Strict Duality and Overlapping Productivity Distributions between Formal and Informal Firms

This paper develops a multi-industry general equilibrium model where en-trepreneurs within each industry can decide to operate formally or informally.The model yields a rich set of predictions about how firms interact in the econ-omy. It reconciles the seeming contradiction between the canonical model ofstrict productivity dualism and the empirical literature that shows an aggre-gate overlap in productivity across the formal and informal sectors. We showthat this “contradiction” is a natural outcome of fixed costs varying acrossindustries. Our model is consistent with a set of stylized fact derived fromWorld Bank Enterprise Surveys. They show that 51% of formal firms reportcompeting with informal firms. Competition decreases with a country’s de-velopment, and larger firms face less competition from informal firms. Thesefacts, in tandem with out model, highlight the complexity of informality indeveloping countries.