Estimating Dynamic Contracts: Risk Sharing in Village Economies

Abstract

This paper studies the role of preference and income risk heterogeneity when risk sharing is partial due to limited commitment. I estimate the dynamic contract determining self-enforcing insurance transfers in a structural manner, and allow the coefficient of relative risk aversion and multiplicative income risk to differ across households. I find that the model explains the consumption allocation significantly better than the homogenous version and the benchmarks of perfect risk sharing and autarky, using household survey data from rural Pakistan. Enforcement constraints bind more often with heterogeneous households, implying less risk sharing. The paper then examines how social policies would interact with existing informal insurance arrangements. I simulate the effects of counterfactual transfers targeting the poor on consumption by both eligible and ineligible households. In the case of a one-time transfer, the heterogeneous (homogeneous) model predicts that consumption by ineligible households increases by one fifth (one fourth) of the transfer; if the transfer is permanent, the predicted share of ineligible households is one tenth (one fifth).