The "Dark Side" of Deregulation: How Competition Affects the Size of the Shadow Economy

This paper builds a theory that explains the dramatic expansion of the underground economy in the late 1990s by the sharp increase in market competition worldwide. I model an oligopoly game where firms first decide on entry and sector, and then compete in price. Operating in the underground sector reduces variable costs, but comes at the risk of being detected and fined. As competition intensifies (i.e., as consumers become more and more price-sensitive), underground firms attract more demand, thus stealing business and profits from official firms. As a consequence, more firms enter the underground economy. A lenient policy toward the underground economy may increase welfare when markups are high, but will be welfare-detrimental when markups are low.