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Optimal Collective Contract Without Peer Monitoring

Listed author(s):
  • Arup Daripa

    (Birkbeck College, London University)

If entrepreneurs have private information about factors influencing the outcome of an investment, individual lending is inefficient. The literature emphasizes improvements through non-market organizations that harness local information through peer monitoring. I investigate the complementary question of designing a credit mechanism when local information is limited, disabling peer monitoring. I show that a pooling mechanism that does not rely on peer monitoring can implement a market for rights-to-borrow, restoring efficiency. The mechanism achieves a strict Pareto improvement - providing incentive for each type of agent to join. Further, even though the mechanism involves pooling - and consequent implicit transfers from better types to worse types - it has a ``collective'' feature that makes it immune to the Rothschild-Stiglitz cream-skimming problem under competing contracts. Finally, the presence of even weak local information implies that the mechanism cannot be successfully used by formal lenders. Thus a local credit institution can emerge as an optimal response to the informational environment even without peer monitoring. I apply the results to contracts offered by rural moneylenders in developing countries.

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Paper provided by EconWPA in its series Development and Comp Systems with number 0511019.

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Length: 27 pages
Date of creation: 17 Nov 2005
Handle: RePEc:wpa:wuwpdc:0511019
Note: Type of Document - pdf; pages: 27
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