Why the Invisible Hand does not work in the informal economy

The invisible hand assumes that when individuals act in pursuit of their own self-interest, their decisions cumulatively generate outcomes that benefit society. This principle rests on several assumptions—perfect information, rational decision-making, and institutions that allow private choices to align with broader welfare. Yet in the informal economy, particularly among micro and small enterprises (MSMEs) in Indonesia, these assumptions collapse.

In theory, formalization should be privately beneficial for MSMEs. A business permit unlocks access to credit, legal protection, government assistance programs, and eligibility for loan schemes such as KUR. If MSME owners understood the full value of these benefits, the logic of self-interest would encourage them to formalize. These aggregated across millions of enterprises, would then support a stronger tax base and economic growth.

In reality, however, most MSMEs remain informal. This outcome reflects not irrational decision-making but structural failures that distort how MSME owners perceive their own best interests. The primary distortion arises from information asymmetry. Government institutions often communicate the advantages of formalization inconsistently, using language or channels that do not effectively reach informal entrepreneurs. As a result, the benefits of formalization—access to credit, simplified taxation, and business protections—feel distant, uncertain, or abstract. Meanwhile, the perceived costs are immediate and concrete. Entrepreneurs anticipate increased tax obligations, bureaucratic procedures, compliance burdens, and potential scrutiny from authorities. Without accurate or trusted information, MSMEs calculate their benefits based on fear and misperceptions, not on the true economic value of formalization.

Consequently, MSME owners act rationally within the limits of the information they possess, but those actions collectively produce suboptimal outcomes, both for themselves and for society. The invisible hand fails not because individuals are irrational, but because their decisions are shaped by fear and distrust. For the invisible hand to function in the informal economy, institutions must first correct these structural failures.