The implications of capital-skill complementarity in economies with large informal sectors

In most developing nations, formal workers tend to be more experienced, more educated, and earn more than informal workers. These facts are often interpreted as evidence that low-skill workers face barriers to entry into the formal sector. Yet, there exists little direct evidence that such barriers are important. This paper describes a model where significant differences arise between formal and informal workers even though labor markets are perfectly competitive. In equilibrium, the informal sector emphasizes low-skill work because informal managers have access to less outside financing, and choose to substitute low-skill labor for physical capital.