Informal Sector Enterprises in the Light of New Institutional Economics

Müller-Falcke, D. (1997). Informal Sector Enterprises in the Light of New Institutional Economics. International Small Business Series (No. 24). Göttingen.

Informal sector enterprises absorb a large portion of the labour force in many developing countries. Most of these enterprises are small, work with low level labour intensive technology, and have only limited growth prospects. The application of concepts of the New Institutional Economics (NIE) promises to provide considerable insights into behavioural and structural dimensions of informality.

NIE deals with the question how individuals adapt their behaviour to the constraints imposed by institutions, i.e. by specified sets of rules. From the viewpoint of NIE, informal sector enterprises differ from formal ones in the sense that they are governed by other institutional frameworks. Informal enterprises’ activities are not subject to public laws and regulations. Their activities are governed by other, informal arrangements. To this behaviour there exist no other alternative, if:

  • regulations impose high costs on formality,
  • informal entrepreneurs lack the skills to comply even with simple regulations, and
  • the state is too weak to protect private contracts and property rights efficiently.

Doing business outside legality puts informal sector enterprises at a disadvantage in many ways. It is costly for them to sustain their informal status. Lacking access to public law institutions limits their property rights and the use of certain means of production. Additionally, economic policy often discriminates against these enterprises. The application of Williamson’s concept of governance structures shows that the use of all types of contractual arrangements is in fact restricted for informal enterprises. Therefore, it is not profitable for informal entrepreneurs to expand their activities or to use more sophisticated technologies. If they want to do so, they have to comply at least with some public laws and regulations which cause new transaction costs.

In this context, NIE suggests that small enterprises would seek to optimise their commercial activities by using public institutions only as much as necessary, thus avoiding the disadvantages of informality as well as avoiding excessive costs of formality. This thesis is supported by recent empirical research on the behaviour of micro-enterprises by the OECD and the ILO.

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