Learning Objectives

After reading this chapter, students will be able to:

• Define and describe informality related to property, labor, business firms and finance
• Identify the advantages and disadvantages of informality in each sector for development

Chapter Summary

This chapter focuses upon domestic economic institutions which are defined as a set of rules or organizations which structure human decisions about how to allocate material resources. The chapter is organized around the four kinds of major economic institutions: property markets, labor markets, the structure of business firms and financial services. Within this discussion, the informal sector is emphasized because this is an often distinguishing feature of LDC economies. The informal sector is economic activity that occurs without state recognition and outside state regulation: it may be illicit activity, but it may also be merely extralegal.

Property markets are how states organize the exchange and ownership of land, housing and business capital. In wealthier countries, a significant aspect of this is the protections for property rights through systems of recorded deeds and mortgages with enforcement through an impartial judicial system. This creates a high degree of certainty. In LDCs however, property markets are organized more informally, creating significant uncertainty as to ownership. Many urban settlements are informal, with flimsy housing being erected on land that the residents do not own. There are few or no public services in these settlements. In rural areas, much land is subject to customary law. Often the ownership rights are delimited through traditional authorities interpreting customary law and decisions are often unrecorded.  

This informality occurs for several reasons. First, even where formal ownership systems exist, they may be costly, complicated and time-consuming. It may also require the payment of taxes. Second, land ownership systems are costly to the government, so the government may underfund them, making them ineffective. Third, politically it may be difficult for leaders to formalize land ownership when they may seek to later use this property for other purposes; additionally, disturbing current systems may ignite political conflicts that politicians would wish to avoid.

Development scholars using the new institutionalism approach see this informality in property markets as a cause of underdevelopment. These scholars believe that institutions shape behaviors by creating incentives and disincentives for certain actions. When property ownership is uncertain, those using the property will be unlikely to invest in ways of making the property more productive. The absence of clear legal codes, effective judiciaries and bureaucracies and the limitations on state capacity all interfere with the ability of people to trade and make contracts.

A second perspective, advanced by economist Hernando de Soto, sees the lack of property rights protection as a cause of underdevelopment because it creates dead capital. Dead capital is an asset that has no value beyond its immediate purpose. Residing in a house by an individual that lacks a recognized deed means the house can be used for shelter, but there is uncertainty as far as how long such shelter can be used since the government or others might dispossess the individual at any time. Additionally, the house and land cannot be used as collateral for a loan since banks require some proof of ownership. The lack of formal systems of reliable registration increase transaction costs for exchanges.  It would be difficult to not only determine the ownership of some informal house to be sold, but also its value since this kind of transaction would not be recorded. Additionally, governments hesitate to construct infrastructure in areas where there is no formal ownership of property. Informality means it would be difficult to charge residents for services like water and electricity. De Soto claims that by formalizing ownership, LDCs could discover an important source of capital for investment within their own societies.

Critics of these approaches dispute the alleged benefits of formalization. Some analysts claim that residents in informal settlements actually do feel secure and do invest in improvements. Other critics claim that formalization would interfere with traditional systems that have worked well in the past, especially in rural areas. Still others claim that formalization is unlikely to increase the ability of the poor to borrow and will only impose costs on the government and the residents of the settlements.

Labor and the organization of business firms are often inter-related in LDCs. Many people in the labor force are part of the informal sector—up to 80% in some LDCs. Frequently this means individuals start their own small informal businesses, and perhaps hire a few other individuals if they are successful. This means that worker/owners avoid taxation, safety rules, minimum wages and other forms of regulation.

One reason why there is so much informality is that there may be high entry costs to the formal sector. Registering a business may be a costly, time-consuming and corrupt process that has few benefits for the business owner. Once certified, the process of maintaining a business license may also be costly. These problems may be encouraged by bureaucrats as ways of justifying their position and also by already existing enterprises who want to limit competition.

Finance capital is also subject to a high degree of informality in the global south. Few commercial banks are willing to lend the small sums of money that poor entrepreneurs would find most useful. This is because small loans have high administrative expenses and because lending to poor people is considered high risk. Poor people borrow from friends and family or from a local moneylender. There may also be local informal self-help groups that provide loans to members.

Recently formal microfinance institutions, like the Grameen Bank in Bangladesh, have been established. These often work through making loans to a group of poor people; one person actually gets the capital but all are responsible for repayment. When the loan is repaid then another member of the group gets a loan, and so on until all benefit. Thus there is incentive for peer pressure to assure that each loan is repaid so each member can get their turn.

Formal savings accounts are rare among poor people in LDCs. Part of the reason is the high administrative costs of setting up such accounts that will contain such small amounts of money. In fact, often banks charge poor depositors for saving rather than paying them interest.

Informality in labor, firms and finance create obstacles to development according to many analysts. According to de Soto, hard working poor people are prevented from becoming capitalist entrepreneurs because formalization is so complicated and expensive; informality makes it difficult to make the needed investments that will increase productivity and bring growth to these businesses. Small businesses survive on narrow profit margins because they cannot expand to take advantage of opportunities; even when they accumulate profits, owners tend to save them to carry through lean times rather than re-investing to take advantage of current opportunities for growth. Many of these businesses may also decide to stay “small” to avoid state detection that would impose taxation.

Some analysts contend that these self-employed individuals are reluctant entrepreneurs because they would much rather have the security of a formal sector job. Being self-employed entails considerable economic risk. Those who are informal sector employees face health and safety risks, as well as the risk of unemployment on a regular basis. Informality also hurts the state as they cannot collect taxes to fund needed infrastructure.

Informal finance does not really meet the needs of the poor according to some analysts. First, there are high costs to most informal lending, because money lenders charge much higher interest rates than commercial banks. And they are also notorious for using violence and intimidation to collect what they are owed. Lack of access to formal saving accounts makes poor people vulnerable to theft. It also means that banks themselves have less capital to cycle into business lending that could be used to grow the economy.

Some analysts claim that formalization is not a solution to underdevelopment. First, formalization would incur all the costs of complying with the many state regulations and taxation, something that would make many informal firms unprofitable. Second, the reason that many informal firms stay small, according to analysts, is because they are poorly run. Even if they were formalized, they would not be able to grow. Microfinance, is also criticized since it charges relatively high interest rates and inflexible terms.

Peru, a country with a very large informal economy is presented as a case study. In the 1980s, de Soto’s research found bureaucracy and corruption here, but there has been at least some improvement. Other analyses claim Peru has comparatively low entry costs and a positive environment for microfinance. Colonial rule imposed rigid class structures and authoritarian governance and neocolonial trade subjected the Peruvian economy to cycles of boom and bust. Finally, geography is examined to explain the factors that made the Inca Empire vulnerable to defeat by a small force of Spaniards.