Differences in Efficiency in the Formal–Informal Dichotomy—A Study of Indian Firms

Abstract

The unorganised manufacturing industries play a vital role in the process of industrial development of the Indian economy. Informal firms are relatively less productive than formal firms, because a majority of the firms are technically inefficient, producing far below the actual attainable level of production. This article examines differences in efficiency and output between formal and informal production firms across India’s manufacturing industries. The key novelty in this article is in studying both the formal and informal sectors simultaneously by applying the technique of Oaxaca–Blinder decomposition to determine efficiency differences across the sectors. The results suggest that capital is a positive and the most significant determinant of the output of efficient industries. Output gaps can be explained by coefficient, endowment and interaction aspects of capital and capital productivity, while efficiency differences are explained by coefficient and interaction characteristics of emoluments and capital productivity. The results of density plots show that informal firms are no longer functioning as a pool of surplus labour in the context of Indian manufacturing industries during these years. The results dispel the notion that the informal sector is a poor performer in terms of total output compared to the formal sector. Also, capital and capital productivity are less in informal manufacturing industries than in the formal sector. JEL Codes: E26, J46, O14, O17