Understanding the Informal Sector

Understanding the Informal Sector

Sam Choon Yin (2003)

People are generally rational. They make decisions after assessing the benefits and costs of each alternative and choose the one that yields the highest net benefits. If this is true, then the decision to participate in the informal sector as opposed to the alternative of non-participation must imply that the former option generates higher net benefits to the participants. Why is this so? What are the benefits and costs of participating in the informal sector? This essay tries to answer these questions. But first, it may be useful to know what the informal sector constitutes.

Unlike the formal sector, an informal sector is unregistered with the government. Usually, the government has very little idea about the sector’s contribution to the country’s economy, the number of people employed in the sector and the actual activities being carried out there. No doubt, economists and policy makers have attempted to estimate the size of the sector but they are at best uncertain. Examples of industries normally found in the informal sector are the prostitution industry, drugs industry, ‘pirated goods’ industry and gambling industry. On a smaller scale, the sector encompasses hawking, peddling and street trading. They essentially operate illegally.

What are the advantages that the informal sector may bring to the country’s economy? It may sound weird to even talk about its advantages. They have low government support and they can create social and political problems. But the fact is that the informal sector is not totally bad at least from the economics point of view. They help to generate more employment opportunities. The informal sector provides job opportunities to the urban poor and rural migrants. Without the sector’s existence, more people are likely to be unemployed. Accordingly, unemployment related problems could worsen during economic recession. Loss of income and increased humiliation due to retrenchment can create other problems like crime and stealing. With the informal sector, employment opportunities are more abundant thus providing individuals with income to spend. The country’s economy may turn out better than expected. Moreover, autonomous expenditures create multiplier effects on the equilibrium national income.

The informal sector also helps firms to sustain their businesses. A good example is the small retailing industry. With so many large grocery stalls like NTUC Fair Price, Giant and Carrefour to compete with, the smaller ones in Singapore actually find themselves losing customers to the biggies. It appears that the law of one price does not really hold very well in this industry at least for some household goods. The larger retailers can sell similar products at lower prices perhaps due to their ability to reap economies of scale. This problem (faced by smaller retailers) is particularly acute in Singapore because of the close proximity between these larger retailers and public housing estates. Good communication and transportation networks in Singapore compound the problem since the consumers can easily bypass the smaller retailers and visit the larger ones instead. To survive, it is not uncommon for the small retailers to offer illegal gambling opportunities. They are of course informal. They are able to attract households to visit the small retailers located near housing estates. Bets can be placed there at different amounts without the hassle to queue up in legal betting places. The latter is a clear advantage. It is not uncommon to see long queue at legal gambling places in Singapore. 

Generally, the informal sector generates utility to the consumers. People become happier after visiting the illegal brothel or gambling houses. They are pleased for being able to buy pirated compact discs and computer games at lower prices. It may be argued that individuals have actually become more computer literate and technologically savvy because of their ability to purchase computer software like Microsoft Office at much more affordable prices in the informal sector. They end up being more productive. In the process, the country benefits. Potentially, they can contribute more the country’s economy both in the formal and informal sectors thanks to the ‘contributions’ from the latter.

It is for these reasons that economists have argued that contributions from the informal sector should be included in economic statistics like national income and employment. Depending on its actual magnitude, the sector can significantly affect the direction in which the economy is heading. It is unfortunate that accurate estimations of the sector’s size are missing. A problem with the missing data is that the government may not be able to properly assess the country’s economic performance. As a result, wrong policies may be introduced leaving the economic problem unsolved or worsened. For example, the government may overestimate the economic recession that the country is suffering. Unnecessary expansionary policies can lead to higher inflation and enlarged budget deficits.

There are other problems related to the growth in the informal sector. People generally become more hostile. Drugs taking and desire for sexual services can lead to more stealing and brawls. The other problem relates to the loss of tax revenue to the government. Since the businesses are not registered with the government, taxes are not paid. Tax evasion affects the quantity and quality of public services offered in the country. Accordingly, external costs are generated. The interests of third parties are negatively affected. The society may end up with less public service to enjoy or poorer quality of public services offered by government (or both).

As I have mentioned earlier, the government may not be able to introduce the right policies to stabilise the economy when the informal sector booms. The government can thus be blamed for not being able to solve the country’s problem. This can lead to political chaos. The government may be overthrown as a result.  It is perhaps because of this reason why governments are usually very much interested in the informal sector. Their reputation is basically at stake if the informal sector is not properly understood and contained.

What are the benefits to individuals taking part in the informal sector? There are several benefits. First, the participants can evade taxes. Their income and profits appear higher. The sector is by definition unregistered with the government. Without any records of income earned, it is not possible to catch the culprits who evaded taxes unless the Inland Revenue officers obtain tip-offs about their whereabouts and activities carried out. Second, businesses operating in the informal sector can avoid going through the government to get things done. Being informal, they can essentially bypass the government. In countries with rampant corruption problems, they can avoid paying bribes to government officers. They can cut red tapes. The above can be viewed positively. Non-compliance to bad rules can actually foster economic development.

The other reason explaining why individuals participate in the informal sector is the huge reward that accompanies success in that sector. Generally, the informal sector is a luxury sector to enter. The demand for the goods and services there is very high thus leading to high rewards to be reaped as least as perceived by some. Imagine, both the rich and the poor gamble. Both rich and poor individuals need drugs when the urge arrives. Both the rich and poor want to enjoy savings from the purchase of pirated compact discs rather than buying the original ones. With the supply of such services being relatively price inelastic, increased demand for these services basically translates to high potential rewards. Accordingly, the attractiveness in entering the informal sector increases with other things remaining unchanged.

The desire to enter is compounded by the strong desire to ‘win’. Widening income inequality and westernisation encourage more people to take risk and venture into the informal sector. The temptation to take more risk increases, as people perceive that the world’s income is not fairly distributed. Interestingly, the above is true regardless of what others do. If others do not participate in the informal sector, one will be tempted to enter since the odds of winning is then enhanced. If others participate in the informal sector, then the temptation for one to enter is still very much present. This is so as he/she does not want to lose out to those who enter. He/she wants to share the ‘winnings’ (if any) with the rests.

If the government wants to limit the size of the informal sector, then the costs of participating in the sector must be highlighted and made known to potential and current participants. Raise the probability of catching them and raise the penalty costs incurred by the offenders. Shame them in public. Set up appropriate institutions to tackle the problem. Provide the institution(s) with the necessary resources and decision-making power. The role of media should not be underrated. It plays the role of the educator. It helps to transmit information to the people. Only with information can rational individuals make more informed decision using benefits and costs analysis. And it is hoped that with the information, the perceived costs of participating in the informal sector outweigh the perceived benefits. But then, these initiatives should only be introduced if the government feels that the informal sector provides more harm than good to the country. The debate on this issue is (unfortunately) still ongoing.