Shades of Grey: How do Informal Firms Navigate Between Macro and Meso Institutional Environments?

• Author: Garry D. Bruton,Susanna Khavul,Julio O. De Castro
• Date: 01 March 2014
• DOI: http://doi.org/10.1002/sej.1172
• Published date: 01 March 2014

SHADES OF GREY: HOW DO INFORMAL FIRMS

NAVIGATE BETWEEN MACRO AND MESO

INSTITUTIONAL ENVIRONMENTS?

JULIO O. DE CASTRO1*, SUSANNA KHAVUL2, and GARRY D. BRUTON3

1IE Business School, Madrid, Spain

2Department of Management, College of Business, University of Texas at

Arlington, Arlington, Texas, U.S.A.

3Neeley School of Business, TexasChristian University, Fort Worth, Texas, U.S.A.

Our qualitative research shows that when making decisions about informality,entrepreneurs in

emerging economies purposefully navigate between the enabling and constraining rules of the

macro institutional environment and the norms of the meso institutional environment.We show

that: (1) informality is a multidimensional continuum along which path to formalization

unfolds; (2) as entrepreneurs grow more successful they become simultaneously more attuned

to the countervailing constraints of both the macro and meso institutional environments; and

(3) informal firms and formal firms weave together an exchange system that legitimizes the

persistence of informality. In the context of informality, meso institutions serve as the connec-

tive tissue which cross-link levels of the environment and shape the context in which entrepre-

neurs make decisions. Copyright © 2014 Strategic Management Society.

INTRODUCTION

Firms that fail to legally register and pay taxes rep-

resent one common form of firm activity that falls

within the boundaries of the informal economy. Such

firms make up the informal economy and represent

40 to 60 percent of the GDP in emerging economies

(Schneider, 2005; Portes and Schauffler, 1993; de

Soto, 1989). A prominent view of informality sug-

gests that firms start and remain informal because

the economic costs, in both money and time, to for-

mally register with the government are too high (de

Soto, 2000; Webb et al., 2013). By implication, if

governments lower costs or reduce the time and

complexity required to complete registration, then

entrepreneurs would react by converting their infor-

mal ventures into formal ones (de Soto, 2000). Pro-

ponents of this ground their argument in the nexus of

behavioral responses of individuals to changes in

macro institutional regimes. An alternativeargument

suggests that by staying informal, entrepreneurs are

making rational decisions based on cost-benefit

analysis (de Mel, McKenzie, and Woodruff, 2013;

Perry et al., 2007). That is, the cost of being formal

is too high relative to the benefit. Whether initial

registration costs or ongoing costs impede formal-

ization remains a hotly contested academic question

that also confounds policy makers as they design

interventions to stem the tide of informality.

In this article, we argue that informality is a

nuanced phenomenon best examined at the intersec-

tion of institutional environments that entrepreneurs

face. Using qualitative field data, we show that in

making decisions about informality, entrepreneurs in

emerging economies purposefully navigate between

the enabling and constraining powers of the macro

and meso institutional environments they face. At

their core, institutions consist of rules and norms,

both formal and informal, which structure social

Keywords: informality; entrepreneurship; emerging market;

institutional environments

*Correspondence to: Julio O. De Castro, IE Business School,

Maria de Molina 6, E, 28006 Madrid, Spain. E-mail:

Julio.castro@ie.edu

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Strategic Entrepreneurship Journal

Strat. Entrepreneurship J., 8: 75–94 (2014)

Published online in Wiley Online Library (wileyonlinelibrary.com). DOI: 10.1002/sej.1172

Copyright © 2014 Strategic Management Society

interaction by constraining and enabling actors’

behaviors (Helmke and Levitsky, 2004). Institutions

exist at the macro, meso, and micro levels that, in

the context of our work, broadly correspond to the

national (federal or common union), local (including

communities of practice), and individual levels,

respectively. Prior research has focused on the top-

down effects of macro regulatory environment on

informality. We believe it is time to drill deeper

(Bruton, Ireland, and Ketchen, 2012) and unpack

how informal entrepreneurs navigate among levels

of institutional environments. To motivate our

research we ask three questions:

Research Question 1: How do the macro and

meso institutional environments affect entrepre-

neurs’ decisions to formalize their businesses?

Research Question 2: As their firms become more

successful, how do the countervailing demands of

the macro and meso institutional environments

influence the informal entrepreneurs’ cost-benefit

considerations related to formalizing?

Research Question 3: How does the interaction

between informal firms and formal organiza-

tions affect the cost-benefit decisions that

informal entrepreneurs make with respect to

formalization?

We examine these research questions in the

Dominican Republic, where informality is central to

the local economy (42% of GDP, Vuletin, 2008) and

a key source of economic growth. Despite its sig-

nificant role in countries such as the Dominican

Republic, informality remains understudied, espe-

cially from an entrepreneurship perspective (Bruton,

Khavul, and Chavez, 2011; Khavul, 2010; Bruton,

Ahlstrom, and Obloj, 2008; de Soto, 1989).

Our study makes several contributions to the lit-

erature. First, we show that entrepreneurs see

formalization of their firms in terms of multiple stra-

tegic choices that unfold over time and are not

simply excluded from formalization by the cost or

complexity of registration. We suggest that the

binary classification of formal versus informal firms,

into which the management literature has tended to

pigeonhole this decision, needs to evolve into a mul-

tidimensional continuum that is responsive to insti-

tutional differences and cross-country variation.

Second, we demonstrate that when successful entre-

preneurs face the challenges of institutional plural-

ism, they become simultaneously more attuned to

the countervailing constraints of both the macro and

meso institutional environments. Finally, we show

that informal and formal firms weave together an

exchange system that legitimizes the persistence of

informality.

Informal firms and institutional environments

Informal firms

Informal firms are organizations that conduct market-

based activities with legal goods produced and dis-

tributed without regard for taxation or regulation

(Portes and Castells, 1989; de Soto, 1989; Portes and

Haller, 2005; Schneider, 2005; Webb et al., 2009).

The distinction between legal and illegal activity is

important because many informal businesses supply

illegal goods (i.e., pirated media and software) and do

not register with their governments. By contrast, our

research focuses on the vast majority of unregistered

businesses that provide legal goods and services (de

Soto, 1989), and we leave aside questions of illegal

goods that notionally fall within the boundaries of the

informal economy. Albeit at different rates, informal

firms are prevalent in both mature and emerging

economies. As a defining characteristic of entrepre-

neurial life in emerging economies (Khavul, Bruton,

and Wood, 2009; Khavul, 2010; Kodithuwakku and

Rosa, 2002), the effect of informality on firm produc-

tivity and growth is much debated (LaPorta and

Shleifer, 2008). Scholars have long accepted that

institutional context influences entrepreneurial activ-

ity (Estrin, Korosteleva, and Mickiewicz, 2013), so

the face of entrepreneurship differs between emerg-

ing and mature economies (Peng, 2000; Bruton et al.,

2008). Similarly, the causes and consequences of

informality in emerging and mature economies likely

differ. Indeed, research that distinguishes the con-

tours of informality in emerging and mature econo-

mies is gaining momentum (Estrin and Mickiewicz,

2012). The spotlight on the role of institutions in firm

entry and growth is particularly intense (Estrin et al.,

2013).

Institutions

Institutions and their governance play an important

role in the rise and fall of nations (Acemoglu and

Robinson, 2012), the evolution of organizational

forms (Khavul, Chavez, and Bruton, 2013), and poli-

cies to promote economic inclusion (Banerjee and

76 J. O. De Castro, S. Khavul, and G. D. Bruton

Copyright © 2014 Strategic Management Society Strat. Entrepreneurship J.,8: 75–94 (2014)

DOI: 10.1002/sej