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Contract structure, risk sharing and investment choice

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  • Fischer, Gregory

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.

Suggested Citation

  • Fischer, Gregory, 2011. "Contract structure, risk sharing and investment choice," LSE Research Online Documents on Economics 41890, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:41890
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    File URL: http://eprints.lse.ac.uk/41890/
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    References listed on IDEAS

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    Cited by:

    1. Altınok, Ahmet & Sever, Can, 2014. "Efficient Microlending without Joint Liability," MPRA Paper 56598, University Library of Munich, Germany.
    2. Renate Strobl & Conny Wunsch, 2017. "Does Voluntary Risk Taking Affect Solidarity? Experimental Evidence from Kenya," CESifo Working Paper Series 6578, CESifo.
    3. Farah Said, 2016. "Access to Finance and Agency: An Overview of the Constraints to Female-Run Enterprises," Lahore Journal of Economics, Department of Economics, The Lahore School of Economics, vol. 21(Special E), pages 331-349, September.
    4. Strobl, Renate & Wunsch, Conny, 2018. "Risky Choices and Solidarity: Why Experimental Design Matters," Working papers 2018/17, Faculty of Business and Economics - University of Basel.
    5. Fenella Carpena & Shawn Cole & Jeremy Shapiro & Bilal Zia, 2013. "Liability Structure in Small-Scale Finance: Evidence from a Natural Experiment," The World Bank Economic Review, World Bank, vol. 27(3), pages 437-469.
    6. Yaron Azrieli & Christopher P. Chambers & Paul J. Healy, 2018. "Incentives in Experiments: A Theoretical Analysis," Journal of Political Economy, University of Chicago Press, vol. 126(4), pages 1472-1503.

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    More about this item

    Keywords

    investment choice; informal insurance; risk sharing; contract design; microfinance; experiment;
    All these keywords.

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • C92 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Group Behavior
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • O12 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Microeconomic Analyses of Economic Development

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