The existence of a large informal sector may be a factor constraining formal firms' choices of innovation strategies in many developing countries. This paper addresses this issue and studies the impact on innovation of competition against firms in the informal sector. Using the World Bank's Enterprise Survey data from a sample of African and Latin American countries, we find that the marginal impact of informality on innovation by formal firms decreases with the intensity of competitive pressure from informal firms, consistent with an inverted-U relationship between propensity to innovate and competitive pressure from firms in the informal sector. This pattern arises even after controlling for the number of competitors, suggesting that the pressure that informal firms exert on formal firms go beyond a mere increase in the number of competitors.

Article.