The Informal Economy: What It Is and Why It Is Important? The informal economy refers to commercial activities that occur at least partly outside a governing body’s observation, taxation, and regulation. In slightly different words, sociologists Manuel Castells and Alejandro Portes suggest that the “informal economy is characterized by one central feature: it is unregulated by the institutions of society in a legal and social environment in which similar activities are regulated.” Firms located in the informal economy are typically thought of as businesses that are unregistered but that are producing and selling legal products (that is, they sell many of the same products you might buy in legal businesses but perhaps cheaper because they do not pay government fees and taxes). In contrast to the informal economy, the formal economy is comprised of commercial activities that a governing body taxes and monitors for society’s benefit and whose outputs are included in a country’s gross domestic product. For some, working in the informal economy is a choice, such as is the case when individuals decide to supplement the income they are earning through employment in the formal economy with a second job in the informal economy. However, for most people working in the informal economy is a necessity rather than a choice—a reality that contributes to the informal economy’s size and significance. Although generalizing about the quality of informal employment is difficult, evidence suggests that it typically means poor employment conditions and greater poverty for workers. Estimates of the informal economy’s size across countries and regions vary. In developing countries, the informal economy accounts for as much as three-quarters of all nonagricultural employment, and perhaps as much as 90 percent in some countries in South Asia and subSaharan Africa. But the informal economy is also prominent in developed countries such as Finland, Germany, and France (where the informal economy is estimated to account for 18.3 percent, 16.3 percent, and 15.3 percent, respectively, of these nations’ total economic activity). In the United States, recent estimates are that the informal economy is now generating as much as $2 trillion in economic activity on an annual basis. This is double the size of the U.S. informal economy in 2009. In terms of the number of people working in an informal economy, it is suggested that “India’s informal economy … (includes) hundreds of millions of shopkeepers, farmers, construction workers, taxi drivers, street vendors, rag pickers, tailors, repairmen, middlemen, black marketers, and more.” There are various causes of the informal economy’s growth, including an inability of a nation’s economic environment to create a significant number of jobs relative to available workers. This has been a particularly acute problem during the recent global recession. In the words of a person living in Spain: “Without the underground (informal) economy, we would be in a situation of probably violent social unrest.” Governments’ inability to facilitate growth efforts in their nation’s economic environment is another issue. In this regard, another Spanish citizen suggests that “what the government should focus on is reforming the formal economy to make it more efficient and competitive.” In a general sense, the informal economy yields threats and opportunities for formal economy firms. One threat is that informal businesses may have a cost advantage when competing against formal economy firms because they do not pay taxes or incur the costs of regulations. But the informal economy surfaces opportunities as well. For example, formal-economy firms can try to understand the needs of customers that informal-economy firms are satisfying and then find ways to better meet their needs. Another valuable opportunity is to attract some of the informal economy’s talented human capital to accept positions of employment in formal economy firms. Answer the following question: 1. What are the implications of the informal economy for firms that operate only in the formal economy?

MINI CASE The Informal Economy: What It Is and Why It Is Important? The informal economy refers to commercial activities that occur at least partly outside a governing body’s observation, taxation, and regulation. In slightly different words, sociologists Manuel Castells and Alejandro Portes suggest that the “informal economy is characterized by one central feature: it is unregulated by the institutions of society in a legal and social environment in which similar activities are regulated.” Firms located in the informal economy are typically thought of as businesses that are unregistered but that are producing and selling legal products (that is, they sell many of the same products you might buy in legal businesses but perhaps cheaper because they do not pay government fees and taxes). In contrast to the informal economy, the formal economy is comprised of commercial activities that a governing body taxes and monitors for society’s benefit and whose outputs are included in a country’s gross domestic product. For some, working in the informal economy is a choice, such as is the case when individuals decide to supplement the income they are earning through employment in the formal economy with a second job in the informal economy. However, for most people working in the informal economy is a necessity rather than a choice—a reality that contributes to the informal economy’s size and significance. Although generalizing about the quality of informal employment is difficult, evidence suggests that it typically means poor employment conditions and greater poverty for workers. Estimates of the informal economy’s size across countries and regions vary. In developing countries, the informal economy accounts for as much as three-quarters of all nonagricultural employment, and perhaps as much as 90 percent in some countries in South Asia and subSaharan Africa. But the informal economy is also prominent in developed countries such as Finland, Germany, and France (where the informal economy is estimated to account for 18.3 percent, 16.3 percent, and 15.3 percent, respectively, of these nations’ total economic activity). In the United States, recent estimates are that the informal economy is now generating as much as $2 trillion in economic activity on an annual basis. This is double the size of the U.S. informal economy in 2009. In terms of the number of people working in an informal economy, it is suggested that “India’s informal economy … (includes) hundreds of millions of shopkeepers, farmers, construction workers, taxi drivers, street vendors, rag pickers, tailors, repairmen, middlemen, black marketers, and more.” There are various causes of the informal economy’s growth, including an inability of a nation’s economic environment to create a significant number of jobs relative to available workers. This has been a particularly acute problem during the recent global recession. In the words of a person living in Spain: “Without the underground (informal) economy, we would be in a situation of probably violent social unrest.” Governments’ inability to facilitate growth efforts in their nation’s economic environment is another issue. In this regard, another Spanish citizen suggests that “what the government should focus on is reforming the formal economy to make it more efficient and competitive.” In a general sense, the informal economy yields threats and opportunities for formal economy firms. One threat is that informal businesses may have a cost advantage when competing against formal economy firms because they do not pay taxes or incur the costs of regulations. But the informal economy surfaces opportunities as well. For example, formal-economy firms can try to understand the needs of customers that informal-economy firms are satisfying and then find ways to better meet their needs. Another valuable opportunity is to attract some of the informal economy’s talented human capital to accept positions of employment in formal economy firms.

Answer the following question:

1. What are the implications of the informal economy for firms that operate only in the formal economy?