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Reducing Informality Using Two-Sided Incentives: Theory and Experiment

Author

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  • Francisco B. Galarza

    (Universidad del Pacífico)

  • Fernando Requejo

    (Universidad del Pacífico)

Abstract

We study the impact of two-sided incentives on the reduction of informality. We model those incentives using the notion of network externalities, which link the (formal or informal) merchant’s profits to the type of customers they serve (formal or informal). Our theoretical framework yields two straightforward testable implications: the merchant will find more profitable to become formal (or informal), as long as more of their customers are formal (or informal); and, formal and informal commercial sectors may coexist in equilibrium. We test these hypotheses using data from a field experiment, conducted with micro and small enterprises in Lima, Peru. Our subjects had to choose, in a repeated fashion, among three ‘platforms’, which proxy for being formal, informal, or performing a reservation activity. We then changed the relative size of the network of formal vis-á-vis informal customers, in order to calculate the consumer’s network externality. We find that the network externality is relatively large, a result that opens up the possibility to reduce commercial informality using two-sided incentives. Moreover, the platform choice between the formal and informal sectors is sensitive to risk preferences.

Suggested Citation

  • Francisco B. Galarza & Fernando Requejo, 2019. "Reducing Informality Using Two-Sided Incentives: Theory and Experiment," Working Papers 149, Peruvian Economic Association.
  • Handle: RePEc:apc:wpaper:149
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    References listed on IDEAS

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    More about this item

    Keywords

    Network externality; informality; two-sided incentives; experiments;

    JEL classification:

    • C93 - Mathematical and Quantitative Methods - - Design of Experiments - - - Field Experiments
    • E26 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Informal Economy; Underground Economy
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements

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