The Law of Diminishing Marginal Returns

By Dave Weber, KF16 Cambodia

The Kiva Stories from the Field blog is nearing 1,000,000 views so the KF16 and remaining KF15 teams are jockeying for the post which receives the milestone view. For most blog visitors, the idea of reading a blog post about an economic principle is about as appealing as polishing off a platter of pig snout, ears, stomach, tongue, and congealed blood, which I participated in yesterday here at CREDIT.

I promise that my blog post will be interesting and educational. Blogging geniuses suggest that good blog posts should begin with quotes and I’ve already missed the mark there, so here they are after buried in the post, but in bulleted form to increase readability:

• “I used to think microloans helped families get out of poverty, but then I heard about 40% interest rates.” – Ariel from the Caribbean Sea
• “There’s no way I could pay back a jeep loan or a credit card at a 40% interest rate, so how could a poor farmer in Uganda be expected to do so?” – Pumba from the Serengeti
• “Looking at these interest rates, MFIs must be profit-centers with no more interest in the well-being of their clients than a corrupt moneylender.” – Jafar from Persia

Yes, microloan interest rates are high by Western standards. Many people, myself included, have initial reactions similar to the mock quotes above. This blog post will attempt to justify these interest rates as both (1) necessary and (2) acceptable.

(1) First of all, high microloan interest rates are a necessity. I am far from the first person to make this claim and recommend that you view these linked articles to learn more about the justification behind seemingly high microloan interest rates. The variable costs of a loan do not vary much with the size of a loan. If we asked a bank how much more it costs them to administer a $20,000 loan than a $200 loan, there is a difference, but it diminishes with size. But in both the case of the $20,000 loan and the $200 loan, the bank incurs fixed costs. No matter the size of the loan, the bank has to send a loan officer out into the field, go through the appraisal process, make entries in their management information system (MIS), process payments, and manage a bank-borrower relationship. These fixed costs as a percentage of the original loan amount are inherently going to be larger among smaller loans. Therefore, banks must charge higher interest rates to borrowers of smaller loans in order to cover their fixed costs.

Part of my academic research at the W. P. Carey School of Business at Arizona State University looks at how information and communication technologies reduce transaction and coordination costs associated with microloans. As MFIs automate and computerize more tasks which reduce time, transportation, and staff costs, they can make smaller and smaller loans while still remaining financially viable in their markets.

(2) Secondly, seemingly high interest rate microloans are acceptable as they can be paid back. Let’s take a trip in the way, way back machine to your sophomore year of undergrad where you took your first principles of microeconomics course. My professor was Dr. Hadley T. Mitchell, whom students dubbed ‘The Oracle’ due to his PhD and 4 masters degrees in subjects ranging from economics, mathematics, philosophy, and systematic theology. When a man’s hobby is acquiring degrees, no other nickname is even worthy of consideration. I attribute the way I look at the world from an economic standpoint largely due to the 15 credit hours I took with him at Taylor University. He taught me that the law of diminishing marginal returns states that for every additional unit of input, the expected returns (or utility) from that additional unit decreases. In terms of a production plant, the 101^st factory line worker will add to the output of the factory, but not as much as the 100^th worker. In terms of the microenterprise of a Kiva entrepreneur borrower, the 200^th dollar invested in their business will have a greater impact on revenue than the 20,000^th dollar. Therefore, smaller loans can be repaid at higher interest rates because at those low amounts of input, the entrepreneur benefits from higher productivity of inputs.

This should come as a great encouragement to supporters of microlending. According to these principles, 100 loans in the amount of $500 each offered by microfinance institutions worldwide will have a much greater impact on global productivity than a single $50,000 loan. As technology drives down administrative, coordination, and transaction costs, microfinance institutions can lend to poorer and poorer clients while still maintaining financial viability.

I urge you to join me in supporting entrepreneurs that can benefit from the law of diminishing marginal returns by making a $25 loan to an entrepreneur on Kiva.

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Dave Weber is a 4th year PhD candidate in Information Systems at the W. P. Carey School of Business at Arizona State University. His dissertation topic is on the impact of information and communication technologies on the microfinance industry. He and his wife worked at Woodstock School in the Himalayan foothills of India and have volunteered with NightLight in Bangkok aimed at assisting the victims of sex trafficking. When he is not reading, writing, and researching, Dave enjoys playing basketball and tennis, music, traveling, wreaking havoc on his Harley, and rooting for the pathetic Cincinnati Bengals.