Formal and Informal Employment in Central Asia: Testing Labor Market Theories

This study investigates factors influencing individuals' choices between Central Asia's formal and informal employment sectors. Two competing hypotheses seek to explain employment in these sectors. The first is the labour market segmentation theory, which views the informal sector as a distinct marginal sector that provides economic opportunities primarily for people experiencing poverty. According to this theory, workers are involuntarily in the informal sector due to being rationed from the high-wage formal sector. The second is the comparative advantage theory, which assumes workers self-select into the sector where they can earn the highest return because of systematic differences in their characteristics. Utilising the Life in Transition Survey III data, this research applies a Heckman-type two-stage selection model to test labour market segmentation and comparative advantage theories. The findings indicate that the labour market in Central Asia is segmented, and selection based on comparative advantage primarily applies to the formal sector. This study highlights the need for policy measures that reduce barriers to formal employment and emphasises the importance of educational investments to address informal sector employment effectively.