In village economies, limited commitment models have been proposed as theoretical
alternatives to the complete markets hypothesis and have been shown to be empirically
relevant. Yet, village institutions might be able to enforce some contracts. We construct a
theoretical model which shows how households can insure through both formal and informal
contracts when some verifiable production takes place in an environment of incomplete
markets. This theoretical setting nests the case of complete markets when all risks can
be insured by formal contracts (because all states of nature would be verifiable) and the
case where only informal agreements are available (agreements specifying informal transfers
that needs to be self-enforceable). We derive two equations of interest, the income equation
which is partially determined by the formal contract and an Euler-type equation where
consumption growth is affected by lagged consumption instead of being a martingale. Using
semi-parametric specifications, we derive testable restrictions of our model. We estimate
both equations using data of village economies in Pakistan. Empirical results are consistent
with the model. The estimation and allows to show that the incentive constraints due to self-enforcement
bind and that formal contracts are used to reduce the probability of binding
the constraint. |
