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Labor regulations and the informal economy

Author

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  • Loayza, Norman V.

Abstract

The informal economy, which evades labor regulations, provides employment for much of the labor force in developing countries. The author explores how labor regulations and imperfections in informal capital markets affect income inequality and the speed of industrialization. Empirical evidence shows that labor costs are higher in the formal sector, and that the cost of capital is higher in the informal sector (in part because many informal activities are illegal, so contracts are unenforceable). The author develops a theoretical model based on such factor-cost asymmetry. He applies it to an urban economy with and without ample supplies of labor from the rural sector. The dynamic analysis considers rural-urban migration and optimal capital accumulation. He finds the following. First, labor regulations that mandate workers'compensation above its market-dictated level induce the formation of an informal sector and thus the dispersion of wages across homogeneous workers. And labor regulations slow capital accumulation and retard the process of rural-urban migration. Second, when capital allocation to informal producers becomes more efficient, the informal sector expands relative to the formal sector, the gap between formal and informal wages narrows, and rural-urban migration speeds up. Finally, policies with an urban bias hasten rural-urban migration, inducing an expansion of the informal labor force relative to the total labor force. Post-World War II experience in informal economies in Latin America motivates and in some respects supports the theoretical findings, says the author.

Suggested Citation

  • Loayza, Norman V., 1994. "Labor regulations and the informal economy," Policy Research Working Paper Series 1335, The World Bank.
  • Handle: RePEc:wbk:wbrwps:1335
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    References listed on IDEAS

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    1. Alberto Alesina & Dani Rodrik, 1994. "Distributive Politics and Economic Growth," The Quarterly Journal of Economics, Oxford University Press, vol. 109(2), pages 465-490.
    2. Fields, Gary S., 1975. "Rural-urban migration, urban unemployment and underemployment, and job-search activity in LDCs," Journal of Development Economics, Elsevier, vol. 2(2), pages 165-187, June.
    3. Stark, Oded, 1982. "On modelling the informal sector," World Development, Elsevier, vol. 10(5), pages 413-416, May.
    4. Rauch, James E., 1991. "Modelling the informal sector formally," Journal of Development Economics, Elsevier, vol. 35(1), pages 33-47, January.
    5. Williamson, Jeffrey G., 1988. "Migration and urbanization," Handbook of Development Economics,in: Hollis Chenery & T.N. Srinivasan (ed.), Handbook of Development Economics, edition 1, volume 1, chapter 11, pages 425-465 Elsevier.
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    Citations

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    Cited by:

    1. John Bennett & Saul Estrin, 2007. "Informality as a Stepping Stone: Entrepreneurial Entry in a Developing Economy," CEDI Discussion Paper Series 07-11, Centre for Economic Development and Institutions(CEDI), Brunel University.
    2. Bruno Chiarini & Elisabetta Marzano & Francesco Busato & Pasquale De Angelis, 2007. "State Aid Policies and Underground Activities," Discussion Papers 4_2007, D.E.S. (Department of Economic Studies), University of Naples "Parthenope", Italy.
    3. Francesco Busato & Bruno Chiarini & Pasquale de Angelis & Elisabetta Marzano, 2005. "Capital Subsidies and the Underground Economy," Economics Working Papers 2005-10, Department of Economics and Business Economics, Aarhus University.
    4. Loayza, Norman & Palacios, Luisa, 1997. "Economic reform and progress in Latin America and the Caribbean," Policy Research Working Paper Series 1829, The World Bank.
    5. Cunningham, Wendy V & Maloney, William F, 2001. "Heterogeneity among Mexico's Microenterprises: An Application of Factor and Cluster Analysis," Economic Development and Cultural Change, University of Chicago Press, vol. 50(1), pages 131-156, October.
    6. Joanna Tyrowicz & Stanisław Cichocki, 2011. "Employed unemployed? On shadow employment in transition," Empirica, Springer;Austrian Institute for Economic Research;Austrian Economic Association, vol. 38(2), pages 259-281, May.
    7. Banerji, Arup & Jain, Sanjay, 2007. "Quality dualism," Journal of Development Economics, Elsevier, vol. 84(1), pages 234-250, September.
    8. Maloney, William F., 1998. "The structure of labor markets in developing countries : time series evidence on competing views," Policy Research Working Paper Series 1940, The World Bank.
    9. Maloney, William F., 2004. "Informality Revisited," World Development, Elsevier, vol. 32(7), pages 1159-1178, July.

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