In many areas of the world, a significant part of the cost of obtaining a good or service is the cost of enforcing the contracts entailed in its provision. We present models of markets with endogenous enforcement costs, motivated by studies of rural credit markets. We show that subsidies may have perverse effects under monopolistic competition, increasing prices or inducing exit. Higher prices (interest rates) result from the loss of scale economies or from negative externalities among suppliers. The models are consistent with the puzzling evidence that infusions of government-subsidized formal credit have not improved the terms offered by moneylenders.
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