Entrepreneurial Entry in Developing Economies: Modeling Interactions Between the Formal and Informal Sector

Using a simple two-firm, two-period model, we analyze for a developing economy theprocess of ‘entrepreneurial entry,’ that is, entry by new firms into an industry that didnot previously exist in that country, focusing on the choice between formal andinformal status. Thus we explore issues such as how informality may enable anentrepreneur to test the profitability of an industry without incurring large sunk costs,and how strategic interaction may affect such entrepreneurial decisions. In thiscontext we examine comparative statics, e.g. with respect to the minimum formalsector wage rate and the realized profitability of the industry. Under some parametervalues there is churning in terms of both the number of firms and their status. Also,we show that financial constraints can interact with the option of informality to induceentry.