June 2008

IZA DP No. 3550: Formality, Informality, and Social Welfare

published as 'Informal Production and Labour Market Segmentation' in: Journal of Institutional and Theoretical Economics, 2011, 167 (4), 686-707

An industry is modeled in which entrepreneurs, who are heterogeneous in ability, may produce formally or informally. It is shown how the formal-informal mix depends on the distribution of ability, product demand and various parameter values. The industry equilibrium is compared to one in which informality is prohibited. With relatively high product demand, the effect of entrepreneurs being free to choose informality is that consumer surplus and total employment are reduced, but profit is redistributed towards more able entrepreneurs. With relatively low product demand the opposite effects obtain. We also show that informality may be a built-in stabilizer or destabilizer.