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Contract structure, risk sharing and investment choice


  • Fischer, Gregory


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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    References listed on IDEAS

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    Cited by:

    1. 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.

    More about this item


    investment choice; informal insurance; risk sharing; contract design; microfinance; experiment;

    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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