The Choice of Institutions: The Role of Risk and Risk-Aversion

Abstract:     
Institutions can affect individual behavior both via their efficiency impact and via their risk reducing mechanisms. However there has been little study of the relative importance of these two channels in how individuals choose between simultaneously extant institutions. This paper presents a simple model of institutional choice in a labor market when there is a risk/reward trade-off, and tests the predictions of the theory. Using a novel empirical approach that adapts an ARCH-in-mean to cross-sectional survey data from China, we find that risk and risk aversion are strongly related to the choice of a labor market institution. Further, risk and risk aversion are quantitatively more important than the sectoral wage differential in explaining employment institution choices. Specifically, we find that wage risk has two orders of magnitude greater impact on labor market institutional choice than the wage difference, with a one standard deviation increase in earnings risk reducing the number of workers choosing jobs in the private (risky) sector by 22%.

Number of Pages in PDF File: 22

Keywords: Institutions, Risk, Labor Market, Risk Aversion

JEL Classification: P3, J21, J40

working papers series