The informal sector as a substitute for social security

We consider an economy with two groups of individuals, rich and poor. A central authority can either directly redistribute income to the poor, or allow for some degree of informality in economic activities by not enforcing property rights. The optimal degree of informality depends upon the characteristics of the resources used by the poor if property rights are not perfectly enforced. It is shown that the degree of enforcement falls if the resource is becoming less rivalrous in use. Hence, the informal sector is a better substitute for social security, the more the resources used by the informal sector have the character of public goods. We explore the basic trade-offs and discuss the special cases of anarchy, perfect civil society and the absence of a welfare state. In addition to this we analyze the similarities and differences between a welfare-maximizing state and a predatory state.