The Informal Economy and the Dual Economy

Why most workers in developing countries work outside formal jobs, and the competing theories of how economies move from informal to formal work.

The informal economy includes work and businesses that operate outside government regulation, taxation and legal protection: street vendors, small repair shops, day laborers, domestic workers and most small farmers. It is not a small fringe. The International Labour Organization estimates that roughly 2 billion people, around three in every five workers worldwide, earn their living informally, with the share far higher in low-income countries. Understanding informality is central to understanding how poor economies work and how they grow.

The dual economy

In 1954 the economist W. Arthur Lewis, from the Caribbean island of Saint Lucia, described developing countries as a dual economy. One part is a modern, capitalist sector of factories, mines and offices, where workers use machines and earn wages. The other is a large traditional sector of small farms and household enterprises, where productivity is low.

The Lewis model proposed that the traditional sector contains surplus labor: so many workers share the same land or trade that some could leave without output falling much. As the modern sector expands, it can hire these workers at a wage only a little above what they earned before. Profits are reinvested, the modern sector grows again, and more workers move over. Development, in this view, is the gradual shift of people from low-productivity to high-productivity work. Lewis shared the Nobel Prize in economics in 1979, and his model helps explain the rapid industrialization of countries such as China, where hundreds of millions moved from farms to factories.

Moving from the village to the factory

Imagine five siblings who all work on a family farm that could be run just as well by three of them. Together they produce enough food for the family, but two siblings add almost nothing to the harvest. If one takes a garment factory job in the city paying the equivalent of 8 dollars a day, the farm's output barely falls, while the economy gains a whole day of productive factory work. That movement, repeated by millions of people, is the engine of growth that Lewis described.

Three ways to see informality

Economists interpret the informal sector in different ways.

The first view sees it as a waiting room: people who cannot yet find formal jobs survive through informal work until the modern sector grows enough to absorb them. This matches the Lewis model.

The second view, associated with Peruvian economist Hernando de Soto, sees informality as a response to excessive red tape. De Soto documented how registering a business or getting a legal title to a home could take months or years. He argued that the homes and land of the poor become dead capital: valuable assets that cannot be used as collateral for loans because ownership is not formally recorded.

The third view, supported by research from economists Rafael La Porta and Andrei Shleifer, finds that most informal firms are very small, low-productivity businesses that rarely grow into formal companies even when rules are eased. In this view, growth comes mainly from new formal firms, not from converting informal ones.

Why it matters for policy

Informal workers usually lack pensions, health insurance, sick pay and protection against unsafe conditions, and governments collect little tax from informal activity, limiting what they can spend on schools and roads. Policies that have helped include simplifying business registration, extending social protection to informal workers, and digital payment systems that make it easier for small businesses to enter the formal financial system.

Equating informal with illegal

Informal work is not the same as criminal activity. A woman selling tea at a railway station or a tailor working from home is producing legal goods and services; she simply operates outside registration, tax and labor rules. Treating informal workers as lawbreakers can lead to harsh crackdowns that destroy livelihoods without creating any formal jobs to replace them.

Key takeaways

Around three in five workers worldwide work informally, with far higher shares in poor countries.
The Lewis model describes development as workers moving from a low-productivity traditional sector to a modern one.
De Soto argued that red tape pushes people into informality and leaves their assets as dead capital.
Other research finds most informal firms rarely grow, so new formal firms drive growth.
Informal workers often lack social protection, and governments lose tax revenue.