Microfinance, Micro-entrepreneurship and Misallocation

Microfinance has been shown to have limited average impacts on incomes and profits in developing countries. In addition to credit constraints, the poor also face labor market frictions which may lead them to make constrained occupational choices and investments in businesses. Some entrepreneurs start a business due to lack of alternatives (“involuntary entrepreneurs”) while others do so by choice (“voluntary entrepreneurs”). These two groups of entrepreneurs may respond very differently to microfinance but are difficult to distinguish empirically. We structurally estimate a heterogeneous agent model of occupational choices based on Karaivanov and Yindok (2022). We use data from two randomized experiments in microfinance to test the predictions of the model and differentiate voluntary from involuntary entrepreneurs. We find that the majority of entrepreneurs are involuntary who earn significantly lower income than voluntary ones. This misallocation at the extensive margin translates into significant misallocation in capital and labor investments in businesses. Microfinance leads to a positive impact on incomes for both types of entrepreneurs and wage workers by increasing credit and labor investments, but reduces the overall entrepreneurship rate. Income gains are driven by voluntary entrepreneurs and those with lower wealth levels. Simulating policy counterfactuals provides evidence that relaxing credit constraints lead to lower impacts than relaxing labor market constraints and thus, labor market policies may deserve relatively more consideration.