On the Dynamics of Development with Formal and Informal Economy∗ by

In a democratic and liberal development, transition towards a market oriented system for institutions is often gradual, also because of informal rules that need time to change. During this gradual transition, institutions do not become immediately “efficient ” market-wise. When institutions are not efficient, transactions costs are very high and the economy is not able to follow more “orthodox ” and linear rules of growth, which presuppose zero transaction costs. These premises lead to two possible patterns of economic development. On the one hand, economic growth is extremely slow if not even negative for long periods; on the other hand, economic activity finds other ways to develop. This paper focuses on the latter point. Market oriented institutions – yet not completely efficient – induce a rapid development of the informal economy on a large scale. The informal economy, in turn, firstly helps development, but then slows down growth of the entire economy, as it has a very little growth rate with respect to the amount of resources employed. Informal economy indeed reduces free competition, limits free access to the capital, has high insecurity costs, increases in general transaction costs and implies markets highly concentrated and little rules clarity