https://macropaperwarehouse.com/authors/ethan-ligon/Ethan LigonHugo -- gohugo.ioen-ushttps://macropaperwarehouse.com/papers/risk-sharing-tests-and-covariate-shocks-drought-floods-and-pests-in-uganda/https://macropaperwarehouse.com/papers/risk-sharing-tests-and-covariate-shocks-drought-floods-and-pests-in-uganda/<p>This paper identifies and corrects a fundamental flaw in the standard methodology for testing efficient risk-sharing when shocks are covariate (affecting common prices rather than only individual incomes). The standard Townsend (1994) approach infers marginal utilities of expenditure (MUEs) from total expenditures, which implicitly assumes homothetic preferences — specifically Constant Relative Risk Aversion (CRRA) — under which all goods have unitary income elasticities and a single scalar price index captures all price effects. Ligon demonstrates that this assumption causes the standard test to fail when applied to covariate shocks such as droughts, floods, and agricultural pests, because these shocks change relative prices in ways that cannot be captured by a single price index. The perverse consequence is that in Ugandan data, every covariate shock — drought, floods, pests, and adverse prices — appears to improve household welfare under the CRRA specification (significant positive coefficients of 0.046, 0.097, 0.095, and 0.103 respectively, all significant at p&lt;0.01), a result the paper argues is mechanically induced by the mis-specification rather than reflecting reality.</p>