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Hayley Smith-Kirkham

English 321-S01

Argumentative Essay

July 2010

Transforming the Informal Economy into Economic Growth

2472 Words


Economic development has been one of the most contentious, frustrating, and

urgent areas of economic study and practice since the emergence of underdeveloped

nations sixty or so years ago. Before the 1950s, the “poor” areas of the earth were largely

controlled through colonialism. However, as these former colonies began achieving

independence in the 20th century, the world found itself full of rich (developed) nations

and poor (undeveloped, underdeveloped, or developing) nations. A common feature of

nearly all developing nations is a large informal sector, or more commonly referred to

now as the informal economy. The informal economy will be described in detail below

but can most simply be described as the collection of economic activity that is not

formally registered, and therefore outside of government regulation and taxation. The

participants are almost always poor, unskilled, or semiskilled. Although the informal

economy can be found in both rural and urban areas, it is more dense and varied in cities

than in the countryside, and the urbanization phenomenon goes hand in hand with both

development problems and the growth of the informal sector. The informal economy is

largest in African countries, being on average 42% of GNP, whereas in the developed

OECD countries the average is 18% (Schneider 2002). The proportion of informal

employment to total employment is also highest in Africa (Reddy 2007). Therefore, this

paper will focus on the urban informal economy throughout Africa and argues that the

informal sector should be incorporated into development plans and projects.

Development theory has gone through countless metamorphoses since its

inception in the mid-twentieth century. Everything from aid, loans, debt forgiveness,

education, and condoms have been proffered as the key to growth. But no distinct path to

development has been found, and empirical evidence points to no clear panacea (Easterly

2002). Clearly economists need to keep looking, or to look at the economies of poorer

nations in a different way. Development theorists often overlook or ignore the informal

economy, and development projects that neglect the real situation on the ground may be

doomed to failure.

Urbanization is a prevalent phenomenon in nearly all developing nations and

goes hand in hand with the informal economy. Poor people with no prospects in their

rural villages flock to cities in search of jobs, leading to overcrowding, congestion, and

unemployment. Interestingly, unemployment itself is an urban phenomenon (Guerrero).

In agricultural rural areas, most employment is either subsistence and/or through family.

It is when individuals move to cities, without land or family connections, that

unemployment arises. The urban informal economy emerges when the formal economy

of a city cannot absorb all of its surplus labor. According to Lundvall (2008), “The sheer

size of the informal sector makes it a fundamental development issue… in every

developing country where it has grown to these proportions.”

The informal economy has been defined in various ways, but most definitions

share a number of key characteristics. Latham Shinder, in a U.S. Bureau of Labor report,

offered the following description

Informal economies have been defined as economic activity not included in a

nation’s data on gross domestic product, and not subject to formal contracts,
licensing, and taxation. These businesses generally rely on indigenous resources,
small-scale operations, and unregulated and competitive markets… most often
the informal economy refers to owner/operator businesses of the urban poor,
unskilled, or semiskilled. (Shinder 1998)

It is important to note that informal economic activity is not included in a nation’s GDP,

and therefore it cannot be easily quantified as a contributor to economic development or

growth. This can distort the way economists, politicians, and even investors view the

state of an economy. Since the informal economy is not licensed, regulated, or taxed it

also cannot receive government assistance or subsidies. Informal markets are typically

more competitive because they are not subject to minimum wage standards or

government price fixing, and this means they are likely to pay lower wages in order to

charge lower prices. However, since prices are lower quality is usually lower (Lundvall

2004). Some economists refer to the informal economy as the traditional sector, due to

the use of simple technology and indigenous resources as well as the low level of

productivity (“with many people producing what one could in the formal sector” [Potts

2008]) and efficiency compared to modern industry. Lundvall adds that informal firms

are usually small, with less than 20 employees. Some economists include crime while

others don’t, for example Mahandra Reddy (2007) includes prostitution and drug sales

while some economists don’t include crime because there is no formal sector equivalent.

Examples of informal operators are street traders and roadside vendors, artisans,

mechanics, and some domestic workers. To use Carr’s (2001) more intuitive examples,

the informal economy refers to “street vendors in Bogota; shoeshine boys and rickshaw

pullers in Calcutta; garbage collectors in Cairo; home-based garment workers in Manila,

Montreal, Madeira, or Mexico City; and home-based electronic workers in the Leeds,

Istanbul, and Kuala Lumpur.” For an almost literary description, Chen (2005) describes

“City streets and village lanes in most developing countries – and in many developed

countries – are lined with barbers, cobblers, garbage collectors as well as vendors of

vegetables, fruit, meat, fish, snack-foods or a myriad of non-perishable items. In many

countries, head-loaders, cart pullers, bicycle peddlers, rickshaw pullers, bullock or horse

cart drivers jostle to make their way down narrow village lanes or through the maze of

cars, trucks, vans and buses on city streets.”

The informal economy has a number of advantages and benefits that the

formal sector does not. It is best to differentiate between advantages for individuals who

work within the sector, and benefits for the economy as a whole. The primary benefit for

individuals is that the informal economy provides employment opportunities for those

who would not find work otherwise. According to Potts, “the sector’s low productivity

was, at the same time, one of the reasons for its creating so much employment.” Even

though low productivity is a bad thing in economic terms, it serves a beneficial purpose

by absorbing excess labor. There are also benefits to the whole economy. According to

Reddy, the informal economy plays a supplementary role in employment and income

generation (by absorbing excess labor from the formal sector), and a complementary role

in the provision of goods and services (by providing cheaper goods and services to other

low income persons, or providing them where the formal sector wouldn’t) (Reddy 2007).

In addition to these benefits, the informal economy has a number of costs or

disadvantages associated with it. Owners and workers both lack legal or social protection

(Chen 2005). Workers have no guarantee of secure work. There are no labor standards

or minimum wages, which can lead to exploitation. Child labor is common, and many

economists and sociologists have examined gender roles within the sector since a large

portion of the informal economy consists of women. “In sub-Saharan Africa, 84 per cent

of women non-agricultural workers are informally employed compared to 63 per cent of

men” (Chen 2005). Chen’s research revealed that women also overwhelmingly represent

the lowest-paid jobs within the informal economy. Pensions, health benefits, and social

security are also unheard of. As Potts points out, growth in the informal economy can be

good or bad. Competition can lower profits, turning jobs into “coping strategies” rather

than “routes to accumulation and improved life chances.” Low productivity and low

investment are macroeconomic concerns as well.

Development economists have had changing perspectives of the informal

economy over time, and have recently began looking more seriously at the possibilities it

holds. According to Chen, “The recent re-convergence of interest in the informal

economy stems from the recognition that the informal economy is growing and is not a

short-term but a permanent phenomenon. Also, it is not just a traditional or residual

phenomenon but a feature of modern capitalist development, associated with both growth

and global integration. For this reason, the informal economy needs to be seen not as a

marginal or peripheral sector but as a basic component – the base, if you will – of the

total economy.”

There have been three major schools of though regarding the informal economy;

the dualist, the structuralist, and the legalist. In her 2008 paper, “The urban informal

sector in sub-Saharan Africa: from bad to good (and back again?)”, Deborah Potts

examines the history of the dualists in modernization theory. Initially, the modernization

school of development had a dualistic approach separating the modern aspects of the

economy from the traditional aspects.

One was typified as capitalist in its mode of production—‘modernising’,

dynamic, progressive, perhaps capital intensive. The other, the ‘subsistence’, or
‘peasant’ sector in societies dominated by agriculture (or, in later terminology,
and ominously, the ‘marginal’ sector), was characterized by pre-capitalist modes
of production, often depending on family labour, was unsophisticated in its
operations and production patterns, used low technology and had low levels of
productivity. (Potts 2008)

It was believed that as development occurred, the traditional sector would fade away as it

was absorbed by the more productive modern sector. But this hasn’t occurred. In fact, in

most places the informal sector is growing (Lundvall 2004, Carr 2001). At the same

time, the so-called modern sector has not grown in the way economists hoped.

According to Magbaily Fyle, “There gradually developed by the 1980’s a search for

alternative strategies of development… One result of this shift has been an attention to

what came to be called the informal sector” (Fyle 1987).

The structuralist school took a different view than the dualists. In their view, the

informal economy is linked with the formal economy, supplying inputs and reducing

labor costs to make larger firms more competitive. According to this theory, the informal

economy remains due to the “nature of capitalist development”, rather than that there

simply wasn’t enough development (i.e. that the modern sector didn’t grow enough to

absorb the traditional) (Chen 2005).

The third school of thought is referred to as the legalist perspective. Legalists

maintain that inefficient, costly, or “cumbersome” government policies are the reason so

many have chosen to turn to the informal sector (Chen 2005). Thus, a solution would be

to reform governmental and economic policies until they are no longer “stifling private

enterprise” (Chen 2005).

Thus there are differing views on what responsibility the government has or what

role it should play. In a nice summary of the three schools of thought described above,

Chen maintains that “some observers view informal workers as a nuisance to be

eliminated or strictly regulated; others see them as a vulnerable group to be assisted

through social policies; still others see them as dynamic entrepreneurs to be freed from

cumbersome government regulations.” Reddy (2007) describes one view, taken by the

International Labour Organization, which “recognizes the poverty and low productivity

characteristics of the informal sector for which the sector requires supportive state

intervention in the areas of credit, technical support and infrastructure.” Reddy attributes

a second approach to the World Bank, which “assumes that the main obstacles to

informal sector development are the market distortions created by state intervention,

controls and restrictions. The requirement is, therefore, not state support, but

deregulation…” Whatever role the government should play should be decided after

careful consideration of the context-specific nature of the informal economy within a

nation or region.

In order to incorporate serious considerations of the informal economy into

development plans and goals, Potts (2008) introduces a study wherein the informal

economy and the formal economy are not seen as inherently disconnected, but rather are

complementary. Many formal sector firms subcontract to informal firms, or buy their

inputs in the informal economy. Ranis and Stewart (1999) developed a model wherein

the informal economy is divided into “a more productive component of the urban

informal sector and a relatively stagnant, ‘traditional’ component.” The traditional

component is marked by low capital, low labor productivity, low incomes, very small

size (three or fewer workers), and static technology. The modern component is capital-

intensive, larger (up to 10 workers), uses dynamic technology, and is linked to the formal

sector. This distinction resembles the early modernization theorists’ distinctions between

the modern and traditional, but allows for a more practical examination of the real-world

situation in developing countries. Thus, economists can help these more efficient sectors

grow and examine ways to either integrate the less efficient sectors or find alternatives

for those who need work. Economists need to examine Ranis and Stewart’s model,

improve or localize it if necessary, and incorporate it into economic strategies in order to

achieve a more realistic and practical theory of development.

The informal economy is a large and ever-growing part of the world’s developing

countries. It is not going to disappear, so it can either be ignored (along with the lives of

its millions of dependents) or governments, economists, and activists can look for ways

to integrate it into economic growth and better qualities of life. According to Martha

Chen, an informed policy approach understands that the informal economy is diverse

(including survival activities as well as dynamic enterprises), that it can contribute to

economic growth and poverty reduction, that it is caused by many factors, that it is

affected by all policies, and that it is affected differently than the formal economy (Chen

2005). The goals of any policies should be to promote opportunities, to secure rights and

protect informal workers, and to build and recognize the voice of informal workers (Chen

2005). With a more informed, sympathetic, and optimistic look at the world’s informal

economies, we can find a new path to growth and prosperity for the world’s poor.


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