In Simple Words
Imagine an insurance company offering a policy covering risky driving at a higher price. If only the riskiest drivers sign up (adverse selection) and those drivers start driving even faster because they feel protected (moral hazard), the insurance company suffers huge losses. To avoid going bankrupt, the company cancels the risky policy entirely and only offers restrictive plans, even though good drivers would have benefited from better coverage.
Research question
Despite high client demand and willingness to pay higher interest rates for flexible grace period loans, microfinance institutions rarely offer them. Asymmetric information—specifically adverse selection and moral hazard—makes flexible contract pricing unsustainable for lenders without external subsidies.
Participants
Model calibration based on trial repayment data from 845 clients and survey willingness-to-pay data from 769 study participants and 13 non-client candidates in Kolkata, India.
Study Design
Empirical profit calibration model of microfinance institutions testing zero-profit separating equilibria under varying interest rates, adverse selection, and moral hazard elasticities.
Results
Microfinance institutions require charging a 38% APR (up from 17.5% baseline) to break even under adverse selection. No zero-profit separating equilibrium exists if moral hazard elasticity exceeds 0.46, leaving regular rigid contracts as constrained efficient for lenders.
Takeaway
Provide targeted policy subsidies (estimated at Rs 150 per client) to microfinance institutions to offset asymmetric information costs and enable flexible debt offerings.