Individuals in a given village have incomes described by the following equation:
y = A +ε +θ
where A denotes risk-free income, ε denotes an idiosyncratic (individual-level) shock and θ denotes a village-level shock.
(a) Suppose full insurance were possible within this village. How would this affect individual income? (3 pts)
(b) Name two advantages and two disadvantages of limiting insurance to (within) the village.