The linkages between formal and informal sectors: A segmented labor markets analysis

This paper analyses the effects of various macroeconomic and labor market policy changes in an economy with an informal sector and significant informal employment, defined as employment which does not abide with labor market regulations, including minimum wage and social security laws. It has been documented in the literature that foreign trade liberalization reforms expose domestic firms to increased foreign competition, leading them to seek ways to cut back production costs, most notably labor costs. Cutting labor costs can be accomplished in one of three ways, including laying off workers (who subsequently look for employment in the informal sector); cutting down or eliminating worker benefits, putting the workers in informally employed or unregistered status; or establishing subcontracting relationships with smaller scale firms which already employ workers informally. In this paper, we concentrate on the first two effects. The effects of increased exposure to foreign competition (in the form of lowered tariffs and subsidies) are examined in the context of a dynamic general equilibrium model of a small open economy with three sectors including an informal sector, a formal sector, an agricultural sector, and a segmented labor market. Additionally, as the timing of domestic labor market policies stimulating flexible employment may coincide with that of trade reforms, we also explore the effects of changes in minimum wage and in social security tax rates, on the allocation of labor in different sectors, as well as the effects on the informal wage.In this paper we utilize a multi-sector Ramsey growth model to observe the dyamics of the baseline economy, and conduct comparative statics with respect to policy experiments at the steady state. In the theoretical model, we examine a small open economy with three production sectors. The production sectors included in the model economy are the agricultural sector, the informal sector and the formal sector. The primary objective in constructing the theoretical model is to analyze the linkages between the formal and informal sectors as capital accumulates and as the economy grows through time. The linkages between these two sectors materialize through the workings of the labor market. The secondary objective is to observe the changes in the production sectors as the economy exposes its markets to increased foreign competition and labor market policy changes. In the model economy, in addition to three production sectors, there are three economic agents: the producer, the household and the government. The production takes place using four production factors: capital, skilled labor, unskilled labor, and land. The household owns all production factors, and generates income from renting them. The formal sector utilizes capital, unskilled labor and skilled labor in production, and produces a traded good which is both an investment and a consumption good. The informal sector uses capital and unskilled labor in production, and produces a non-traded consumption good. The agricultural sector rents land and hires unskilled labor in production, and produces a traded pure consumption good. Although foreign trade of goods are allowed in the model, there is no international mobility in labor and capital. Within the economy, capital is perfectly mobile across all sectors, while the labor market is segmented. Land can be rented in and out only within the agricultural sector. Finally, the government only serves to collect taxes and tariffs, and distribute subsidies and transfers, and has no consumption and investment behavior.Conducting the comparative statics with respect to formal sector subsidies (lowering subsidies to formal sector in the context of liberalization policies) leads to a lower informal output, lower informal wages, lower allocation of unskilled labor in both sectors (formal and informal), but a higher allocation of skilled labor in the formal sector, therefore a higher formal output, and thus a higher overall income in the economy. A devaluation of the domestic currency will have the opposite effects, therefore the task of the policymaker is to find an optimal balance between lowering subsidies in the formal sector, and encouraging formal sector production through a devaluation of the domestic currency. An increase in the minimum wage, on the other hand, creates opposite effects to lowering subsidies, but similar effects with a devaluation of domestic currency: a rise in the minimum wage decreases informal wages, encourages use of unskilled labor in the informal sector, discourages use of unskilled labor in the formal sector, to be substituted by an increase in the use of skilled labor in the formal sector, and raising production there. We can say that the increase in the minimum wage would raise the gap bwetween the wages of the unskilled in the formal sector and the unskilled in the informal sector, rendering the informally employed even more disadvantaged in the labor market. In terms of the dynamic solution of the model, we observe that as capital accumulates and the income grows over time, the formal sector producer shifts from formal skilled labor to formal unskilled labor as the skilled labor wages increase, and as the formal skilled labor wages remain constant at the minimum wage. As the economy progresses over time and informal wages increase, the unskilled labor in the agricultural sector leaves this sector, to be employed in the informal sector, raising output there. Therefore in transition and in the long run, we observe a movement of unskilled labor out of agriculture into the informal sector.