EntErprisE survEys 60351 EntErprisE notE sEriEs InformalIty 2010 necessity vs. opportunity Entrepreneurs in the informal sector Mohammad amin S ome informal or unregistered businesses are established to take advantage of business opportunities (opportunity firms) while others are established because the owner cannot find a satisfactory job (necessity firms). Comparing opportunity vs. necessity informal firms in Africa, this note finds that opportunity firms are more efficient and larger. They are also more EntErprisE notE no. 17 likely to use external finance, and suffer less from infrastructure bottlenecks such as power outages. However, all these differences apply to the manufacturing sector alone. With the exception of having more educated managers and more businesses located outside than inside household premises, opportunity firms in the service sector are not too different from the necessity firms in the same sector. In short, the motivation behind starting a business influences the performance of informal manufacturing firms but has little effect on the performance of informal service firms. Schumpeter's idea of an entrepreneur is one who motivation-related inefficiencies do not necessarily go away is dynamic and willing to take risks to exploit existing by getting the informal firms to register--the usual policy business opportunities and create new ones. However, prescription for the informal sector. Rather, what may be many businesses in developing countries are established required are wage jobs for the necessity entrepreneurs. not to exploit business opportunities but because the Second, anecdotal evidence suggests that informal firms owners cannot find satisfactory jobs. This is especially face numerous problems, for example, in accessing credit true for the informal sector, the focus of this note. For and benefiting from government programs because of their example, a survey of informal (unregistered) firms in unregistered status. Policies aimed at bringing the informal Côte d'Ivoire, Madagascar and Mauritius conducted by firms within the fold of the formal or registered sector can the World Bank's Enterprise Surveys in 20091 shows be better targeted toward necessity vs. opportunity firms that 39 percent of the firms were established because depending on how the costs and benefits of registering vary the individual owning the single largest share of the firm across these firm groups. Third, the choice of becoming a World Bank Group (henceforth, largest owner) could not find a satisfactory job necessity vs. opportunity entrepreneur may reflect underlying (necessity firms or, equivalently, necessity entrepreneurs), differences in the level of education or entrepreneurial while the remaining 61 percent were established to take skills of the individual. If this were true, then the extent advantage of business opportunities (opportunity firms of the problem entrepreneurs face in accessing credit or or, equivalently, opportunity entrepreneurs). Using these obtaining a power supply, for example, may be different for data, this note compares opportunity vs. necessity firms opportunity firms than for necessity firms. Policies aimed at with respect to structure, performance and problems faced providing a better business environment for informal firms when doing business. The comparison is useful for a variety should be adjusted to address the underlying motivation for of reasons. First, significant differences between necessity starting a business (see, for example, Adragna and Lusardi and opportunity firms in how they operate and the sorts 2008; de Mel et al. 2008). of problems they face may signal inefficiencies due to the What to expect from a comparison of opportunity underlying motivation for starting a business. Such possible firms vs. necessity firms is not immediately clear. On the one hand, opportunity entrepreneurs might be better in the service sector, 2 times in Mauritius, 1.4 times in Côte motivated and more skilled at running a business; therefore, d'Ivoire and 1.2 times in Madagascar.2 Somewhat surprisingly, such entrepreneurs should face fewer problems in there is little difference in total employment between necessity running a business and also perform better than necessity firms and opportunity firms. These findings imply that output entrepreneurs. On the other hand, informal per worker, a measure of firm efficiency, businesses usually operate on a small is much higher among opportunity firms scale involving simple business activities. An average worker relative to necessity firms. The difference Therefore, it is possible that entrepreneurial in an opportunity is most pronounced in the sample of skills and the underlying motivation for firm produces twice manufacturing firms where opportunity starting a business may not matter as much entrepreneurs generate 3 times more output to the functioning of informal businesses. as much as a worker per worker than necessity entrepreneurs The issue is best treated as an empirical one. in a necessity firm. compared with a much smaller figure of 1.3 The results discussed below are mixed. The multiple times in the service sector (figure 1).3 These That is, opportunity firms perform better increases to 3 times differences in efficiency levels continue to than necessity firms along some important hold even after accounting for differences dimensions, but there is no difference for firms in the between necessity and opportunity firms in between the two along other dimensions. manufacturing firm characteristics such as age of the firm, More importantly, where differences do sector. managerial experience, difficulty in accessing exist between the two firm groups, they are finance, electricity usage and country- and largely restricted to the manufacturing sector. sector-specific factors. Unobservable factors It seems that the motivation for starting a business does not associated with the motivation for starting a business could be have much effect on how firms in the service sector operate the reason for the stated differences in efficiency levels. and perform. in the service sector, opportunity firms are opportunity firms are more efficient more likely to have educated main decision than necessity firms makers than necessity firms On average across the three countries, total sales in a The relationship between the educational level and the regular month for an informal firm run by an opportunity motivation for starting a business in the informal sector is entrepreneur equal US$304 or about 1.7 times the same for not obvious. A lack of jobs in the formal sector may force an informal firm run by a necessity entrepreneur. While the individuals to temporarily work in the informal sector former is higher than the latter within various sub samples, there (see for example, Tokman 2007; Fields 2004). If the are significant differences in the magnitude of the difference. more educated people have greater aspirations for formal Total sales of an opportunity firm are 2.8 times the total sales jobs, one may expect necessity entrepreneurs to be more for a necessity firm in the manufacturing sector, 1.3 times educated than opportunity entrepreneurs. However, the informal sector may serve as a stepping stone to formal Figure 1 opportunity firms generate business ownership (see for example, Bennett and Estrin more sales per workers than 2007; Bosch and Maloney 2007). If the more educated are necessity firms more aware of business opportunities, as is likely to be the case, one may expect the opportunity entrepreneurs to be Sales per worker in a regular month (USD, 400 more educated than the necessity entrepreneurs. 350 300 Our data show mixed results that vary sharply across 250 manufacturing and service sectors (figure 2). Overall, median) 200 necessity firms are more likely to have educated (secondary 150 100 education or higher) main decision makers than opportunity 50 firms, a finding largely confined to the service sector. In fact, 0 with the exception of Côte d'Ivoire, manufacturing firms show a somewhat greater likelihood of having educated s g r d le ire r s r d ne ice rin te ca ne iu te Cô mp Ivo ow ca rit as rv ow ca tu u au ag Se a main decision makers among opportunity firms than among ac du d' Ed ale ll s ale M ad uf te te Fu m an m M No fe Fe M necessity firms.4 A possible interpretation of these findings No Opportunity entrepreneurs Necessity entrepreneurs could be that educated individuals are more hopeful of Source: Enterprise Surveys. finding a job in the formal sector than uneducated individuals Educated implies that the main decision maker has a secondary education or higher, while Not educated implies and hence may choose the service sector, which is known to the rest (primary or no education). Female owner implies that have lower entry and exit costs than the manufacturing sector. the firm has at least one female owner. Other firm characteristics, including the age of the firm, 2 Motivation for starting a business their businesses from a list of 7 obstacles, which includes Figure 2 (other than access to finance) access to land, corruption, and education level are related crime, electricity, political instability, and transport. differently across sectors Overall, opportunity entrepreneurs have better access All rms Manufacturing Service rms by country rms by country by country to financing and banking than necessity entrepreneurs do. % of rms with the main decision maker having 100 90 However, this distinction between opportunity and necessity 80 entrepreneurs is largely confined to manufacturing firms. For secondary education or higher 70 60 example, in the full sample, 39 percent of all firms have a bank 50 40 account for running their business with the figure varying 30 20 between 43 percent for opportunity firms and 33 percent 10 for necessity firms. Within the manufacturing sector, these 0 figures equals 38 percent for opportunity firms as compared ag e ag e ac le Se g s ag e au r s M car s au r s ca ca ice iu iu iu ir ir ir rin p with only 24 percent for necessity firms. Corresponding M Ivo M 'Ivo M 'Ivo rit rit rit as as as an am rv tu au d' d d ll s M M ad ad ad te te te uf Fu figures for service sector firms equal 47 percent and 45 Cô Cô Cô M Opportunity rms Necessity rms percent, respectively. Similarly, among the firms that have a bank account, 72 percent of opportunity firms in the manufacturing sector and 42 percent of the necessity firms Source: Enterprise Surveys. have business accounts that are separate from the household managerial experience, the gender of the largest owner, account. For the service sector firms, the corresponding proportion of sales to final consumers vs. intermediaries figures are 63 percent and 69 percent, respectively. and whether the firm is located within or outside the A similar picture emerges in the use of internal vs. external household premises, seem to vary little with the underlying funds for the day to day operations of businesses. More than motivation of starting the business. 81 percent of the firms in the full sample report using internal funds (retained earnings of the firms and/or personal funds in the manufacturing sector, opportunity firms of the owners) as their most important or most commonly have better access to electricity than necessity used source of finance. The percentage does not vary much firms do between opportunity and necessity firms in the full sample (81 percent vs. 83 percent). However, in the manufacturing Compared with necessity firms, opportunity firms are sector, fewer opportunity firms, relative to necessity firms, more likely to use electricity for their businesses and also report using internal funds as their most important source face fewer losses due to power outages. However, these of funds (79 percent vs. 92 percent). In contrast, in the differences are entirely limited to firms in the manufacturing service sector, internal funds are more prevalent as the most sector. Service sector firms show the opposite trend although important source of finance among opportunity firms as not a strong one. For example, 73 percent of opportunity compared with necessity firms although this result is driven firms vs. 63 percent of necessity firms in the manufacturing almost entirely by a single country, Madagascar (figure 3). sector use electricity. Corresponding figures for service sector firms equal 53 percent and 55 percent, respectively. Similarly, opportunity and necessity firms differ in in the manufacturing sector, losses due to power outages for their location inside vs. outside the household opportunity firms average 2.3 percent of the annual sales of premises, but only within the service sector a firm as compared with 5.9 percent for necessity firms. In contrast, opportunity firms in the service sector show higher Available evidence suggests that a substantial proportion losses at 4.2 percent compared with 2.2 percent for necessity of informal businesses operate from inside the household firms although this difference is not statistically significant. premises than from outside the household premises. The use of other infrastructure services, such as e-mail and One reason could be that working from home (inside the cell phones, is roughly similar for necessity and opportunity household premises) eliminates the cost of renting or buying firms irrespective of the sector they belong to. land outside, which may be particularly attractive to necessity entrepreneurs who hope to find wage-earning jobs in the access to finance is better for opportunity near future. Working from home also allows greater flexibility firms than for necessity firms in the in balancing work and family life, which is particularly manufacturing sector important to women entrepreneurs in most developing countries. While these reasons suggest that working from Anecdotal evidence suggests that access to finance is one home may be efficient and even desirable, it is possible that of the biggest problems faced by informal firms. Our data working from home could be due to the lack of resources also show that more than 53 percent of the respondents (to set up an establishment outside household premises). It rank access to finance as the most important obstacle to 3 Figure 3 internal funds are the most used Figure 4 location of business inside vs. source of finance for the day to outside the household premises day operations of firms All rms Manufacturing Service rms All rms Manufacturing Service rms by country rms by country by country by country rms by country by country % of rms reporting internal funds as the most 120 100 used form of nance for day to day operations 90 100 % of rms located inside 80 household premises 80 70 60 60 50 40 40 30 20 20 10 0 ag e 0 ag e ac le Se g s ag e au r s au r s au r s ag e ag e ac le Se g s ag e au r s M car s M car s ca ca ca ice iu iu iu ir ir ir ca rin ice iu iu iu ir ir ir rin p p M 'Ivo M 'Ivo M 'Ivo M 'Ivo rit rit M 'Ivo rit M Ivo as as as m rit rit rit as as as an am rv tu rv tu M ll sa au au d' d d d d d ls M M M ad ad ad te M te te ad ad ad te te te uf l uf Fu Fu Cô Cô Cô Cô Cô Cô an M Opportunity rms Necessity rms Opportunity rms Necessity rms Source: Enterprise Surveys. Source: Enterprise Surveys. may also lower business efficiency and may signal that the 3. The difference in the output per worker between necessity and business activity is only tangential to other household duties. opportunity firms in the service sector is not statistically significant whereas for the manufacturing sector it is significant. We find substantial evidence of home-based businesses 4 Information on the level of owners' education is not available. in our sample (figure 4). About 63 percent of opportunity The main decision maker is also the largest owner for approximately firms and 74 percent of necessity firms are located inside 95% of the firms. the household premises. As figure 4 reveals, this difference between necessity and opportunity firms is largely limited to the service sector firms. For example, 82 percent of references opportunity firms as compared with 95 percent of Ardagna, S. and A. Lusardi. 2008. "Explaining International Differences in necessity firms in the service sector are located inside Entrepreneurship: The Role of Individual Characteristics and Regulatory the household premises in Madagascar. Corresponding Constraints, in International Differences in Entrepreneurship, edited by: Josh Lerner and Antoinette Schoar, NBER. figures for Côte d'Ivoire are 80 percent and 97 percent, Bennett, J. and S. Estrin. 2007. "Entrepreneurial Entry in Developing respectively. With the exception of Côte d'Ivoire, there is Economies: Modeling Interactions between the Formal and Informal little difference in business location across necessity and Sector," Working paper, London School of Economics. opportunity firms in the manufacturing sector. Bosch, M. and W. Maloney. 2007. "Comparative Analysis of Labor Market Dynamics using Markov Processes: An Application to notes Informality," Policy Research Working Paper No. 4429, World Bank. de Mel, S., D. McKenzie and C. Woodruff. 2008. "Who are the 1. Data and sampling methodology are available at www. Microenterprise Owners? Evidence from Sri Lanka on Tokman v. de enterprisesurveys.org. Soto," Policy Research Working Paper Series No. 4635, World Bank. 2. Throughout the note, the service sector includes construction. Fields, G. 2004. "A Guide to Multi-sector Labor Market Models," The construction sector constitutes 1.03 percent of the sample and Working paper, Cornell University. excluding this sector does not make any significant difference to the Tokman, V. 2007. "Modernizing the Informal Sector," UN/DESA results discussed. Working Paper No. 42. The Enterprise Note Series presents short research reports to encourage the exchange of ideas on business environment issues. The notes present evidence on the relationship between government policies and the ability of businesses to create wealth. The notes carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this note are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. 4