Information Economics & Microfinance

Information Economics and Micro-finance
Prabal Roy Chowdhury

Indian Statistical Institute, Delhi Center
March, 2014
Information Economics: Introduction

What is Information Economics all about?
Asymmetric Information: Some agents do not know the
type/payoff/utility/profit function of the other agents - some
agents are uninformed, others informed.
In an auction, the seller will not know the valuation of the
buyers.
An used car buyer will not know the quality of the car being
offered - whether a lemon, or a peach.
An employer will not know the quality of an applicant.
Moral Hazard: Agents cannot verify the action taken by

others.
A firm cannot verify whether an worker is working, or shirking.
An insurance company cannot verify whether the insurer is
taking adequate preventive activity against
fire/accident/theft, or not.
A life insurance company cannot ensure whether an insurer is
leading a healthy life-style or not.
Motivation
Motivation: Why study information? Central to an

understanding of institutions, e.g. firms.
Consider one striking institution from development economics:
Micro-finance.
Grameen Bank in Bangladesh:
Loans with no collateral.
Under M.Yunus, Grameen I had astounding rates of
repayment, some reports say close to 98 per cent.
Yunus and Grameen jointly won the 2006 Noble Peace Prize.
Motivation
Under Grameen I, many interesting institutional features:
Average group size is 5.
Two members given loans initially.
Have to start repaying within a few weeks, in equal weekly
installments over an year.
If they repay the first few installments, then two other
members receive loans, etc.
Frequent repayment, sequential financing and dynamic joint
liability are woven together.
All three adopted by Grameen I and its replicators, e.g. ASA
(Association for Social advancement), RDRS (Rangpur
Dinajpur Rural Service), etc. in Bangladesh.
Why? We shall argue that an explanation for all these

institutional features can be provided based on informational
aspects.
Asymmetric Information
Issues:
Market failure: Outcome is inefficient because of asymmetric
information.
Signaling: A good type may try to signal its type.
Screening: The uninformed side may try to elicit information
regarding who is who.
Asymmetric Information
Market failure: Akerlofs market for lemons (bad quality used

car).
Example:
100 lemons: Valuation 0 for both buyers and sellers.
100 peaches (good quality used car): vB (Pe) = 100,
vS (Pe) = 60. Thus a surplus of 40 created in case the
transaction goes through.
500 buyers, who do not know which is which.
Efficient outcome: All peaches are traded.
Market for lemons: No asymmetric information
First consider a benchmark case where the buyer knows

exactly which car is which.
Then there are two separate markets, one for peaches and
another for lemons.
Peach market: All peaches will be sold at a price of 100 (since
demand exceeds supply at any lower price). All peaches are
traded.
Lemons market: will have a price of zero, and traded quantity
is indeterminate.
Thus, with complete information, the outcome is efficient.
Market for lemons: Asymmetric information

Now consider the case with asymmetric information.
Proposition
The equilibrium price is zero, and no peaches are traded.
Inefficiency!
Proof: Suppose to the contrary:
Market price exceeds 60. Then value of an average car is 50,
which is less than the price. Thus there is no demand.
p = 60. Maximum possible valuation is 50, which is less than
price.
0 < p < 60. Only lemons with vB = 0 will be supplied. Thus
again demand will be zero.
Intuition: Uniformed agents value the informed agents at the

average level, thus offering an average price, at which the
good quality agents may not want to transact.
Market for lemons: Applications
Credit market: Consider a borrower who has a project

requiring 1 unit of setup capital.
The quality of the borrowers project is private information, it
is good with probability 1/2, and bad with probability 1/2.
A project yields 3 with probability 0.001, and 0 with
probability 0.999.
A project yields 3 with 1/2, and 0 with 1/2.
Good project is efficient: Net return is 3
1
2
1 = 0.5.
There is a competitive banking sector, with an opportunity

cost of 1, which may lend 1 to the borrower. Banks do not
know which project is which.
Market for lemons: Credit market

Credit market:
Proposition
In equilibrium there is credit rationing - the good project is not
funded, i.e. there is inefficiency.
Proof:
In any equilibrium where the good borrower gets a loan, so will
the bad borrower, i.e. no separating equilibrium with good
borrower getting the loan exists.
Suppose to the contrary it exists. At the equilibrium interest
0
rate, say r 0 , the bank must break even, so that r2 = 1, so that
0
0
r = 2. But at this r , it is profitable for a bad borrower to
take a loan.
No pooling equilibrium where both types of borrowers obtain

a loan exists.
Given the zero profit condition, the gross interest, r , must
satisfy
1/4r 1.
But r 4, so that the good borrower does not want a loan.

Market for lemons: Possible resolutions

Resolutions:
Getting a mechanic to check the car: may be too costly. Even
if its not costly, it may lead to a waste of scarce resources.
Signalling: Warranty
Consider the lemons market example discussed above.

Suppose that a lemon is a lemon because there is a probability
1/2 that the car breaks down, whereas a peach never breaks
down.
In such a situation, an warranty can help signal quality:
Let the peach owner ask for a price of 100, and moreover, offer
to pay an warranty of 201 in case the car breaks down.
Note that mimicking this warranty is too costly for the lemon
owner. Hence this is a credible signal. Further, offering this
warranty is completely costless for the peach owner.
Market for lemons: Advertising

Consider a good which can be either high quality, or low
quality, say with probability 1 and 2 . In case its high
quality, the consumers per period utility is v 0 , otherwise its
v < v 0 . The quality is exogenously chosen by nature.
Consumers are unsure about the type.
Per period cost of production c, where v 0 > c > v , so that
producing the good quality is efficient.
Two periods, with = 1.
Once nature chooses its type i, the firm may, or may not
produce good i, with the product surviving for exactly one
period. In period 1 the consumers get to know if the good is
high quality, or low. Thus there is no uncertainty in period 2.
Full information: The high type sells the object for v 0 in both
periods, and the low type does not produce. Thus the
outcome is efficient.
Consider a multi-stage game:

1
Stage 1 (period 1): The firm announces its price, and possibly
some advertising call it A (money burning).
Stage 2 (period 1): If a consumer buys, then she gets to
observe the product quality.
Period 2: In the second period, the firm sets a price and the
consumer decides whether to buy or not. Advertising can never
occur in period 2.
Consider a separating PBE, say (p1 , p2 ). In such an

equilibrium, on observing p1 , the belief must be its the high
type, so the consumer purchases iff p1 v 0 . Whereas on
observing p2 , the belief is that it is the low type so that price
must be less than v .

Note that there cannot be a separating equilibrium for A = 0,
as v < c.
Suppose not. Then consumers wont pay more than v for the
bad product, and the firm makes losses in case of production.
However, then the good quality firm will charge p1 = v 0 , which
the bad quality firm will mimic.
Can there be a separating equilibrium with the high quality

> 0 on advertising? Belief: High type iff
firm spending A
A A.
Then the net profit of the low quality firm in case it mimics
this strategy is
v 0 c A.
> v 0 c, the low quality product will not mimic.
Clearly, for A
Whereas the high quality firm will make a gain as long as
< 2(v 0 c).
A
Screening: Micro-finance
Micro-finance: Provision of small loans without collateral to
poor borrowers, often with group-lending.
Grameen I: Average group size is 5.
Dinajpur Rural Service) in Bangladesh (Zeller et. al. (1996,
IFPRI)).
Screening: Micro-finance
JLL: loans given to groups rather than individuals, with
members being liable to repay for others, if possible.
Framework:
4 poor borrowers, 2 good, 2 bad.
All borrowers have projects that require a startup capital of 1,
which the poor borrowers do not have. They do not have any
collateral also.
Good borrowers projects return R with probability G , and 0
otherwise. Bad borrowers projects return R with probability
B < G . Project returns are observable, but borrower types
are not.
1 MFI that breaks even, and has 4 units of capital with
opportunity cost of 1 per unit of capital:
G R > 1 > B R.
Screening: Micro-finance: Individual lending

Proposition
2
> R. Then no projects will be financed under individual
Let G +
B
lending.
We first argue that no separating equilibrium with the good

borrowers only getting the loan exists. Suppose not. Then in
the separating equilibrium, the zero profit constraint implies
that the gross interest r satisfies
r G = 1.
But at this r the bad borrower will mimic.
Under a pooling equilibrium the equilibrium interest rate must
satisfy
r G
r B
2
+
=1r =
.
2
2
G + B
But the good borrower wont take a loan at this r .
Screening: Micro-finance: Group lending
Suppose the MFI instead only offers loans to 2-member

groups, with a gross interest of r , and a joint liability of j.
Thus if say borrower 1s project fails, that of borrower 2
succeeds, then borrower 2 is supposed to repay r + j instead.
Suppose every borrower incurs a fixed cost of f from taking a
loan and doing the project.
There are now two options regarding group formation GG and
BB, or two BG . Which one would form?
BB and GG : Then the relevant payoffs of the borrowers are:
UGG
= 2G u(R r ) + G (1 G )u(R r j) f ,(1)
UBB
= 2B u(R r ) + B (1 B )u(R r j) f .(2)
2 BG : Then the relevant payoffs of the borrowers are:

G
UGB
= G B u(R r ) + G (1 B )u(R r j) f , (3)
B
UGB
= G B u(R r ) + B (1 G )u(R r j) f .(4)
We claim that there is positive assortative matching (PAM),

i.e. the GG and BB group forms.
Assuming that money is transferable, there is PAM iff
G
B
UGG + UBB UGB
+ UGB
.
Straightforward calculations show this is always true.
Given PAM, we can now show that the MFI can, by a judicious
choice of r and j, ensure that only GG asks for a loan.
Let r and j satisfy:
UGG > 0 > UBB ,
where
2G r + G (1 G )(r + j) = 1.
Such a pair (r , j) exists since it is is easy to see that
UGG > UBB for all (r , j) combination.
Incentives in Economic Thought: Adam Smith

Incentives in economic thought!
Adam Smith (1776, bk. 1, chap. 7) identified the conflict
between the masters and the workers in agriculture, with
masters having the greater power.
Identified the agents participation constraint, which limits
what the principal can ask from the agent:
A man must always live by his work, and his wages must at
least be sufficient to maintain him.
.....Smith (1776, p. 67).
Worried about over-incentives, i.e. incentives being too high

powered (multi-tasking):
Workmen . . . when they are liberally paid by the piece, are
very apt to overwork themselves, and to ruin their health and
constitution in a few years.
.....Smith (1776, bk. 1, chap. 8, p. 81).
Adam Smith: Incentives in Agriculture

He stressed the lack of appropriate incentives for slaves:
.... work done by slaves... is in the end the dearest of any. A
person who can acquire no property, can have no other interest
but to eat as much, and to labour as little as possible.
......Smith (1776, bk. 1, chap. 8, p. 365).
In book 3, chapter 2, described the status of share-croppers,

or metayers/steel-bow tenants:
The proprietor furnished them with the seed, cattle and
instruments of husbandry. The produce was divided equally
between the proprietor and the farmer.
......Smith (1776, bk. 3, chap. 2, p. 366).
However:
But said efforts will not be impacted - unaware of the
fundamental trade-off between incentives and the distribution
of the gains from trade.
Rather, he saw the most serious incentive problems in the
absence of tenants investment in the land, and in the
unobservable misuse of husbandry instruments provided by the
proprietor.
Babbage, Barnard and Incentives in Management

Babbage (1835) emphasized the need for precise measurement
of performances to set up efficient piece-rate or profit-sharing
contracts. Literature on subjective performance evaluation
just beginning:
It would, indeed, be of great mutual advantage to the
industrious workman, and to the master manufacturer in every
trade, if the machines employed in it could register the
quantity of work which they perform, ....
The introduction of such contrivances gives a greater stimulus
to honest industry than can readily be imagined, and removes
one of the sources of disagreement between parties.
.....Babbage (1835, p. 297).
Babbage proposed various principles to remunerate labor:

1
That a considerable part of the wages received by each person

should depend on the profits made by the establishment;
That every person connected with it should derive more
advantage from applying any improvement he might discover
than he could by any other course.
....(Babbage 1989, Vol. 8, p. 177).
Chester Barnard and Incentives in Management
Barnard (1938) can be credited with the first attempt to

define a general theory of incentives in management, in The
Functions of the Executive, which he wrote after a long
career in management, most notably as president of the New
Jersey Bell Telephone Company:
[A]n essential element of organizations is the willingness of
persons to contribute their individual efforts to the cooperative
system. . . . Inadequate incentives mean dissolution, or
changes of organization purpose, or failure to cooperate.
Hence, in all sorts of organizations the affording of adequate
incentives becomes the most definitely emphasized task in
their existence. It is probably in this aspect of executive work
that failure is most pronounced.
....Barnard (1938, p. 139).

Barnard had a broad view of incentives:
involving both what we would now call monetary and
non-monetary incentives, emphasising that a delicate balance
of the two was required:
Even in purely commercial organizations, material incentives
are so weak as to be almost negligible except when reinforced
by other incentives
...Barnard (1938, p. 144).
Persuasion . . . includes: a) the creation of coercive
conditions (as forced exclusion of indesirables); b) the
rationalization of opportunities; c) the inculcation of motives.
....Barnard (1938, p. 149).
Furthermore, such a good balance is highly dependent on an

unstable environment (through competition in particular) and
on the internal evolution of the organization itself (growth,
change of personnel).

In his chapter on authority, Barnard recognized that incentive
contracts do not rule all the activities within an organization.
The distribution of authority along communication channels is
also necessary to achieve coordination and promote
cooperation.
In modern language, the incompleteness of contracts and the
bounded rationality of members in the organization require
that some leaders be given authority to make decisions in
circumstances not addressed specifically by the contracts, and
the need to satisfy ex post participation constraints of
members who accept non-contractual orders:
A person can and will accept a communication as authoritative
only when . . . at the time of his decision, he believes it to be
compatible with his personal interest as a whole.
....Barnard (1938, p. 165).
Barnards influence on later economic work
The chapter on authority directly inspired Simons (1951)

formal theory of the employment relationship.
Williamson (1975) followed Barnard and Simon to develop his
transaction costs theory for the case of symmetric but
non-verifiable information between two parties.
Moral Hazard
Moral hazard: Actions taken by/output of some agents are

not observable and/or verifiable:
Ex ante: Say firms cannot observe whether a worker is working
or shirking, but the output is contractible.
Ex post: The output, while observable, is not verifiable.
We begin by arguing that in either case there may be market

failure.
Market failure under moral hazard: Ex ante
Consider a risk neutral worker, working under a risk neutral

manager.
The worker can either work, or shirk.
In case the worker works, the output is 100 with probability
3/4, and zero with probability 1/4.
In case the worker shirks, the output is 100 with probability
1/2. The disutility from working is 20.
Clearly, the efficient outcome is that the worker works since
100 3/4 100/2 + 20 75 70.
Market failure under moral hazard: Ex ante

Limited liability: Consider contracts where the workers wage
must be non-negative.
Consider a contract whereby the worker gets w in case of
success, and zero otherwise. Given that we want the worker to
work, putting the wage in case of failure to zero is the best
one can do.
The incentive contract ensuring that the worker works is that
w
3w
+ 20,
4
2
so that w 80.
However, given inducing work needs such a high wage cost,
the manager will prefer not to induce work.
Exercise: Can efficiency be attained if the limited liability
constraint is not imposed?
Ex ante moral hazard: Applications to Credit market

Consider a borrower who has access to two projects, good and
bad - the bank does not know which project is which.
Both projects require a start up capital of 1.
The good project yields a verifiable return of H, whereas the
bad project yields a private benefit of b.
H 1 > 0 > b 1: So that the efficient outcome is that the
good project should be implemented.
Let the rate of interest be exogenously given by the
government, with
b > H r.
Thus the borrower always has an incentive to opt for the bad
project - Ex ante moral hazard.
First suppose there is no monitoring. Then, in case of lending,
there will be default and the bank will never lend - inefficient!
Ex ante moral hazard: Credit market

Let us extend the model by allowing for monitoring by the
bank. Suppose the bank can monitor the borrower.
By incurring a cost of m2 /2, > 1, suppose the bank gets
to know the identity of the projects with probability m, when
it can ensure that the good project is implemented.
The game form:
1
Stage 1: The bank decides whether to lend 1 dollar to an

individual.
Stage 2: The bank decides on its level of monitoring. If the
bank succeeds, it uses it to make the borrower invest in the
good project.
Stage 3: Then the borrower invests in her project. If she
invests in the good project, then the bank obtains r and she
obtains H r . Otherwise, the bank obtains nothing and the
borrower gets to keep b.

Solve by backwards induction (sub game perfect Nash
equilibrium (SPNE)).
Thus the banks problem is
max mr m2 /2.
m
Solving
r
.
Thus even with monitoring, the bank will not lend whenever
the banks expected payoff from monitoring is negative
m =
r2
< 1.
2
Even if its positive, the monitoring costs have to be incurred.
Grameen I
Average group size is 5.

Dinajpur Rural Service) in Bangladesh (Zeller et. al. (1996,
IFPRI)).
Let us re-interpret this problem in the context of

micro-finance. Would group-lending with joint liability lending
(JLL) help?
Here the idea has been that in a group, the borrowers would
monitor each other because of JLL. Further, living in the same
community, the borrowers can do so for a lower cost.
Let the monitoring cost of a borrower be m2 /2, which yields
the identity of the other borrowers project with probability m.
Assumption:
H < 2r .
Thus in case there is JLL, a borrower is supposed to repay the
whole of H to the bank.

The game form:
1
Stage 1: The bank decides whether to lend 2 dollars to the

group, which is equally divided. There is JLL, so that one
borrower will have to repay for her partner (if the bank can
make her).
Stage 2: The borrowers simultaneously decide on their level of
monitoring. If a borrower succeeds, she passes this information
on to the bank who uses it to make the other borrower invest
in the good project. Information is hard, and there is no
bargaining between the agents.
Stage 3: Then the borrowers invest. If both invest in good
projects, then the bank obtains r each as interest. If one
invests in the good, and the other in the bad project, then the
bank gets the whole of H from the good borrower. Otherwise,
the bank obtains nothing. A borrower investing in the bad
project always gets to keep b.
SPNE: Backwards induction.

Then Bi s payoff, given that Bj s monitoring level is mj , is

i = mi mj (H r ) + mi (1 mj )b + (1 mi )(1 mj )b mi2 /2.
Thus, the FOC is
mi = mj (H r ).
Thus the equilibrium is
m1 = m2 = 0.
Thus, borrowers do not monitor one another, even though
monitoring is cheaper for them - Simultaneous lending does
not work.

Intuition: The intuition follows from the fact that monitoring
levels are strategic complements, i.e
2 i
= H r > 0.
mi mj
Thus borrower 1s incentive to monitor is higher, if the other
borrower is monitoring at a high level. And vice versa. Thus,
if the other borrower is monitoring at a low level, then her
incentive to monitor is also low. Hence the result!
This creates a scope for sequential lending. Suppose that
borrowers are given loans sequentially. Now the borrower who
obtains the loan later, will have a greater incentive to
monitor, otherwise she does not even get the loan.
- Roy Chowdhury, 2005.
Ex post moral hazard: Micro-finance

We shall provide a framework, based on ex post moral hazard,
that can explain both frequent repayment, as well as
sequential lending.
Conceptual problem in formulating frequent repayment.
Consider an individual who has to repay a certain amount.
Clearly her incentive to repay higher if she has to repay 1000,
than if she has to repay 2000.
Question: Let = 1. Suppose the individual has to repay 2000
in two installments, 1000 and 1000, would incentives to repay
increase?
Not clear. It increases at the last installment, but what about
the first installment?
Formalization based on three key ideas:

Project returns modeled as a stream of income over a period
of time.
Dynamic limited liability.
Ex post moral hazard problem, can hide income.
Ex post moral hazard: Micro-finance: A Framework

Framework populated by an MFI, and a set of potential
borrowers, all risk neutral.
Each borrower has a project requiring a start-up capital of k.
Returns of Ki , at ti , where time is discrete and finite (time is
discrete). No discounting.
Project returns are observed by the lender.
The opportunity cost of Rs. 1 is Rs. 1.
Ex Post Moral hazard - The borrower can default, when the
MFI liquidates the project. The borrower obtains a one time
default payoff of di if she defaults at ti .
Dynamic limited liability - Aggregate repayment asked for
cannot exceed the aggregate income till that point.
Individual lending: Frequent Repayment
Example 1:
Setup cost of 1700.
Three periods: t = 1, 2, 3.
Return stream: 1500, 1500, 1500.
Default payoff: 2250, 1500, 750 - Decreasing over time.
One shot repayment does not work:

Given limited liability, payment can only be asked at t = 2.
At t = 2, default payoff is 1500, whereas payoff from
repayment is only 3000-1700=1300!
However consider an immediate and frequent repayment (IFR)

scheme of (1500, 200).
At t = 1, default payoff 2250, repayment payoff is 2800!
At t = 2, default payoff is 1500, repayment payoff is 2800!
Individual lending: Frequent Repayment
Proposition (1)
In Example 1, one-shot repayment necessarily leads to default
under IL, but IFR ensures repayment.
Remark:
The payment stream asks for all of the income at t = 1. Can
we reach more realistic conclusions?
We can if the MFI say, maximizes borrower utility, and either
there is discounting, i.e. the discount factor 0 < < 1, or
the borrower is risk averse, i.e. concave utility function.
Group lending
Example 2: Setup cost of 3001. t = 1, 2, 3, 4. Payoff stream

1500, 1500, 1500, 1500.
Default payoff: d1 = 3000, d2 = 3000, d3 = 1500 and
d4 = 750.
Individual lending, even with IFR, does not work:
Consider t = 1. Default payoff is 3000, whereas the payment
from repayment is 1500 4 3001 = 2999.
Question. Can group-lending, in particular sequential lending,

do better?
Group lending
We will consider group lending in the presence of dynamic

joint liability:
(i) If some borrowers default, then all existing projects are
dissolved, and
(ii) group members who are yet to receive their loans are denied all
future loans.
Group lending: Social Capital

One important objective is to study the complex role played
by social capital in ensuring repayment - the empirical
evidence being quite mixed.
Social capital:
(i) Positive aspects - social ties may help sustain sanctions against
defaulting borrowers.
Besley and Coate (1993) - a defaulting member may be
sanctioned by other borrowers, who are adversely affected - i.e.
borrowers who are either yet to get a loan, or those who have
already received a loan and have repaid it substantially.
(ii) Negative aspects - can also encourage default in case close
social ties in small village communities make social sanctions
difficult to impose. Seems natural to allow for in a context
where borrowers may communicate with one another on a
daily basis.
Group lending: Collusion
Which effect dominates depends on whether collusion is

limited, or it is complete:
Limited Collusion: Collusion takes the limited form of not
imposing the social sanctions when all borrowers gain from
such a deviation.
Complete Collusion: Borrowers can make transfers to one
another, and thus default/repayment decisions are based on
maximizing aggregate group payoff. Clearly, social sanctions
have no bite in this context.
Would group-lending work given that there are no sanctions?
Group lending: Limited Collusion
Example 2 Continued. Recall that setup costs are 3001,

payoff stream 1500, 1500,1500,1500. Default stream is 3000,
3000, 1500, 750.
Let the social sanctions be 20.
Recall that IFR does not work.
Simultaneous lending also does not work!
We claim the following sequential-lending scheme works:
Consider a two member group. Borrower 1 gets a loan at
t = 1, borrower 2 gets a loan at t = 3 (provided borrower 1
has repaid till t = 2).
Limited Collusion: Example 2 continued

t = 1:
If B1 repays, payoff is 6000 3001 = 2999.
If B1 defaults, payoff is 3000 - 20 (social sanctions from
borrower 2), i.e. 2980.
t = 2: Repayment payoff for B1 is 4500 1501 = 2999,

whereas default payoff 3000 20 = 2980.
t = 3:
Borrower 1 has already repaid most of her loans, except $1,
and will not like to either default, or be liquidated. So she will
impose sanctions on borrower 2 in case of default.
Thus borrower 2s payoff from repayment is 2999, and that
from defaulting is 2980.
t = 4: B1 will still impose sanctions in case of default. Thus

payoff from defaulting for B2 is 2980. Repayment payoff is
2999.
t = 5: Borrower 2 herself does not want to deviate.
Limited collusion
Proposition (2)
In Example 2, IL even with IFR leads to default. As do
simultaneous lending. However, sequential lending with limited
collusion and IFR ensures repayment.
Limited collusion
Remarks:
(i) Needs IFR for the argument - with one-shot repayment,
repayment can only be asked at t = 3 from B1 . Her payoff
from payment is 3000 3001 < 0, by defaulting she gets
1500 20 = 1480, so will default.
(ii) Also need sequential lending, with simultaneous lending there
would have been coordinated default at t = 1. Thus provides a
theory of interaction between sequential lending, and IFR.
(iii) Importance of timing:
If B2 gets it at t = 2, then there will still be coordinated
default.
If B2 gets it at t = 4, then there would be no check on her at
t = 5, when she defaults.
(iv) Say, the social sanctions are 0.75. Would need a larger 4
member group, with 2 members at every stage.
Complete Collusion
Example 2 continued. With complete collusion there are no
social sanctions, even so we argue that the same 2 member
group, with the second loan at t = 3, works.
t = 1: Group payoff from repayment: 2999 2. Group default
payoff: 3000.
t = 2: Group payoff from repayment: 2999 2. Group default
payoff: 3000.
t = 3: Group payoff from repayment 2999 2. Group
payment from default 3000 + 1500.
t = 4: Group payoff from repayment 1500 + 2999. Group
payoff from default 3000 + 750.
t = 5: Only B2 . Repayment 2999, default 1500.
t = 6: Only B2 . No further repayment.
Complete Collusion
Proposition (3)
In Example 2, sequential lending with complete collusion and IFR
ensures repayment.
Thus group lending does better, even in the presence of
complete collusion when there are no social sanctions.
This is because it takes group payoffs into account, while
deciding on default.
- Chowdhury, Roy Chowdhury, Sengupta, 2013.
Hume, Wicksell, Groves: The Free-Rider Problem
Moral hazard in economic thought!

Hume (1740) may be credited with writing the first explicit
statement of the free-rider problem:
Two neighbours may agree to drain a meadow, which they
possess in common; because it is easy for them to know each
others mind; and each must perceive, that the immediate
consequence of his failing in his part, is the abandoning the
whole project. But it is very difficult, and indeed impossible,
that a thousand persons shoud agree in any such action; it
being difficult for them to concert so complicated a design,
and still more difficult for them to execute it; while each seeks
a pretext to free himself of the trouble and expence, and woud
lay the whole burden on others.
....Hume (1740, p. 538).
Hume, Wicksell, Groves: The Free-Rider Problem
At the end of the nineteenth century, a lively debate over

public finance, in particular taxation, took place among
European economists like Mazzola, Pantaleoni, and de Viti de
Marco in Italy, and Sax in Austria.
Wicksell (1896), in his discussion of Mazzolas contribution:
If the individual is to spend his money for private and public
uses so that his satisfaction is maximized he will obviously pay
nothing whatsovever for public purposes. . . . Whether he
pays much or little will affect the scope of public service so
slightly, that for all practical purposes, he himself will not
notice it at all. Of course, if everyone were to do the same, the
State will soon cease to function.
......Wicksell (1896, p. 81)
References
References:
1
2
3
4
Ghatak, M., Screening by the Company You Keep, Economic

Journal (2000).
Ghatak, review paper in JDE.
Aghion and Morduch, Micro-finance.
J.J. Laffont and D. Mortimort, The Theory of Incentives: The
Principal-Agent Model, 2002, PUP. Chapter 1.
Micro-finance competition: motivated micro-lenders,
double-dipping and default (PRC with Brishti Guha). 2013,
Journal of Development Economics.
Group-lending: Sequential Financing, Lender Monitoring and
Joint Liability (PRC). Journal of Development Economics 77,
415-439, 2005.
Group-lending with Sequential Financing, Contingent Renewal
and Social Capital (PRC), Journal of Development Economics
84, 487-507, 2007.
Gradual repayment with sequential financing in micro-finance
(PRC with S. Chowdhury, K. Sengupta), 2013:
http://www.isid.ac.in/ pu/conference/dec 10 conf/Papers/PrabalRoyChowdhury.pdf

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Information Economics &amp; Microfinance

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Information Economics and Micro-finance

Prabal Roy Chowdhury

Prabal Roy Chowdhury

Information Economics and Micro-finance

Information Economics: Introduction

Moral Hazard: Agents cannot verify the action taken by

Prabal Roy Chowdhury

Information Economics and Micro-finance

Motivation: Why study information? Central to an

Prabal Roy Chowdhury

Information Economics and Micro-finance

Why? We shall argue that an explanation for all these

Information Economics and Micro-finance

Prabal Roy Chowdhury

Information Economics and Micro-finance

Market failure: Akerlofs market for lemons (bad quality used

Efficient outcome: All peaches are traded.

Prabal Roy Chowdhury

Information Economics and Micro-finance

Market for lemons: No asymmetric information

First consider a benchmark case where the buyer knows

Prabal Roy Chowdhury

Information Economics and Micro-finance

Market for lemons: Asymmetric information

Intuition: Uniformed agents value the informed agents at the

Information Economics and Micro-finance

Market for lemons: Applications

Credit market: Consider a borrower who has a project

There is a competitive banking sector, with an opportunity

Prabal Roy Chowdhury

Information Economics and Micro-finance

Market for lemons: Credit market

No pooling equilibrium where both types of borrowers obtain

But r 4, so that the good borrower does not want a loan.

Information Economics and Micro-finance

Market for lemons: Possible resolutions

Consider the lemons market example discussed above.

Prabal Roy Chowdhury

Information Economics and Micro-finance

Market for lemons: Advertising

Information Economics and Micro-finance

Market for lemons: Advertising

Consider a multi-stage game:

Consider a separating PBE, say (p1 , p2 ). In such an

Prabal Roy Chowdhury

Information Economics and Micro-finance

Market for lemons: Advertising

Can there be a separating equilibrium with the high quality

Information Economics and Micro-finance

Prabal Roy Chowdhury

Information Economics and Micro-finance

Prabal Roy Chowdhury

Information Economics and Micro-finance

Screening: Micro-finance: Individual lending

We first argue that no separating equilibrium with the good

Information Economics and Micro-finance

Screening: Micro-finance: Group lending

Suppose the MFI instead only offers loans to 2-member

= 2G u(R r ) + G (1 G )u(R r j) f ,(1)

= 2B u(R r ) + B (1 B )u(R r j) f .(2)

Prabal Roy Chowdhury

Information Economics and Micro-finance

Screening: Micro-finance: Group lending

2 BG : Then the relevant payoffs of the borrowers are:

Information Economics & Microfinance

Information Economics & Microfinance