Informal Input Suppliers

Transcription

1 Sergio Daga Pedro Mendi February 3, 2016 Abstract While a large number of contributions have considered how market outcomes are affected by the presence of informal producers, there is scarce empirical evidence and theoretical analysis of the impact of informality on firms whose main customers are other firms. Using data from the World Bank Enterprise Survey, we present evidence that informality also affects firms upstream in the value chain. We propose a theoretical model in which formal firms downstream may purchase an input either from another formal firm upstream, or from a large number of informal suppliers, which offer an input with a lower quality than that of the formal supplier. We analyze the welfare consequences of the presence of informality upstream. An extension of the analysis is the effect of upstream informality on the formal upstream firm s incentives to engage in quality upgrading. Keywords: Welfare economics; Product Differentiation; Supply chain; Informal sector. JEL Classification: D60; L13; L14; O17. Navarra Center for International Development. Edificio Bibliotecas,, Pamplona, Spain. sdaga@alumni.unav.es Department of Economics, Edificio Amigos,, Pamplona, Spain. pmendi@unav.es

2 1 Introduction In the economics literature there are at least three major views of the informal sector. First, informal firms are seen as an untapped reservoir of entrepreneurial energy held back by government regulations, and poor protection of property rights, see de Soto (2000). Under this view, relaxing these burdens would more likely bring growth and development. Second, informal firms are parasites competing unfairly with law-abiding formal firms, see Levy (2008). In this view, informal firms should not be helped, but suppressed. Third, formal and informal firms are fundamentally different Porta and Shleifer (2014). In this view, while formal firms tend to be run by educated entrepreneurs, comply with taxes and regulations, reach new consumers, are financially less restricted, and their business are more profitable, informal firms, on the other side, are mostly run by people less educated and unproductive, their output is of low-quality and reach mostly low-income consumers. According to the latter authors, this dual view seems more consistent with the data, and offer five factors about the informal economy. Depending on the indicator, the informal sector accounts for between 30 and 40 percent of total economic activity in the poorest countries, and a higher share of employment. Informal firms are typically small, inefficient, and run by poorly educated entrepreneurs. Lowering registration costs neither brings many informal firms into the formal sector, nor unleashes economic growth. Informal firms rarely transition to formality, and continue their existence, often for years and even decades, without much growth or improvement. Finally, as countries grow and develop, the informal economy eventually shrinks, and the formal economy comes to dominate economic life. Furthermore, due to the fact that informal firms have a more difficult access to capital, technology, and skilled labor, it is reasonable to think that informal firms will produce products whose level of quality is lower than those produced by formal firms. For instance, Banerji and Jain (2007) affirm that there is a great deal of support for the stylized fact that informal sector output competes with, and is a substitute for, the 2

3 output of the formal sector. There is nevertheless a quality gap between outputs of the two sectors. This quality gap can be traced to the different factor prices faced in production, and to the heterogeneity of consumers preferences. Therefore, the informal sector should be thought of as a sector whose output overlaps and competes with that from the formal sector. The aim of this paper is to contribute to the existing literature by introducing an element that in our opinion has received scarce attention, namely the impact of informality upstream in the value chain. In particular, we propose a theoretical model with a single formal upstream firm and two formal downstream firms. The upstream firm supplies the downstream firms with an input that is transformed into vertically differentiated products by the downstream firms. The vertical differentiation comes from the fact that the downstream firms have different transformation capacities, which lead that the same input is transformed in products with different qualities. In the presence of consumers with heterogeneous willingness to pay for quality, as in Shaked and Sutton (1983), higher willingness-to-pay consumers will purchase the high-quality product, whereas other consumers with lower willingness to pay will purchase the low-quality product, and some consumers will not purchase at all. The informal sector is modeled as a competitive fringe that supplies at marginal cost an input with a lower level of quality than that of the formal supplier. We find in our analysis that, in the absence of informal suppliers, the upstream firm chooses a wholesale price such that only the downstream firm with the highest transformation capacity is active. If an informal sector is active, this effectively constitutes a constraint on the formal supplier s choice of the wholesale price. The welfare impact of informality depends on the comparison between the output expansion effect brought about by informality, which is positive, and the negative effect of some consumers switching to the low-quality product, which is offered only if informal suppliers are active. While the net effect is ambiguous, a sufficient condition for welfare to increase with upstream 3

4 informality is that the output of the downstream producer of the high-quality product do not decrease. There is also a rich literature that connects competitive pressure and incentives to innovate (Arrow (1962)). Aghion et al. (2005) find that there exists an inverted-u relationship between product market competition and innovation. Supported by the data, the average technological distance between leaders and followers increases with competition. Vives (2008) finds that increasing the number of firms tends to decrease cost reduction expenditure by firms, but increasing the degree of product substitutability, with or without free entry, increases it. Lately, Mendi (2015) develops a theoretical model to examine the incentives of a firm producing a product of a higher quality than that produced by a competitive fringe to engage in costly quality upgrading as a function of the difference in quality between both products. He finds that there are parameter values such that the relationship between innovation incentives and competition, measured by the difference in quality levels, has an inverted-u shape, as found in Aghion et al. (2005). An extension of our model is the analysis of the effect of upstream informality on the formal upstream firm s incentives to engage in quality upgrading. The remainder of the paper is organized as follows. Section 2 presents evidence of informality affecting both downstream and upstream firms. Section 3 presents our theoretical model. Section 4 discusses the welfare implications of informality upstream. Finally, Section 5 presents some conclusions. 2 Upstream and downstream informality The purpose of this section is to provide evidence consistent with the claim that informality affects formal firms both upstream and downstream; and that informality also affect innovation incentives on these type of firms. As in Mendi and Costamagna (2015), we make use of the World Bank s Enterprise Survey data. The Enterprise Survey makes 4

5 use of an extensive questionnaire that is administered in a number of different countries, mostly developing countries. For a number of African and Latin American countries, the manufacturing module of the Enterprise Survey included in 2006 two questions directly related with innovation outcomes, as well as questions providing information on up to what degree practices of firms in the informal sector represented an important obstacle to firm activities, and whether the firm sold mostly to other firms or directly to final consumers. Mendi and Costamagna (2015) analyzes the impact of informality on firm s innovation decisions. In this paper, we make use of the same data to explore whether there is evidence of informality more likely affecting downstream firms, that is, those that sell mostly to final consumers rather than to other firms. Furthermore, we study whether the effect of informality on firms innovation decisions is different for downstream firms. Table 1 presents variable definitions, which includes the indicator of the firm being an upstream firm 3. Table 2 presents summary statistics of the variables used in Mendi and Costamagna (2015), distinguishing between firms that sell to final consumers (first column), and those that sell mainly to other firms (second column). By comparing the averages of the different indicators of competitive pressure from informal firms, there is no clear evidence of upstream firms bearing less competitive pressure from informal firms. This is a first piece of evidence suggesting that informality may affect firms both upstream and downstream. We now proceed to verify whether the effect of informality on innovation is different for upstream firms than for downstream firm. This we do by interacting the upstream variable with our indicators of competitive pressure from informal producers. The dependent variable of the different specifications is in all cases innovative, the indicator of the firm having introduced a new product or process. The indicators of competitive pressure from informal producers are allowed to affect innovative in a non-linear way. 3 For an extensive description of the data, see Mendi and Costamagna (2015) 5

6 Table 1: Variable definitions Dependent variables innovative Dummy that takes value 1 if the firm introduced either a new product or a new process, 0 otherwise innprod Dummy that takes value 1 if the firm introduced a new product, 0 otherwise innproc Dummy that takes value 1 if the firm introduced a new process, 0 otherwise Independent variables competpres Number of competitors that the firm faces obstacle Relevance of informal firms as obstacle to firm s operations obst region Regional average of informal firms as obstacle to firm s operations Percentage of firms in the region that declare operations of top3 region informal firms to be among the top-3 obstacles to firm s operations Controls group Dummy that takes value 1 if the firm belongs to a group of firms, 0 otherwise lnemp Logarithm of the number of employees age Firm age, in years exportint Percentage of the firm s sales that are exported manager exp Manager s experience, in years upstream Dummy that takes value 1 if the main buyers for the firm s product are other firms, 0 otherwise 6

7 Table 2: Summary Statistics 0 1 Total Innovative (0.489) (0.445) (0.463) Product (0.500) (0.479) (0.488) Process (0.498) (0.488) (0.496) Competpres (0.290) (0.269) (0.276) Obstacle (0.368) (0.362) (0.364) Obst top (0.476) (0.489) (0.485) Group (0.285) (0.333) (0.319) Ln(Emp) (0.964) (1.238) (1.214) Ln(Age) (0.989) (1.007) (1.015) Expinten (8.324) (16.822) (14.971) Manexper (0.843) (0.758) (0.797) 7

8 Table 3: Effect of competitive pressure, full sample Probit Probit Probit (1) (2) (3) Innovative Innovative Innovative upstream (0.179) (0.555) (0.301) Competpres 0.608* (0.355) upstream Competpres (0.494) Competpres 2 Competpres (0.298) upstream Competpres (0.367) Obst region 3.642*** (1.278) upstream Obst region (2.403) Obst region ** (1.381) upstream Obst region (2.547) T op3 region 5.407*** (1.683) upstream T op3 region (1.676) T op3 region ** (2.573) upstream T op3 region (2.275) Constant *** *** *** (0.169) (0.327) (0.281) Observations All specification include country and industry fixed effects. Standard errors in parenthesis are clustered at the regional level. *** p < 0.01, ** p < 0.05, * p <

9 Table 3 presents estimated coefficients using the Enterprise Survey data. The estimation method is in all cases probit, since the independent variable is innovative, which is a binary variable. While the regressions include a number of time-varying controls, the coefficients displayed on the table are on the indicators of competitive pressure from informal firms, and those coefficients interacted with the upstream variable. What the results suggest is the absence of evidence of the impact on innovation activities of informality being different for upstream than for downstream firms. This suggests that the analysis of the welfare consequences of the presence of informal firms deems attention, at least at the same level of the effect of informality downstream. 3 The Model We assume that there is a single formal firm upstream, and two formal firms downstream. The downstream firms could purchase a input from the formal upstream firm, or, alternatively, from informal input suppliers. In the model with informal suppliers, we assume a large number of producers that produce an input with the same quality level and that compete in prices. This way, the price of the input supplied by informal firms will equal marginal cost. We assume that downstream firms differ in their capacities to transform inputs into outputs. Specifically, we assume that the transformation capacities of firms 1 and 2 are 1 and φ, respectively, with φ > 1. The transformation that takes place downstream increases a given input s quality level in a multiplicative way. Therefore, if the quality level of a given input is x, the quality levels of the products produced by firms 1 and 2 will be x and φx, respectively. We assume that the quality level of the input supplied by informal firms is 1, whereas that supplied by the formal upstream firm is γ > 1. That is, the quality level of the input in the formal sector is higher than that in the informal sector. 9

10 As in Shaked and Sutton (1983), Shaked and Sutton (1982), we assume that consumers differ in their willingness to pay for quality. Specifically, we assume that there is a mass one of consumers with heterogeneous willingness to pay for quality, described by the parameter θ. We assume that θ follows a uniform distribution over the [0, 1] support. Every consumer consumes at most one unit of one of the two goods, which differ in their quality levels. If a consumer characterized by θ consumes a unit of a good with quality level s, and pays a price p, his net utility is given by u(θ) = sθ p. Of course, as it is done in this type of models, consumers choose which product to purchase (or not to purchase at all) based on the comparison of the net utilities from consuming one unit of each product. Notice that under these assumptions the expression for the demand function of a product with quality level s i, assuming that it was the only product offered, would become p i = s i (1 q i ). In the presence of several vertically differentiated products that are simultaneously offered in a given market, we may interpret these functions as those summarizing consumers willingness to pay for the different products. Regarding marginal costs, we normalize those of informal input suppliers to zero. The marginal cost of the upstream formal firm is c > 0. Downstream firms take input prices as given and compete in prices producing vertically differentiated products. We assume for now that the pricing scheme posted upstream consists on a wholesale price. The timing of the moves is as follows: 1. The formal firm upstream posts a wholesale price w. If informal input firms are active, their posted price equals zero. 2. Downstream firms decide on which input to use. 3. Given their procurement choices, downstream firms simultaneously choose their product prices, and quantities and profits are realized. In the following subsections, we will analyze the version of the game without informal input suppliers, and that with informal input suppliers in turn. 10

11 3.1 No informal input suppliers In this version of the model, the formal firm is a monopolist upstream. The upstream firm s problem is to choose the wholesale price w that maximizes its own profit, given the downstream firms purchasing decisions, which in this case are limited to buying from the formal firm. Analyzing first the downstream firms problems, we see that the firms that produces the higher-quality product will attract the consumers with the highest willingness to pay, whereas the firm that produces the low-quality product will sell to consumers with lowest willingness to pay. It may even be the case that the firm that produces the low-quality product does not sell at all. In particular, the quality level of the input is γ, and downstream firm 1 will offer a product with quality level γ, whereas that offered by firm 2 will have a quality level φγ. Hence, given a wholesale price w, the two downstream firms reaction functions are given by: p 1 (p 2 ) = p 2 + φw 2φ p 2 (p 1 ) = p 1 + γ(φ 1) + w 2 (1) (2) Now, firm 1 s reaction function will be as given in (1) as long as in equilibrium firm 1 s output level is positive. Ignoring this possibility for the moment, the equilibrium prices would be: p 1 = w(2φ + 1) + γ(φ 1) 4φ 1 p 2 = ( ) φ 3w + 2γ(φ 1) 4φ 1 (3) and equilibrium quantities are: 11

12 q 1 = φ(γ 2w) γ(4φ 1) q 2 = 2φγ w γ(4φ 1) (4) Notice that if 2w > γ, then downstream firm 1 does not produce at all, in fact, its output level is negative according to these expressions. This is because firm 1 s reaction function takes another functional form for some values of p 2. For relatively low values of p 2, firm 1 s reaction function is given by p 1 (p 2 ) = p 2. This ensures that firm 1 s output φ level is zero. If this is firm 1 s reaction function, then the equilibrium quantities are given by q 1 = 0 q 2 = φγ w 2γ(φ 1) (5) and these constitute the upstream firm s demand for the input that it produces, for 2w > γ. Now, the upstream firm s problem is: max w c (w c)[q 1(w) + q 2 (w)] and the first-order condition of the problem, for w > c reads: [ q1 q 1 (w) + q 2 (w) + (w c) w + q ] 2 = 0 w where the expression for q 1 w changes depending on the value of w (which in turn determines firm 2 s reaction function). It turns out that the solution to the upstream firm s problem lies at the range of w such that q 1 = 0. In particular, it is given by: w = φγ + c 2 (6) 12

13 which leads to: q 2 = φγ c 2γ(2φ 1) p 2 = φ[c + γ(3φ 2)]. (7) 2(2φ 1) Regarding welfare, this is given by W NI = q 2(φ, γ) 2 [1 + p 2 (φ, γ) c] where NI refers to no informal firms upstream, and q 2 = φγ c 2γ(2φ 1). 3.2 Informal input suppliers We now turn our attention towards the case of informal input suppliers being an alternative input source for downstream firms. At the time of choosing suppliers, downstream firms compare profits under different combinations of marginal costs. Specifically, let the marginal costs of firms 1 and 2 be c 1, c 2 = {0, w} depending on whether they purchase from the informal or the formal suppliers. Depending on their procurement choices, the products of firms 1 and 2 will have quality levels s 1 {1, γ} and s 2 {φ, φγ}. Then, given costs c 1, c 2 and quality levels s 1, s 2, the equilibrium prices at an interior solution will be: p 1 = s 2(s 1 + 2c 1 ) s 1 (s 1 c 2 ) 4s 2 s 1 p 2 = s 2(2s 2 2s 1 + 2c 2 + c 1 ) 4s 2 s 1 (8) whereas equilibrium quantities are given by: q 1 = s 2 [s 2 (s 1 2c 1 ) s s 1 (c 1 + c 2 )] s 1 [4s s 2 1 5s 1 s 2 ] q 2 = 2s2 2 + s 2 (c 1 2s 1 2c 2 ) + c 2 s 1 ) s 2 [4s 2 5s s 2 1] (9) Notice that the downstream firms marginal costs c 1, c 2 will depend on their input 13

14 procurement choices. In fact, c i = 0 if downstream firm i purchases an input from informal suppliers, whereas c i = w if it purchases the input from the formal upstream firm. This will imply that the downstream firm s profits may be expressed as π I (s i, s i, c i, c i ), where i and i denote its own quality/cost and the other downstream firm s quality/cost, respectively. Then, given w, downstream firms choose between the formal upstream firm and the informal suppliers. Notice that this introduces a constraint on the formal firm s choice of w. 4 Welfare analysis In this section, we analyze the welfare implications of the presence of informal input suppliers. Since informal upstream firms supply a lower-quality input at zero price, there will always be an output expansion. In principle, an increase in output is associated with a welfare increase. However, in our model there is another effect that goes in the opposite way. In particular, if the output of the high-quality product decreases in the presence of informal suppliers, there is a negative welfare effect. This is because some consumers that would purchase the high-quality product in the absence of informal suppliers (and thus in the absence of a low-quality product in the output market) purchase the low-quality product if informal suppliers are active. Depending on the size of this effect, informal suppliers may bring about either a welfare increase or a welfare decrease. However, if the equilibrium output of the high-quality product does not decrease with informal suppliers, we know that welfare increases with informal input suppliers. This is presented in Proposition 1. Proposition 1 A sufficient condition for welfare to increase with informal input suppliers is that the sales of the high-quality product do not decrease. 14

15 5 Conclusions While the presence of informality has attracted the attention of economists, most of the research efforts have been devoted to the study of informality downstream in the value chain. This paper contributes to filling a void in the literature and analyze the impact of informality upstream. We present empirical evidence drawn from the World Bank Enterprise Survey data to study whether informality actually affects upstream firms as well as downstream firms. The empirical evidence suggests that this is indeed the case. Furthermore, we find that the effect on informality on firms innovation decisions is the same upstream and downstream. We propose a theoretical model to analyze the welfare implications of the presence of informality upstream. As in Mendi (2015), we model informal firms as a competitive fringe that offers a lower-quality input at marginal cost. Therefore, this constitutes an alternative input source for downstream firms, and hence affects the formal upstream firm s ability to charge a high wholesale price. We show that the welfare implications of the model are not straightforward. Indeed, while informality brings about an output expansion effect, which is welfare-increasing, it also induces some consumers to switch to the low-quality product, which is welfare-decreasing. The net welfare effect depends on the relative sizes of these two effects. We believe our model is of relevance for the design of policies dealing with informality in developing countries. References Aghion, P., N. Bloom, R. Blundell, R. Griffith, and P. Howitt (2005). Competition and innovation: An inverted-u relationship. Quarterly Journal of Economics 120 (2), Arrow, K. (1962). Economic welfare and the allocation of resources for invention. In 15

16 The Rate and Direction of Inventive Activity: Economic and Social Factors, NBER Chapters, pp National Bureau of Economic Research, Inc. Banerji, A. and S. Jain (2007). Quality dualism. Journal of Development Economics 84 (1), de Soto, H. (2000). The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. Basic Books. Levy, S. (2008). Good Intentions, Bad Outcomes: Social Policy, Informality, and Economic Growth in Mexico. Brookings Institution Press. Mendi, P. (2015). Competitive pressure and innovation in vertically differentiated markets. Economics Bulletin 35 (4), Mendi, P. and R. Costamagna (2015). Managing innovation under competitive pressure from informal producers. Porta, R. L. and A. Shleifer (2014). Informality and development five facts about informality. Journal of Economic Perspectives 28 (3), Shaked, A. and J. Sutton (1982). Relaxing price competition through product differentiation. Review of Economic Studies 49 (1), Shaked, A. and J. Sutton (1983). Natural oligopolies. Econometrica 51 (5), Vives, X. (2008). Innovation and competitive pressure. Journal of Industrial Economics 56 (3),