A model of economic transitions

I'll argue that any forced transitions to formality or higher labour or environmental standards is a supply shock induced demand compression, which invariably lowers the output. In general, any economic transition increases costs which if not supported by associated increases in demand, will necessarily lower output.  

I have blogged earlier in the context of formalisation of the economy that formality introduces layers of production costs which increases the market prices, which in turn reduces market demand. At the higher price, only a smaller number of customers can afford the good or service. The cost structure of the formal market can be met by only a small proportion of the total demand. The market settles down to a lower equilibrium output. 

In fact, it can create perverse incentives. In case of goods and services which are essential (or which have inelastic demand), the reduced affordable formal supply has to invariably result in substitution with lower cost informal supply. If formality is tightly enforced (as in case of certain goods and services), the informal market supply becomes an illegal (or harmful) market supply. 

Supporters will point out that increased formality will raise wages, productivity, profits, and quality which in turn will benefit workers, firms, and consumers in a virtuous loop. But this simplified belief assumes away the considerable adjustment requirements on all sides, which in the real world takes an inordinate time, and in many cases never materialises. It's for these reasons that such transitions have historically taken time, as with the developed countries of today. This ain't an area for leapfrogging. 

The supply will be constrained at both the intensive and extensive margins. At the intensive margin, the informal workers will not be able to acquire the skills required and the informal businesses will not be able to put up the capital for the increased production costs. At the extensive margin, supply of both new sets of workers and businesses will not expand as required. And, in any case, demand cannot expand enough in quick time to create a market which can absorb the higher production costs. 

This dynamic is just as true of labour or environmental or any other set of standards, which can all be seen as dimensions or aspects of formality. Each of these standards adds a layer of production and supply cost to the industry. And these costs must be passed through in the form of higher costs. 

In fact, we can extend this logic to economic growth itself. Economic output can grow sustainably only if the demand side can grow at the same pace as the expansion in supply. While it's possible for the supply to expand rapidly (say, with foreign capital), it cannot do much in the short-run to increase demand. In other words, sustained high economic growth requires the growth to be broad-based enough as to support growth in demand. 

The exception, which China and East Asian economies benefited from, is if the increased demand can come from an external market. In this case, the local economy can benefit with more investments and jobs, and greater productivity and higher incomes, without the proportionate expansion in demand. This positive supply shock will, in course of time, create the foundations for sustained broad-based economic growth. But this opportunity appears to have shrunk considerably. 

In the circumstances, any action plans for economic transitions, like that involving informality or renewables, should acknowledge its limitations and financial costs.