Contract Structure, Risk Sharing and Investment Choice

61 Pages Posted: 30 Sep 2011

See all articles by Greg Fischer

Greg Fischer

London School of Economics & Political Science (LSE) - Department of Economics

Date Written: February 2011

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.

JEL Classification: O12, D81, C91, C92, G21

Suggested Citation

Fischer, Greg, Contract Structure, Risk Sharing and Investment Choice (February 2011). LSE STICERD Research Paper No. EOPP023, Available at SSRN: https://ssrn.com/abstract=1935769

Greg Fischer (Contact Author)

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom

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