Access to Credit Markets and Decisions of an Entrepreneur

Abstract

One of the biggest characteristics in the developing world is the existence of large informal sectors. In this paper, we develop a model of an individual’s choice between the formal sector and informal sector. Using the occupational choice model developed by Lucas (1978) and Haniff (2015), we map the choices of an individual based on skills and assets and access to credit markets. This paper examines how access to credit markets affect the decisions made by entrepreneurs. We find that entrepreneurs with high ability but lack assets for collateral will not be able to get loans to pay for the costs associated with formalization. Lack of access to credit markets further increases the cost of formalization due to increase in financial costs. The entrepreneur will then choose to be operated in the informal sector. An individual who lacks both assets and skill will choose to be worker in the formal sector.