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Development Discussion Paper
Contract Structure, Risk Sharing and Investment Choice
Greg Fischer
February 2011
Paper No' EOPP 023:
Full Paper (pdf)

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

Tags: investment choice; informal insurance; risk sharing; contract design; microfinance; experiment.

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.