Social Investments, Informal Risk Sharing, and Inequality

Abstract

This paper studies the formation of risk-sharing networks through costly social investments. First, individuals invest in relationships to form a network. Next, neighboring agents negotiate risk-sharing arrangements, in a generalized version of the model in Stole and Zwiebel (1996). This results in the social surplus being allocated according to the Myerson value. In particular, more centrally connected individuals receive higher shares. We fi nd a novel trade-off between efficiency and equality. The most stable efficient network, which minimizes incentives to overinvest, also generates the most inequality. When individuals are split into groups and relationships across groups are more costly but incomes across groups are less correlated, there is never underinvestment into social connections within group, but underinvestment across groups is possible. More central agents have better incentives to form across-group links, reaffirming the efficiency inequality trade-off. Evidence from 75 Indian village networks is congruent with our model.