Stylized Facts

that idiosyncratic distortions and their associated effect on innovation decisions of firms have a first-order effect on the expected profitability of formal entrants, whereas the productivity growth and the death rates are key determinants of expected profitability in the informal sector. Entry barriers and idiosyncratic distortions in the formal sector interact in shaping the entry decision of prospective firms.

EQUILIBRIUM

The stationary equilibrium of the model, which we characterize formally in annex 2C, involves solving for individual outcomes, the distribution of firms across productivity levels in both sectors, the wage rate, and the relative price of formal and informal goods, so that decisions are optimal and markets are clear. Two key equilibrium objects, then, which will subsume the information of how distortions affect outcomes and which will signal the reallocation of production to the informal sector, are the wage rate and the relative price.

MECHANISMS

Consider the mechanisms underlying the economy’s response to each type of distortion. Suppose there is an entry barrier τe , but there are no idiosyncratic distortions. The entry barrier increases the cost of entering the formal sector, and the number of formal firms falls, and so does the aggregate productivity in the sector. The relative price of formal goods increases, inducing a reallocation of expenditure, entry, and employment to the informal sector.

Consider the effect of idiosyncratic distortions that misallocate resources from the high to the low productivity firms. There are two sources through which aggregate productivity in the formal sector declines. First, there is the misallocation effect, which reduces allocative efficiency. Second, firms are discouraged from innovating, anticipating that the productivity-dependent distortion reduces the rate of return of growing their productivity. Similar to the entry barrier case, then, the relative price of formal goods increases, and firms and employment reallocate from the formal to the informal sector.

Prior to delving into the main quantitative exercise of the chapter, it is instructive to review a few empirical regularities characterizing the formal and informal sectors in India.

Informal production accounts for about 80 percent of total employment in the manufacturing sector, far higher than the 8 percent share exhibited in a developed economy like the US. Furthermore, an exploration of the size distribution of establishments in the informal sector reveals that informality is mostly a microentrepreneurship production activity.