Gadjah Mada International Journal of Business - January-April, Vol. 16, No. 1, 2014

Gadjah Mada International Journal of Business
Vol. 16, No. 1 (January-April 2014): 23-38

Explaining the Informal Sector in Indonesia from the
Transaction Costs Perspective*
Yohanna M. L. Gultom
Faculty of Economics, Universitas Indonesia, Indonesia

Abstract: The informal sector in Indonesia is massive, and has become a challenge to the growth of the
open market economy. Explanations of the cause of informality have shifted over time from structural
dualism to excessive government regulation. This paper argues that merely focusing on the high cost
regulation may not reveal the bottom line of informality. Assessment and elaboration of infomality need
the help of the transaction cost approach that suggests that informality in the economy exists due to the
high-transaction-cost institutional framework. To support the argument, this paper provides a preliminary study on the transaction costs borne by firms in the industrial manufacturing sector based on two
industrial surveys conducted by BPS-Statistics Indonesia, which are the 2009 survey on medium and
large-scale enterprises (MLEs) and the 2010 survey on micro and small-scale enterprises (MSEs). This
paper shows that micro and small-scale enterprises with no legality bore the least transaction costs compared to those operating legally, both micro and small-scale, as well as medium and large-scale enterprises.
Consequently, regulatory reforms aimed at reducing transaction costs, not merely aimed at reducing
official costs and simplifying procedures, are the keys to achieving economic growth while ensuring full
participation of the private sector.
Abstrak: Sektor informal di Indonesia bersifat masif dan menjadi tantangan tersendiri bagi perkembangan
ekonomi pasar terbuka. Berbagai penjelasan tentang penyebab dari informalitas dalam dunia usaha tersebut
akhir-akhir ini telah bergeser dari penjelasan dualisme struktural kepada regulasi pemerintah yang berbelitbelit. Paper ini mengusulkan bahwa fokus yang terbatas pada regulasi yang mahal saja tidak akan
mengungkapkan kenyataan yang sebenarnya dari informalitas. Telaah dan elaborasi atas informalitas
membutuhkan bantuan dari pendekatan biaya transaksi yang mengusulkan bahwa informalitas dalam
ekonomi muncul akibat adanya kerangka institution yang menimbulkan biaya transaksi yang tinggi. Untuk
mendukung argumentasi tersebut, paper ini menyampaikan suatu studi awal tentang biaya transaksi yang
ditanggung oleh perusahaan dalam sektor industri manufaktur berdasarkan dua survey industri yang
dilakukan oleh BPS, yaitu Survey Industri Besar dan Sedang tahun 2009 dan Survey Industri Mikro dan
Kecil tahun 2010. Paper ini menunjukkan bahwa perusahaan mikro dan kecil yang tidak memiliki legalitas

* A previous version of this paper, with the title of “The Role of Informal Sector in the Era of ‘Global Shift’:
The Case of Indonesia,” was presented during The Society for the Advancement of Socio-Economics (SASE) 24th
Annual Meeting, at Massachusetts Institute of Technology (MIT), Cambridge, USA, in June 28, 2012.
* Corresponding author’s e-mail: yohanna.magdalena@ui.ac.id
ISSN: 1141-1128
http://www.gamaijb.mmugm.ac.id/

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Gultom

usaha menanggung biaya transaksi paling kecil dibanding perusahaan-perusahaan yang beroperasi secara
legal, baik yang berskala mikro dan kecil, maupun menengah dan besar. Dengan demikian, reformasi
kebijakan yang ditujukan untuk mengurangi biaya transaksi, bukan sekedar bertujuan untuk mengurangi
berbagai biaya resmi dan menyederhanakan berbagai prosedur, merupakan kunci bagi upaya untuk
mencapai pertumbuhan ekonomi dengan turut memastikan adanya partisipasi yang penuh dari dunia
usaha.

Keywords: business environment; informal sector; institutional framework; micro and
small-scale enterprises; transaction costs

JEL Classification: D23 (transaction costs); O17 (formal and informal sector).

Introduction
The rise of new emerging-market economies, especially in the East, which lead to a
‘global shift’ in the world economy and international trade, calls for Indonesia’s attention
to take part in the economic renaissance. As
Indonesia’s economy is characterized by a
majority of micro and small-scale enterprises
(MSEs), their role is significant in the
economy. In 2010, they accounted for more
than 99 percent of total enterprises and absorbed 94.59 percent of the workforce. Their
major contributions are in terms of job creation and a safety net for the poor. Yet, compared to that of medium and large-scale enterprises (MLEs), they contribute relatively
little to national output, only 43.66 percent
compared to 56.34 percent from MLEs, and
especially to non-oil exports, contributing 5.38
percent compared to 94.63 percent (Ministry
of Cooperative and Small and Medium Enterprise in www.depkop.go.id). One specific
characteristic of MSEs in Indonesia, as in
most developing economies, is that of common informality. Meanwhile, commercial
liberalization requires strong economic institutions that establish and secure exclusive
property rights to support voluntary exchanges
based on contracts. Informality would prevent firms from growth and competitiveness

24

due to the absence of secure property rights
and lack of access to strong law enforcement,
credit and other business facilities.
Explanations of the causes of informality have shifted over time from structural
dualism to excessive government regulation.
Yet, this paper tries to approach the problem
of informality from the transaction costs perspectives which originated from the study by
de Soto (1989). This paper provides a preliminary study on the transaction costs borne
by firms in the industrial manufacturing sector, to show that informality in the sector may
exist partly due to the high-transaction-cost
institutional framework. A comparison of
transaction costs borne by firms in the industrial sector which are registered formally and
those which operate informally will be made
using national statistics on industry. The data
is based on two recent surveys on industry,
the 2009 survey on medium and large-scale
enterprises (MLEs) and the 2010 survey on
micro and small-scale enterprises (MSEs),
taking three major provinces on the island of
Java (DKI Jakarta, West Java and East Java)
as the sample. In so doing, this paper attempts
to show that government initiatives to ensure
a better business environment for new entrants to start a business legally are necessary, but not sufficient for the firms in the
informal sector. Empowering their access to

Gadjah Mada International Journal of Business - January-April, Vol. 16, No. 1, 2014

legality through minimizing transaction costs
is as important as the reformation of business regulations to increase their access to
competition, growth and job creation, thus
ensuring the poor people enjoy the benefit
of the ‘global shift.’

The Challenge of Informality in
the Manufacturing Sector
In the manufacturing sector, MSEs become the source of income for people with
low education, for females, and for the poor.
In Indonesia, the 2010 manufacturing survey
on MSEs shows that MSEs have created jobs
for around 6.4 million people. However, 92
percent of them have not been registered legally, according to local law, and thus operate in the informal sector (MSE Survey; and
BPS 2010, processed).1 Meanwhile, the World
Bank’s Entrepreneur Survey (2009) shows
that around 30 percent of registered firms
being surveyed, started their operations without being formally registered, and only considered the legality of the business when they
planned to enlarge the business or enter the
export market. A large portion of the informal sector in the economy would bring negative consequences. Informality can be a source
of unfair competition for the formal, or registered firms, and also deprive the government
of potential tax revenue (World Bank 2011).
In addition, from the firm’s perspective, doing business outside the formal structure also
has implications. The absence of formal property rights may not give firms the incentives
to increase their productivity, and thus realize full gain of their rights over the property
used. It may also restrict the firms from having a self-enforcing type of contract in doing
exchange, thus limiting their access to large-

scale business and direct exports. These implications would end up as a high cost structure in doing exchange.
According to the result of the MSE
Survey in 2010 (BPS, processed), informality also explains the differences between formal and informal MSEs in terms of capital,
access to credit, as well as economic performance such as income, expenditure and value
added. Although lack of capital is the major
problem faced by MSEs, the informal MSEs
found the problem more severe. Not only do
they have less capital than the formal ones,
usually 2.5 times less, but also they have
much more limited access to various sources
of capital. The majority of the informal
MSEs (89.2%) rely on their own personal finance as the source of capital, while only a
small amount of the formal MSEs (10.8%)
do. Informality has caused them to have restricted access to formal credit due to the
absence of legality and property rights. The
consequence of their lack of capital is that
their expenditure and income are also less
than those of formal MSEs. The data also
shows that the limited amount of added value
in MSEs is largely contributed by the informal MSEs. The differences signify that informality has led to the low contribution by
MSEs in the manufacturing sector to growth
and competition. The informality has further
hindered MSEs from growth in their capital.
It is shown by fact that more informal MSEs
(52.1%) than formal MSEs (42.0%) claim
that they are not interested in borrowing
money from a bank for their capital. When
the bank is not the preferred option for formal MSEs, because of its high interest rates,
it also restrains informal MSEs from accessing it due to its collateral requirements.

1

The number refers to entrepreneurs who have not registered legally out of 2,732,724samples in the 2010
Manufacturing Survey on Micro and Small Enterprises, Central Bureau of Statistics (BPS), processed.

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Gultom

The small contribution of MSEs in the
manufacturing sector to GDP is because of
their low productivity due to their limited
access to primary sources of productivity’s
growth, i.e. capital, technology and skilled
labor (Tambunan 2007). Several constraints
have hampered MSEs from growth and productivity. However, studies show that the
lack of legality may count as one important
cause to MSEs’ low performance (de Soto
1989; Jaramillo 2004; World Bank 2009; and
Kaplan et al. 2007). Informal enterprise cannot obtain all the benefits that formality can
bring. Informal firms, due to their lack of
good equipment and trained personnel, produce low quality products. This situation
makes copyrighting or trade marking, and the
fulfillment of export procedures difficult and
unattractive to these firms, thus many of the
entrepreneurs focus not primarily on their
firms growth, but rather on providing employment for family members. Doing Business
report (2012) also states that firms in the informal sector typically grow more slowly, have
poorer access to credit, and employ fewer
workers. A study on starting business in Peru
showed that informality was claimed as the
second most commonly barrier after financing among Peruvian entrepreneurs (Jaramillo
2004: 10).

Literature Review
The explanation of the causes of informality has shifted over time from structural
dualism to excessive government regulation
(de Soto 1989; Kaplan et al. 2007; Djankov
et al. 2002; and the World Bank 2009). Excessive governmental regulation, related to

business start-up, is claimed to be the incentive for firms to operate in the informal sector (Jaramillo 2004; and Kaplan et al. 2007).
In Indonesia’s case, according to IMF Country Report (2010), onerous regulatory framework is one out of three major bottlenecks
to business expansion, besides skilled labor
shortages and poor infrastructure, indicating
a high cost regulatory environment. The
World Bank’s report on Doing Business
(2012) also showed that the overall business
regulatory environment in Indonesia was not
yet conducive for trade and investment,
shown by the lengthy and onerous procedures
for doing business there.2 The main challenge
to the approach of excessive government
regulation in the issue of informality in Indonesia, is that it cannot really explain why,
in spite of many regulatory reforms already
made, the profile of MSEs in Indonesia has
not really change. Kaplan (2007) argued that
if the main reason for informality is excessive regulation, then actually it is possible for
firms to avoid the excessiveness through
bribes. On the other hand, if firms choose to
be informal simply to evade tax, then the explanation of excessive government regulation
would have little significance to the issue of
informality.
Meanwhile, institutional economists
(North 1990; Benham and Benham 2001;
Jaramillo et al. 2004; and Zylbersztajn et al.
2005) claim that costly regulation is only one
indication of inefficient institutional framework that provides the structure for production and exchange in the economy. An unfavorable business regulatory environment will
result in high transaction costs,3 in which the
costs per exchange are much greater than the

2

However, the real cost faced by entrepreneurs due to the regulatory environment has not been reflected in this
study, since it measures only the official days and official costs required by the regulatory procedures.
3

The concept of transaction costs itself has been originated in Coase’s classics (1937, 1960) as the cost of using
price mechanism.

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Gadjah Mada International Journal of Business - January-April, Vol. 16, No. 1, 2014

costs per exchange in other economies with
good institutional framework for the the same
good being exchanged. Eggertson (1990: 1415) explains that when information is costly,
transaction costs appear as the result of some
activities related to the exchange of property
rights by individuals, which include: 1) the
search for information about the distribution
of price and quality of commodities and labor inputs, and the search for potential buyers and sellers and for relevant information
about their behavior and circumstances; 2)
the bargaining that is needed to find the true
position of buyers and sellers when prices are
endogenous; 3) the making of contracts; 4)
the monitoring of contractual partners to see
whether they abide by the forms of contract;
5) the enforcement of a contract and the collection of damages when partners fail to observe their contractual obligations; and 6) the
protection of property rights against thirdparty encroachment, for example, protection
against pirates or even against the government
in the case of illegitimate trade.
These transaction costs appear not only
because of the excessive and incoherent regulation per se, but also because of existing
social institutions that give in to diversion
activities, such as thievery, squatting, Mafia
protection, and the norms of giving gratification. Thus, a broader concept of “business
environment,” or what North (1990) called
the institutional framework, and Hall and
Jones (1999) called social infrastructure, will
take into account not only the formal aspects
of institution (law, policy, and regulation), but
also the informal aspect of institution that
goes beyond government policy. According
to Hall and Jones, favorable social infrastructure, which consists of institution and government policy, is one that will provide an
economic environment that supports productive activities and encourages capital accu-

mulation, skill acquisition, invention and
technology transfer (1999: 84). Such institution that promote suppression against diversion would lead to a low transaction as individual capture the social returns to their actions as private action (North and Thomas
1973) or what property rights theorists may
claim as the full internalization of externalities (Coase 1960; and Demzets 1968).
With this approach, North (1990) argued that firms come into existence to take
advantage of profitable opportunities defined
by the institutional framework. In an environment with high transaction costs, informal sectors may exist to provide a structure
of exchange, yet such structure comes with
high costs due to the lack of formal property
rights and self-enforcing types of contracts
when doing exchanges. Such an inefficient
institutional framework eventually demands
costs of transactions be borne by the firms
having transactions in the market due to the
problems of imperfect information, adverse
selection, and the moral hazard they face.
Therefore, any explanation about the issue
of informality needs to refer to the concept
of transaction costs that reflect the inefficiency in the institutional framework that
governs production and transaction in the
economy in its entirety. This concept reflects
the overall complex sets of institution, both
formal (legal codes and regulations) and informal (norms/rules and traditions), that
determines the relevant prices faced by individuals in the market. This relevant price is
thus refer to the cost of exchange that is the
opportunity cost faced by an individual to
obtain a good using a given form of exchange
within a particular institutional setting
(Benham and Benham 2001: 3). Therefore,
the relevant price includes the price of the
goods themselves plus the transaction costs
of obtaining the goods. The transaction cost

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Gultom

perspective will help reveal how inefficient
institution may have affected firms’ opportunity costs by operating in the informal sector.

Methods
While the significance is not questionable, measuring transaction costs is problematic since transaction costs and production
costs are jointy determined, thus it is difficult to measure transaction costs separately.
Besides, there are no specific data of transaction cost available in most statistics of industry. Some studies suggest how to do a
measurement of transaction cost from a range
of perspectives (See Wang 2003 for an extensive literature study about measuring
transaction costs). This study will follow
Benham and Benham (2001: 3) who suggest
a new approach to measuring transaction cost
by introducing the concept of “the costs of
exchange.” This approach helps in determining the non-marketed transaction from the
perspective of the firm’s cost structure. They
refer the costs of exchange to the opportunity cost faced by an individual that captures
both the cost of the item itself and the transaction costs incurred by the individual to
obtain the item. This concept allows this research to approach the transaction costs by
comparing opportunity cost alternatives available in the market, for example, between the
opportunity costs faced by the registered and
non-registered firms (firms operating in the
informal sectors). This is important since,
especially in the market with high transac-

tion costs, many kind of transactions may not
take place at all, or if a specific kind of transaction occurs, it may not occur in an open
market with money prices. Comparing alternatives will help this research to estimate the
potential transaction costs faced by individual
firms and why certain choices are made.
Using the approach of cost of exchange,
this study aimed to conduct an examination
on the transaction costs incurred by MSEs,
both formal MSEs and informal MSEs, compared to that of MLEs.4 This study used statistical data from the 2009 industrial survey
on MLEs and the 2010 industrial survey
MSEs, restricted to only 3 major provinces
in Indonesia, DKI Jakarta, West Java and East
Java, to provide a sample of the informal sectors in these provinces. The survey on MLEs
covers only firms with legal status, thus the
data represents the formal sector. The survey on MSEs covers both firms with and without legal status in the raw data, thus this research has the advantage of categorizing the
sample into two groups, the one with legal
status to represent the formal MSEs and the
one without legal status to represent the informal MSEs, for the purpose of analysis.5
The analysis was made by comparing the
cost structure and performance between the
formal MSEs and informal MSE on one side
and with the MLEs on the other side. The
cost structure includes both production costs
and transaction costs. The production costs
cover four basic components of costs including: 1) costs for raw materials; 2) wage/salary of workers; 3) costs of fuel, lubricants
and electricity; and 4) other expenses.

4

Indonesian Central Bureau of Statistics (BPS) defines micro, small, medium and large-scale enterprises as those
business units consist of 1-4 workers, 5-19 workers, 20-99 workers and more than 100 workers respectively.
5

While studies usually categorize micro and small-scale with medium-scale enterprise (small and medium-scale
enterprise or SME), regrouping them to micro and small-scale in one group and medium and large-scale in the other
group will give further insight to discuss the informality issues.

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Gadjah Mada International Journal of Business - January-April, Vol. 16, No. 1, 2014

For the MLEs, “other expenses” covers
six sub-components of: (a) rental and contract payments; (b) tax, industrial services;
(c) interest paid on loans; (d) charitable contributions; (e) representation cost and royalties; and (f) other.6 However, from those six
sub-components, category (f) “other” was
excluded from the “other expenses” to become the proxy for transaction costs in MLEs.
This “other” category includes: a) representation costs; b) royalties; c) management fees;
d) promotion and advertising costs; e) water,
postage, facsimile, and telephone costs; f)
travel expenses; g) prevention of environment
pollution costs; h) research and development
expenses; and j) human resource development
expenses. This category is taken as the proxy
for transaction costs since it includes mostly
expenses related to transaction-cost-related
activities, such as acquiring information, conducting negotiations, making a contract or
agreement, monitoring and enforcing the contract, and the protection of, and enforcing,
property rights.
For MSEs “other expenses” in the production costs covers 10 sub-components: a)
stationary; b) interests paid on loans; c) delivery, postage and telecommunication costs;
d) services and maintenance; e) rental and
contract payments; f) land leasing; g) third
party industrial services; h) indirect tax (including entertainment and retribution); i) expenses for other-party services (such as services for accounting, promotion and advertising, etc); j) others (costs related to packaging and supporting materials). Out of those
10 sub-components, category (c), (h), and (i)
were excluded from the “other expenses” to
be counted as the proxy for transaction costs
in MSEs. For MSEs, since the survey records
6

the component of other expenses differently,
the proxy for transaction costs is the sum of
the three sub-components of (c), (h), and (i)
that are comparable to the proxy for MLEs
as well as sensitive to the problem of the high
transaction cost environment faced by MLEs.
Total expenditure is then regarded as
the cost of exchange, which is equal to the
production cost needed to transform input
into output plus the transaction costs of doing the exchange in the market in order to
produce the goods. Thus, the cost of exchange
is measured by:
Cost of Exchange (MLE, MSE)=
Production Costs (MLE, MSE) +
Transaction Costs (MLE, MSE)
..................................................(1)

The Findings and Some
Qualification to the Findings
The findings confirm that the portion
of transaction costs borne by MLEs is higher
than that of MSEs. The portion of transaction costs in MLEs which count for 5.27 percent of the total opportunity costs of the
firms is considered high since it has about
the same value as the portion spent on fuel,
lubricants and electricity (5.70%) as well as
other costs (5.02%) which include rents, tax
(excluding income and personal tax), industrial services and interest paid on loans. A
relatively high ratio of transaction costs to
cost of exchange faced by MLEs suggests
that MLEs in general were facing a hightransaction-cost institutional framework or a
high-transaction-cost economy in the manufacturing industry. Moreover, Figure 2 shows

The category f) other is used as the proxy for the transaction costs in this paper.

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Gultom

Figure 1. Composition of Cost of Exchange in MSEs and MLEs in 3 Provinces in Indonesia (DKI Jakarta, West Java and East Java), 2009/2010 (%)

Source: 2009 Manufacturing Survey on MLEs and 2010 Manufacturing Survey on MSEs,
Central Bureau of Statistics, processed.

Figure 2. Composition of Cost of Exchange among MLEs, Formal MSEs and Informal
MSEsin 3 Provinces in Indonesia (DKI Jakarta, West Java and East Java), 2009/
2010 (%)

Source: 2009 Manufacturing Survey on MLEs and 2010 Manufacturing Survey on MSEs, Central Bureau of Statistics, processed.

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Gadjah Mada International Journal of Business - January-April, Vol. 16, No. 1, 2014

that MLEs have a higher portion of transaction costs than MSEs in general and informal MSEs in particular. By dividing the MSEs
into formal MSEs and informal MSEs, the
study shows that in terms of transaction costs,
the gap between MLEs and informal MSEs is
even wider (3.39 %). A previous study
(Gultom 2012) showed that the high portion
of transaction costs among MLEs in the industrial sector would affect firms’ decisionmaking in the allocation of resources. As other
cost components are given by the market price,
the only component in cost of exchange that
is under the firms’ control is their labor cost.
In fact, labor wages in Indonesia are set by the
minimum wage controlled by the government,
not by labor productivity.

However, the high-transaction-cost
economy, or the inefficient institutions would
have influenced firms’ cost structure with
some qualifications. First, the effect of a hightransaction-cost economy on the firms’ cost
structure is determined by the scale of the
firms, and the legal status they have. The
high-transaction-cost economy may have
more impact on the MLEs than on the MSEs.
Nevertheless, it may have impacted the informal MSEs the least. The characteristics
of MLEs explain this finding. MLEs tend to
have more capital intensive technology by
having more expenses in raw materials and
less expense in labor. However, the fact that
MLEs count for almost 3 times higher than
the proportion of transaction costs borne by

Table1. Composition of the Cost of Exchange by Type of Enterprise in 3 Provinces in
Indonesia, 2009/2010 (Rp. 000)
Cost of Exchange

MLEs

Formal MSEs

Informal MSEs

Mean

%

Mean

%

Mean

%

3,670,848.63

78.32

13,603.76

71.45

5,937.71

69.43

Labor compensation

293,569.55

6.26

688.73

18.10

474.92

18.01

Fuel, gas, electricity,

237,096.49

5.06

3,447.28

3.62

1,540.18

5.55

Other expenses

237,096.49

5.06

885.73

4.65

435.77

5.10

Transaction Costs

248,621.97

5.30

415.33

2.18

163.62

1.91

Cost of Exchange

4,687,233.12

100

19,041.18

100

8,552.33

100

Raw materials

water

Source: 2009 Manufacturing Survey on MLEs and 2010 Manufacturing Survey on MSEs, Central Bureau of Statistics, processed.

Notes: Costs of MSEs are based on expenditures in June 2010 while costs of MLEs are based on
monthly average expenditures during 2009.

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Gultom

MSEs also suggests that the size of, and technology used by the MLEs may have affected
the proportion of the transaction costs they
faced. Meanwhile, MSEs might have a lower
portion of transaction costs due to, among
other factors, the characteristics of informality they have, characterized by the absence
of property rights and the lack of asset specificity.
Furthermore, Table 1 shows that the
portion of expenses for raw materials tends
to decrease as the firm’s size gets smaller and
if informality exists. A similar trend is found
in the case of the transaction costs. Compared
to MLEs, the portion of the transaction costs
to the cost of exchange is lower in formal
MSEs, however, it is even more so in informal MSEs. As the portion of the transaction
costs are seen to declined from MLEs to formal MSEs and from formal MSEs to informal MSEs, this would explain why the transaction cost would be a constraint on them,
as the firms operate with legality and as those
firms with legality grow into a bigger business. Although a conclusion about the
strength of the relationship between the transaction cost and informality could not be
drawn from this data, the findings clearly confirm that some firms in the informal sectors
could escape the burden of transaction costs
faced by those operating legally.
This finding suggests that there is a relationship between the transaction costs
borne by the manufacturing sector, with the
informality in the sector. According to North,
firms come into existence to take advantage
of profitable opportunities defined by the
institutional framework of the business regulatory environment, reflected by the kind of
technology they use. He explains, “with insecure property rights, poorly enforced laws,
barriers to entry, and monopolistic restrictions, the profit-maximizing firms will tend
32

to have short time horizons and little fixed
capital, and will tend to be small scale” (North
1990: 67). In this situation, the informal sectors exist to provide a structure of exchange.
Nevertheless, such structure comes at a high
cost due to the lack of formal property rights
and the self-enforcing type of contract in
doing exchange (ibid).
Therefore, the massive and persistent
informality in the manufacturing sector could
also be explained by the high transaction
costs faced by the industries. As firms become
more formal, they may require more mechanisms to define and protect their property
rights, for example, by making contracts, submitting to the applied regulation related to
doing business, trading, exporting and importing, as well as employing workers. These activities require more costs in finding relevant
price, negotiating the contract, enforcing and
monitoring the contract, as well as using the
facilitator services to obtain the goods/permits they need. In conclusion, the absence
of formal property rights would allow informal MSEs to waive the transaction costs as
they find these transaction costs too costly
for their scale and state of business.
Second, the effect of a high-transactioncost economy on firms’ cost structure is determined by the variance of local institutional
framework. Table 2 shows that transaction
costs vary across provinces. This variation
indicates that the institutional framework,
both the formal (law and regulation) and informal (business culture, trust, and norms)
institutions, also varies among regions. The
variance still confirms the trend suggested in
previous discussions though, that formal
MSEs tend to have a higher portion of transaction cost, based on provinces and the scale
of enterprise. The ratios between each component to production costs and to cost of
exchange are presented for the purpose of

Gadjah Mada International Journal of Business - January-April, Vol. 16, No. 1, 2014

comparison. The cost structure presented
below also suggests that the relevant price
of manufacturing goods in the market is determined not only by the production costs but
also by the transaction cost of obtaining the
goods. Thus, the 5.3 percent of transaction
costs faced by MLEs means that in general,
the money price of industrial products has
departed by 5.3 percent from the neo-classical economics’ margin. Across the 3 provinces,
West Java tends to have the higher portion
of transaction costs compared to DKI Jakarta
and East Java, especially among MLEs
(5.74%) and formal MSEs (2.36%). While
among the informal MSEs, the highest portion of transaction cost is found in DKI
Jakarta.
Third, the effect of a high-transactioncost economy on a firm’s cost structure is
also determined by the firm’s type of industry. In this case, the type of industry relates
to the level of specificity of investment or
technology. As explained by Williamson
(1975, 1985, 1996, 2000), the cost of transaction tends to be higher when a transaction
is characterized by higher frequency of trade,
higher level of uncertainty in doing the transaction, and a higher level of asset specificity.
Under the assumption that economic agents
are not fully rational, but only boundedly rational (as they face costly information and

uncertainty in the market), as well as opportunistic in nature(See Williamson 1979, 2000,
2002 for the new institutional economics’
behavioral assumption of economic agent),
such a transaction may lead to a higher cost
of searching information, negotiating and
concluding the contract, enforcing the contract, and other activities related to defining
and protecting property rights.
Table 3 shows that the portion of transaction costs varies across 8 types of industry
where most of the MSEs operate. The portion of transaction costs tend to be high in
industries with a high level of investment
specificity or technology used. Industries with
the highest portion of transaction costs that
are shows consistently across the scale of
firms (MLEs, formal MSEs or informal
MSEs) are the pharmaceutical and chemical
product industries and other non-metallic
mineral product industries Among MLEs,
these industries are the garment industry
(7.55%) and pharmaceutical and chemical/
traditional product industry (6.80%); among
formal MSEs, they are pharmacy and chemical/traditional product industries (4.55%)
and other non-metallic mineral product industries (2.07%); and among informal MSEs,
they are other non-metallic mineral product
(3.62%) and pharmaceutical and chemical/
traditional product industries (3.42%).

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Gultom

Table 2. Component of Costs by Types of Enterprise during a Month (Rp. 000)
PROVINCE

Component of Costs (Mean)
Transaction
Costs
(a)

Production
Costs
(b)

Cost of
Exchange
(a+b)

Ratio
(a) to (b)

Ratio
(a) to (a+b)

MLEs

248,621.97

4,438,611.15

4,687,233.12

5.60

5.33

Formal MSEs

415,331.90

18,625,849.68

19,041,181.57

2.23

2.18

Informal MSEs

163,621.89

8,388,704.94

8,552,326.83

1.95

1.91

5,879,696.18

306,315.48

6,186,011.66

5.21

4.95

Formal MSEs

804.51

35,334.60

36,139.11

2.28

2.23

Informal MSEs

477.89

23,742.48

24,220.37

2.01

1.97

4,341,272.07

264,423.45

4,605,695.51

6.09

5.74

Formal MSEs

432.73

17,887.08

18,319.81

2.42

2.36

Informal MSEs

178.76

9,313.55

9,492.32

1.92

1.88

3,094,865.21

175,126.98

3,269,992.20

5.66

5.36

Formal MSEs

113.39

6,961.75

7,075.14

1.63

1.60

Informal MSEs

95.62

4,912.89

5,008.51

1.95

1.91

3 Provinces

DKI Jakarta
MLEs

West Java
MLEs

East Java
MLEs

Sourc es: 2010 Manufacturing Survey on MSEs and 2009 Manufacturing Survey on MLEs,
Central Bureau of Statistics (BPS), processed.
Notes: Costs of MSEs are based on means of expenditures in June 2010 while costs of MLEs on
monthly average expenditures during 2009.

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Gadjah Mada International Journal of Business - January-April, Vol. 16, No. 1, 2014

Table 3. The Average of Transaction Cost Spent in a Month by Types of Industry and
Types of Enterprise in 3 Provinces (DKI Jakarta, West Java and East Java) in
Indonesia, 2009/2010 (Rp.)
Type of Industry

MLE s

Formal
MSEs

Informal
MSEs

Mean

%
to CoE

Mean

%
to CoE

Mean

%
to CoE

Food and beverages

279,736,727.50

5.82

167,162.83

1.57

106,377.54

1.37

Wood and products
of wood

36,025,099.17

4.14

88,066.67

1.67

75,331.85

2.82

Textiles

98,411,260.00

5.09

28,002.77

0.44

43,927.09

1.69

Garment

74,373,608.33

7.55

396,660.81

1.81

175,468.32

1.37

Other non-metallic
mineral products

239,750,919.44

5.54

192,518.75

2.07

209,662.01

3.62

Pharmacy, chemical,
1,173,266,096.94
and traditional products

6.80

126,800.00

4.55

56,430.67

3.42

Leather and products
of leather

65,685,621.11

4.99

427,791.26

0.94

359,608.88

1.51

1,040,428,875.28

4.93

180,000.00

1.68

410,105.68

2.37

Automotive

Sources: 2010 Manufacturing Survey on MSEs and 2009 Manufacturing Survey on MLEs,
Central Bureau of Statistics (BPS), processed.
Note: CoE stands for cost of exchange

Conclusion
The high cost economy in the manufacturing sector is a double-edged sword, with
implications to the growth and competitiveness of the sector in the era of ‘global shift.’
On one side, it restrains the growth and productivity of MLEs in the manufacturing sec-

tor which account for 75.4 percent of total
non-oil exports. On the other side, it restrains
MSEs optimal participation in the growth and
productivity of the sector due to the high rate
of informality. Assessment and elaboration
of these implications need the help of the
transaction cost approach to show that there
are significant relations between the transac-

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Gultom

tion costs and the scale of firms, firms’ investment specificity, local institutional framework, and the status of formality.
While efficiency in production costs
mostly depends on firms’ internal factors,
such as the choice of technology used, labor
productivity and capital intensity ratio, efficiency in transaction costs depends more on
external factors, especially those from the
social institution and government regulation.
In this context, a good and effective economic
institution would value social inclusion, thus
promoting development and poverty reduction. The challenge is thus to have a business
environment which is supportive to micro and
small-scale enterprises, to assist them to optimally access the market in doing exchange,
thus improving their productivity and job creation. Strengthening their access to information regarding business procedures, access to
registering and ensuring property rights, access to credit, access to enforcing contracts,
and access to conduct trading are major issues in regulatory reform efforts. Increasing
such access requires a favorable social infrastructure that protects against diversion in the
economy, thus minimizing minimizing transaction costs in the economy. Diversion includes expropriation, confiscatory taxation,

corruption, as well as thievery, squatting,
mafia protection, and so on (Hall and Jones
1999: 84). Consequently, regulatory reforms
aimed at reducing transaction costs resulted
from such high-transaction-cost economy
which are not merely aimed at simplifying
procedures and reducing official costs, are the
key to achieving economic growth while ensuring full participation by the private sector.
This paper suggests that the existence
of the informal sector in Indonesia could also
be explained by the high transaction costs
borne by entrepreneurs in the manufacturing
sector. The findings would open the door of
opportunity for future empirical research to
investigate further how transaction costs
would affect the informality in industries.
Such research will provide essential information for future business regulatory reform. As
Hall and Jones stated, in order to show the
strong relationship between social infrastructure and output per worker, “Countries with
corrupt government officials, severe impediments to trade, poor contract enforcement,
and government interference in production
will be unable to achieve levels of output per
worker anywhere near the norms of western
Europe, northern America, and eastern Asia”
(1999).

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