What It Is and Why It Is Important

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Case: The Informal Economy: What It Is and Why It Is Important?

The informal economy refers to commercial activities
that occur at least partly outside a governing body’s
observation, taxation, and regulation. In slightly differ-
ent words, sociologists Manuel Castells and Alejandro
Portes suggest that the “informal economy is character-
ized by one central feature: it is unregulated by the insti-
tutions of society in a legal and social environment in
which similar activities are regulated.” Firms located in
the informal economy are typically thought of as busi-
nesses that are unregistered but that are producing and
selling legal products (that is, they sell many of the same
products you might buy in legal businesses but perhaps
cheaper because they do not pay government fees and
taxes). In contrast to the informal economy, the formal
economy is comprised of commercial activities that a
governing body taxes and monitors for society’s bene-
fit and whose outputs are included in a country’s gross
domestic product.

For some, working in the informal economy is a
choice, such as is the case when individuals decide
to supplement the income they are earning through
employment in the formal economy with a second job in
the informal economy. However, for most people work-
ing in the informal economy is a necessity rather than a
choice—a reality that contributes to the informal econo-
my’s size and significance. Although generalizing about
the quality of informal employment is difficult, evidence
suggests that it typically means poor employment condi-
tions and greater poverty for workers.

Estimates of the informal economy’s size across coun-
tries and regions vary. In developing countries, the infor-
mal economy accounts for as much as three-quarters of
all nonagricultural employment, and perhaps as much
as 90 percent in some countries in South Asia and sub-
Saharan Africa. But the informal economy is also prom-
inent in developed countries such as Finland, Germany,
and France (where the informal economy is estimated to

account for 18.3 percent, 16.3 percent, and 15.3 percent,
respectively, of these nations’ total economic activity).
In the United States, recent estimates are that the infor-
mal economy is now generating as much as $2 trillion in
economic activity on an annual basis. This is double the
size of the U.S. informal economy in 2009. In terms of the
number of people working in an informal economy, it is
suggested that “India’s informal economy … (includes)
hundreds of millions of shopkeepers, farmers, construc-
tion workers, taxi drivers, street vendors, rag pickers, tai-
lors, repairmen, middlemen, black marketers, and more.”

There are various causes of the informal economy’s
growth, including an inability of a nation’s economic
environment to create a significant number of jobs rel-
ative to available workers. This has been a particularly
acute problem during the recent global recession. In the
words of a person living in Spain: “Without the under-
ground (informal) economy, we would be in a situation
of probably violent social unrest.” Governments’ inabil-
ity to facilitate growth efforts in their nation’s economic
environment is another issue. In this regard, another
Spanish citizen suggests that “what the government
should focus on is reforming the formal economy to
make it more efficient and competitive.”

In a general sense, the informal economy yields
threats and opportunities for formal economy firms.
One threat is that informal businesses may have a cost
advantage when competing against formal economy
firms because they do not pay taxes or incur the costs of
regulations. But the informal economy surfaces opportunities as well. For example, formal-economy firms can
try to understand the needs of customers that informal economy firms are satisfying and then find ways to
better meet their needs. Another valuable opportunity
is to attract some of the informal economy’s talented
human capital to accept positions of employment in
formal economy firms.

What threats does the informal economy present to firms operating in the formal economy? Use examples from your personal experience with the informal economy.


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