Formal Informal Interactions: A Simple Chayanov Model

Needless to say, the topic of formal-informal interaction is well traversed. Several dual economy models have been in operation to understand the dynamics of formalization-or in its popular acronym-development. Development discourse is essentially a way in which the economy becomes increasingly formalised or its operations become visible to the panoptic vision of law and legal institutions. The story is essentially the same. Formalisation raises efficiency and productivity thereby yielding benefit to all concerned. Also it adds to the society’s overall capacity to reproduce and produce itself giving way to future growth and prosperity. The story told and retold many a times fails to capture the reason for continuous existence or even (re)creation of informality even in a world where formality is the sure way to succeed. In an interesting paper Porta and Shleifer (2014) deals with this issue and comes out with an interesting conclusion. The informal sector does not merely exist for taking advantage of legal loopholes. Even if these loopholes are somehow stitched, the informal sector will not become formal. The clue perhaps lies in an old view expressed by Chayanov (though not included in the standard Chayanovian models) that in certain circumstances an informal sector can outperform a modern capitalist sector. This paper is a modest attempt to include this clue in a formal model of the simplest possible type that tries to unravel the relation between formal and informal sector as also the consequences of policies that leads to forced formalisation.