Microfinance and Missing Markets

The existing theoretical analysis of microfinance focuses on the nature of the loan contract such as group liability. We draw attention to the role of missing or imperfect labor market in understanding some of the important `second generation' debates in microfinance. Our analysis helps explain a number puzzles in microfinance such as (i) high repayment rates with high interest rates, (ii) difficulties in scaling up projects, (iii) conflicting views about interest rate elasticity of demand for microcredit. The analysis implies that while microcredit can play a vital role when labor markets are underdeveloped, demand for such loans may progressively decline as markets develop.