Contract Structure, Risk Sharing, and Investment Choice

Few micro…nance-funded businesses grow beyond subsistence entrepreneurship. This paper considers one possible explanation: that the structure of existing micro…nance contracts may discourage risky but high-expected return investments. To explore this possibility, I develop a theory that uni…es models of investment choice, informal insurance, and formal …nancial contracts. I then test the predictions of this theory using a series of experiments with clients of a large micro…nance institution in India. The experiments con…rm the theoretical predictions that joint liability creates two ine¢ ciencies. 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 pro…tability. However, the theoretical prediction that group lending will crowd out informal insurance is not borne out by experimental evidence. While observed levels of informal insurance fall well short of the constrained Pareto frontier under both individual and joint liability, joint liability increases observed insurance transfers. Equity-like …nancing, in which partners share both the bene…ts and risks of more pro…table projects, overcomes both of these ine¢ ciencies and merits further testing in the …eld. Keywords: investment choice, informal insurance, risk sharing, contract design, micro…nance, experiment. JEL Classi…cation Codes: O12, D81, C91, C92, G21 I would like to thank my advisors Esther Du‡o, Abhijit Banerjee, and Antoinette Schoar for their time, advice and and encouragement. I am indebted to Shamanthy Ganeshan who provided outstanding research assistance. Daron Acemoglu, David Cesarini, Sylvain Chassang, Raymond Guiteras, Rob Townsend, Tom Wilkening, and the participants of the MIT development and applied micro lunches generously contributed many useful comments and advice. In Chennai, the Centre for Micro Finance, particularly Annie Du‡o, Aparna Krishnan, and Amy Mowl, and the management and employees of Mahasemam Trust deserve many thanks. I gratefuly acknowledge the …nancial support of the Russell Sage Foundation, the George and Obie Schultz Fund, and the National Science Foundation’s Graduate Research Fellowship. yE-mail: g…[email protected] / Land-mail: Department of Economics, E52-391; Massachusetts Institute of Technology; 50 Memorial Drive; Cambridge, MA 02142.