Efficient informal trade: Theory and experimental evidence from the Cape Town taxi market

Abstract

Informal sectors in developing countries are often thought of as responses to rigid and cumbersome market regulations. In this paper I study informal trade as a first-best outcome. In the model I propose rigid regulations can be necessary to achieve efficiency even though they are always sidestepped. The key assumption is that the regulations define the trading parties' fall-back position in case the informal bargaining process breaks down. I set up a field experiment to test the model's mechanisms in the Cape Town market for metered taxis. Consistent with the model, I find that sidestepping the regulations increase cost efficiency (taxis take the shortest route). The price is however unaffected, suggesting informal bargaining leads to a Pareto improvement.