Informality costs: Informal entrepreneurship and innovation in emerging economies

• Date: 01 September 2020
• Published date: 01 September 2020
• DOI: http://doi.org/10.1002/sej.1358
• Author: Alvaro Cuervo‐Cazurra,Juan Bu

SPECIAL ISSUE ARTICLE

Informality costs: Informal entrepreneurship and

innovation in emerging economies

Juan Bu

1

| Alvaro Cuervo-Cazurra

2

1

Indiana University, Kelley School of Business, Bloomington, Indiana

2

Northeastern University, D'Amore-McKim School of Business, Boston, Massachusetts

Correspondence

Juan Bu, Indiana University, Kelley School of

Business, HH3100, 1309 E 10th Street,

Bloomington, IN 47405.

Email: jbu@iu.edu

Abstract

Research Summary: We analyze the impact of informal

entrepreneurship on innovation in emerging markets. Build-

ing on agency and imprinting theories, we introduce the

concept of informality costs, that is, the higher agency costs

from adverse selection and moral hazard problems caused

by a firm's informal creation. These informality costs

become imprinted and affect internal agency relationships

among employees and managers and external agency rela-

tionships with suppliers and distributors, constraining the

firms' incentives and ability to innovate even after formaliza-

tion. As a result, informally created firms engage more in imi-

tative and less in innovative new product development. We

further propose that changes in ownershipand the innovation

environmentalter the persistence of informality costs. Specif-

ically, foreign firm and business group ownership reduces the

persistence of informality costs and results in more innova-

tiveness, while state ownership heightens informality costs

and leads to less innovativeness. Moreover, improvements in

national innovation systems decrease informality costs,

strengthening the innovativeness of informallycreated firms.

Managerial Summary: We study how the informal creation

of new ventures in emerging economies affects their inno-

vation after they become formal firms. We propose that

informally created new ventures suffer from informality

Received: 9 November 2018 Revised: 1 June 2020 Accepted: 4 June 2020 Published on: 19 August 2020

DOI: 10.1002/sej.1358

© 2020 Strategic Management Society

Strategic Entrepreneurship Journal. 2020;14:329–368. wileyonlinelibrary.com/journal/sej 329

costs established as a result of being informal at the begin-

ning of their lives that reduce their incentives and ability to

innovate. As a result, these firms tend to introduce new

products that are imitative rather than innovative. We also

propose that changes in the firm's ownership and in the

national innovation system alter the persistence of informal-

ity costs and their impact on innovation. First, informally

created new ventures acquired by foreign firms or private

business groups have reduced informality costs and inno-

vate more, while those acquired by the state have enhanced

informality costs and imitate more. Second, national innova-

tion system improvements reduce informality costs and sup-

port innovativeness.

KEYWORDS

agency theory, business groups, emerging economies, foreign firms,

informal entrepreneurship, informality costs, innovation, ownership,

state-owned firms

“There is certainly lots of innovation going on, and it takes many different forms. For the informal metalworkers in

Nairobi, it is often a case of reverse engineering products sold by formal businesses and working out how to make

cheaper alternatives from available materials.”(Boyd, 2017, WIPO Magazine).

1|INTRODUCTION

Informal entrepreneurship, or starting up a business venture without registering with government agencies, is a com-

mon phenomenon in emerging economies. Informal firms account for more than half of all nonagricultural employ-

ment, contribute approximately one-third of gross domestic product (GDP), and provide a livelihood for billions of

people in developing and emerging economies (Charmes, 2012; La Porta & Shleifer, 2014; Webb, Tihanyi, Ireland, &

Sirmon, 2009). Despite its prevalence, however, the strategic implications of firms' informal creation have not

received much attention (Williams, Martinez-Perez, & Kedir, 2017). Most existing research has focused on under-

standing the determinants of informal entrepreneurship (Dau & Cuervo-Cazurra, 2014; de Castro, Khavul, &

Bruton, 2014; Thai & Turkina, 2014; Webb, Bruton, Tihanyi, & Ireland, 2013), the benefits of formalization

(Assenova & Sorenson, 2017; de Mel, McKenzie, & Woodruff, 2013; Demenet, Razafindrakoto, & Roubaud, 2016;

McKenzie & Sakho, 2008; Rand & Torm, 2012), and the impact of informal firms on formal ones (Distinguin,

Rugemintwari, & Tacneng, 2016; Iriyama, Kishore, & Talukdar, 2016; McCann & Bahl, 2017). Thus, there is still a

need to better understand the influences of informal entrepreneurship on firm behavior even after informally created

firms have become formal ones (Williams et al., 2017). Moreover, informal entrepreneurship is not only an important

and interesting topic, but also a theoretically relevant issue. Most theories have been developed by analyzing formal

firms that can legally enter into contracts and defend them. In contrast, informal firms are not legal persons. Their

unregistered status limits their ability to establish and maintain formal contractual relationships. Hence, studies of

informal firms can open novel and insightful venues for theorization.

330 BU AND CUERVO-CAZURRA

To address this topical and theoretical research gap, we analyze the impact of informal entrepreneurship on

innovation in emerging economies. Entrepreneurship has long been considered a driver of innovation (Busenitz,

Gomez, & Spencer, 2000), but the role of informal entrepreneurship in promoting or impeding innovation remains

unclear despite its importance. To explain this question, we integrate agency theory (Ross, 1973) and imprinting the-

ory (Stinchcombe, 1965) and propose that new ventures that were initially created informally suffer from the

imprinting of informality costs, that is, the higher agency costs from adverse selection and moral hazard problems in

contracting caused by a firm's informal creation. The informality costs persist and constrain firms' incentives and abil-

ity to invest in the development of sophisticated innovations. As a result, even after becoming formalized, informally

created firms engage more in imitative new product development and less in innovative new product development.

We add depth to this idea by explaining the transformation of the imprinting of informality costs with changes

in two situations: (a) firm ownership and (b) the institutional support of innovation. We first propose that the acquisi-

tion of the informally created firms by other companies changes the persistence of the informality costs because the

acquirers possess different agency relationships and monitoring ability. Specifically, we argue that, in comparison to

firms that remain independent, the acquisition of informally created firms by foreign firms and private business

groups reduces the informality costs. This leads informally created firms to create new products that are more inno-

vative and less imitative. In contrast, the acquisition of such firms by the state heightens the informality costs, lead-

ing informally created firms to develop new products that are more imitative and less innovative. We then propose

that improvements in a country's institutional environments of innovation systems reduce the persistence of infor-

mality costs. This encourages informally created firms to generate new products that are more innovative and less

imitative.

We test these ideas on a sample of 9,148 new ventures from 71 emerging economies during the period

2010–2016. All the new ventures analyzed are formal firms, but 723 initiated their operations as informal companies

and thus had the informality costs imprinted on them. We find that those informally created new ventures are more

likely to introduce imitative new products and less likely to introduce innovative new products than new ventures

that started life as formal firms. We also find that new ventures that were informally created and became part of pri-

vate business groups are more likely to introduce innovative new products, while those that become state-owned

are less likely to introduce innovative new products. Surprisingly, we do not find that foreign ownership alters the

innovativeness of informally created new ventures, but we do find that foreign-owned firms are more likely to intro-

duce innovative new products. Finally, we find that improvement in the innovation system of the country results in

informally created new ventures introducing more innovative new products.

These ideas and findings provide important and novel contributions to two streams of literature: the study of

entrepreneurship in emerging economies, and research on agency and imprinting theories. First, the arguments add

to a better understanding of informal entrepreneurship in emerging economies by analyzing and explaining how new

ventures' informal creation continues to affect their innovativeness even after they have become formal firms.

Research on entrepreneurship has commonly focused on formal new ventures, that is, firms that registered with the

authorities (Klapper, Amit, Guillen, & Quesada, 2007). Despite the prevalence of informally created firms, we know

little of the impact of their informal creation on innovation. Our study sheds light on the consequences of informal

entrepreneurship by focusing on its implications on innovation strategy. We introduce the concept of informality

costs as the driver of informally created firms' behavior. We explain how the incentives and governance structures

established internally among managers and employees and externally with suppliers and distributors when the new

ventures started up informally are imprinted and persist after the firms' formalization, resulting in new products that

are less innovative and more imitative. This idea highlights the long-term consequences of informal entrepreneurship

in terms of the imprinting of informality costs and their impact on innovation.

Second, the arguments help extend agency and imprinting theory by building bridges in their theorization on

informal entrepreneurship. Agency theory has been traditionally applied to the study of contractual relationships for

formal firms between owners and managers (Fama & Jensen, 1983; Jensen & Meckling, 1976), between employer

and employees (Holmstrom & Tirole, 1989; Prendergast, 1999), and between partner firms (Camuffo, Furlan, &

BU AND CUERVO-CAZURRA 331