The Informal Sector, Firm Dynamics, and Institutional Participation

Abstract

The high informality and mortality and apparent stagnation of developing country microfirms are often thought to result from government-induced distortions in labor or product markets. A new approach assumes that these informal firms have dynamics similar to firms in industrial countries, and that formality can be thought of as the decision to participate in societal institutions. This leads to a substantially different vision of the relationship between formality and the nature of the small firm that emphasizes the informal firm first as a normal enterprise and second as informal. The informal microfirm sector is believed to be large, accounting for 20-40 percent of employment in many developing countries. The literature tends to view the sector as the disadvantaged sector of a segmented labor market, as existing to evade government regulations, or as constrained by lack of access to government services. Levenson and Maloney offer a unique theoretical framework to analyze informality and microfirm growth behavior-one that emphasizes the entrepreneurial nature of informal firms and sees informality as a secondary characteristic. First, they assume that informal firms in developing countries have dynamics similar to firms in industrial countries: entrepreneurs have unobserved, differing cost structures that determine their long-run size and survival-structures that they can only discover by going into business. Second, informality can be thought of as a decision to participate in societal institutions. Access to mechanisms that ensure property rights, pool risk, or enforce contracts become more important as a firm grows, and the entrepreneur will be willing to pay for them through taxes in a way that was not the case as a small firm. The combination of these assumptions generates several of the stylized facts emerging from cross-sectional data and identified in existing models-informal firms tend to remain small and have high rates of mortality, and lower productivity-without recourse to government-induced distortions in labor or product markets. Further, the framework predicts that firms whose cost structures dictate that they should expand will make the transition to formality as they grow. Using detailed observations from Mexico, Levenson and Maloney find their view consistent with patterns of formality and growth of microfirms. This paper-a product of the Poverty Reduction and Economic Management Sector Unit, Latin America and the Caribbean Region-is part of a larger effort in the region to understand the structure of labor markets in developing countries. William Maloney may be contacted at wmaloney@worldbank.org.