The Informal Economy, Entry Barriers and the Legal System
A Blog Post by Pablo Markin.
In his paper, Francesco Flaviano Russo has used a dynamic model of market equilibrium to “show that the costs of the legal system can explain the cross-country variability of the size of the informal economy” (49). The model that Russo has applied builds on those of “Hopenhayn (1992) and Hopenhayn and Rogerson (1993)” (49), while extending it “it to an economy with taxation and with two sectors, the legal and the informal” (49). According to Russo, this research approach has suggested that “the start-up costs explain roughly 75% of the cross-country variability of the informal economy, while operational costs only 25%” (49).
Based on his econometric study, Russo argues that “the market equilibrium involves switching if the equilibrium price in the legal market is sufficiently higher than the illegal, so that the most productive informal firms will find it profitable to switch. How much higher it should be depends, among others, on the consumer preferences for the legal versus illegal good, on the technological shock and on the fixed and variable costs” (56). The author has also found that “less persistent technology shocks make it also less attractive to start a new informal business” (67).
The quantitative analyses Russo performed suggest that “[i]mposing a high and, sometimes, disproportionate cost to legally start a business discourages potential entrepreneurs, making it more attractive to start informally” (67). This study indicates a negative influence of “unnecessary bottlenecks in the bureaucratic process, whose only scope is rent seeking” (67), while not arguing against “screening procedures that assess the quality of new entrants, that are likely to be welfare enhancing” (67).
By Pablo Markin
Featured Image Credits: Barrier of Entry, July 9, 2009 | © Courtesy of Kevin Spencer/Flickr.