Decreasing Relative Risk Aversion

The testable implication of the complete risk-sharing hypothesis depends on what is assumed on households' relative risk aversion (RRA) coefficient. We therefore use a hyperbolic absolute risk aversion (HARA) utility function, which includes increasing, constant, and decreasing RRA as special cases, to test this hypothesis. Using household level total non-durable consumption data from Indian villages, we find evidence supporting the decreasing RRA (DRRA) hypothesis, along with evidence favoring full risk-sharing hypothesis at the village level, and rejecting it at the inter-village level. When RRA is restricted to be constant, we replicate the previous findings in the literature: reject the full risk-sharing hypothesis at both levels. Our tests, however, reject this restriction and favor DRRA. These results suggest that it is important to allow for DRRA in testing the complete risk-sharing hypothesis, especially when data containing low-income households are investigated.