The Search and Matching Equilibrium in an Economy with an Informal Sector: A Positive Analysis of Labour Market Policies

This paper contributes to the theoretical analysis of the informal sector through the search and matching framework. Building upon the work of Albrecht, Navarro and Vroman (2009), where the informal sector consists of unregulated selfemployment, I describe the search and matching equilibrium in an economy with an informal sector where workers are risk neutral and the government is able to see whether a worker is in the formal sector or in the informal one. In this case, I solve the matching equilibrium by introducing three policies: unemployment benefits, a formal lump sum tax, and a job creation subsidy. I analyse the effects of these policies on unemployment rates, formal employment and informal employment. I show that these policies affect the incentives of workers insofar as joining the formal or informal sectors, changing the composition of these two types of workers in the labor market.