Selected for the Global Economic Symposium 2011

Poor households in developing countries face a number of risks. As access to formal insurance and credit markets is limited, they need to rely on informal strategies in order to reduce these risks ex ante and cope with shocks once they have materialized. One empirically relevant risk reduction strategy is income diversification. In addition to diversifying income, poor households generally choose low-risk, low-return activities. In particular, households tend to be reluctant in adapting new technologies which prevents them from exploiting their full production potential. If adverse shocks occur despite these risk reduction efforts, poor households often have to rely on support from relatives and friends or sell their financial and non-financial assets. These strategies might be effective in case of idiosyncratic shocks like illness or job loss. They fail, however, in case of aggregate shocks like drought or hurricanes that affect the whole environment.