Stochastic Wealth Dynamics and Risk Management among a Poor Population

Abstract

We use herd history data collected among pastoralists in southern Ethiopia to study stochastic wealth dynamics among a poor population. Although covariate rainfall shocks plainly matter, household-specific factors, including own herd size, account for most observed variability in wealth dynamics. We find no support for the tragedy of the commons hypothesis. Past studies may have conflated costly self-insurance with stocking rate externalities. Biophysical shocks move households between multiple dynamic wealth equilibria ‐ the lowest suggesting a poverty trap ‐ according to nonconvex path dynamics. These findings have broad implications for development and relief strategies among a poor population vulnerable to climatic shocks. A vast economic literature on risk management rests, explicitly or implicitly, on the classic Friedmanite permanent income hypothesis. Studies of portfolio management, consumption smoothing, social insurance, and the like all depend on the canonical assumption that stochastic income realisations are drawn from a stationary income distribution, leading to consumption smoothing off a stable asset base. The possibility of asset accumulation connects this literature to the immense literature on the theory and empirics of economic growth.