Dual Credit Markets, Expected Output and Welfare
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Abstract
Differences in monitoring cost is a commonly observed feature of the credit markets of LDCs. Typically the informal lender (IL) has a lower ex-post monitoring cost compared to the formal lender (FL). This paper develops a model of credit market with costly state verification in which financial dualism is defined in terms of this difference in monitoring cost. It analyses the welfare implications of formal and informal credit in terms of their effect on interest rates, expected output and total surplus under different contract forms. We conclude that informal loans induce low effort, result in lower expected output and may also result in lower total surplus. This paper thus contends the argument that higher monitoring cost of the FL is necessarily inefficient. Interestingly, it also follows from the analysis that informal interest-rate is higher than the formal interest-rate in spite of the lower monitoring cost faced by the IL.
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