An Economic Framework for Understanding Micro-Credit in Developing Countries

To reduce vulnerability and food insecurity this paper investigates the economics of micro-credit. We provide a model that shows how a micro-credit market based on trust can co-exist with a commercial collateral-based market. This model is developed in detail and certain propositions are supported using dominant strategies in a trust-honour game based on the prisoners dilemma. From a policy point of view the theoretical model indicates that trust-based lending, coupled with certain incentives, can go far in supporting growth opportunities in developing countries. It is argued that development policy should be flexible enough to permit trust-based micro-lending to the poor, regardless of how counter-intuitive this must appear to the conventional wisdom.