Who Is Afraid of Informal Competition?

Competition by informal firms is one of the most severe business constraints in developing and transition economies: When asked for the three main business obstacles, 12 % of firms listed informal competition, only topped by access to finance (16 %) and tax rates (15 %, see figure 1). In general, two thirds of firms considered informal competition as an obstacle to their business. As we argue in current research (Friesen and Wacker, 2013), it is this externality of informal competition to formal firms that is most important from a welfare perspective, and not so much the size of the informal sector per se.

We therefore investigate what causes firms in developing and transition economies to suffer from informal competition. We find lacking access to finance to be the main cause of informal competitive pressures, together with labor market over-regulation and corruption.

Figure 1: The Relative Importance of Business Obstacles
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Note: Based on a sample of 40,757 firms in the World Bank Enterprise Surveys 2006-2011.

Study design

More specifically, we use World Bank enterprise survey data of 42,000 firms in 114 developing and transition countries over the last years (2006-2011). Participating (non-agrarian, private, formal) firms were asked to rank the degree of obstacle that competition by the informal sector and other business constraints present to their operations, and to provide other firm characteristics. According to this survey design, we use an ordered logit model and identify the impact of access to finance and other variables on informal competition within countries and conditional on the firm’s industrial sector. A wide set of robustness checks was applied, including instrumenting access to finance by country-industry-location-size averages and controlling for firms’ productivity shocks.

Main results

We find that firms with ‘very severe’ financial constraints are 174 % more likely to suffer from higher levels of informal competition than firms with ‘no obstacle’ in accessing finance. For illustration purpose, figure 2 depicts the likelihood of an ideal firm to be confronted with informal competition, depending on its access to finance. As the red area shows, the probability of facing ‘moderate,’ ‘major’ or ‘very severe’ informal competition increases from 45 to 69 % when the firm suffers from ‘very severe obstacles’ in access to finance instead of facing ‘no obstacle’ in the latter.

Figure 2: Predicted Probabilities of Informal Competition for an Ideal Firm
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Note: Predicted probabilities are calculated for a small, non-exporting, female-owned, domestic firm that is not part of a larger firm, is located in the capital and faces a moderately constraining business environment. All other variables are set to their mean.

In fact, our study shows that financial constraints are the most important reason why firms suffer from informal competition. Other influential variables are highly over-regulated labor markets, corruption, and firm size. Furthermore, we show that firms in industries that are more dependent on external finance report less severe informal competition and that the effect of financial constraints is larger in these industries.


Generally, we find that informal competition is higher in market environments which are not as much dependent on innovation and product quality, e.g. the textiles sector or industries that are independent of external finance. This suggests that incentives and opportunities to innovate can boost firms out of market segments where informal competition is fierce. Finance is an evident promoter in this context because of its relevance for “economic opportunity” (Demirgüç-Kunt and Levine, 2008).

Making finance more accessible could therefore have large welfare effects by greatly reducing negative externalities of informality. There is especially large scope for action since only 30 % of surveyed firms see “no” obstacle in accessing finance, while it is at least a “moderate” obstacle for more than 50 % of firms.

However, improved access to finance is not a panacea. Firms will only actively access finance if its “economic opportunity” can be put in place. This requires a stable and favorable business environment. It is hence not too surprising that labor market over-regulation and corruption are other relevant reasons for firms to suffer from informal competition.


Demirgüç-Kunt, Asli and Ross Levine (2008): “Finance and Economic Opportunity.” World Bank Policy Research Working Paper 4468

Friesen, Julia and Konstantin M. Wacker (2013): “Do Financially Constrained Firms Suffer from More Intense Competition by the Informal Sector? Firm-Level Evidence from the World Bank Enterprise Surveys.” Courant Research Centre ’Poverty, Equity and Growth’ Discussion Paper 139

2 Responses to "Who Is Afraid of Informal Competition?"

  1. Sarel van der Walt   July 10, 2013 at 8:34 am

    From a different point of view: informal businesses (in particular if in competition to established formal businesses) is merely the symptom of a bigger problem (which may differ from country to country):

    Finance is too difficult to come by
    The market is over regulated – there is simply too much red-tape
    Access to land – established/formal businesses are monopolising available land
    Tax rates – the cost of being formal is too much, there is an incentive to being informal,