Informal economic activity is pervasive in developing countries. It includes both output produced
by firms that are not registered with the government, and output by registered firms that is sold for cash
and is not reported to the government. Unregistered firms might be entirely unknown to the government,
or might be registered with some authorities (such as municipalities) and not others (such as tax).
Employees of informal firms rarely have formal employment contracts, or pay taxes. Altogether,
unofficial output often accounts for half or more of the total in a developing country. Informality declines
sharply as countries grow.
The prevalence of informality in poor countries raises a number of important questions for
economic development. Are informal firms just like formal firms, except that they fail to register because
of the ominous tax and regulatory burdens? Are they as productive as formal firms? Do they sell the
same kinds of output? Should informality be fought because it provides unfair competition for formal
firms, as Farrell (2004) expressing the views of the McKinsey Global Institute has argued, or encouraged
because it creates employment where there would be none otherwise? What are the basic characteristics
of informal firms?
In an earlier article (La Porta and Shleifer 2008), we have presented evidence that informal firms
are qualitatively different from formal firms. In particular, they are much smaller and much less
productive. Their managers have much less human capital than do managers of formal firms. They sell
to very different customers, who are predominantly themselves informal. They do not advertise, have less
capital, and rely to a smaller extent on public goods such as police protection. Very few of the formal
firms have been previously informal, inconsistent with the view that formality is a later stage of a firm’s
life cycle, as its business grows.
In our earlier paper, we referred to this as the dual theory of informality, inspired by the ideas of
dual economy and the big push in development economics (e.g., Harris and Todaro 1970, Murphy,
Shleifer and Vishny 1989). According to these models, the source of economic growth and
transformation to modernity is the creation of large formal firms, often taking advantage of increasing
returns technologies. Informal firms operate in the so-called dual economy, providing subsistence to
their owners and employees, but not being productive enough to become a source of economic progress.
Our research points to an intimate connection between duality and informality.
In this paper, we seek to extend and deepen this analysis, with a particular emphasis on African
countries. There are three reasons for doing so. First, Africa is one of the poorest regions in the world,
and informality is the dominant form of economic activity. Moreover, informality in Africa, as in other 2
very poor countries, may take more dramatic forms than in middle income countries such as Brazil, where
it largely consists of tax evasion in cash transactions. Second, since we wrote our paper, the World Bank
has made available a great deal of new data from its Enterprise Surveys, including for African countries,
so we can significantly expand the analysis. Third, we have had the opportunity to make research trips to
Madagascar, Mauritius, and Kenya, and to visit a modest number of formal and informal firms to make
comparisons. Our particular focus was on furniture makers, although we visited several other types of
business. The idea was to gain a more subtle understanding of the working of the informal economy, and
in particular to put more meat on the statistical bones of Enterprise Surveys.
The results we obtain from this investigation confirm many of our earlier findings, but add a new
and potentially crucial element to the story. Specifically, the strong impression we obtained from country
visits is a substantial difference in the quality of goods sold by informal and formal firms. The lower
product quality of informal firms might be the unifying factor of the dual theory: it explains how smaller
size, production to order rather than mass production, lower human capital of the managers, lower use of
capital, the absence of advertising, and sales to largely informal retail clients for cash all go together.
Informal firms can only supply low quality inexpensive goods, but fortunately their customers demand
low quality inexpensive goods. Informal firms thus occupy a very different market niche than formal
firms do, and rarely become formal precisely because there is very little demand for their products from
the formal sector. Quality segments the economy. This idea of quality segmentation of markets is known
international trade as the Linder effect, according to which poor countries trade with other poor countries
rather than with the rich ones (see Murphy and Shleifer 1997 for a model), but as far as we know the
relevance of this phenomenon to informality and development has not been emphasized.
In the next section of the paper, we briefly review some observations from our visits to formal
and informal firms in Madagascar, Mauritius, and Kenya. In Section 3, we describe the main data we use
in the paper and present some information on the characteristics of formal and informal firms. Section 4
presents the main results on the productivity of formal and informal firms. Section 5 focuses on obstacles
do doing business. Section 6 concludes.