The underground economy and the underdevelopment trap

A general equilibrium model is proposed which assumes that firms hire both official and unregistered workers as imperfect substitutes, that entrepreneurs differ in their ability to increase the efficiency of official labour, and that this ability is due to heterogeneous original ability and to Marshallian (non-linear) externalities. In equilibrium, smaller firms hire fewer official workers and are less efficient. If externalities increase sufficiently when firms are numerous, two stable equilibria exist where the number and the size of firms, the proportion of official employment, overall output and efficiency are, respectively, small (the trap) and large. The increase of individual ability due to, e.g., educational policies, has positive effects on the equilibrium number of firms, overall output, and labour regularisation. High and evenly distributed entrepreneurship also make it more likely that increased externalities and penalties on the underground economy will have positive effects. These results may contribute to the current debate on the underground economy in the Southern areas of Italy