Social Investments, Informal Risk Sharing, and Inequality

This paper studies costly network formation in the context of risk sharing. Neighboring agents negotiate agreements as in Stole and Zwiebel (1996), which results in the social surplus being allocated according to the Myerson value. We uncover two types of inefficiency: overinvestment in social relationships within group (e.g., caste, ethnicity), but underinvestment across group. We find a novel tradeoff between efficiency and equality. Both within and across groups, inefficiencies are minimized by increasing social inequality, which results in financial inequality and increasing the centrality of the most central agents. Evidence from 75 Indian village networks is congruent with our model.