This very nice paper is filled with interesting facts about firms in developing countries: about the size of the informal economy (around half that of the formal sector, on average); about the extent of theft among both small and large firms (less than 5 percent of sales); and about the number of days per year that firms face power outages (around 50, even for large firms). The tour through the extensive firm-level surveys across many countries is itself a valuable contribution. Indeed, but for the expert guidance provided by the authors, it would be easy to get lost along the way.

Rafael La Porta and Andrei Shleifer helpfully frame their discussion in terms of three “views” of the informal economy. The romantic view of Hernando de Soto and others suggests that the informal sector is an engine of growth just waiting to be released by giving informal firms property rights.¹ The parasitic view, associated with the McKinsey Global Institute,² sees the informal sector as a collection of firms that remain small (and unproductive) in order to avoid taxes and regulations, which allows them to inefficiently take away market share from more-productive formal firms. Finally, the dual economy view, associated with John Harris and Michael Todaro,³ among others, suggests that informal firms are not so much a threat to formal firms as a social safety net that provides a livelihood for millions of very poor, uneducated people. In this view the informal economy is not so much a drag on development as it is a way station where people can [End Page 353] wait until development leads to the establishment of additional productive formal firms that can provide them with jobs.

After studying a wide range of correlations, facts, and survey responses in extensive firm-level surveys, La Porta and Shleifer conclude that the evidence is most consistent with the dual economy view. The main evidence against the romantic view is that informal firms look very different from formal ones—for example, the managers of informal firms are much less well educated—and the authors see very little evidence that growth occurs by informal firms eventually becoming large, productive formal establishments. The main evidence they offer against the parasitic view is that formal firms do not view competition from informal firms as a serious problem; they are much more concerned with access to markets, access to finance, and taxes.

A fact that emerges quite clearly from the data is that the informal sector is very large in the poorest economies and surely provides a kind of social safety net for many workers. By avoiding taxes and regulations, this sector can employ people who are not sufficiently productive to work in the formal sector. Given that this sector can encompass as much as half of the labor force, this is a substantial safety net. A question that naturally follows is whether or not this is the most effective way of providing it. What is the cost?

The firm-level surveys and a recent paper by Chang-Tai Hsieh and Peter Klenow suggest one way to make progress on this question.⁴ Because this approach also provides some useful insights into the meaning of “value added per worker,” I will outline a simple story along these lines in what follows.