Microfinance and Missing Markets

The existing theoretical analysis of microfinance focuses on the nature of the loan contracts that mitigates the pervasive problems of moral hazard and adverse selection in the absence of physical collateral. We depart from the existing literature and draw attention to the role of missing or imperfect labor market in understanding some of the important 'second generation' puzzles and debates in the microfinance movement. Our analysis shows that a focus on the labor market helps explain a number puzzling aspects of microfinance in developing countries like (i) credit-worthiness of poor women borrowers facing very high interest rates, (ii) the microentrepreneurs unwillingness or inability to scale up their economic activity, (iii) conflicting views about interest rate elasticity of demand for microcredit (i.e., a zero elasticity according to practitioners, but a significant negative elasticity according to econometric estimate). The analysis has important implications for the appropriate role of microcredit in the long-run development of a developing economy