Firm-Size Wage Gaps Along the Formal-Informal Divide: Theory and Evidence

Observationally equivalent workers are paid higher wages in larger firms. This fact is often named as the “firm-size wage gap” and is regarded as a key empirical puzzle. Using a nationally representative micro- level survey data from Turkey, this paper documents a new stylized fact: the firm-size wage gap is more pronounced for informal (unregistered) jobs than for formal (registered) jobs. To explain this fact, we develop a two-stage wage-posting game with market imperfections and segmented markets, the solution to which produces wages as a function of firm size in a well-defined subgame-perfect equilibrium. The model proposes two distinct mechanisms. First, setting high tax rates on formal activity generates a wedge between formal and informal size wage gaps. Thus, government policy can potentially affect the magnitude of the firm-size wage gaps. We provide auxiliary empirical evidence justifying this finding. The model is able to explain the stylized fact through a second mechanism-even when the tax dimension is shut down. Higher wages offered by a larger firm for a formal job can attract a larger number of applicants, than the same amount offered by the same firm can attract for an informal job. The larger pool of applicants for the formal job, in turn, enables the firm to keep the size differentials modest, while this mitigating effect is weaker for informal jobs.