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Contract structure, risk sharing and investment choice

Fischer, Gregory (2011) Contract structure, risk sharing and investment choice. Economic Organisation and Public Policy Discussion Papers, EOPP/2011/23. Suntory and Toyota International Centres for Economics and Related Disciplines, London School of Economics and Political Science, London, UK.

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Abstract

Few microfinance-funded businesses grow beyond subsistence entrepreneurship. This paper considers one possible explanation: that the structure of existing microfinance contracts may discourage risky but high-expected return investments. To explore this possibility, I develop a theory that unifies models of investment choice, informal risk sharing, and formal financial contracts. I then test the predictions of this theory using a series of experiments with clients of a large microfinance institution in India. The experiments confirm the theoretical predictions that joint liability creates two inefficiencies. First, borrowers free-ride on their partners, making risky investments without compensating partners for this risk. Second, the addition of peer-monitoring overcompensates, leading to sharp reductions in risk-taking and profitability. Equity-like financing, in which partners share both the benefits and risks of more profitable projects, overcomes both of these inefficiencies and merits further testing in the field.

Item Type: Monograph (Discussion Paper)
Official URL: http://sticerd.lse.ac.uk
Additional Information: © 2011 The Author
Library of Congress subject classification: H Social Sciences > HB Economic Theory
Journal of Economic Literature Classification System: C - Mathematical and Quantitative Methods > C9 - Design of Experiments > C91 - Laboratory, Individual Behavior
C - Mathematical and Quantitative Methods > C9 - Design of Experiments > C92 - Laboratory, Group Behavior
D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D81 - Criteria for Decision-Making under Risk and Uncertainty
G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
O - Economic Development, Technological Change, and Growth > O1 - Economic Development > O12 - Microeconomic Analyses of Economic Development
Sets: Departments > Economics
Collections > Economists Online
Research centres and groups > Suntory and Toyota International Centres for Economics and Related Disciplines (STICERD)
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: EOPP/2011/23
Date Deposited: 14 Feb 2012 11:40
URL: http://eprints.lse.ac.uk/41890/

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