How Microfinance Is Used – First World Application

Costco is glorious. I remember as a kid sitting in the cart and getting piled in massive boxes as my mom stocked up for the pleasure of having us kids running around all summer free from the prison that is school. Otter pops and bagel bites for days.

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Costco is often dubbed the “$200 dollar store” because you can’t leave without at least burning through a good chunk of your wallet. It is often a love hate relationship but one that saves its customers hundreds of dollars through buying bulk and taking advantage of large sales. Despite Costco’s greatness, a new study out of Michigan’s Ross School of Business finds that people who have the greatest incentives to take advantages of these savings are the least able to do so.

“Households commonly utilize strategies that provide long-term savings for everyday purchases in exchange for an increase in their short-term expenditures” the study states. Poor households are often limited in using these strategies because of the cash required needed to spend at a given time. You can’t take advantage of the “$200 dollar store” if you don’t have $200 even though in the long run it saves you money. This is a liquidity constraint. Taking advantage of sales can save you a lot of money but if you don’t have money at that particular time you can’t do so. We know the saving you need money to make money, well you also need money to save money.

Microfinance is always pitched as providing capital to invest in small businesses but often this only occurs with about 50% of the loans. Solving this liquidity constraint is one of its biggest uses and can be very beneficial to the poor. Larger expenses are difficult for the poor to address. The poor can’t afford to save for tomorrow because they have nothing left over after paying for today. Those living paycheck to paycheck face similar problems. With credit they could pursue longer term strategies that save them money but without it those options are off the table.

Microfinance recipients are discouraged to use loans for consumption which on the surface makes sense. We always want to poor to invest but we are naive in not recognizing that sometimes consumption actually helps us save. In Kenya, the poor who receive cash grants by Give Directly often purchase tin roofs to their homes. This is a wise decision even though it is consumption because  tin roof lasts longer and will have a cost advantage over thatch in a relatively short time. Thus freeing up money in the future.

Perhaps it isn’t so surprising that the Costco phenomenon usually takes place in suburban settings because the middle class is best positioned to have enough cash on hand to buy bulk and wait for sales. Whereas Walmart focuses more on lower-income customers and doesn’t focus as much on offering customers goods in bulk.

It is obviously counter intuitive that spending rather than investing will help the poor save more money but we subconsciously do this all the time in our own lives. This week I received a rather poor diagnosis on the my car (though I knew such a report was bound to be coming soon with a 15-year-old car and 225,000 miles on it). Luckily the car is still functioning fine for the time being and I can spend time doing research and find the right deal on a car. The poor typically can’t do research and have to spend now. Thus costing them more money in the end.

Smoothing consumption is the term giving to the ability to spread out spending regardless of when money comes in. Since most of the poor are in agriculture when income only comes after harvest, the ability to smooth consumption can be life changing. Microfinance is a tool that can do exactly that.

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