A Model of Market Power with Formal and Informal Firms: Discussion Paper

Market power among firms is a common feature in many economies, including in developing countries where a significant share of firms operate informally. This paper examines the interaction between market power and informality, and how this interaction shapes the impact of government policies. We develop a general equilibrium model with firm heterogeneity and oligopolistic output markets, in which firms endogenously decide whether to operate formally or informally. Informal firms evade taxes but incur enforcement costs. Our framework jointly incorporates informality and market power, providing a quantitative tool to assess the macroeconomic effects of micro-level reforms.