Abstract

We consider a model where two downstream firms purchase inputs from upstream firms, and each of them produces one good with different transformation capacities. Final consumers differ in their willingness to pay for the quality of the product. The novelty is that in the upstream, one formal firm faces the competition of a large number of informal firms. The formal firm produces a higher-quality input, whereas the informal firms produce a lower-quality input. The downstream firms decide which input to buy. We show that this model may be used to analyze the innovation incentives for upstream formal firms in developing countries, in the presence of a competitive informal sector.