Investments in Social Ties, Risk Sharing and Inequality

This paper provides a framework to study the formation of risk-sharing networks through costly social investments, in particular the inefficiencies and resulting inequality associated with such processes. First, individuals invest in relationships to form a network. Next, neighboring agents negotiate risk-sharing arrangements. There is never underinvestment, but overinvestment is possible and we find a novel trade-off between efficiency and equality. The most stable efficient network also generates the most inequality. When the income correlation structure is generalized by splitting individuals into groups, such that incomes across groups are less correlated but these relationships are more costly, there can be underinvestment across group but not within group. We find that more central agents have better incentives to form across-group links, reaffirming the efficiency inequality tradeoff. In general, endogenous network formation in the risk sharing context tends to result in highly asymmetric networks and stark inequalities in consumption levels. Evidence from 185 Indian village networks is congruent with our model.