Efficient informal trade: Theory and experimental evidence from the Cape Town taxi market

Informal sectors in developing countries are often thought of as responses to rigid and cumbersome market regulations. In this paper I study informal trade as a first-best outcome. In the model I propose rigid regulations can be necessary to achieve efficiency even though they are always sidestepped. The key assumption is that the regulations define the trading parties' fall-back position in case the informal bargaining process breaks down. I set up a field experiment to test the model's mechanisms in the Cape Town market for metered taxis. Consistent with the model, I find that sidestepping the regulations increase cost efficiency (taxis take the shortest route). The price is however unaffected, suggesting informal bargaining leads to a Pareto improvement.