Entrepreneurial Challenges to (In)Formality in Emerging Markets:
An Institutional Polycentricity Perspective
Justin W. Webb
School of Entrepreneurship Oklahoma State University Presented to: IE Business School
February 20, 2011
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The Informal Economy
• Economic activities that occur outside of formal institutional boundaries yet remain within
informal institutional boundaries
– Illegal yet legitimate/socially acceptable (Webb, Tihanyi, Ireland, & Sirmon, 2009)
• Account for
– 5-15% of GDP in developed economies – 30-50% of GDP in emerging economies
– >50% of GDP in some developing economies (Schneider, 2002)
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Informality – Undocumented Workers
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Informality – Child Labor
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Informality – Piracy/Counterfeiting
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Informality – Tax Evasion/Unregistered
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Informality – Skirting Regulations
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Benefits and Drawbacks
• Benefits of an informal economy
– Serves as a stepping stone to the formal economy (Bennett, 2010)
– Provides a livelihood where institutions have failed, thereby providing economic/social stability (De Soto, 1989)
– Provides products and services that would serve markets that would not otherwise be served (Tokman, 1978)
– Supports competitiveness of the formal economy (Beneria, 1989)
• Drawbacks of an informal economy
– Lost sales
– Obscures economic indicators (Alford & Feige, 1989) – Unfair competition to formal economy firms
– Undermines economic development (Frey, 1989) – Ties to the criminal economy (Coletto, 2010)
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Research Stream
• You Say Illegal, I Say Legitimate:
Entrepreneurship in the Informal Economy
– Webb, Tihanyi, Ireland, Sirmon
– Published in Academy of Management Review
• Framing Research on Entrepreneurship in the Informal Economy in the Boundaries of Three Prominent Theories: A Foundation for
Entrepreneurship Scholars
– Webb, Bruton, Tihanyi, and Ireland
– Revise and resubmit at Journal of Business Venturing
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Research Stream
• Firm Informality as a Strategic Choice for
Entrepreneurs in Emerging Economies: Industry and Firm Effects
– Siqueira, Webb, and Bruton
– To be submitted to Academy of Management Journal
• Entrepreneurial Challenges to (In)Formality in
Emerging Markets: An Institutional Polycentricity Perspective
– Kistruck, Webb, Sutter, and Bailey
– Submitted to Journal of Business Venturing
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Research Motivation
• Emerging markets
– Latin America, Asia, Africa
– Rapid economic growth and more liberal
government policies (Hoskisson et al., 2000)
• Yet distribution of wealth remains severely unbalanced (Khanna & Palepu, 1997; World Bank, 2009)
– Primary cause?
• INFORMALITY (De Soto, 1989; Easterly, 2006; Perry et al., 2007)
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Research Question
How does (in)formality influence challenges to growth of microenterprises in emerging markets?
Growth-related challenges in terms of:
1) Accessing financial capital
2) Accessing human capital
3) Susceptibility to crime
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Theoretical Background
• Formal institutions
– Laws, regulations, and supporting apparatuses that provide structure to economic activity (North, 1990)
• Via a system of incentives and controls (DiMaggio & Powell, 1983)
– Compliance enables resource access, more efficient transactions, opportunity to vie for contracts
– Deviance surfaces threat of fines, termination of ventures, or even imprisonment
– Can provide general public services (i.e.,
infrastructure) and for basic needs (i.e., food and shelter)
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Theoretical Background
• Weak institutions in emerging markets (Khanna &
Palepu, 1997)
– Failure to support market mechanism/economic activities
• In a highly efficient and effective manner
– Burdensome bankruptcy laws – Exorbitant lending rates
– Lack of property rights – Lack of utilities
– Corrupt enforcement agents – High levels of crime
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The Tension of (In)formality
• Informality’s advantages
– Avoiding costs
• Taxes, license fees, and extensive time investments to gain regulatory approval (Grosh and Somolekae, 1996)
• Informality’s disadvantages
– Inability to garner resources (North, 1990)
• Financial capital (McPherson & Liedholm, 1996)
• Skilled labor (Sleuwaegen & Goedhuys, 2002)
– Susceptibility to bribery and fines (Cross, 2000)
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Theoretical Background
• Institutional polycentricity (Ostrom, 2005;
Ostrom, Tiebout, & Warren, 1961)
– Within any overall institutional environment exists numerous, independent institutional centers with
authority and responsibility for defining the rules and norms within their particular domains (Ostrom, 1999)
• Institutional centers
– Legal, financial market, educational, labor, regulatory – Viewed as
• Mutually reinforcing in facilitating market mechanisms
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Elaborating the Research Question
Does formal business registration, which represents compliance with regulatory institutions, create
benefits or challenges for entrepreneurs in terms of financial market institutions, educational
institutions, and legal institutions?
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Hypotheses – Financial Capital
• Even very small amounts of financial capital are considered crucial to supporting
microenterprise growth (Mead & Liedholm, 1998)
• Financial market institutions remain very weak (George & Prabhu, 2000)
– In terms of venture capital and equity financing
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Hypotheses – Financial Capital
• Initial improvements being made
– Privatization of infrastructure investments (Banerjee, Oetzel, & Ranganathan, 2006)
– Lending options via Post Offices, credit unions, and informal lending groups (Grosh & Somokelae, 1996) – Thousand of microlenders (Khavul, 2010)
• Formal lending options have become increasingly available even for informal entrepreneurs
(Lensink, McGillivray, & Tra, 2006)
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Hypotheses – Financial Capital
• Formal lenders seek to reduce risks (Guirkinger, 2008)
– Incremental growth of loans – Requirement of collateral
• Informal entrepreneurs increase risks
– Associated with fines, termination, and imprisonment
– While perhaps avoiding enforcement is possible (Bromley, 1978), this reduces attractiveness of the opportunity
Hypothesis 1: Formal business registration is negatively related to financial capital challenges.
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Hypotheses – Human Capital
• Educational institutions in emerging markets continue to improve
– Private investments of nongovernmental
organizations and private universities (Parry, 1997)
• As with financial market institutions, however, educational institutions remain weak
– A significant portion of the labor market remains
predominantly uneducated and unskilled (Calero,
Bedi, & Sparrow, 2009)
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Hypotheses – Human Capital
• The limited set of employees with education and relevant skills are likely to favor formal
employment (Perry et al., 2007)
– Stable form of employment (Kistruck, Webb, Sutter,
& Ireland, 2011)
• Avoid enforcement risks
• Avoid risk of being laid off (Portes, 1994)
Hypothesis 2: Formal business registration is negatively related to human capital challenges.
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Hypotheses – Crime
• Crime
– Any action that deviates from a country’s formal legal institutional prescriptions
– Occurs due to
• Lack of institutional controls (Gottfredson, 2009)
• Strain created by uneven distribution of resources among individuals in society (Merton, 1968)
• Perceptions of incompetence of institutional leadership (Maloney, 2004; Rosenfeld & Messner, 1997)
• Differences in beliefs regarding legality and legitimacy (Webb et al., 2009)
– Failure of formal institutions
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Hypotheses – Crime
• Crime
– Relatively high levels in emerging markets, likely due to high levels of socioeconomic deprivation (Ksenia, 2008; van Dijk & Zvekic, 1993)
– Decreases the attractiveness of undertaking
entrepreneurial activities (Fintoka & Chindoga, 2011)
• Creates additional costs so that entrepreneurs cannot appropriate full value from their activities
• Especially costly in emerging markets as entrepreneurs often operate without insurance (Barnett, Barrett, & Skees, 2008)
– Leaving entrepreneurs to absorb losses via
personal/familial savings (Hulme & Shepherd, 2003)
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Hypotheses – Crime
• We expect formal entrepreneurs to be more susceptible to crime
– Enforcement in emerging markets
• Underpaid and understaffed (Aron, 2003; Feder & Feeny, 1991)
• Do not really have privatization of enforcement – Formal entrepreneurs
• Incur significant costs to gain formal status (De Soto, 1989)
• Operate in more visible, attractive premises
• Publicly display registration
– Signal to criminals a relatively more attractive target
Hypothesis 3: Formal business registration is positively related to challenges associated with crime.
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Hypotheses - Crime
• Different forms of crime
– Theft (+)
– Vandalism (+) – Extortion (+) – Bribery (-)
• Enforcement agents wield significant power and can enter business premises unannounced (Safavian et al., 2001)
• Corrupt enforcement agents can squeeze informals more tightly than formals
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Methodology
• Sample
– 247 microentrepreneurs in Guatemala City
• 55 cases removed due to missing data (n=192)
• Identified via partnership with a microfinance division of a local Guatemalan bank
– Guatemala
• 2nd highest rate of nascent entrepreneurship as well as business ownership (GEM Global Report, 2009)
• Emerging market with high levels of poverty (World Economic Outlook Report, 2010)
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Methodology
• Data collection
– Survey (n=192)
– In-depth interviews (n=52)
• On average, 20 minutes each
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Methodology
• Measures
– Dependent variables: Challenges (4-point Likert-type scale)
– Independent variable: Formal business registration, yet selling a legitimate product (dichotomous: yes or no)
• Registering a business takes 37 days and requires a minimum equivalent of $625 deposit in a bank and business name
search, legal representative, and notary to sign and submit documentation
– Control variables: Entrepreneur age, gender, and education; Business age, size, and zone; Level of competition
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Results
• 45% of sample is formal
• Average size of business: 2.6 employees
• Average age of business: 15 years old
• Approximately half of our sample captures women-led microenterprises
• All hypotheses supported except for the
hypothesis related to bribery
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Results – Exploring Crime
• Why was bribery not statistically significant?
• A restaurant owner suggested:
“We don’t have to pay the police. The police are aligned with the gang members, to the
extortioners. The extortioners pay the police. If we call the police, there’s no response. People are
afraid of the gangs and the police. Even when the police get a criminal in the police car, they let him go around the corner. We can’t really count
on them.”
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Results – Exploring Crime
• What systematic factor drives formal’s susceptibility to crime
• Stated by a bank representative and entrepreneur:
“Formal businesses are more vulnerable. The businesses that are registered regularly end up on a directory, whether it be the registry
of property or the tax registry. They enter their name, address, and telephone number, and when criminals have this information, it’s
easier to contact the business and extort them.”
“When a business is registered , it is obligated to pay taxes and give receipts. So they have to comply with an administrative regime. For
someone who wants to extort, they can go and ask ‘Do you give receipts or not give receipts?’ and then they know.”
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Results – Exploring Crime
• What are the effects on businesses?
“I had a warehouse and would travel to all of Central America to buy things and bring them to Guatemala to
sell. The criminals began to watch me very carefully.
They told me, ‘We need this amount of money, and if not, we’ll kill your daughter. We know where she studies. We know where your wife works.’ I had to change phones. I also had to change the location of my business and my warehouse. Now I go out as a walking
salesman and only offer products to those I have received a reference.”
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Results – Exploring Crime
• What are the effects on businesses?
“There are people that tried to extort us. They were people that were in jail, but they got our telephone number. The phone started ringing and we were talking
to this person, and there was also a person in the market that kept track of when we got there. As soon as
we opened, the phone started to ring. This happened to about 50 of us in the market. We tried changing our hours and we came at noon, but as soon as we got there
the phone would start to ring. He knew where my kids go to school and the way they came home from
school.”
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Discussion
• Emerging economies are characterized by significant poverty
– Attributed to high levels of informality
• Both formal and informal microenterprises face challenges
– Informal: Access to financial and human capital – Formal: Susceptibility to crime
• Variance in development of formal institutional
centers
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Discussion
• Key points
– Differences in the ability of separate institutional centers can produce constraining rather than
enabling effects on individual actors – Chicken-and-the-egg
• You need to fix the institutions to facilitate
formalization, but institutions can’t be fixed without tax revenues which are lost due to informality