Modelling Interactions between the Formal and Informal Sectors in a Developing Economy

Using a simple two-firm, two-period model, we analyze for a developing economy the process of entrepreneurial entry, that is, entry by new firms into an industry that did not previously exist in that country, focusing on the choice between formal and informal status. Thus we explore issues such as how informality may enable an entrepreneur to test the profitability of an industry without incurring large sunk costs, and how strategic interaction may affect such entrepreneurial decisions. In this context we examine comparative statics, e.g. with respect to the minimum formal sector wage rate and the realized profitability of the industry. Under some parameter values there is churning in terms of both the number of firms and their status. Also, we show that financial constraints can interact with the option of informality to induce entry. JEL Classification: O17.