framework for inter-temporal choice decisions made by lenders and borrowers in the
microfinance markets and determination of interest rates by lenders, leading to the theory
of credit rationing.
Economic Framework
The microfinance industry operates in the financial markets, which are economic in
nature but affected by complexities of risk and timing. In this section, an exposition of
the basic economic logic behind financing decisions is provided. Subsequently, the key
principles of the more advanced theories of credit provision will be described. The issues
of incomplete information and incentives will then be linked specifically to the conditions
of microfinance.
Financing decisions arise because individuals can choose to maximize their utility
over multiple periods of time, in addition to choosing between different goods based on
the prices of the goods relative to the contribution of the goods to the individual’s utility.
Consider a simple two-period conceptual framework (Nicholson 2005). The consumer
chooses between consumption in the present or consumption in the future, subject to a
constraint that reflects current income. The consumer has the option of investing the
portion of income not spent on present consumption and earning a rate of return.
Successful investment or savings enable future consumption to be greater than would
otherwise have been possible.
The two-period consumption choice can be represented graphically, as depicted in
figure 1. Present consumption is represented by C0, while future consumption is
represented by Ci. The individual’s budget constraint is represented by
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