This brief is part of the Insights @ Center for Emerging Markets, a publication focused on cutting-edge ideas and advice for global leaders about emerging markets.
By Juan Bu (Indiana University) and Alvaro Cuervo-Cazurra (Northeastern University)
Informal Entrepreneurship in Emerging Economies
Informal firms are businesses that operate without registering with government agencies. They are a common phenomenon in emerging economies and are not legal persons, which limits their ability to establish and maintain formal contractual relationships. They account for more than half of all nonagricultural employment and contribute approximately one-third of gross domestic product (GDP) in emerging economies.
Informal entrepreneurship often arises due to the high costs and complexity of registration procedures in emerging markets. Informal entrepreneurs provide legal products and services to customers, but do not pay taxes, fees, and social security contributions, leading to cost advantages over formal firms.
Research by Bu and Cuervo-Cazurra examines more than 9,000 firms in 71 emerging markets. It shows that although informal firms may enjoy lower costs, they also suffer from lower innovativeness, thus hampering their future. Informality has a cost.
The Persistence of Informality Costs and Innovation
Since informal firms are not legal persons, they cannot publish hiring information to potential candidates through public platforms and provide information to potential employees. This limited information makes competent, skilled employees feel that the prospects for advancement and growth in informal firms are more limited and less appealing than working for a formal company. Informality also affects external relationships, hindering information exchange and making it difficult to establish long-term relationships with suppliers and distributors. Additionally, informally created firms are vulnerable to expropriation and abuse from corrupt government officials.
The costs associated with informality continue to affect firms' behavior even after they formalize. While formalization can help firms access external resources and achieve higher value-added and profitability, many of the informality problems are likely to persist. For instance, the internal practices of hiring and managing employees and external relationships with suppliers and distributors are particularly difficult to change.
Even after formalization, managers are likely to continue trusting their personal connections and relationships more than public platforms when searching for and hiring new employees. Existing employees often develop work attitudes that they may struggle to change. Moreover, the practices of managing employees based on short-term relationships can become ingrained in the corporate culture. Finally, the firm's history creates reputation challenges that increase perceived uncertainty and thus discourage promising talent from joining the firm even after it joins the formal economy.
The outcome of these informality costs is that they hamper innovation as employees and managers are more focused on the short term than on the long term and improvements needed for innovation.
The Impact of Ownership on Informality Costs and Product Development
Although informality costs persist after the firm becomes formalized and harm innovation, they can be altered through changes in ownership, as they can force an alteration of the company's mindset and practices. The impact of such ownership changes depend on whether the firms become owned by foreign firms, domestic business groups, or the state. The authors show that foreign ownership and domestic business group ownership alleviate informality costs, leading to more innovative new products, while state ownership increases informality costs, resulting in more imitative new products.
This is because, on the one hand, foreign ownership and business group affiliation can help informal firms overcome the challenges of innovation, incentive alignment, and relationship building, by providing them with access to resources, knowledge, and networks. On the other hand, state ownership can exacerbate these challenges by creating a culture of imitation, and risk aversion, due to the political interference and soft budget constraints of state-owned firms. Therefore, informal firms should seek foreign or group ownership rather than state ownership to reduce their informality costs and enhance their performance.
- Managers who are keen on establishing innovative new ventures in emerging markets should consider formalizing their firms from the start to avoid the costs associated with informality that persist over time even after their firms have become formal ventures. Alternatively, if they have already created their firms informally, they may consider formalizing them and also joining private business groups.
Bu, J., & Cuervo‐Cazurra, A. (2020). Informality costs: Informal entrepreneurship and innovation in emerging economies. Strategic Entrepreneurship Journal, 14(3), 329-368.
If you are interested in learning more about this work, contact Professor Cuervo-Cazurra.