Informality and Development

In developing countries, informal firms account for up to half of economic activity. They provide livelihood for billions of people. Yet their role in economic development remains controversial with some viewing informality as pent-up potential and others viewing informality as a parasitic organizational form that hinders economic growth. In this paper, we assess these perspectives. We argue that the evidence is most consistent with dual models, in which informality arises out of poverty and the informal and formal sectors are very different. It seems that informal firms have low productivity and produce low-quality products; and, consequently, they do not pose a threat to the formal firms. Economic growth comes from the formal sector, that is, from firms run by educated entrepreneurs and exhibiting much higher levels of productivity. The expansion of the formal sector leads to the decline of the informal sector in relative and eventually absolute terms. A few informal firms convert to formality, but more generally they disappear because they cannot compete with the much more-productive formal firms.