Lecture 2

Question 1

Diminishing Marginal Returns to Capital (MRTC)

Answer 1

• One of the first lessons in introductory economics.
• Enterprises with relatively little capital should be able to earn higher returns to their investments than enterprises with a great deal of capital

Diminishing MRTC indicates that returns to a woman selling flowers in a market stall should be higher than General Motors, IBM or Tata Group.

• Investments should flow from rich to poor countries, not to flow from poor to rich countries.

This does not work - of course: (given that investors are basically prudent (Act with thought of the future) and self-interested).

Question 2

Why are investors wary of lending to poor communities

Answer 2

Risk

• Investing in countries like India, Kenya or Bolivia is much riskier.
• Local conditions are unstable, but global investors lack the time and resources to keep them up-to-date.
• Lending to flower-sellers is, again, riskier for the same reasons than lending to large, regulated corporations

The important factors are

• The bank’s incomplete information about poor borrowers, and
• The poor borrowers’ lack of collateral to offer as security to banks.
• Banks don’t know who is who – raise interest rates for everyone.

Question 3

Moral Hazard

Answer 3

In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk.

Handling many small transactions is far more expensive than servicing one large transaction for a richer borrower.

Another potential solution would be available if borrowers had marketable assets to offer as collateral.

So, new ways of delivering loans are needed precisely because borrowers are too poor to have marketable assets.

Question 4

High interest rates in low-income communities

Answer 4

The rates may reflect how costly it is for moneylenders to
* Acquire capital, * Transact business, * Monitor clients, and * Accommodate risk.

• When default rates are high, moneylenders may have to charge a lot merely to stay afloat

Question 5

Absence of formal credit institutions

Answer 5

• The lender may have little, if any, reliable information about the quality of the borrower.
• Second, once the loan has been granted
• The lender does not entirely know how the borrower will use the resources.
• Third, once investment returns have been realized
• The lender may not be able to verify the magnitude of the returns

Question 6

Limited Liability

Answer 6

• The poor have very to little to put as a guarantee while borrowing.
• Formal titles to land and clear property rights over assets.
• Seizing assets: runs against the anti-poverty missions of many microfinance banks and also may lead to stiff community opposition.

Question 7

Ex Ante Moral Hazard

Answer 7

Unobservable actions or efforts are taken by borrowers after loan disbursement * But before project returns are realized.

Question 8

Ex Post Moral Hazard

Answer 8

This is also referred to as the “enforcement problem.”

• The term ex post refers to difficulties that emerge after the loan is made and the borrower has invested.
• Even if those steps proceed well, the borrower may decide to “take the money and run” once project returns are realized.

Question 9

Group Liability Lending

Answer 9

• Make everyone in a group (of around 5 borrowers) jointly liable for repaying each of the loans disbursed to group members.
• If the group does not repay each loan,
• Other members in the group will be held liable, and * No-one in the group gets subsequent loans.

Helps solve the asymmetric information problems

Reduces moral hazard, because microfinance * Creates incentives for within-group monitoring and enforcement

Disadvantages

Increases tension among members * Leads to voluntary dropouts, and * Can harm social capital among members * More costly for clients who are good risks, because they are more likely to pay off loans of their peers * Bad clients can “free ride” off good ones