Microfinance: Is it a trap?

Jeroen writes*

Microfinance (MF) was invented in the 1970’s as a means of uplifting the poor. Since then, it has been widely pursued by NGO’s and even international organizations such as the World Bank. Its inventor, Muhammad Yunus, even earned a Nobel Prize for it. But does microfinance really deliver on its promise? Or are there adverse effects that outweigh its benefits? This post will examine microfinance’s effect on entrepreneurs’ prosperity. In the blog’s one-handed tradition, I will be fairly biased, in that I zoom in on a drawback of microfinance: displacement effects.

Displacement refers to when microloan entrepreneurs crowd other business out of the market, as Milford Batesman argues in his book Why Doesn’t Microfinance Work? Displacement occurs when microfinance entrepreneurs compete with other small businesses over limited jobs for self-employed workers in developing nations. Exceptions to this rule exist, such as in newly formed Bosnia-Herzegovina, where many unemployed were highly educated and could therefore perform a wider variety of tasks. However, in many developing countries, such as Bangladesh, MF workers stick to jobs like farming, craftmanship or keeping a small shop.

This competition has two adverse effects for workers in the sector. First, it pushes prices down. For example, more barber shops open, but the demand for haircuts hasn’t necessarily changed. Thus, as illustrated in the figure below, the supply curve moves outward and prices drop. Second, the new barber shops steal away customers from the old barber shops. Even though the quantity demanded of haircuts rises slightly, that quantity has to be shared among more workers. The result of both these mechanisms, is profits decrease, as Honohan discusses.

Price falls as microloan entrepeneurs enter the market. Source: Batesman

The shrinking of profits due to displacement has two implications. First, it is a key limitation to many studies examining MF’s economic benefits, as Honohan points out. Second, it means that capital accumulation for the poor becomes much harder.  Microfinance advocates themselves admit that capital accumulation is key to poverty alleviation. They use anecdotes of entrepreneurs that put their profits into their children’s education, or the expansion of their business. Displacement undermines this ability.

The story of rent reduction seems to be one of collective-action failure. Microfinance benefits individuals who take a microloan and start a business. However, it hurts all workers in that business by pushing their profits down.

One might object to the displacement argument, that microloans can also be used to make investments that boost productivity, thereby boosting the profits made by businesses. Honohan provides an example of this: a trader buying a bike, making him faster (and more efficient) than other traders on foot. Here, the bikeless trader is outcompeted and replaced by a more efficient service (i.e. creative destruction). There is no literature about how these productivity loans compare to the loss of profits for entrepreneurs. However, I would argue these examples are less frequent. Micro-finance loans tend very small, typically around $27. This is often enough to buy the basic supplies for a business, but not to make additional investments. Thus, entrepeneurs might use microcredit to improve on the margins (i.e. buying a bike), but it is uncertain whether this will create enough value to compensate for profits lost due to displacement.

Bottom line: Microfinance can reduce entrepeneurial profits and thus slow the poor’s rise out of poverty. From this perspective, Microfinance looks more like a trap than an escape.

* Please help my Growth & Development Economics students by commenting on unclear analysis, alternative perspectives, better data sources, etc. (Or you can just say something nice 🙂

Author: David Zetland

I'm a political-economist from California who now lives in Amsterdam.

6 thoughts on “Microfinance: Is it a trap?”

  1. First of all, thank you for a very interesting article. I can kind of see how displacement effects could harm the existing businesses when new ones enter the smaller-scale markets (with too much competition), although that is not the only complication of MF. Certainly, microfinance did not live up to its initial expectations. So how can we make it better? I think it would be interesting to look at how microfinance can be more effective/ the ways to improve it (although you don’t have to include that to your research). Give this article a read that talks about how small “tweaks” in the system could potentially benefit more people. [https://hbr.org/2016/10/making-microfinance-more-effective#comment-section].

    1. Thank you for your kind words Yeseong! I had a look at your link. All the solutions they discuss are definitely good, but I don’t think they directly address the issue that I highlighted in my post. Most are directed at making sure the entrepeneur himself is able to get a loan more easily and pay it back. However, displacement is even relevant if MF is executed perfectly (i.e. only given to viable businesses and 100% repayment rate). But if you have a counterpoint/something I missed, I’d love to hear it of course! 🙂

  2. Interesting topic and a well-written post! I suppose that the displacement effect depends on how the microloans are invested (and to whom the loans are awarded). You write that the loans are typically around $27, I doubt that that financing is enough to help someone open a barbershop in most countries. But suppose that you own a tailor shop and sew with needle and thread. If you had a sewing machine, you could make more clothes, sell them at lower prices, but still get more profit. In this case you win, because you earn more, and your customers win because they have to pay less. The losers here are your competitors, but this situation is different to the one that you paint. In this case there is no over-supply, but rather a form of ‘creative destruction’, where the economy as a whole does gain. So I think the key is in extending these loans in a smart way (I’d say that the bank doesn’t stand to gain from lending to someone who’s gonna open yet another barbershop in a satisfied market) but I’m sure that your paper is gonna show us that this is in fact proving to be much harder than it sounds.

    1. Thanks for your comment, Willem! Indeed, your point touches on the weakest part of my argument! I tried to address this in my last paragraph, but have of course not done so perfectly. Interestingly, there is a lot of information on macroeconomic effects/RCT’s looking into the effects, but a lot less discussion on what EXACTLY microfinance should be used for. I completely agree that the trick to microfinance ‘work’ is focussing on creative destruction, rather than saturating the market! Hopefully this addresses your comment.

  3. As Willem has said already, it seems that the task ahead is for those distributing micro-loans to assess the sustainability of the business it invests in. It seems that ideally micro-loans would be invested in places where there is an under-supply of desired goods. I wonder if a shift in focus from ‘helping people’ to making profit on the investments would be beneficial? As we have seen with many development interventions, the focus on the desire to alleviate poverty might not do much good. But this is still the framing of micro-loans as far as I know?

    1. Thank you, Jade! A lot of what I’ve said to Willem’s response also applies to your comment, so I won’t repeat. You’re completely right that a lot of the ‘rhethoric’ of MF is surrounding poverty alleviation of the entrepeneur, rather than uplifting the region as a whole. This is a problem, because it diverts attention from some of MF’s biggest flaws.

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