When the notion of informal economy was first established, influential economists like Arthur Lewis (1954) believed that informal sector would slowly fade away as development happens and finally, when development riches a certain maturity level, the informal economy will completely disappear. History, however, signals rather the opposite of what Lewis and others wished for: formal and informal economies are highly interlinked, and now the dualist narrative seems somewhat irrelevant. This short article discusses the composition of informal sector. It also looks into the prospects of growth for different components of the sector.
Researches show that the informal sector is very heterogenous. In this sector, you can find businesses that do not employ any machinery and laborers work complete their work manually. Some of the businesses have only one worker who is working for subsistence and employ no employees, while some other informal business may employ several workers and some primitive or even a few sophisticated tech machines.
Ranis and Stewart (1999) made a distinction between the traditional and modern parts of informal sector. Figure 1 shows the distribution of informal business along a modernity continuum based on a number of characteristics.
Traditional informal businesses are at the very bottom of the continuum. They employ no hired worker, no or a very low level of capital, have extremely low or no capital usage and make no use of hired labor. As to their location, they operate within the premises of a household or do not have a fixed location, and the type of activities they engage in are very low value-added activities. when we move upwards along the continuum, at the very top of the distribution, we have informal businesses that use some capital, produce standardized goods and services, hire low- and medium-skilled labor, have a fixed address outside the household and offer competitive wages that are comparable with the wages offered in the formal sector. However, what make them informal is the fact that they do not comply with all the rules and regulations imposed by government and other legal entities on the formal sector.
The above discussion of informal sector composition is based on making a distinction between traditional and modern sectors of informal economy. Though, Nattrass (1987) approaches the composition of informal sector from a very different perspective. He bases his theoretical analysis on a triangle, composed of 3 sub-triangles, where parts of industrial reserve army, marginal pole and formal sector make up the components of informal sector (see Figure 2). The main argument in this perspective is that only some part of the marginal pole fits into the informal sector, that the industrial reserve army may or may not participate in informal activities, and that people who are not marginalized can also form part of the informal sector.
The triangle of industrial reserve army has two sub-parts a and b. The people who are seeking full time jobs in the formal sector and are living, probably on savings or borrowing from relatives and friends, constitute sub-part a. They are not part of the informal sector because they are not doing any productive economic activity, and therefore they are excluded from the inner circle of the diagram. Sub-component b consists of those people who have temporally joined the informal sector but theoretically speaking, they could get a job in the formal sector. These people will immediately leave the informal sector when a job is available for them in the formal sector.
The marginal pole triangle consists of people who have no formal sector skills or experience. A section of these people (see d in Figure 2) probably works for low wages in the informal sector. Component e consists of the truly marginalized people who are not even employed in informal sector.
The other triangle is formal sector triangle which includes people working in the formal sector full-time (see f in Figure 2); but at the same time, some of them have jobs in the informal sector to supplement their income (see c in Figure 2).
In the framework that Nattrass has drawn, formal and informal sectors are negatively correlated, because most of whose who are working for informal sector are also looking for jobs or are capable of getting jobs in the formal sector. This means expansionary activities in formal sector pull labor force from the informal sector; but a recession will push many to the informal sector. In different terms, when formal sector expands, informal sector will shrink and vice versa. In this sense, informal sector is a necessary appendage to a capitalist economy that cannot full fill its obligations optimally, and thus leaves a part of its duty to the informal sector. In other words, informal sector is born out of a necessity that stem from faulty function of capitalism. Faulty function in the sense that its labor market cannot employ everyone in the formal sector; so, it produces an appendage such as informal sector to tackle the issue of unemployment and underemployment to some degree. However, note that the benefit of formal sector expansion will be extremely small for marginal pole, but significant for industrial reserve army and formal sector workers who complement their income with earnings from informal sector.
Some economists, like Stark, see informal and formal sectors as complements for each other. They argue that the two sectors depend on each other. The formal sector produces some of its goods in informal market, for the informal sector’s labor is much cheaper. Take the RMG sector for example. This conception of relationship between formal and informal sectors, again, sees informal sector as a byproduct of capitalism, but not because it cannot function optimally, rather because the existence of informal sector is profitable to capitalism.
Some other economists, such as Datta Choudhury, propose inverse linkages between formal and informal sectors. In Datta Choudhury’s model, formal sector produces Xu and Mu while the informal sector produces Mz. We see that M is produced competitively in both sectors. That why M is produced in both sectors is because some businesses do not or cannot choose to enter formal sector due to constraints, legal obligations and the extra costs that the formal sector imposes on them. In the formal sector, the cost of labor is very high, while in the informal sector, the cost of credit is extremely high; but, because the two sectors compete on M, they cannot set their prices higher than market prices. This model suggests that in some products, formal and informal sector have inverse relationship. Lower prices, better productivity and improved technology in the formal sector might reduce the sight of informal sector. Conversely, hike in cost of production of M in formal sector may increase the size of informal sector.
Suppose the government steps in and provides credit support to the informal sector, and bring down credit costs substantially. In such a situation, because informal sector becomes more profitable, the formal sector businesses will seek ways to join informal sector to reduce their labor costs and reap the benefits of low wages in the informal sector. However, the credit costs in the informal sector are very high that government intervention cannot produce any remarkable result. Thus, in the developing world, informal sector cannot graduate to formal sector because of persistently high costs of credit.
As to the relation of informal sector with growth, the existing literature indicate forward production links for modern informal firms with formal firms. It can be shown that growth and competitiveness in the formal sector benefits the modern informal sector. Competition within formal sector leads formal businesses establish links with the informal sector and this will expand activities in the informal sector.
In the consumer market, traditional informal firms survive operate in a different market segment than formal firms, and thus they do not pose a direct threat to the formal sector. But, modern informal firms may grow to the level that they can compete with formal firms. This will pose a threat to the size and growth of formal firms. Informal firms are advantaged over formal SMEs because they have lower start-up and operational costs. When it comes to size expansion, informal businesses are at disadvantage because they cannot expand beyond certain size even if their profitability permits it. Thus, from the consumer market perspective, the size and growth of informal firms will also depend on the regulatory framework.
Ranis and Stewart (1999) argue that the demand for products from the informal sector depends, among other things, on the level of per capita income and its distribution. A low per capita income means income inequality is high and thus a larger part of people will demand goods and services provided by traditional informal firms. This means the traditional informal sector will grow when income per capita is low or when income inequality is high. But, when income increases or when income distribution improves, more and more people will demand goods and services produced by the modern informal sector. This implies that modern informal sector will grow if income increases or when income inequality declines.
References:
LEWIS, W. A. (1954). Economic Development with Unlimited Supplies of Labour. The Manchester School, 22(2), 139–191. doi:10.1111/j.1467-9957.1954.tb00021.x
Nattrass, N. J. (1987). Street trading in Transkei—a struggle against poverty, persecution, and prosecution. World Development, 15(7), 861–875.
Ranis, G., & Stewart, F. (1999). V‐Goods and the Role of the Urban Informal Sector in Development. Economic Development and Cultural Change, 47(2), 259–288. doi:10.1086/452401
