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Optimal Collective Contract Without Peer Monitoring

Arup Daripa ()

Development and Comp Systems from EconWPA

Abstract: If entrepreneurs have private information about factors influencing the outcome of an investment, individual lending is inefficient. The literature emphasizes improvements through non-market organizations that harness local information through peer monitoring. I investigate the complementary question of designing a credit mechanism when local information is limited, disabling peer monitoring. I show that a pooling mechanism that does not rely on peer monitoring can implement a market for rights-to-borrow, restoring efficiency. The mechanism achieves a strict Pareto improvement - providing incentive for each type of agent to join. Further, even though the mechanism involves pooling - and consequent implicit transfers from better types to worse types - it has a ``collective'' feature that makes it immune to the Rothschild-Stiglitz cream-skimming problem under competing contracts. Finally, the presence of even weak local information implies that the mechanism cannot be successfully used by formal lenders. Thus a local credit institution can emerge as an optimal response to the informational environment even without peer monitoring. I apply the results to contracts offered by rural moneylenders in developing countries.

Keywords: Informal Credit; Market for Rights-To-Borrow; Participation Incentives; Competition in Contracts and Cream Skimming; Local Information; Rural Moneylending (search for similar items in EconPapers)
JEL-codes: O12 D78 D82 (search for similar items in EconPapers)
Date: 2005-11-17
Note: Type of Document - pdf; pages: 27
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Working Paper: Optimal Collective Contract Without Peer Monitoring (2005) Downloads
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