The Informal Sectors

Examine the reason for the existence and persistence of the informal sector in either Colombia or
Mexico. Is the informal sector helpful or harmful to economic development in the country you have
chosen? (2008)

‘The Harris-Todaro model views informal workers as comprising the less-advantaged sector of a
dualistic or segmented labour market’. Do you agree? Consider the development significance of the
informal sector in light of evidence from a country or countries you have studied. (2007)

How useful is the Harris-Todaro model of labour migration as an explanation for the emergence of
an informal sector in low-income countries? (2004)

1. In particular, outline the Harris-Todaro model as an explanation of the

formation of an informal sector.

2. Briefly outline the alternative arguments for the existence of an

informal sector. If the question states that the informal sector is ‘less-
advantaged’ note that there are a number of reasons that people
voluntarily enter the informal sector.

3. Outline arguments for and against the informal sector, highlighting in

particular upon Brazils poor economic growth as a result of the size of
their informal sector.

4. Compare this to the success story of Peru who minimised the size of their
informal sector.

The Harris-Todaro model (1970)

The Lewis model of dualism explains how rural-urban migration occurs, but does not explain urban
dualism. A more sophisticated model is required to explain urban unemployment.

The Harris-Todaro hypothesis attempts to explain the persistence of rural to urban migration in the
presence of widespread urban unemployment, a pervasive phenomenon in many less developed
countries (Suits (1985) and Partridge-Rickman (1987)). It is natural to ask why such unemployment
does not act as a deterrent to further migration. According to the Harris- Todaro hypothesis as
presented in Corden and Findlay (1975), the answer lies in the migrant leaving a secure rural wage
for a higher expected urban wage even though the latter carries with it a possibility of urban
unemployment.. The model states that people will only migrate to urban areas if the urban wage
times the probability of getting employed is above the going rural wage.

Assumptions:

1. Neo-classical production functions (labour and capital for manufacturing; labour, capital and
land for agriculture)
2. Prices for both sectors are exogenously given
 3. Labour is fully flexible between sectors
4. High but falling marginal productivity (MRPm) in manufacturing
5. Lower but falling marginal productivity (MRPa) in agriculture

0a0m comprises the entire labour force. 0a implies no employment in agriculture but full
employment in manufacturing, 0m implies no employment in manufacturing but full employment in
agriculture.

In an integrated neo-classical world, z would be the equilibrium with an exogenously fixed wage.
However if industrial wages were set institutionally higher at Wm, a smaller proportion of the
population would work in the urban area, and the rest would remain on a very low wage in
agriculture.

In reality, migration occurs as people in agriculture seek the higher wages of the manufacturing
sector. The extent of migration will depend upon the probability of gain urban employment.

The probability of employment is determined by the proportion of employed to unemployed urban

labour; if there are 5 million in the urban labour force (Lu), but only 2 million actually get employed
then the chance of getting a job is 2/5. Hence labour will migrate from rural to urban sectors until
the point where the rural wages equalled 2/5 of urban wage:

The rural wage Wa is now determined by where q (The Harris-Todaro Curve) cuts A; also
determining the rural labour force. The urban employment equals 0mLm. The urban employed
receive no income and hence live off the urban employed. Subsequently the urban unemployed
make up the informal sector.

Criticisms of the Harris-Todaro Model:

 An ILO study indicates that the average urban wage is twice that of the rural wage in Asia
and Latin America. Assuming a ratio of 2, urban unemployment must be 50% to comply with
the Harris-Todaro model. However, urban unemployment rarely exceeds 20% in Latin
American countries (ILO, 1972)
 This develops into an issue that has received increasing attention from development
economists in the last fifteen years. The Harris-Todaro hypothesis centres on the urban
unemployed being unproductive, living on zero wages and a parasite on the formal sector.
However the differences between the models predictions and the evidence provided by the
ILO can be explained by the existence of a dynamic informal urban sector.

The Informal Sector

The informal sector is a concept first introduced by Hart (1970). In 2000, the informal sector was
estimated to constitute on average 40% of GDP, while in OECD countries it was only 18% (Economist,
2004)

Pretap and Quintin (2006) highlight the key features of the informal sector with (particular reference
to Mexico):

1. Less advantaged sector

2. Flexible and unregulated
3. Unskilled and labour intense
4. Self-financed
5. Ease of entry and exit
6. Family based with low productivity
7. Low education
8. Lower wages than the formal sector

The informal sector has an interesting relationship with the formal sector; it serves it by providing
low-cost inputs, but relies on it for a market.

Much literature argues that the informal sector is a second-best solution for many who find
themselves in it. Portes (1980) argues that the informal sector is merely exploited by the formal
sector, and used as a residual dustbin for formal sector discards. There are a number of issues that
may explain porter argument; issues that disadvantage the informal sector (Pretap and Quintin,
2006):

1. Burdensome institutional environments (Besoto, )

a. De Soto (1989) found that in Peru it took years to set up small businesses, but in
Miami only 3 hours. Hence the informal sector is a product of rational choices by
entrepreneurs faced with high cost of legality
2. Barriers to entry into the informal sector-highlighted by the concentration of women and
old-aged persons in the informal sectors (Maloney, )
 3. Lack of access to resources or markets
4. Lack of collateral (because of property rights) makes it hard to secure capital
5. Difficult to grow ‘mystery of capital’
6. Pretap and Quintin (2006) found that the size of the informal sector had a positive
correlation with tax burdens and labour market constrictions. Hence this implies that when
tax burdens and bureaucracy is too high the size of the informal sector increases
7. Pretap and Quintin also found that the size of the informal sector is negatively correlated
with the quality of government. When the government is of better quality, the informal
sector is smaller.

Although the informal sector is traditionally seen as a disadvantaged sector, Maloney ( ) found that
in Latin America 62% of informal workers wanted to remain informal; in Argentina that was 80%.
Balan, Browning and Jelins (1973) argue that this could be as a result of greater wages or
independence that is associated with informal employment. Pretap and Quintin (2006) highlight that
greater flexibility, particularly for women who can balance work and children. Furthermore,
Maloney’s study shows that people who enter the informal sector voluntarily actually can earn
greater wages than those in formal employment. This is extended by Pretap and Quintin who found
that many people in Mexico, enter the formal section to learn management skills, with the intention
of returning to the informal sector.

Edwards’ explanation of why such a large informal sector exists in Latin America

In Latin America, during the late 1940’s, as a result of high levels of protectionism, government
controls and an artificially high domestic currency, unemployment and the informal sector became
increasingly large. The policies implemented throughout the 1940’s created a highly dualistic labour
market; some labourers found employment in the highly protected industries, particularly
manufacturing, while others had to suffice with employment in the informal sector. Despite having
similar skill sets, the workers in formal employment received higher salaries, health benefits and
other such benefits.

As protectionism grew so did informality; in 1950, on average, 9% of the labour force was in informal
employment. By 1989, 52% of non-agricultural labour was informal.

The combination of a stagnant and unproductive agricultural sector, in addition to increased wages
in the manufacturing sector, caused despite limited jobs, mass migration to the cities. Many of these
families found limited employment, ended up in the informal sector earning very low wages and
ended up in a ‘perpetual circle of poverty and despair’.

Government intervention only resulted in tragic irony. Short run relief was provided by policy,
particularly those aimed at improving conditions by installing sewerage and electrical installations.
Subsequently, families found that over generations they achieved some capital wealth. Despite this
the lack of deeds to properties left them with no collateral to secure loans. ‘Even if they wanted to,
even if they had the ability and entrepreneurial spirit , they just couldn’t do it’.

The Informal Sector is a drain on society

Pretap and Quintin (2006) find that the size of the informal sector has a negative correlation with
economic growth, implying that the informal sector may inhibit economic growth (although the
causality may lay in the opposing direction, that poor growth increases incentives to exist in the
informal sector.

Capp et al. ( ) state that the informal sector is the prime reason that Brazils growth in recent
times is only 3-4% compared to India’s 7-10%; in Brazil the informal sector comprises 40% of the
labour force, while in India it is only 20%.

Capp et al. argue that this is because the informal sector:

1. limits the effectiveness of macroeconomic policy

2. restrains productivity
3. discourages business investment
4. avoids taxes, copyrights and quality standards

All of these factors are cost saving for the informal sector, but cause law abiding firms to lose out on
profits and market share, reducing formal sector investment, R&D and innovation.

Pretap and Quintin (2006) argue that the lost taxes associated with the informal sector cannot be
invested into infrastructure, limiting economic growth and particularly development.

Capp et al. ( ) argue that in Brazil the informal sector has only 46% the productivity of the formal
sector, because of:

1. No economies of scale
2. No credit markets
3. No property rights
4. Limited technology or capital
5. Increased gang protection

Capp et al. state that GDP growth would be 1.5% higher if there were no informal sector.

The informal sector is not a drain on society

Funkhouser (1996) found that in Central America, returns to informal education and learning by
doing is greater than in the formal sector. Hence higher returns to investment indicate a
developmental role.

An international labour organisation (1970) study found similar results in Kenya. It found that the
informal sector generates a surplues, even when denied credit. Furthermore, the formal sector only
requires a fraction of the capital/training of the formal sector.

Allal ( ) studied Thailand and found similar results; that if the informal sector is important for
growth of the entire economy. Hence Allal argues that government should encourage enterprise
friendly policies; which would generate wealth, alleviate poverty and create jobs.
Country Specific Information

Brazil:
The informal sector size grew rapidly with both the early-1980s and early-1990s recessions in Brazil,
although the majority of the growth in the size of the informal sector was concentrated after 1990,
just after the country started the market-oriented reforms, such as privatization and the process of
trade liberalisation. The size of the informal sector in the 2000s -almost 40% of wage workers
(although Neri (2009) puts that figure at 60%)– causes both a social and a fiscal problem in a country
that has been struggling to replicate the high growth rates witnessed until the 1970s (Soares, 2004).

Peru:
In 1990 the vast informal sector of Lima's economy was the most striking feature of its commercial
life. There, 91,000 street vendors, sold food in the streets or public squares of central Lima or the
residential area of Miraflores. As Hernando de Soto has abundantly documented in El otro sendero
(The Other Path), this freewheeling entrepreneurial sector of the labor force was, in the 1980s,
producing the equivalent of almost 40 percent of the national income. As "unregistered" business,
this activity is outside the control of the national economic institutions, whose cumbersome and
often corrupt bureaucratic regulations stifle initiatives, especially if one lacks resources to pay all the
bribes and formal start-up costs. In the circumstances of 1991, the public need to participate in the
economy had, in essence, neutralized and bypassed the official system. Despite this entrepreneurial
spirit, legal changes aimed at reducing bureaucratic barriers to entering the formal sector in the late
1980’s (for example, Peru’s Administrative Simplification Law, 1989), and new property rights, were
successful in integrating more entrepreneurs into the formal economy (Islam, 2007). For example,
the time to register a business was cut from around 300 days to < 1 day. 300,000 businesses were
integrated into Peru’s formal economy, accounting for 560,000 legal jobs and contributed additional
$300 million in tax revenue.