Theory of imperfect competition in rural credit markets

Some evidence suggests that they have not even reduced the rates that moneylenders charge to the small and landless farmers who continue to rely on them. This paper offers a theoretical model within which this puzzle can be explained. The model is motivated by field studies of rural areas of developing countries in Asia that have documented the importance of credit interlinked with trade as well as the advantages that the trader-moneylender has in enforcing loan contracts. In the model presented in this paper, the ability to enforce loan contracts provides a return to becoming a trader that induces entry into that activity by those who have funds. Government subsidies that expand bank credit to large farms may induce further entry by large farms into the trader-moneylending sector. The induced entry leads to higher excess capacity among trader-moneylenders and higher unit costs. Rather than being passed on to the small farms and tenancy, the credit subsidy may be wholly or partly absorbed in the reduced efficiency of the monopolistically competitive moneylending- trading sector. (Author abstract)