Formality, Informality, and Social Welfare

An industry is modeled in which entrepreneurs, who are heterogeneous in ability, may produce formally or informally. It is shown how the formal-informal mix depends on the distribution of ability, product demand and a variety of parameters. The industry equilibrium is compared to one in which informality is prohibited. With relatively high product demand, the effect of entrepreneurs being free to choose informality is that consumer surplus and total employment are reduced, but profit is redistributed towards more able entrepreneurs. With relatively low product demand the opposite effects obtain. With high (low) demand informality is a built-in stabilizer (destabilizer)