Recent work on consumption allocations in village economies finds that idiosyncratic variation in consumption is systematically related to idiosyncratic variation in income, thus rejecting the hypothesis of full risk-pooling. We attempt to explain these observations by adding limited commitment as an impediment to risk-pooling. We provide a general dynamic model and completely characterise efficient informal insurance arrangements constrained by limited commitment, and test the model using data from three Indian villages. We find that the model can fully explain the dynamic response of consumption to income, but that it fails to explain the distribution of consumption across households. (2002) 69, 209-244 0034-6527/02/00090209$02.00 ß 2002 The Review of Economic Studies Limited 209 2. Examples include applications to sovereign debt by Kletzer and Wright (2000) and Atkeson (1991) (who also considers asymmetric information), Chari and Kehoe (1993) who consider a model in which both the government and private citizens can default on their debt to each other, a two-country international business cycle model with both production and capital accumulation by Kehoe and Perri (1998), a two-party model of political bargaining by Dixit, Grossman and Gul (1998) and a model of asset pricing by Alvarez and Jermann (2000). Review of Economic Studies3. Alvarez and Jermann (2000) obtain a similar characterization to that here in a two-sided risk aversion case but assume symmetry, no aggregate uncertainty and a monotonicity property.

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When an investor, for example a transnational corporation invests abroad it runs the risk that its investment will be expropriated. The host country although it might have a short-term incentive to expropriate has a long-term incentive to foster good relations to attract more investment in the future. This conflict between short-term and long-term incentives determines the type of contracts agreed by transnational corporations and host countries. In a model of the manufacturing industry with a continuous flow of investment it is shown that investment is initially underprovided, increases over time, tending, for certain parameter values, to the efficient level. This version prepared on 19th January, 1990. * The support of the Deutsche Forschungsgemeinschaft through SFB 178 at the Universitat Konstanz is gratefully acknowledged. We thank Keith Cowling for comments on an earlier draft. This paper is circulated for discussion purposes only and its contents should be considered preliminary. HEADNOTE: When an investor, for example a transnational corporation, invests abroad it runs the risk that its investment will be expropriated for the simple reason that international contracts are practically impossible to enforce. Any agreements or contracts then undertaken by the transnational company and the host country must be designed to be self-enforcing. It could be possible for the host country and the transnational corporation to find such self-enforcing agreements if there are future gains from trade. Thus although the host country might have a short-term incentive to expropriate it has a long-term incentive to foster good relations with potential investors to attract more investment in the future. This conflict between short-term and long-term incentives determines the type of investment contracts agreed. This paper extends previous work on the general underprovision of investment when contracts are incomplete or only partially enforceable (see e.g. Grout, 1984) to a dynamic context. It is likewise shown that investment is initially underprovided but it increases over time and for certain parameter values it tends to the efficient level. The expected future discounted returns to the transnational company declines over time, extending Vernon's observation of the obsolecing bargain (Vernon, 1971). The model is also extended to allow for capital accumulation and consideration is given to renegotiation-proof contracts.

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