Entrepreneurial Challenges to (In)Formality in Emerging Markets: An Institutional Polycentricity Perspective Justin W. Webb School of Entrepreneurship

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

http://okstate.edu/

IMAGINE > BELIEVE > CREATE

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)


Informality – Undocumented Workers


Informality – Child Labor


Informality – Piracy/Counterfeiting


Informality – Tax Evasion/Unregistered


Informality – Skirting Regulations


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)


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


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


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)


Research Question

How does (in)formality influence challenges to growth of microenterprises in emerging markets?

Growth-related challenges in terms of:1) Accessing financial capital2) Accessing human capital3) Susceptibility to crime


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)



• 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


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)



• 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


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?


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



• 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)



• 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.


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)


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.


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



• 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)



• 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.


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


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)


Methodology

• Data collection– Survey (n=192)

– In-depth interviews (n=52)• On average, 20 minutes each


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


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


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.”



• 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.”



• 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.”



• 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.”


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


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

– Crime has a glass-ceiling effect on entrepreneurial growth


Thank you!

Gracias!

Documents

Entrepreneurial Challenges to (In)Formality in Emerging Markets: An Institutional Polycentricity Perspective Justin W. Webb School of Entrepreneurship