A Theory of Imperfect Competition in Rural Credit Markets

Credit programs in developing countries have significantly expanded rural credit to large farmers. But they have not succeeded in putting informal moneylenders out of business, and there is some evidence that they have not even reduced the rates that moneylenders charge to the small and landless farmers who continue to rely on them. This paper offers a theoretical model within which this puzzle can be explained. The model is motivated by fields studies of rural areas of Asian developing countries which have documented the importance of credit interlinked with trade and the advantages that the trader-moneylender has in enforcing loan contracts. In the model presented in this paper, the ability to enforce loan contracts provides a return to becoming a trader that induces entry into that activity by those who have funds. Government subsidies that expand bank credit to large farmers may induce further entry by large farmers into the trader-moneylending sector. The induced entry leads to higher excess capacity among trader-moneylenders and higher unit costs. Rather than being passed on to the small farmer and tenant, the credit subsidy may be wholly or partly absorbed in the reduced efficiency of the monopolistically competitive moneylending-trading sector.