Choosing between the formal and informal economy

Abstract

Why do managers in emerging markets conduct some activities in the informal economy and others in the formal economy when they have a choice? Using institutional economic theory, previous research shows that, at the country level, weak formal institutions create institutional voids that increase the transaction costs of using the formal economy. To evade high transaction costs, managers in emerging markets use the informal economy. However, previous research does not explain, at the firm level, why managers in emerging markets conduct some activities in the informal economy while conducting others in the formal economy. I theorize that, at the firm level, managers' social ties with formal institutions protect them against being singled out for enforcement and against potential opportunistic behaviors by business partners. In particular, opportunism, which increases transaction costs, might take place in the informal economy because contracting parties cannot be held legally accountable. That is, managers' social ties with formal institutions allow them to keep the transaction costs of using the informal economy lower than the transaction costs of using the formal economy for a specific activity. Moreover, I argue that not all managers who have social ties with formal institutions are prone to conduct more activities in the informal economy. In particular, based on regulatory focus theory, I argue that managers who have a promotion focus mindset are more prone to use their social ties with formal institutions to conduct activities in the informal economy. Using a sample of 206 Lebanese respondents, I developed two new scales: manager's social ties with formal institutions and manager's propensity to use informal economy. I then used these scales to empirically test my theory. The results of this study support my theory that managers who have social ties with formal institutions are more prone to conduct activities in the informal economy. However, the results of this study did not support the argument that managers who have a promotion focus mindset are more prone to use their social ties with formal institutions to conduct activities in the informal economy.