Performance Discrepancy, Social Embeddedness, and Informal Firms’ Willingness to Formalize

Abstract

Despite the social embeddedness of informal firms, there is limited understanding of how this key characteristic influences their formalization decisions. Drawing on the behavioral theory of the firm and social embeddedness theory, we test a behavioral mechanism by which the search for improved performance rather than improved performance by itself triggers informal firms' willingness to formalize. We test the proposed mechanism using a random sample of 1,898 informal firms across 10 Latin American and African countries. We find that informal firms with sales performance below their aspiration level are more willing to formalize than informal firms with sales performance equal to or above aspiration level. We further test the moderating effect of two dimensions of social embeddedness, family and local embeddedness, on the proposed mechanism. We find that social embeddedness affects the relationship between performance discrepancy and willingness to formalize but primarily among firms with performance above aspiration level.