the underground economy

BUCHAREST ACADEMY OF ECONOMIC STUDIES – INTERNATIONAL ECONOMIC RELATIONS
An Economic Analysis on The Underground Economy
A CONCEPTUAL APPROACH

BISOCEANU MARIA-CRISTINA
NEGREA BIANCA-DENISA

Summary:
I. Introduction
II. Conceptual clarifications and a theoretical approach
II.1 The labor market. The minimum wage.
II.2 Unemployment. The opportunity cost of labor.
III. The Underground Economy
III.1 The illegal economy
III.2 The informal economy
III.3 The underground production
IV. Conclusions

I. Introduction
Everything that happens in the social world in our time is the result of ideas. What is needed, is to fight against bad ideas, and in order to accomplish this, we -and by “we” it shouldn’t only be understood the population of a nation, but the entire world- have to identify and substitute them with irrefutable ones, to persuade people to adopt an assertive approach on every economic matter which by no means has a global impact, to pull apart unhealthy ideologies, to place the basement of the sustainable development of tomorrow’s world.
Over the past century, there have been several waves of both economic growth and drop, associated to historical milestones such as the World War I, the following so called “Great Depression”, the World War II, the Social Totalitarianism regime, the climb to a transitional economy followed by the emergence of a free-market system, and, where the world stands nowadays, the Global Recession. Periods of economic prosperity are referred to as “booms” or “expansions” while the economic declines would be “recessions” or “depressions”. The world is now struggling to overcome the externalities of the latest and, in the same time, greatest recession, period in which the underground economy, the black market and all its implications are becoming of higher importance to the revival of the global economic system and to the income inequality issue in and between nations.
The aim of this paper is not just to outline the major economic illnesses, but to go beyond the intrigues and make an in depth analysis regarding the whole economic phenomena, in which the vast majority consists of underground economy and has, nevertheless, been neglected as having a critical involvement. In the following sections, it is intended to shed light to the causes, reasons, implications and results of the ascending black market, while, by the end of the paper, stress out the inherent uncertainty : Is it benefic to persuade the track of the black market?
Economy is a science, and it is acknowledged that science will never be able to explain absolutely everything, especially when it comes to the most unpredictable element, the human nature, the human behavior. Thus, this scientific approach must begin with assumptions, model-studying, and then proceed from there in order to acquire a close-to-reality conclusion. Further on, facts will be taken for granted and their effects will be closely analyzed.

II. Conceptual clarifications and a theoretical approach

1. The labor market. The minimum wage.
The motivation to work arises from the social, psychological and economic forces. People need income to pay their bills, but they also need a sense of achievement. As a consequence, people are willing to work – to supply labor. The market supply of labor represents the quantity of labor that workers are willing and able to supply at alternate wage rates in a given time period, ceteris paribus. The labor supply has several determinants such as: tastes income and wealth, expectations, prices and, last but not the least, taxes. Nevertheless, regardless of how many people are willing and able to offer their services, it is the employers who decide who and whether or not to hire.
There is no such thing as a perfect functioning market. Thus, any imperfect, in this case, labor market, functions according to the interaction between the suppliers of labor services, meaning the employees, and the demanders of labor services, referred to as employers. Labor is a measure of the work provided by human beings, and is usually contrasted with the other factors of production, being the land and capital.
The natural functioning of the market establishes an equilibrium wage, point in which demand meets supply and which also represents the optimum level of salaries, generally speaking. The equilibrium wage would be the optimal one, normally imposed by the market, but in attempt to provide assistance for the less qualified people, or the ones closer to the poverty line, the government usually intervenes and established a minimum wage, supposed to provide them with the opportunity of earning an amount which would suffice the most basic needs for survival.
There are several intrigues regarding whether or not this intervention of the government comes in the benefit of either the employers or employees. It is acknowledged that there are plenty people which, due to their high skills, experience reached, and superior studies, are not to be affected in any way by this measure, because they already are provided with a wage far above the minimum one. For the others, though, and they are even more than the above mentioned ones, the situation is not that thrilling. Entry level workers, students, or unskilled persons are not only doomed just to receive the minimum wage, but some of them would not even receive this little amount, fact which leads them to choose the other obvious option.
Concerning the employers, a firm’s demand for workforce reflects labor’s marginal revenue product. A profit-maximizing employer will not pay a worker more than he produces. Therefore, there are two situations worth mentioning. In the case of the highly skilled workers, when it comes to negotiating their salary, due to taxation reasons, employers face the situation in which they are forced to make a good offer, but not completely legal. The remuneration is usually split in a part that consists of the minimum wage, and the remaining difference up to the established sum, is to be handed without being declared. In the second case, regarding the bottom class of labor suppliers, the employers are either not even willing to offer the minimum established wage, choosing to seek and alternative for handing them a smaller, illicit amount, or do not hire them at all, leaving them unemployed.
According to Walter Block, the law of the minimum wage is, under no circumstances, a law regarding the occupation of the workforce, but rather one concerning the latter category, the unemployed and/or unemployable. The law does not oblige an employer to hire a person offering the minimum wage, but it constraints the employer not to offer an amount beyond the bottom limit. If this law would be properly enforced, the employee would therefore be forced to decline any offer of working for a lower remuneration, and choose to opt for unemployment dole. As a consequence, the government would have to raise taxation in order to support the high demand for unemployment benefits.
Having these theoretical aspects approached, there is still a critical highly debated question standing: Should the government intervene and establish a minimum wage?

2. Unemployment. The opportunity cost of labor.
Okun’s law states that one percent more unemployment is estimated to equal two percent less output. In the same time, regardless of the output concerns, there also exists an opportunity cost involved in working, namely, the amount of leisure time one has to sacrifice in order to work. In the same manner, the converse situation would regard the opportunity cost of not working, which is, not earning the necessary amount of money that would satisfy the minimum consumption needs.
Any increase in the wage rate is an incentive for people to substitute leisure for labor. This substitution effect may only last up to one point where an additional gain in income would not compensate for the possible spare time therefore lost. That is, when income effects outweigh substitution effects, the labor supply curve bends backward. (GRAPH)
It has been proved that, when government intervenes by establishing certain taxation levels and imposes a certain minimum wage, the rate of unemployment will be on an upward trend. But this is just one of the possible explanations. Unemployment actually arises from various situations and due to a wide range of causes, such as recessions, inflations, undulating business cycles, rapid changes in technology, discrimination at the place of work, transition between jobs, employee values, lack of experience. Hence, not being a uniform phenomenon, there are to be found several different types of unemployment:
i. Frictional unemployment. This refers to people displaced by the normal working of the economy. It is commonly found in a developing economy because it always occurs a gap in time between changing workplaces, and, thus, people may perhaps be unemployed for several weeks or even months until they find or take the next job offered. ii. Seasonal unemployment. There are some jobs which are dependent on the weather conditions and/or the season in cause. There can be found many seasonal businesses such as tourism and construction related ones. The cold season is especially hit by high rates of unemployment due to the dependency between the impossibility to work and the unfavorable weather conditions. iii. Residual unemployment. Beyond the unexpected conditions of unemployment, some of the people are simply not willing to work. This category of people includes not only the ones that benefit considerably from inheritances, but also the ones who are unwilling to obey an employer. iv. Structural unemployment. This type is a result of a change in the structure of the economy. It can be caused by any unbalance created by the fall of an industry or the requirement of different categories of skills. Ever since the high-tech industry has emerged, structural unemployment has registered concerning rates.
v. General / Cyclical unemployment. As it has previously been stressed, it is expected that in time of economic development or growth, the rate of unemployment registers a decrease, and in times of recession, the rate of unemployment increases. Nowadays, since the world is still recovering from the global recession, the unemployment is still at a concerning high level. vi. Technological unemployment. It arises due to the perpetuity of technological development. There are two reasons of unemployment in this case: firstly, the technology may overcome the people’s skills, and, secondly, the demand for high skilled individuals increases, thus, the others, are inclined to lose their jobs.

However, regardless of the above, it should be added that a large part of the unemployed individuals is still active on the labor market, but in a different manner and under other circumstances, as it follows in the next section.

III. The Underground Economy.
The market in other words is like fire, or a gun, or a knife, or a typewriter: a splendidly efficient means toward both good and bad ends. Through free enterprise we are capable of achieving virtuous actions, but also they are very opposite as well. ( W. Block, 2008, Defending the Undefendable)
The underground economy should by no means be identified exclusively with illegality. Some of the activities performed within this type of economy are fully legal, just not subject to taxes, due to various reasons – small-size businesses, and, therefore, their outcome cannot be measured or included in statistics. In the same manner, the use of the phrase “underground economy” is often confused with underground production. Indeed, the underground economy includes the underground production, but it involves by far more issues than just that.
Moreover, it is general acknowledged that the market only produces goods and services for which demand exists. And besides the obvious, there are some outcomes of the market which are subjects of debate due to their less moral character - prostitution, gambling, drugs, weapons, pornography.
Regarding the sensitive topic which is about to be approached, it should be mentioned that there is not a single existing economy, there are many, they are omnipresent in the daily life, and there are some of which people are not even aware. All of these may be referred to as “NOE” activities – non-observed economic activities. Criminal drugs, the illegal economy, the unreported economy, the unrecorded or informal economy, the shadow economy, the households, all of them contribute somehow to the development of what we refer to as global economy.
The non-observed economic activities should, again, not be confused with the underground economy; they strictly refer to the activities which are not subject to measurement in the economic indicators of production. Thus, the underground production and underground income are different, as well as the untaxed income and untaxed production.
Further on, the distinguishing of the above mentioned concepts will be clarified, the pros and cons of their existence will be presented, as well as the causes of their occurrence and the resulting implications at all levels: economic, accounting, wealth.
It is acknowledged that there are two major categories of underground activities: the ones from which there is an input in the economy, and the ones that can under no circumstances be measured or controlled in numbers.
3.1 The illegal economy
To begin with, the illegal economy consists of activities undergone under an infringement of the law, and whose participants engage themselves in the production and distribution of prohibited goods and services. It includes, therefore, the production and distribution of illegal goods and services – narcotics, pornography, prostitution, the resale of stolen goods, money laundering, smuggling – in particular of tobacco, weapons, alcohol, and the activities which are normally legal, but become illegal when carried out by unauthorized parties – unlicensed gambling activities, unlicensed medial practice, fishing, hunting, tree cutting. In addition to these ones, there are many types of illegal activities, but they are not worth debating due to their minor importance and occurrence in Romania – contract murders, espionage, etc. With very few exceptions, all the active participants on this market are usually registered as unemployed, which, due to their high number, leads to increases in unemployment rates, but actually, their activity is not to be neglected.
The illegal goods and services above mentioned embrace a high inelastic demand in Romania, due to the reduced accessibility to them in Romania, and, the prices on the market are so high that dealers receive considerable revenues from selling them. In this sense, even if the consumers are continuously daring the authorities to legalize the drug consumption and prostitution, the providers of this type of goods and services do not share their opinion, because their activity would otherwise be subject to taxes, and eventually, their income would lower considerably. In the current situation, their income represents much more than the needed amount in order to support the household’s expenses, fact which can only lead to those certain persons never to require, request or even need a job. This illegal situation which every active participant on this market faces, further leads to the necessity of justifying in one way or another their higher-than-normal income, money-laundering being the most accessible and facile solution. In this manner, the revenue which results from illegal activities is integrated in the economy, and is reflected in the increase of the economic indicators.
Thus, from both economic and social points of view, this matter comes, eventually, one way or another, in the benefit of one nation’s welfare: the unemployed people have an activity from which income results, poverty rates might be diminished, and money are brought and cycled into the economy.
On the other hand, this illegal activities lead to several issues in the nation’s accounting at both low and high financial levels. Neither is there any plausible existing justification for the money brought into the economy, nor can the householders explain the source of income to support their expenditures.
More and more attention should be directed to the prostitution and pornographic industries which are somehow related, their common point being constituted by the third party, the drug industry. Even if the prostitution has not yet reached alarming rates on the territory of Romania, the number of active Romanian persons in this industry is increasing day by day, the most preferred “work-placements” being Switzerland, Italy, France, and mainly all the developed European Union economies.
There is one particular affirmation that caught our attentiont “The function of the pimp is that of a broker. In the same way as do brokers in real estate, insurance, stock market, shares, investments, commodity futures, the pimp serves the function of bringing together two parties at a transaction at less cost than it would take to bring them together without his good offices.” (Walter block, 2010).
What is alarming in this sense, is that one so called transaction requires four parties, each engaged in an illegal activity, at least three of them are involved in what it was previously defined as non-observed economic activities, and only one or two – the “pimp” and the dealer, would bring up an input in the economy through legal businesses meant to justify their income. Moreover, statistically speaking, 60% of the prostitutes consider that they have no other legal option of working, while over 45% of them would not trade their “job” for anything else.
More than 55% of the Romanians aged between 18 and 28 have at least consumed drugs for one time, while 35% of them admit they “sometimes” or “often” consume. Even if the drug consumption in Romania has a plausible explanation which is, in fact, used as an excuse for the authorities towards the increasing drug trafficking, is that, back in 2008, the so called “ethno-botanicals” were legal, and subject to internal commerce. That was the breaking point of consumption, moment from which, many under-aged or unaware people started consuming, then trafficking and, eventually, when the ethno-botanicals were delegalized, they enlarged their boundaries to more dangerous and ever-illegal drugs.
Unlike the former industry, the latter has absolutely no positive externalities within the economy. Unless the two are related, or practiced by the same party, which, in fact, is the most common case, the outcome of drug trafficking is proven not to enter into the legal economic activities.
All in all, is should be acknowledged that the illegal economy has always been fast developing and has its own pros and cons, but the question of whether or not it can or should be stopped remains unanswered. Because this activity cannot be fully measured and because the amount resulted from such activities which is afterwards brought into the economy is, again, uncountable, the opportunity cost of practicing this kind of work cannot be established. Deeply analyzing, and strictly from the economical point of view, if the difference between the income of a person from this activities and the amount then brought into the monetary cycle would be insignificant, meaning that almost all the revenue gained from illegal activities will then be invested in a legal one, would this “illegal economy” be that harmful, or even harmful at all?

3.2 The informal economy
Another subject of underground economy which should be brought to attention is represented by the informal economy.
The term of informal economy or informal sector economy has gained a broader sense and a greater significance through the fast-developing and globalizing economy in which we are nowadays living. The phenomenon of informal economy basically consists of units engaged in the production of goods and services with the primary objective of generating employment and incomes to the persons concerned. The issue here is that, the labor relations, where they exist, are based mostly on casual employment, on social relationships rather than legal, contractual arrangements with formal guarantees. The phrase “where they exist” was not used randomly in this case, but to emphasize the fact that the activities present in the informal economy, are divided as follows:

All informal sector enterprises can be regarded as household unincorporated enterprises, but not all household unincorporated enterprises belong to the informal sector. Within the household unincorporated enterprises, a distinction was made between enterprises of employers and own-account enterprises, and it was based on whether or not an enterprise employs at least one employee on a continuous basis. Thus, enterprises of employers have a higher degree of formality in their operations.
Informal sector enterprises can be defined according to the following criteria: small size of the enterprise in terms of employment; non-registration of the enterprise; non-registration of the enterprise’s employees. In any of these three cases, the situation is less risky if the size of the enterprise is extremely small. Unfortunately, though, no flourishing small to medium size unregistered business will diminish its activity, because it is acknowledged that the governments draws much more attention to the large enterprises, where the prejudice is greater in terms of the taxes they should have and did not pay, the quantity produced illegal, and the high number of people supposedly unemployed, but actually working and not declaring their revenues.
This is the general framework of fraud in Romania. The reason? As mentioned in the conceptual clarifications, there may be plenty reasons for the occurrence of this types of informal economic activities, usually regarded to as “black labor”, such as: tax payment avoiding, little to least skilled people willing to work for lesser than the minimum wage in return, people from the rural zones merchandising or trading their own production, and the list can go on and on.

As it can be seen in the statistic above, generated by the National Institute of Statistics following February 2014, most of the unemployed persons, who are also active on the informal sector, have even less then the needed requirements for a legal, minimum paid job. These are the same persons present in other statistics as aged above 40 and/or leaving in rural zones. The latter criterion stands, probably, as the one of the most important ones, due to the agricultural inclinations of the rural activities. Moreover, most active rural participants in agriculture are not only self-sufficient as households, but also providers for goods and services within the informal sector.
Needless to say, if all of these people’s incomes from their activities were to have been subjects to taxes, they would never have been able to earn enough in order to support themselves, fact which would have eventually led to an increase in the poverty rate.
These being said, the question advanced at the end of the previous section is also available in this case: If all of these informal activities were to be transformed into legal ones, would this have been, or would this come in the actual benefit of the participants to the economy?

3.3 The underground production
The last, but not the least subject to be approached is the underground production. This concept is often misunderstood and confounded with the underground economy itself. Actually, it concerns only the production, as the title itself suggests, and not the whole process. It usually includes the self-sufficient households, the production undertaken for own final use, and basically all the underground activities except the ones included in the illegal sector. Not all monetary transactions are productive and conversely, not all productive activities are monetary. It is important to recognize the distinction between them.
These type of activities occur due to various reasons such as: to avoid payment of income value added taxes, to avoid having to meet legal standards – minimum wage, maximum working hours, health and safety standards, to avoid complying with certain administrative procedures.
The underground production activity is usually referred to as “hidden”. To be fair, the hidden economy is part of live, it comes in everybody’s benefit – the products and services needed for every day’s life purchased in the hidden economy reduce household expenses, increases the differences in incomes – the greatest incomes from the hidden economy land up in the underworld.
In Romania, the underground production is not just an economic issue; it is also a psychological, social and cultural one. More than half of the active population has faced the communist period, the period of limiting consumption, of aggressive governmental regulations, the period of socialism. Therefore, it is acknowledged that, the Romanian mentality that has only slightly changed since 1989, is the mentality of excessive consumption, of compulsory buying without needing, of assuring their wealth in any possible method. All of these psychological issues are the result of the socialist doctrine fear, and have consequences on the Romanian consumer behavior even nowadays. And the worst part is that some of these beliefs are justified and not at all debatable.
Take as an example, a 65 year old married couple living in those mountain shadow villages. They have absolutely no legal income, no reason to enter the economic cycle, and even if they would have a reason, most likely they wouldn’t have the possibility due to the unfavorable region in which they live. But, with all these, they meet the most basic survival needs, obtained by farming and agricultural activities for their own use.
The reason why this issue has been approached was not to emphasize this single case, but to bring to light that the existence of these households should not be neglected, and that the shadow economy, the underground production lies everywhere amongst the country, from the housewife who grows rosemary and basil in her apartment, to the peasant countryman who produces large quantities of goods for his own use, or further underground trade in his village.
Indeed, with the change of generations, the underground production will eventually reach disparity, because young and upcoming generations tend to get involved in the tertiary and quaternary industries, much more than in agriculture of manufacturing. But until then, it should be recognized, that the underground production exists as a general concern in Romania.

IV. Conclusions

Through this paper, we strongly believe that we have brought to light and emphasized concerning issues regarding the Romanian economic system, issues on which more attention should be drown. While the underground economy is present in all the economies that surround us, some segments of the Romanian economy mentioned above might be the sheer consequences of the demanding process of transition that that this country has been through. These are the natural consequences of the prolonged deprivation of day to day resources and the activity in this site of the economy might be the effect of the eagerness of acquiring more and attaining a higher profit.
The underground economy, as a national issue, has always been present, but ever since the emergence of the Great Recession, it has increased with concerning rates. Whatever would the type of the underground economy be, it cannot be denied the fact that it contributes to a high extent to our economy, but the issue is that no empirical evidences can be found to judge the exact influence it has on the Romanian economy. Some of the economic indicators are able to capture fragments of the data that this paper is concerned about, but since there is not a prescribed circuit of the money according to which they reenter the visible economy, the scale of this activities remains a subject of estimations and suppositions.
As far as the opportunity cost of choosing on which facet of the economy one may be tempted to activate, this paper has tried to outline the main favorable factors and, on the other hand, the opposing elements that would drive the decisional process to a transparent and fair segment or one of the others. In the same time, there is still a psychological mechanism behind this decision of undergoing an untraceable activity, and it is influenced by all events that have occurred in this country, as well as by the means each individual has and considers to be the most accessible.
Indeed, it is recognized that in time, the number of unqualified and unskilled people will be decreasing, and, therefore, the national productivity will increase, but there are issues which can be ameliorated sooner, if the right decisions are taken. Persistent throughout this paper is the question of the sanity of the possibility of eradicating this site of economy. Would it be beneficial at all?

References:
OECD (2002) Measuring The Non-Observed Economy: A Handbook
Block, W. (2010) Defending the Undefendable
Acemoglu, D. (2012) Why Nations Fail
Ravenhill, J. (2014) Global-Political Economy
Garibaldi, P. (2006) Personnel Economics in Imperfect Labour Markets
Motru, C. R. (1999) Psihologia poporului Roman
Voicu, C. (2009) The Mimetic Principle in the Underground Economy
Mankiw, G. N. (2006) Principles of economics
Beardshaw, J. (2005) Economics. A student’s guide
Șerban, R. (2011) Recesiunea 2008-2010: Vitraliu European
Ludwig von Mises Institute, http://www.mises.org
National Institute of Statistics, http://www.insse.org
Economie teoretica si aplicata, http://www.ectam.ro

References: OECD (2002) Measuring The Non-Observed Economy: A Handbook Block, W Acemoglu, D. (2012) Why Nations Fail Ravenhill, J Garibaldi, P. (2006) Personnel Economics in Imperfect Labour Markets Motru, C Voicu, C. (2009) The Mimetic Principle in the Underground Economy Mankiw, G Beardshaw, J. (2005) Economics. A student’s guide Șerban, R