeneity among individuals shapes the pattern of risk-sharing coalitions and thus limits the extent of risk sharing within a large community. We discuss the empirical consequences of social segmentation on partial risk sharing. We show that the coefficients of the consumption function specification used in econometric studies depend on the number and size of risk-sharing coalitions. We use the average value of the coefficient on individual income as a measure of the extent of risk sharing. One implication of our approach is that this coefficient is larger, respectively smaller, when there is more, respectively less, discrepancy between idiosyncratic shock variances. In brief, we claim that empirical studies on risk-sharing must search for the right boundaries of risk-sharing communities.
Original title of the academic article : “Heterogeneity and the formation of risk-sharing coalitions”
Published in: Journal of Development Economics, 2015, vol. 114, 79–96
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