For almost half a century, microfinance has been seen as a powerful tool to improve access to credit for the poor. However, the evidence on microfinance in developing countries is characterised by modest take up and limited average impacts on income, profits and consumption, raising questions about the extent to which microfinance can catalyse significant growth. Another major challenge faced by the poor are imperfect labour markets, characterised by a lack of wage work or large search frictions. The interplay of both imperfect credit and labour markets may lead poor households to make constrained occupational choices. Those who prefer to do wage work may start a small business for sustenance due to lack of appropriate jobs or out of necessity (“involuntary entrepreneurs'') while those who prefer to start a business (“voluntary entrepreneurs'') may face credit constraints and not be able to grow their business optimally. The presence of involuntary entrepreneurs signifies excess entrepreneurship in the economy. These constrained occupational choices may lead to over- or under-investment of resources in businesses, i.e., allocative inefficiency of resources and hence, lower returns to credit or investments. In this paper, we focus on the interplay between credit and labour market frictions and their role in generating misallocation in occupational choice and business investments. We then investigate whether this interplay can help explain the low average returns of microfinance.
