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Optimal Collective Contract Without Peer Monitoring

Author

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  • Arup Daripa

    (Department of Economics, Mathematics & Statistics, Birkbeck)

Abstract
If entrepreneurs have private information about factors influencing the outcome of an investment, individual lending is inefficient. The literature emphasizes improvements through non-market organizations that harness local information through peer monitoring. I investigate the complementary question of designing a credit mechanism when local information is limited, disabling peer monitoring. I show that a pooling mechanism that does not rely on peer monitoring can implement a market for rights-to-borrow, restoring efficiency. The mechanism achieves a strict Pareto improvement - providing incentive for each type of agent to join. Further, even though the mechanism involves pooling - and consequent implicit transfers from better types to worse types - it has a "collective" feature that makes it immune to the Rothschild-Stiglitz cream-skimming problem under competing contracts. Finally, the presence of even weak local information implies that the mechanism cannot be successfully used by formal lenders. Thus a local credit institution can emerge as an optimal response to the informational environment even without peer monitoring. I apply the results to contracts offered by rural moneylenders in developing countries.

Suggested Citation

  • Arup Daripa, 2005. "Optimal Collective Contract Without Peer Monitoring," Birkbeck Working Papers in Economics and Finance 0519, Birkbeck, Department of Economics, Mathematics & Statistics.
  • Handle: RePEc:bbk:bbkefp:0519
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    File URL: https://eprints.bbk.ac.uk/id/eprint/26973
    File Function: First version, 2005
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    Keywords

    Informal Credit; Market for Rights-To-Borrow; Participation Incentives; Competition in Contracts and Cream Skimming; Local Information; Rural Moneylending;
    All these keywords.

    JEL classification:

    • O12 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Microeconomic Analyses of Economic Development
    • D78 - Microeconomics - - Analysis of Collective Decision-Making - - - Positive Analysis of Policy Formulation and Implementation
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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