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
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