The objective of the paper is to understand the transforming relationship between the formal and informal sector in a liberalizing open developing economy. There are various facets in this relationship, and we focus on three essential aspects. First, we look at the impact of deregulatory policies in the informal sector on informal wages, the earning index of the substantial majority of the workforce in a developing economy. Theoretical discussions are followed by empirical evidence on informal manufacturing in India. Implications of introducing labour laws are also discussed. Then, we highlight the vertical relationship between the formal and the informal sectors and the consequence of reformatory policies, in particular, the impact on the relative size of these segments within an erstwhile protected sector. Empirical evidence from Brazil and Colombia seems to match our theoretical conjectures. We conclude with a discussion of a fieldbased survey on the changing relationship between formal and informal entrepreneurs in a range of rural industries in India, as these industries gear up for expanded markets and export. This is done to provide further insight into the transformation process.