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Good And Bad Equilibria With The Informal Sector

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Bouwe Dijkstra
Abstract

We examine whether an economy can have a bad (small or no formal sector, high taxes) as well as a good (small or no informal sector, low taxes) equilibrium. When the government maximizes instantaneous formal sector welfare, this can occur if the elasticity of average to marginal cost for the public good is less than one. More regard for the informal sector leads to a worse equilibrium, and a higher prevalence of multiple equilibria.

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Paper provided by University of Nottingham, School of Economics in its series Discussion Papers with number 06/01.

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