Why Informal Businesses Are Doomed to Fail

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Read the full story by Jonathan Riggs, published by the Tuck School of Business.

There is a furniture firm in Antananarivo, Madagascar, with primitive machinery and cracked work tables covered in sawdust. Half-finished bedframes lean against broken-slatted windows, but there are no employees present to finish or clean anything. Outside, in what passes for a showroom—the muddy ground lining a street—completed beds wait in the open air, exposed to the elements and constantly in danger of being stolen.

Rafael La Porta

Rafael La Porta is the Noble Foundation Professor of Finance at the Tuck School of Business. (Photo by Mark Washburn)

What’s holding this firm back? It could be the owner’s inability to manage his inventory, keep his workers busy, successfully forecast his sales, or produce standardized goods. The owner, however, sees only a lack of capital standing in his way. The truth more likely lies in the firm’s very nature as an “informal” business that exists outside of taxation and governmental regulation. In a new research paper called “Informality,” Rafael La Porta, Tuck’s Noble Foundation Professor of Finance, and Harvard’s Andrei Shleifer take a close look at these businesses to see how they fit into the modern economy.

“The biggest surprise when we began our research was to discover how hugely unproductive these informal firms are,” La Porta says. “What we frequently found was that owners of informal firms seemed to earn less than an employee of a formal firm, which was a little shocking.”

Informal firms employ billions of people around the world. Bridging the spectrum from subsistence farmers to self-employed peddlers to firm owners like the one mentioned above, the informal economy accounts for up to 40 percent of total economic activity in the poorest countries.

Despite the prevalence of informal firms around the globe, however, their role in economic development remains controversial. By conducting a series of field experiments, cross-country regressions, and data analyses, the authors focused on firms like the aforementioned example to assess whether a more optimistic view (informal firms are “an untapped reservoir of tremendous entrepreneurial energy”) or pessimistic view (informal firms are “parasites competing unfairly with law-abiding formal firms”) was accurate.