Chicago Booth Review Podcast How Do Informal Markets Work?

Rimmy Tomy: Traders here are just not very wealthy. And so, indirect reciprocity is an insurance mechanism in the sense that if I help my community members, then when a shock hits, my community members would help me.

Hal Weitzman: Much of the world's economy is informal with transactions taking place in street markets. How does business credit operate in that environment?

Welcome to the Chicago Booth Review Podcast, where we bring you groundbreaking academic research in a clear and straightforward way. I'm Hal Weitzman. Today I'm talking with Chicago Booth's Rimmy Tomy about her research on the huge Iewduh Bazaar in Shillong, the largest and oldest market in Northeast India. Tomy finds that vendors often prefer not to share business metrics with lenders. So how do they get credit?

Rimmy Tomy, welcome back to the Chicago Booth Review Podcast.

Rimmy Tomy: Thank you. Thank you for having me.

Hal Weitzman: Well, we had such fun with you last time talking about trust in the banking sector. We wanted to have you back to talk about your research on informal markets. We've all been to informal markets, many of us all around the world, but you've actually studied them, which is fascinating. And the place that you focused in on was the Iewduh Bazaar in Northeast India. Tell us why you chose that particular market.

Rimmy Tomy: We went to the Iewduh Bazaar in Northeast India for lots of different reasons. One is that this bazaar is very large. It's historic. There's lots and lots of traders, wholesalers and retailers conducting business in this market, so thousands of traders, which is great for a large sample. It also sort of sits in a important part of that region in the big city of Shillong. And over time, there's been waves of migration to that region because of which there are various different communities that operate in that market and therefore, it again gives us a lot of variation in community. So if you want to study-

Hal Weitzman: That's fascinating. Sorry. Go ahead.

Rimmy Tomy: Yeah. So I was going to say that if you want to study the importance of community in credit allocation, then this is a very good setting for that.

Hal Weitzman: Right. Fascinating. So all these people who moved to the city of Shillong have come from different communities, but then those community ties persist and you see that in the bazaar.

Rimmy Tomy: Exactly. Yes.

Hal Weitzman: Fascinating. Okay. Informal economies contribute up to 30% of GDP and 70% of employment in emerging markets. It's vast, isn't it?

Rimmy Tomy: It is.

Hal Weitzman: Why haven't we been studying these for decades?

Rimmy Tomy: There is research in formal markets. There just isn't as much as you would expect there to be given the scope of this sector. And I recently saw an ILO report which said four out of five businesses are informal, and 60% of the world's employed population, which is two billion people, they work in the informal sector.

So given the scale of the sector, you would imagine that there should be just a lot more attention and a lot more research in this area. And it's hard to say why not, but I can think of a few reasons. So one, I guess, is it's just not where all the money is. It's not where the profits are. If that's what we are studying in business academia, then maybe it's easy to overlook the informal sector, but that certainly is where a lot of people are employed and it definitely touches a lot more lives.

Hal Weitzman: It's huge. When we think about official statistics of economic growth and GDP and things like that, do they capture much of the informal economy?

Rimmy Tomy: They do. There are estimates of how much of the GDP, for example, is from the informal sector. Now, one other issue as to why this sector may not have been studied as much is because there really are not a lot of formal databases that systematically collect information about the sector. There's not a lot of financial reporting in the sector and therefore, for a researcher, it's just very expensive. You have to go into these markets-

Hal Weitzman: You got to create the data.

Rimmy Tomy: You have to create the data. So it's a lot of primary research, which takes time, is expensive and is just more difficult to do, I think.

Hal Weitzman: And that's actually what you're researching, right? Because your idea is looking at whether basic accounting information can stimulate economic growth, which raises the question that some of the stuff you're studying is very basic, like recording sales and profits. And these bazaars presumably have existed for thousands of years.

Rimmy Tomy: Yes.

Hal Weitzman: So why do these traders not use that, and what do they use instead? How do they keep track of their basic things like inventory and how much money they're making and profits?

Rimmy Tomy: Yeah. Okay. So let me correct you there. SA lot of these traders do in fact maintain books of record, so they do maintain accounting records. The critical thing we find is that it's not used a lot in credit allocation. So in credit allocation, they tend to use more non-accounting types of metrics. So for example, what community does this person belong to? What is the relationship length? Can I see their shop from where I sit? And so, distance to the shop is an important predictor. So all of those non-accounting metrics matter much more than accounting information.

Hal Weitzman: So it's not a lack. There's other metrics that are there that maybe aren't conventional financial metrics.

Rimmy Tomy: Exactly. Yeah.

Hal Weitzman: Okay. Fascinating. So this is actually expanding the idea of what accounting is. Okay. So your finding suggests that wholesalers would extend more credit, 11% more credit to retailers with high sales if they had accurate information. Does that mean there's pent-up demand for more formal accounting metrics in these informal markets?

Rimmy Tomy: Yeah, I would say so. In our experiment, we conducted a hypothetical choice experiment where we provided accounting and non-accounting numbers to these wholesalers and estimated their willingness to pay for accounting information. And we find that wholesalers would pay for accounting information and even basic accounting information like sales and profits, yet it's not used very much in the market. And so, a lot of our work is then trying to understand why it's not used. So even though there is this demand, why is it that accounting information is not used?

Hal Weitzman: Just as a headline, why is it not used?

Rimmy Tomy: We look at various mechanisms and what we find is, again, a lack of trust. It seems that wholesalers, they just do not believe the numbers that retailers produce and could be various reasons, but most important one we can think of is that these numbers are not verified. There's a huge risk of retailers overstating their sales and profits. But also, on the other hand, retailers also do not trust the wholesalers to provide them with these numbers. And what we find is that retailers express a type of discomfort with sharing financial information, and we don't precisely understand what the roots of those discomfort are or why they are not comfortable sharing these numbers.

And then we also find that retailers, they don't trust that their accounting information will not be misused by the wholesaler. And again, we don't quite know how they believe wholesalers might misuse this information. And so, these are fascinating avenues to explore more and that's kind of what we're thinking of in a future study to try and understand when retailers and wholesalers talk about trust, what kind of trust do they mean? Do they mean trust in the individual or is it more trust in the system, trust in the institutions that are operating there?

Hal Weitzman: It's sort of interesting because you found that 69% of retailers wouldn't share these sales and profit data, even though it might increase their chance of getting the credit. Do they understand that connection?

Rimmy Tomy: They do. In surveys, we spoke with-

Hal Weitzman: But they would rather not share it.

Rimmy Tomy: They would rather not share it, yes. So one reason is, of course, they feel that their data would be misused, but the other reason could also be that they just feel that these non-accounting metrics might be sufficient for them to get by, that they do not really need to provide accounting information.

Hal Weitzman: So we might assume that not being financially literate prevents people from using accounting. Actually, you didn't find that. You found that financial sophistication is unrelated to people's preference for using accounting. Does that also go back to trust?

Rimmy Tomy: It does. It does in a way because financial literacy is one of the mechanisms that we explored. We thought, well, wholesalers might not use this information, perhaps they don't understand it, but we conducted several tests where we asked wholesalers about various basic financial metrics. We tested them on do they understand inflation? Do they understand interest compounding? Do they understand basic financial metrics? And they do.

So they are fairly financially sophisticated, which is not surprising because they're wholesalers, they've been doing this all their lives. You would expect them to be financially sophisticated and yet we don't find that it really relates to the amount of credit that they would provide in our experiment. So it's not as if the wholesalers that are more financially sophisticated would value financial information more. And so, what we do find is that it's really trust that's driving this lack of use of financial information and not so much financial sophistication or financial illiteracy.

Hal Weitzman: Okay. And wholesalers with what you call low endowments, less wealth of education, are more likely to think about things like reciprocity, right?

Rimmy Tomy: Yes. Indirect reciprocity.

Hal Weitzman: What do you mean by indirect reciprocity?

Rimmy Tomy: So this is a mechanism that we uncover in the market, and it plays an important role in credit allocation. Indirect reciprocity is when material goods and favors, they flow not bilaterally between two people, but between three or more people. So A does something for B and C notices that and therefore does something for A. And this kind of indirect reciprocity we argue is an outcome of lack of insurance. So there is no insurance against income shocks as well as that the traders here are just not very wealthy.

And so, indirect reciprocity is an insurance mechanism in the sense that if I help my community members, then when a shock hits, my community members would help me. Now-

Hal Weitzman: Even if they haven't directly worked with me?

Rimmy Tomy: Exactly. Even if they haven't directly worked with me. And indirect reciprocity, it requires this information system, which we argue is the community because community members share a common language, a common culture. They go to social events, they go to similar places of worship. So they just have more information about each other than they would about someone who's outside of their community.

So indirect reciprocity requires this information system to sustain it, which is what the community membership provides. Indirect reciprocity, like I said, is an insurance mechanism and low endowment wholesalers are just more likely to engage in indirect reciprocity because they get more value out of it.

So in the sense that they have to pay in some portion of their endowment in order to subscribe to this insurance mechanism, so it's kind of an insurance premium, but when an income shock hits, it has the ability to wipe out the low endowment wholesaler completely. Whereas wealthier wholesalers, they have other options, they have other sources of income that could sustain them when that shock hits.

Hal Weitzman: So the smaller wholesalers really need this system, and they really need this indirect reciprocity.

Rimmy Tomy: Exactly. And we see that in post-COVID. So we looked at this market before COVID and after COVID, and we found that the low endowment wholesalers, in fact, they get more help from their community members in terms of greater amount of time to repay their rent. They get more time to repay electricity charges, et cetera, which generally goes to those wholesalers who have been helping their community members before COVID. So we do see this mechanism play out.

Hal Weitzman: If you're enjoying this podcast, there's another University of Chicago Podcast Network show that you should check out. It's called The Pie. Economists are always talking about the pie, how it grows and shrinks, how it's sliced, and who gets the biggest share. Join host, Tess Vigeland, as she talks with leading economists about their cutting-edge research and key events of the day. Hear how the economic pie is at the heart of issues like the aftermath of a global pandemic, jobs, energy policy, and much more.

Rimmy, tell me, in the first half, we talked about your research on informal markets, the Iewduh market in Northeast India and in Shillong. And it's fascinating how important these informal networks are. And you actually dug into them and think about how they work to create a kind of a financial system of its own, right? Sort of an informal financial system based on trust.

It's also based on networking, right? Marriage-based networking is important, but also community social events. Just talk to us about how those play into the credit system.

Rimmy Tomy: So they play into the credit system primarily through the indirect reciprocity mechanism. Like I mentioned before, the indirect reciprocity mechanism, it requires an information system to sustain it. And so, through all of these metrics, like how much does a person in a community attend social events? Do they mostly marry their community members? Are most of their important business contacts, are they within the community or are they outside the community? So all of those metrics go into telling us how information flows within the community. And when information flows more within a community and the community's more aware of a member, indirect reciprocity functions better because-

Hal Weitzman: Fascinating. So whereas we might have in a developed economy like the U.S., you might have due diligence or financial reporting. This has these informal flows that happen at weddings or that happen at other social gatherings or within family relationships, I guess, right?

Rimmy Tomy: Yes. And it's still an information network.

Hal Weitzman: Absolutely. And it's an information network that is critical to the credit system in a way that is not in the U.S.

Rimmy Tomy: Yes, yet it sustains indirect reciprocity, right?

Hal Weitzman: Right.

Rimmy Tomy: And with indirect reciprocity, what we find is that wholesalers, on way in which they build a reputation for being a helping type is by providing more credit to retailers from within their community and then being more lenient when these retailers default or are delinquent because there is no formal default in this market.

Hal Weitzman: Right. So let's talk about that. There's no concept of writing off bad debt. So what do you do about delinquency? They don't use the courts, right? They don't repossess the goods.

Rimmy Tomy: No, they don't use courts. They don't repossess goods. So what they typically would do is call the retailer who doesn't repay, ask them to repay, keep calling them, maybe visit their shop and ask them to repay, but there just isn't any legal recourse, that typically doesn't happen. And so that's what they do. They call them and they ask them to repay. And then of course, future credit is also dependent on whether a retailer repays, but less so within a community.

Hal Weitzman: So if you were really to ignore the friendly warnings, what would be the ultimate sanction?

Rimmy Tomy: So that is what we found, that there is really no ultimate sanction.

Hal Weitzman: Fascinating.

Rimmy Tomy: Their credit is just never written off. So you never said, okay, well, this person is not [inaudible 00:16:38].

Hal Weitzman: So you always owe them.

Rimmy Tomy: You always owe them money. And if you happen to die, then your children owe them money. So that's why, I guess, in these communities also it's seen as a very negative thing to not have children because you're just not credit worthy if there's no one to repay your debt.

Hal Weitzman: Fascinating. Okay. So that's a guarantee that you're going to pay because otherwise you're going to pass it on to the next generation. Fascinating stuff. Okay. So you think that financial literacy programs are maybe not the answer or maybe not appropriate here. So instead, you suggest that there should be a verification mechanism that would increase access to credit. So you wouldn't increase access to credit by getting people to have better record keeping necessarily. It would be some kind of verification mechanism. What is that?

Rimmy Tomy: Well, so record keeping is part of it in the sense that you need to have good records, but then you also need those records to be verified in some sense. For example, those records could be audited so that the wholesaler, when he sees the financial numbers from a retailer, would have more reason to believe it because it's gone through this third-party verification system.

Hal Weitzman: Okay. And there is auditing in this setup?

Rimmy Tomy: There is not, no. There isn't, which is why it's not used.

Hal Weitzman: I see.

Rimmy Tomy: Which is why these numbers are not used-

Hal Weitzman: I see. Okay.

Rimmy Tomy: ... in credit allocation.

Hal Weitzman: So what is your verification mechanism? That would be the audit?

Rimmy Tomy: Well, somewhat like an audit, but there could be other ways to do this. Of course, we don't study that in the paper. We don't know what the optimal verification mechanism should be, but in essence, it would be something like an audit.

For example, if there is a third party mediator that is somehow able to capture transactions that the retailer makes, so not so much that the retailer maintaining their books and the auditor in a typical traditional sense verifying a few of those transactions, but rather it could be like an IT intermediator like a FinTech company, which somehow records all of the transactions that the retailer engages in. Could be a B2B platform that ends up collecting all of this information because of their business model. And then that information is now verified because it's clear. It's clear that these transactions have in fact occurred.

Hal Weitzman: But you're just throwing it out there as an idea.

Rimmy Tomy: Exactly.

Hal Weitzman: So somebody could build a business based on this?

Rimmy Tomy: For sure, yeah. That would be great.

Hal Weitzman: Okay. If they do that, they should let us know. You said you're still doing research on the Iewduh market.

Rimmy Tomy: Yes.

Hal Weitzman: Tell us about what you're working on now.

Rimmy Tomy: So we're trying to follow up on this particular project and trying to better understand trust. And the way we would do it is by interviewing a large sample of these traders and really trying to dig into what they mean by trust or rather what they mean by trust as it relates to their use of financial statements. Both wholesalers' use of retailers' financial statements as well as retailers' willingness to provide these financial statements to wholesalers or rather their financials to these wholesalers.

And the way we're going to do it is by using large language models because these large language models are just so powerful, and we are interviewing them and we are having the large language model transcribe these interviews, translate these interviews and draw insights from these interviews, which is really great. We are trying to do a pilot. Well, actually, we're doing testing pre-pilot where we're doing a couple of these interviews, refining our survey tool.

So I'm quite hopeful that it's going to give us more insights into what exactly wholesalers and retailers mean when they say they don't trust these numbers and don't want to use these numbers.

Hal Weitzman: Fascinating. So we can track inform markets and trust using AI.

Rimmy Tomy: Yeah. It's become easier to collect information or collect data and process this data because of large language models. And that's what we're doing now.

Hal Weitzman: Fascinating. Well, we'll love to have you come back and talk about that.

Rimmy Tomy, thank you very much for coming back on the Chicago Booth Review podcast.

Rimmy Tomy: Thank you.

Hal Weitzman: That's it for this episode of the Chicago Booth Review Podcast, part of the University of Chicago Podcast Network. For more research, analysis and insights, visit our website at chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research.

This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe and please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening.