The Logic of the Informal Economy

CAMBRIDGE – A specter is haunting the world’s developing countries – the specter of the “informal” economy. For some, the informal sector includes all businesses that have not been registered with the authorities. For others, it refers to businesses that escape taxation. The International Labor Organization defines it as comprising firms that are small enough to fall outside the labor code.

Whatever the definition, what has concerned many economists and gained policymakers’ attention is that the size distribution of firms in developing countries has a long tail. Compared to developed countries, an unusually large number of small, unproductive firms coexist with a small number of large, productive firms.

According to standard economic reasoning, this is inefficient. If the small, unproductive firms closed down and the larger, more productive firms hired their workers, total output and well-being would rise. This should happen automatically through the invisible hand of competition, because the more productive firms should be able to deliver a better product at a lower price, while luring workers with higher wages.

So, why doesn’t this happen routinely in developing countries? Why do the inefficient firms survive, trapping resources in low-productivity activities? What is preventing the market from working its magic and making everyone better off?