Prying into the Shadows: A General Equilibrium Model to Analyze the Effects of the Emerging Institutions on the Structure of Production and Welfare in Developing Countries

Abstract

A two-sector general equilibrium model has been developed where the inelastically supplied male labor is used in both sectors, but the elastically supplied female labor is used only in the shadow economy. Women's economic participation involves a welfare loss in addition to the usual disutility from work as it conflicts with the existing social values and limits their access to the informal credit market involving neighbors, friends and relatives. The model disentangles the economic and welfare effects of the credit and non-credit based institutional interventions as observed in many developing countries. The finding suggests that microfinance, if not coupled with women's empowerment, may in fact result in only a zero sum game involving an increase of the percentage share of the shadow economy at the cost of the formal sector. The result also contests the conjectures of the existing literature that high economic growth will ultimately reduce the size of the shadow economy over time. Rather it shows that microfinance can increase the share of the informal sector even in a growing economy. Given the cognition of the literature that a large shadow economy can limit the provision of public goods, the finding of this paper is important for the donor agencies who are euphorically pouring funds for microcredit programs.