Institutions, Strains and the Underground Economy

The paper interprets the dynamics of the underground economy in a transforming environment by highlighting the role of institutions in enforcing the rules of the game and the phenomenon of strain. A basic idea is that the underground economy emerges as a means for the system to diffuse its internal strain; the underground economy operates as a homeostatic mechanism which helps the system survive temporarily -as in the case of a command economy-and affects the structure of output according to consumers' preferences. In the same vein can be judged the emergence of unofficial activities in an over regulated system be it market-based. Part one deals with the command economy and its specific institutions (rules of the game) as a glaring example of neglect of consumers' preferences and as a system developing endemic shortages. In such a system very intense strain emerges. Part two tries to explain strain during system transformation and its impact on the underground economy. In this case the magnitude of strain is related to dramatic changes in relative prices and the imbalance between exit and entry. Similarly relevant for explaining strain are the institutions in the making; still "soft" rules shape agents' behaviors and explain the resilience and the patterns of unofficial activities. Such is the case of reputation seen as an asset, and of the local standards of compliance with the legal framework. The last part applies empirical analysis, a model to the Romanian economy and speculates on the size of local unofficial activities.