Casting a shadow: Productivity of formal firms and informality

Mohammad Amin,Cedric Okou

doi:10.1111/rode.12697

Abstract

AbstractInformality is a salient feature of most developing economies. Two important concerns arise from informality. First, informal firms tend to be less productive than formal firms. Second, the competition from informal firms can weigh on the productivity of firms in the formal sector. These challenges can lower the aggregate productivity and thereby retard overall development in countries where the informal sector is pervasive. Our analysis provides robust evidence on both issues using firm‐level survey data for a large cross section of countries. We also examine the extent to which firm characteristics and business environment quality shape the productivity gap between formal and informal firms as well as the impact of informal competition on the productivity of formal sector firms. The results show that, on average, the labor productivity of informal firms is about one‐fourth that of formal firms. Moreover, competition from informal firms lowers the labor productivity of formal firms by 20%–24%. In line with the “parasite” view of informality, the negative impact of informal competition on the productivity of the formal sector firms is more pronounced when the business environment is less conducive to operating formally due to high corruption, burdensome regulations, and weak institutions.

Highlights

Understanding informality—a prominent feature of most developing economies—and its economic implications is of paramount importance for poverty-reducing and welfare-enhancing policies
Competition from informal firms appears to weigh on the productivity of exposed formal firms: the productivity of formal firms that compete with informal firms is only three-quarters that of formal firms that do not compete with informal firms, after controlling for other firm characteristics
Our analysis offers a rigorous assessment of the impact of informal competition on the activity of exposed formal firms

Summary

Introduction

Understanding informality—a prominent feature of most developing economies—and its economic implications is of paramount importance for poverty-reducing and welfare-enhancing policies. The second part of the empirical analysis involves exploring the heterogeneity in the labor productivity and informal competition relationship To this end, we replace country fixed effects in equation (2) with controls for some macro-level variables and their interaction terms with the dummy for informal competition. Controlling for the various firm characteristics increases the estimated coefficient value of informal competition (in absolute terms) from -0.178 above to -0.268 (column 5) The latter coefficient value implies that the labor productivity of a typical formal firm that faces the highest level (equal to 1) of informal competition is lower by about 24 percent than a firm that does not face any informal competition. All the interaction terms are positive implying that greater economic development (higher values of GDP per capita) and better business environment (lower corruption, less burdensome regulations to the firms, and more freedom to businesses) tend to partly offset the otherwise negative relationship between informal competition and labor productivity.

Conclusion

Findings

Productivity differential between different types of informal firms