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.
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 🙂