Question

According to research by Rafael La Porta of Tuck School of Business at Dartmouth and Andrei Shleifer of Harvard University, in developing countries, the average firm in the informal sector, or underground economy, employs 4 workers as opposed to 126 workers employed by the average firm in the formal sector. a. What is the informal sector, or underground economy? b. Why would we expect firms in the informal sector to be so much smaller than firms in the formal sector?

Short answer

a. The informal sector, or underground economy involves economic activities that are not regulated by the government and do not contribute to the GNP or GDP. b. Firms in the informal sector are typically smaller due to several factors including limited access to markets, less capital and resources availability, evasion of regulations, and flexible business operations that allow for quick dissolution if necessary.

Step-by-step solution

Define the Informal Sector or Underground Economy

The informal sector, or underground economy, refers to economic activities that are neither taxed nor monitored by a government and are not included in that government’s Gross National Product (GNP) or Gross Domestic Product (GDP).

Identify Reasons for Size Difference

There are numerous reasons why firms in the informal sector are much smaller than those in the formal sector. This can mainly due to the lack of access to large markets, minimal capital and resources, avoidance of regulations, and the ability to quickly dissolve a business if need be.

Key concepts

Underground Economy

When delving into the subject of the underground economy, we are referring to those business activities that slip under the regulatory radar. The underground economy encompasses all market transactions that occur outside of official channels. In simpler terms, this means any jobs or services that are paid for in cash, without taxes or records. This could include anything from a local handyman fixing a sink without providing a receipt, to larger unreported transactions involving significant sums of money.

One might wonder, why do these unremarked activities matter? They're significant because they're not captured in traditional economic measurements like GNP or GDP, yet they represent a sizeable chunk of economic activity, particularly in developing nations. An interesting point here is that being 'underground' doesn't inherently mean illegal activities—it includes unincorporated small businesses operating under the taxation threshold, casual jobs, and self-employment that are not reported. Ranging from hairdressing to car repairs, these transactions are ubiquitous but invisible to official statisticians.

GNP (Gross National Product)

Gross National Product (GNP) is perhaps a less familiar term than its cousin GDP, but it's equally important in economics. GNP measures the total economic output produced by the residents of a country, regardless of where they live. Think of it as a financial portrait of a country's residents' economic activity. For example, if a French company operates a factory in Brazil, the profits from that factory contribute to France's GNP, rather than Brazil's.

It's easy to confuse GNP with GDP, so keep in mind that GNP is about the players (the residents), and where they are generating wealth, even if they aren't on their home turf. This metric is particularly relevant for countries with a lot of citizens working abroad sending money back home, as their contributions are acknowledged in GNP calculations.

GDP (Gross Domestic Product)

Gross Domestic Product (GDP) is one of the most commonly referenced terms in economics. It measures the total value of all goods and services produced over a specific time period within a country's borders. It's akin to the scorecard of a country's economic health and vitality. GDP includes the output of all the firms within the country, whether they are owned by residents or foreign investors.

Now, GDP doesn't account for the underground economy since these transactions aren't reported. Because of this, GDP can sometimes understate the actual size and health of an economy, especially in places where the informal sector is substantial. Policymakers, economists, and statisticians use GDP to craft economic policy, gauge economic growth, and make international comparisons. It's not perfect, but it's one of the best tools we have to understand the economic activity of a nation.

Economic Activities

When we talk about economic activities, we're looking at the various ways people and organizations earn income and contribute to an economy. Broadly speaking, these activities can be divided into three categories:

• Primary: Directly extracting natural resources, like mining or agriculture.
• Secondary: Manufacturing and processing—turning raw materials into finished products.
• Tertiary: Service industries, from teaching to banking.

Each of these sectors plays a critical role in a well-rounded economy. The informal sector falls within this structure, often heavily anchored in the tertiary category due to the ease of entry and the necessity of services. By not being formally documented, many of these activities aren't taxed or regulated, making them more flexible and sometimes more attractive to those looking for less cumbersome ways to earn a living.

Firm Size in Economics

In economics, firm size can be an indicator of many factors, including success, stability, and market power. Smaller firms, like those often found in the informal sector mentioned earlier, typically employ fewer workers due to a variety of reasons. They may have limited access to capital, smaller customer bases, and less ability to spread the costs of regulation and taxation. Moreover, the agility of small firms allows them to adapt faster to market changes—although this comes with greater vulnerability to economic shocks.

Conversely, larger firms often have economies of scale, meaning they can operate more efficiently as they grow. They're typically better at weathering economic downturns and are more likely to influence market conditions. In the formal sector, these firms are formally registered, pay taxes, and comply with governmental regulations, which can contribute to their larger size in comparison to firms in the informal sector.