# **<mark>Box 1: Why are most of Africa’s firms informal?</mark>**

African economies have a very large share of informal manufacturing employment, and the informal firms have a vital role to play in the short term be providing a livelihood to a large number of people. Informality offers several benefits to the entrepreneur. Management requirements are less demanding and government policies and regulations, such as labor laws concerning minimum wages and workers’ safety, can be circumvented. Informal firms need not adhere to working hour regulations and informal entrepreneurs may find it easier to control labor, and they can avoid taxes and fees as well as various urban planning regulations. There are also other regulations such as price controls, licensing, and laws pertaining to property rights that informal firms can avoid. When there are fluctuations in demand, an informal firm finds it easier to adjust because of its simple and flexible technology, and hence it can avoid some of the costs associated with idle capacity. The ease with which an informal firm can vary its employment level can save on wage costs.

These advantages must be weighted against the costs and risks associated with operating outside the rule of law. Informal firms risk being detected and punished for operating ‘illegally’. They also receive fewer services from the state, most notably from institutions providing jurisdictional services such as protection against burglars and other policing, as well as contract enforcement. The informal firms may be unable to use formal channels of dispute resolution due to their uncertain legal status, and this also means that it is hard to get access to financial, banking, and other commercial services. Informal entrepreneurs cannot get access to trade fairs or use membership in umbrella organizations to their benefit. Small firms also tend to have few assets that can be foreclosed in the event of breaches of contract, and their transactions are so small that the monetary and time costs <u>associated with court actions would not be justified in any case.</u> The business environment also impacts on how firms do business. Widespread market failures imply that firms face a lot of “holes” in important markets, such as those for insurance and credit. This is especially pronounced for the smallest firms. Fafchamps (2001) identifies two types of responses that aim to reduce the resulting transaction costs, namely development of relationships and the sharing of information within networks. Essentially, when search and verification costs are high, it makes sense to try to establish long-term relationships and share information with other market participants, in order to economize on such costs. The firm data have been extensively used to shed light on these mechanisms.

Trade credit is a good example of how supplier relationships can be utilized to fill in some of the holes in the formal credit market. Fisman (2001) argues that trade credit plays an important role in firm financing in Africa, mainly by enabling firms to manage raw material inventories more efficiently and by reducing the likelihood of raw material shortages. Trade credit may therefore contribute to higher productive efficiency. Fisman analyses these issues using the first waves of RPED data from 17