Abstract
Microfinance contracts have enormous economic and welfare significance. We study, theoretically and empirically, the problem of effort choice under individual liability (IL) and joint liability (JL) contracts when loan repayments are made either privately, or publicly in front of one’s social group. Our theoretical model identifies guilt from letting down the expectations of partners in a JL contract, and shame from falling short of normatively inadequate effort, under public repayment of loans, as the main psychological drivers of effort choice. Evidence from our lab-in-the-field experiment in Pakistan reveals large treatment effects and confirms the central roles of guilt and shame. Under private repayment, a JL contract increases effort by almost 100% relative to an IL contract. Under public repayment, effort levels are comparable under IL and JL contracts, which is consistent with recent empirical results. This indicates that shame-aversion plays a more important role as compared to guilt-aversion. Under IL, repayment in public relative to private repayment increases effort by 60%, confirming our shame-aversion hypothesis. Under JL, a comparison of private and public repayment shows that shame trumps guilt in explaining effort choices of borrowers.
Highlights
Microfinance is a hugely significant economic activity; the 2016 data from BNP PARIBAS reveals 123 million customers worldwide who receive 102 billion US dollars worth of loans
We find a strong causal effect of the signals of the partner’s first-order beliefs, θi, on effort in joint liability without public repayment (JLI) ; this highlights the role of guilt-aversion or internal peer pressure
We find that the role of internal peer pressure in JLI subsides in the Joint liability with public repayment (JLP) treatment due to the role of external pressure that stems from a desire to follow the effort norm
Summary
Microfinance is a hugely significant economic activity; the 2016 data from BNP PARIBAS reveals 123 million customers worldwide who receive 102 billion US dollars worth of loans. Microfinance institutions (MFIs) offer relatively small, short-term, risky loans to borrowers who lack collateral to borrow from the conventional banking sector. Despite impressive advances in the theoretical and empirical literature, several outstanding issues remain unresolved (Banerjee, 2013). Borrowers typically engage in risky projects, but the risk can be mitigated by greater effort that improves the probability of success of the projects. The traditional arguments rely on peer pressure and social capital induced by the joint liability feature of microfinance contracts to explain higher effort and repayment rates (Stiglitz, 1990; Banerjee, Besley, and Guinnane, 1994; Besley and Coate, 1995). Precise and empirically testable definitions of peer pressure or social capital remain elusive. This paper studies, theoretically and experimentally, the factors that underpin these concepts and explains effort choices and repayment rates under different microfinance contracts
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