Contract structure, risk sharing and investment choice

Gregory Fischer

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

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.

Keywords: investment choice; informal insurance; risk sharing; contract design; microfinance; experiment (search for similar items in EconPapers)
JEL-codes: C91 C92 D81 G21 O12 (search for similar items in EconPapers)
Pages: 60 pages
Date: 2011-02
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

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