THE RELATIVE PERFORMANCE OF FORMAL AND INFORMAL SECTORS IN INDIA

Abstract

We evaluate the relative performance of formal and informal sectors in India by looking into their productivity difference. Recognizing the intersectoral linkages in the economy, the competitive general equilibrium prices are computed; these signal the productivities. Our model synthesizes frontier analysis with the general equilibrium approach to generate shadow prices. The formal activities are found to be more productive than the informal. However, the informal services sector is as efficient as the formal one. There would be an overall productivity gain of 22% to the economy if factors were allocated to productive activities. The shadow prices from the model indicate that the formal capital and informal capital are scarce factors, while it has been the opposite for formal (regular) and informal (casual) labour. Formal labour is more productive than its informal counterpart; formal capital and informal capital are equally productive.

Keywords:

• Productivity
• Formal and informal sectors
• Competitive prices
• General equilibrium

Notes

¹ Morrisson (1995), and Fortin et al. (1997) described the differences in terms of scale, legal obligations and wage dualism.

² Instead of considering total factor productivity growth, which is useful for inter-temporal comparisons, we use relative productivity levels more suitable for the comparison of formal and informal industries.

³ DEA measures sectoral efficiency by using distance functions with respect to the production possibility frontier (Färe et al., 1985, 1994).

⁴ The average growth rate of service sector value added has been 7.5% per annum while the average aggregate GDP growth has been 5.8%.

⁵ Capital is defined on the basis of its ownership, namely self-employed or employer (entrepreneur). ‘Formal capital’ is solely used by formal sector. Only the informal ‘construction’ activity requires ‘formal capital’ for its production. ‘Informal capital’ in the formal sector is owned by the self-employed, which is also an employer hiring less than six workers.

⁶ Stark (1982) assumed the existence of a ‘downward linkage’ between the formal sector and the informal sector in order to capture the impact of formal sector job creation on the informal sector.

⁷ This can be defined as X-efficiency (ten Raa, 2006).

⁸ Besides the degree of underutilization, alternative assumptions regarding the mobility and substitutability of factor of production would generate different patterns of specialization at the frontier.