The optimal group size in microcredit contracts

We analyze a model of a repeated microcredit lending and study how group size affects the optimal group lending contracts with joint liability. The story is that one benevolent lender gives microcredit to a group of n borrowers to be invested on n projects. The outcome of each risky project is not observable by the lender. Therefore in case some of the borrowers default on their loan repayments, the lender is not able to identify strategic default. We characterize the optimal contract and determine the optimal size of the group of borrowers endogenously. Our analysis suggests that Joint liability has positive effects on the repayment rate and borrowers’ welfare, and that this effect can increase in the size of the group. However joint liability contracts are feasible under a smaller set of parameter values than individual liability contract. When projects have lower chance of success, the amount of loan that can be granted to borrowers under Joint liability is higher and it is also increasing in the group size. JEL classification: C70, D82, G21