Basic Features of the Informal Sector – Explained!

Read this article to learn about the basic features of the informal sector concept!

The concept of the informal sector was not popular till the 1970s, though this sector existed even before.

For the industrially developed countries of Europe and North America, formal employment was the norm, especially in the US after the Great Depression of 1929 and the post-WWII reforms in Europe.

This type of employment entitles a degree of permanence to the job and the worker is entitled to retirement benefits after they retire from work. The number of workers who were not engaged in formal employment was relatively small and merited little interest.

This idea of permanent employment being predominant in the economy was also echoed by developing countries in Asia and Africa. Though most workers in these countries were engaged in informal employment, their governments chose not to highlight their problems because employment in these countries was overwhelmingly in the agrarian sector. Modernisation of agriculture and industrialisation would surely change the situation as it had happened in developed countries.

It was only in the early 1970s that the notion of informal sector gained currency. At that time, the ILO was carrying out some major studies on the labour market in some of the countries on the continent. One of the researchers was Keith Hart, an anthropologist, who was studying the situation in Accra in the African country of Ghana in 1971.

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He found (1973) that quite unlike the organised markets in England, where he came from, there were workers who came from their villages in the vicinity to offer their services as day labourers. These people would assemble at certain places in the cities and wait for possible employers to hire their services.

He also found that there were sharp differences in retailing in England and these countries. In the developed countries, food grains and vegetables were available in standardised packets that were sold in departmental or grocery stores. In Accra, villagers would come to the cities and sell their wares to the public at large.

These were not standardised goods that were weighed and neatly packed. Instead, the street vendors who sold vegetables or food grains did so in open baskets. These were weighed in front of the customers who wanted to buy these goods. On the whole, the scenario appeared quite chaotic.

There were workers who worked as day labourers and whose employers had no responsibility towards them, except for paying them their daily wage. The retail trade was equally unorganised with individual sellers rather than organised retail outlets. For lack of any other word to describe these activities, Hart labelled them as the informal sector, as compared to the formal sector.

Hart also found that there were four basic features of the informal sector that proved useful for employment in developing countries. These were:

(i) Low levels of skill:

Most of the jobs in the informal economy are labour-intensive, involving low levels of technology. The skills required from workers are rudimentary. Developing countries have large reserves of untrained, unskilled workers who have little or no education.

These people cannot hope to find work in the formal economy as they do not have the skills needed for specialised jobs in the formal sector. Hence they find employment in the informal economy. This sector therefore absorbs the surplus labour in the economy.

(ii) Easy entry:

Because of the low skill requirements, entry to the informal sector is comparatively easy. For example, it is easier for a person with low skills and little capital to take to street vending instead of starting a venture in the formal economy such as a grocery store.

(iii) Low-paid employment:

Wages of workers in the informal economy are low because of the low levels of skills of the workers. Moreover, easy entry in this sector is precisely because of low wages offered to the less-skilled workers.

(iv) Largely immigrant workforce:

The labour force engaged in informal employment does not consist of local people and they are mainly immigrants. Hart presumed that migrants mainly possess low skills and that is why they can find work only in this sector. This inference is not necessarily correct because one finds a large number of local people engaged in this sector, especially in developing countries.

The Employment Mission of the ILO (1972) had noted that the traditional economic sector not only persisted along with modern enterprises but it had expanded. The mission chose to use the term ‘informal sector’ (coined by Hart a year earlier) rather than traditional sector. This sector included small-scale and unregistered economic activities.

Both Hart and the ILO believed that the informal sector was a transitory phase that would disappear when these countries developed. The formal sector would expand and absorb the informal sector. In other words, day labourers or workers in unregistered small factories would be absorbed as formal sector workers, and street vendors would probably be absorbed into the organised retail sector as these countries developed and expanded their formal sector.

Hence, the ILO believed that these two sectors were independent of each other, and the informal sector would disappear or decrease considerably as the formal sector expanded. This approach is known as the ‘dualist approach’, and it is regarded as outdated considering the developments in the economy in recent years. But we find that far from disappearing, this sector has grown tremendously in all countries, even in the developed ones.

It would be unwise to throw out the entire concept of a dualistic approach. These studies were important because they brought to light some important aspects of the informal economy, especially its potential for providing employment. In developing countries, the informal economy was able to absorb surplus and untrained labour.

However, it was by and large a concept that was not able to effectively understand changes in the economy or why, despite development, this sector continued to expand. This brings us to the other approach used to study informal economy, namely the structuralist theory.

The structuralist theory was developed by Manuel Castells, Alejandro Portes and Lauren Benton in late 1989 though the issue had been raised by Caroline Moser in her paper in World Development (Moser 1978). Portes and Castells argue that far from being independent of each other, the formal and informal sectors are related to each other.

The enterprises in the formal sector use the informal sector for manufacturing components as costs are much lower, and informal sector enterprises are not subject to the laws that regulate production in the formal sector. The formal economy thus finds the informal economy as a useful means for increasing its profits.

At the same time, the informal economy depends on the formal sector for its sustenance. The structuralists stress the fact that there is a close, symbiotic relationship between the two sectors. This is to a large extent true as we can see that low-paid, sweated labour in the informal sector is being used to provide inputs to the formal sector for small- scale industries are engaged in manufacture of parts that are used as inputs in the manufacture of goods produced in the formal sector.

The automobile industry depends on a number of small manufacturers who supply the different components for making the vehicle. Similarly, we find that manufacturers in the developed economies outsource their production to the developing countries because manufacturing in the informal sector in these countries is much cheaper.

The structuralist approach is also relevant while examining economic growth during the phase of liberalisation (from about 1991 in India). With laws regarding setting up of industries and foreign investments becoming liberal, one can see a large number of industries in the West that outsource the manufacturing of their goods and promotion of services to the developing countries because of lower costs .

Hence, vehicles manufactured in Germany have much of their parts manufactured in small- and medium-scale industries in India because labour costs are cheaper, the laws are liberal and there are no trade unions in these companies, which would have insisted on observance and maintenance of proper labour standards. Technology plays a major role in this process.

The rapid expansion of information technology (IT) since the 1990s led to the expansion of this industry in India, and now much of the software used by Western companies is made in India by Indian engineers. The call centres too are an important addition, as they are set up by companies in developed countries and operated by their Indian counterparts. The only issue here is that all these industries, especially those in IT, are not self- governing in the sense that they are totally dependent on support or orders from industries in developed countries.

An important point raised by the structuralist is that the informal sector exists because of the needs of the formal sector. This implies that the informal sector is not autonomous as the dualists would want us to believe. According to the structuralist, the informal sector plays a key role in manufacture and cost reduction for the formal sector.

One can see this in several industries especially in large units manufacturing consumer/personal products. There are some multinational corporations of this type in India. In the cases of manufacturing soap, beauty products, personal care products such as shaving creams and perfumes, etc., much of the production is carried out in the small-scale sector. In some cases, MNCs disband their own factories because they get greater advantages in outsourcing their products to the small-scale sector.

Besides the cost advantage due to cheap labour, there is another advantage that gives them greater control over the production process that they have in their own factories. The large factories in the formal sector come under stringent rules and regulations (as discussed earlier). Moreover, in most cases, the workers are unionised and the unions are able to get considerable benefits in terms of wages for them.

The MNC has greater control over production because it places orders with small-scale industries and provides them with raw materials or cash advances to purchase the raw materials. The company, then, lays down its conditions which include quality standards for its products and the delivery time.

The MNC pays the owner of the small- scale enterprise a certain amount which may not be sufficient for him to get a proper return on his capital. The entrepreneur hence pays low wages to his employees and makes them work for longer hours in order to cut costs and make a small profit. In such a case, one will find that both the employer as well as the employee is exploited by the MNC/ large industry. These examples in effect reinforce the structuralist view that the informal sector is indispensible to the formal sector.

The third theoretical approach is that of the legalists. This approach was developed by Hernando de Soto (1989), a Peruvian economist, who gained considerable fame because of his contribution to the understanding of the informal economy and urban poverty. The legalist theory states that the informal sector comprises small operatives who work outside the formal economy because they find the legal procedures too cumbersome to follow.

These operators prefer to operate informally because the government procedures for giving them formal recognition are long-winded, complicated and difficult for them to understand. Hence these people, instead of being deliberate offenders, simply try to circumvent the rules because they find them too complex and time-consuming.

Micro-entrepreneurs such as those owning very small enterprises, street vendors, and home-based workers choose to operate informally in order to cut down their costs. This could be a result of the tax structure which may be a bit stiff for these tiny enterprises. Moreover, the process of registration is complicated involving both time and effort.

The forms may be so complicated that the semi-literate micro entrepreneur may not be able to comprehend them. For example, a street vendor in Patna can get a daily licence to engage in his business only after he fills up a long and complicated application form, which asks for information such as the volume and cost of his goods, expected sales, place of operation, etc. In most cases, vendors are not able to provide such specific information. They, therefore, prefer to take the easier way of bribing the municipal authorities and the police so that they can operate on the streets.

According to de Soto, these people continue to manufacture/ sell informally because government procedures are time-consuming and costly. De Soto argues that in most countries, government bureaucracy evolves intricate rules that lead to either forcing the small entrepreneurs out or compelling them to adopt corrupt means.

One can see this in a study of micro industries in Delhi (Bhowmik 2007). The rules for setting up such an industry (those that operate from one’s home but employ fewer than five workers) are simple when it comes to registration which can be done by filling up a simple form.

Once registered, the entrepreneur is entitled to certain concessions such as cheaper electricity, water, etc., and, most important to the entrepreneur, loans at subsidised rates of interest. This takes care of working capital and other investments. However, despite the simple registration process, once the entrepreneur starts manufacturing, they have to seek clearance from several departments from the government.

In doing so, the entrepreneur has to fill in complicated forms for each of these departments. In most cases, the entrepreneur who may be barely semi-literate and not well-off, would need the help of a lawyer or someone similar for filling in these details and pay fees for these services. The entrepreneur therefore prefers to work without registration.

They may be entitled to cheaper loans but there is a feeling that this is offset by the amount of time and money spent in the so-called legal activities. As a result, the entrepreneur works with low working capital. They hardly have any funds to improve or expand their business.

At the same time, this should not be construed as the willingness of the small entrepreneur to function and operate without registration. In the same study which was done in Delhi on micro entrepreneurs, it was found that most of these enterprises are registered with the sales tax authority and they do pay tax on what they sell. Hence, it should be clear that these people are not habitual offenders, but had the bureaucratic procedures been simpler, they would have certainly been more prone to register.

De Soto himself had carried out an experiment (1989) through the institute that he founded, namely, Institute for Legality and Democracy, Lima, Peru. A fictitious clothing factory was set up in the small-scale sector by this institute. They decided that they would not pay any bribes for having this factory registered.

While attempting to register this factory, they were asked to pay bribes at ten places. The application for registration had to go through several government departments and each of them demanded money for clearing it to the next office; with reluctance, they paid bribes at two places.

The total time taken to register the factory was 289 days and the labour cost of the group was equivalent to 32 monthly wages. De Soto wanted to bring the fact to light that if these are the costs for registering a unit, it is hardly surprising that most such entrepreneurs would try to operate illegally. He notes, ‘when legality is a privilege available only to those with political and economic power, those excluded—the poor—have no alternative but illegality.’

The other point that de Soto emphasised was that of property rights of the poor. He argues that the poor occupy property (slum dwellers’ quarters and other forms of ‘illegal’ encroachments) but they do not have rights over this property, which they may have occupied for several years or decades.

He feels that this is one of the major factors inhibiting the poor from pursuing their self-employed occupations. Had they possessed some legal entitlements, such as ownership of property, they could have mortgaged the same for getting institutional loans at lower rates of interest. In the present situation, the working poor have to depend on moneylenders and other usurers for funds at high rates of interest.

As they borrow at high rates from informal sources, they have fewer surpluses from their business for reinvestment. This can be easily seen in the case of the street vendors. They are usually denied loans from institutional sources (banks and other financial institutions) because they cannot show any security.

The high rate of interest at which they borrow money for running their business eats into their profits and leaves hardly anything for investment or expansion. In this manner, they continue to remain in the same profession and at the same low level of income.

In India, there have been several half-hearted attempts at legalising slums. For example, every plan from the Third Five Year Plan onwards has recommended that slum dwellers in urban areas should be given tenurial rights. The draft National Policy on Slums also stresses this aspect and notes that the urban poor make substantial contributions for the development and welfare of the city and their existence is needed if the city has to function properly.

However, despite these recommendations, the urban poor remain where they were, i.e., as insecure residents who are considered as parasites to the system. More recently, the Rajeev Awas Yojana (RAY), announced in the 2009 Union Budget, was formed to provide permanent houses to slum dwellers in Indian cities in order to give them tenurial rights which was likely to improve their living conditions.

Though the three theories discussed above may appear to be distinct and separate, in reality, we can find elements of each of them while analysing the informal economy. Hart’s contention that as development takes place, the informal sector becomes a part of the formal sector, could be seen soon after Independence. Studies by Lambert show that most workers engaged in these large factories had started their careers in small-scale industries.

This perhaps reinforces Hart’s stand. But more important would be the features that Hart has elaborated. The high rate of migration from rural to urban areas in the decades between the 1960s and the 1990s meant that a lot of the unskilled rural poor were forced to seek employment in urban areas.

These people found gainful employment in the informal sector. Other scholars such as Sethuraman of ILO noted that the population growth rate in developing countries was higher than the economic growth rate, and so the formal sector was not able to absorb all the surplus labour which sought employment.

Such an explanation may not be correct because mere economic development does not ensure labour absorption. We have seen that India, from the year 2000 onwards, has maintained a growth rate of GDP of around 8 per cent per annum, which is considered high compared to the growth rates of developing countries and also some developed ones.

At the same time, it was found that as economic growth increased, labour absorption actually decreased. Hence, it is necessary to have economic growth followed by policies that are directed towards employment that will ensure equity in terms of jobs and employment.