Abstract
This paper analyzes the macroeconomic effects of fiscal and labor market policies in developing countries. The basic framework considers a small open economy with a large informal production sector and a heterogeneous work force. The labor market is segmented as a result of efficiency considerations and minimum wage laws. The basic model is then extended to account for unemployment benefits, income taxation, and imperfect labor mobility across sectors. The analysis indicates, among other results, that a reduction in unemployement benefits has a positive effect on output of tradable goods by lowering both the level of efficiency wages and the relative rent captured by skilled workers.
I. Introduction
Studies of urban labor markets in developing countries have come to distinguish between the formal and informal sectors on the basis of whether employment relationships are subject or not to various labor market regulations and other institutional constraints. 2/ In the formal sector, which consists of medium- and large-scale enterprises, workers are entitled to a variety of benefits, such as minimum standards for working conditions, job security provisions, social security and disability protection, pension plans, and health insurance. Skilled and unskilled workers are hired through formal contracts, with labor unions (or collective bargaining mechanisms) playing in some countries an important role in the determination of wages. The degree of compliance with minimum wage laws may vary considerably across production sectors. By contrast, in the informal segment of the urban labor market—which includes self-employed individuals and small privately-owned enterprises producing mainly services and other nontradables—labor regulations are usually not enforced. Activities in this sector rely mostly on the direct provision of labor services by owners and their families. Paid labor is used (usually without any formal employment contract) only occasionally. Although the informal labor market is characterized by free entry, job insecurity is pervasive, wages are highly flexible, and workers get very few benefits from their employers. Minimum wage laws do not apply or are not consistently enforced, and collective bargaining plays a limited role in the determination of wages.
By most accounts, the informal sector represents a sizable proportion—between 30 and 60 percent—of economic activity and total employment in developing countries, particularly in some parts of Asia, the Middle East, and Sub-Saharan Africa. 3/ A consequence of the formal-informal dualism induced by the lack of enforcement of government legislation is the segmentation of the urban labor market, which plays a crucial role in explanations of urban poverty, unemployment and underemployment in developing countries. Labor market segmentation can be defined as a situation where, because of barriers—institutional or otherwise—to occupational mobility between sectors, a worker in the “low-wage” sector does not have full access to a job in the “high-wage” sector held by an observationally identical worker (Taubman and Wachter, 1986). If there were no barriers, workers in the low-wage sector would enter the high-wage sector and bid wages down until earnings across sectors were equalized. More succintly, labor market segmentation implies persistent wage differentials for observationally identical workers.
The best-known model of labor market segmentation in developing countries was developed by Harris and Todaro (1970), in their attempt to explain the persistence of migration from rural to urban areas, despite the existence of widespread urban unemployment. A key feature of the model is the equality of expected (rather than actual) wages in the urban sector and the rural areas as the basic equilibrium condition of the labor market. Harris and Todaro showed that the existence of a binding minimum wage in the urban sector leads, even if the rural labor market is competitive, to a persistent wage differential between the rural and urban sectors and to the emergence of urban unemployment.
In the Harris-Todaro framework, as in many models of labor market adjustment, labor is homogeneous and perfectly mobile across sectors. Labor market segmentation emerges as a result of the government imposing a minimum wage in urban areas. However, an important feature of urban labor markets in developing countries—and, indeed, of labor markets everywhere—is the observation that workers are endowed with different skills, and may face short-term constraints on mobility across sectors as well as across different skill categories. In addition, wage differentials may emerge not only as a result of institutional constraints but also as a consequence of firms’ wage-setting decisions aimed at enhancing productivity of a given category of workers. Labor force heterogeneity, imperfect sectoral mobility, and productivity considerations add new dimensions to the analysis of labor market segmentation. In particular, they provide important elements for examining potential spillover effects across different segments of the labor market, and the behavior of sectoral wages. Accounting for these features has important implications for understanding the effects of macroeconomic and structural policy shocks in developing countries. 4/
The purpose of this paper is to analyze the effects of fiscal and labor market policies on output, wages, and unemployment in a dynamic, general equilibrium model of a small open developing economy with a large informal sector and segmented labor markets. Our analysis is based on the prevalent view among development economists that the absence—or lack of enforcement—of government regulations is the defining characteristic of the informal sector. Section II develops the basic framework, which distinguishes between skilled and unskilled labor and assumes perfect mobility across sectors, and examines the effect of changes in government expenditure and the minimum wage paid to unskilled workers on the composition of employment. Section III introduces income taxation and unemployment benefits, and analyzes how these modifications affect the determination of equilibrium wages, productivity, and employment. Section IV extends further the basic framework to consider the case where mobility of unskilled workers between the formal and informal sectors is imperfect. Finally, Section V summarizes the main implications of the paper and discusses some possible extensions of the analysis.
II. A Basic Framework
Consider a small open economy in which there are three types of agents: producers, households, and the government. The economy consists of two sectors: a formal sector, which produces a traded good using skilled and unskilled labor, and the informal sector, which produces a nontraded good, using only unskilled labor. 5/ Skilled workers may, however, choose to seek employment as unskilled workers in the informal sector. The relative price of the traded good (the real exchange rate) is determined by the equilibrium condition of the nontraded good market.
The capital stock in each sector and the composition of the labor force between skilled and unskilled workers are assumed fixed during the time frame of the analysis. Workers are assumed initially perfectly mobile across sectors. A mininum wage for unskilled labor imposed by government fiat exists, but is enforced only in the formal sector. The wage rate for skilled labor in the formal sector is assumed set on the basis of efficiency considerations (taking into account workers’ opportunity earnings), leading to an above-equilibrium wage. 6/ By contrast, wages of unskilled workers in the informal sector are fully flexible. Once employment decisions for both categories of labor skills are taken by producers in the formal sector, the informal sector absorbs all workers that are not hired in the formal sector. Since all skilled workers that are unable to find a job in the formal sector are willing to work as unskilled labor in the production of the nontraded good in the informal sector, unemployment cannot emerge—although labor may be inefficiently allocated. Equilibrium of the labor market in the informal sector obtains once total supply and demand are equalized through wage adjustment. 7/
Households consume both traded and nontraded goods produced in the formal and informal sectors, supply labor inelastically and hold a traded bond, which bears a real rate of return determined on world markets. Domestic agents can borrow and lend freely at that rate, which varies inversely with the economy’s stock of bonds as well as the composition of domestic output. The government consumes traded and nontraded goods, and finances its expenditure by varying lump-sum taxes on households. Finally, wage and employment expectations—which affect, as discussed in section IV, the decision to migrate across sectors—are assumed to depend on prevailing conditions in the labor market.
1. Production, effort, and the labor market
The production technology in the formal sector is given by 8/
where QF, denotes output, e the level of effort per skilled worker (which is bounded between 0 and unity by an appropriate choice of units), LS employment of skilled workers and LFU employment of unskilled workers, both measured in natural units. Production takes place under decreasing returns to both categories of labor, which are assumed to be imperfectly substitutable. Setting the world price of traded goods to unity, the domestic price of output of the formal sector is equal to the nominal exchange rate, Ē, which is assumed fixed in what follows.
Equation (3) shows that the level of effort produced by skilled workers depends positively on the real wage in the formal sector and negatively on the real wage in the informal sector, which measures the opportunity cost of effort. It can readily be established that the marginal effect of an increase in the real wage in the formal sector on effort is positive but decreasing, and that an increase in the probabilibty of getting caught shirking raises the level of effort.
Optimality conditions (4a) and (4b) can be solved to yield:
which indicates that, in equilibrium, formal-sector firms always set the efficiency wage for skilled workers at a higher level than the opportunity cost of effort. A graphical determination of the efficiency wage is shown in Figure 1. 12/ Note that skilled workers’ equilibrium wage depends only on the going wage in the informal sector, and not on the minimum wage for unskilled workers in the formal sector. This is because the only employment opportunity available to a skilled worker who loses his job in the formal sector as a result of inadequate performance is to join the informal sector labor force.
Productivity and Wages in the Formal Sector
Citation: IMF Working Papers 1994, 056; 10.5089/9781451968248.001.A001
An increase in the market-clearing wage for unskilled workers reduces the demand for skilled labor but has an ambiguous effect on the demand for unskilled labor in the formal sector. A rise in the real wage in the informal sector increases in the same proportion as the efficiency wage paid to skilled workers in the formal sector, thus maintaining effort constant. The resulting increase in labor costs lowers the demand for skilled workers. An increase in the minimum wage reduces the demand for unskilled workers but has an ambiguous effect on the demand for skilled workers. As shown in Appendix I, a sufficient condition for both ambiguities to disappear is that the elasticity of substitution between skilled and unskilled labor in the production of traded goods should not too large—a fairly plausible assumption in practice.
Substituting this result in (8) implies
Equation (14) shows that the market-clearing wage for unskilled workers is inversely related to the legal minimum wage and the real exchange rate. An increase in the minimum wage lowers the demand for both categories of workers in the formal sector and increases the supply of labor in the informal sector, exerting a downward pressure on real wages there. A real exchange rate depreciation dampens the demand for unskilled workers in the informal sector, requiring a fall in the real wage (measured in terms of traded goods) to maintain equilibrium of the unskilled labor market.
2. Consumption and asset accumulation
Households supply labor in quantity
where β denotes the constant rate of time preference, cI consumption of nontraded goods, and cF consumption of traded goods.
Household hold an internationally traded bond, the stock of which b is assumed to evolve over time according to
3. Dynamics of fiscal and labor market policies
A depreciation of the real exchange rate has a positive effect on the supply of traded goods in the formal sector—since it reduces the market-clearing wage for unskilled workers—but the net effect of an increase in the minimum wage is in general ambiguous. On the one hand, it reduces directly the demand for unskilled workers. On the other hand, it reduces the market-clearing wage for unskilled workers in the informal sector as well as, through the efficiency condition (5), the real efficiency wage for skilled workers, thus raising employment and output. We will determine below the conditions under which the net effect can be unambiguously signed.
In general, the net effect of a real depreciation on output in the informal sector is ambiguous. On the one hand, a real depreciation raises directly the product wage in the informal sector, thus exerting a negative effect on output. On the other hand, it reduces indirectly the product wage since it leads to a fall in the real wage of unskilled workers in the informal sector, which in turn lowers the real wage of skilled workers—in order to maintain constant the level of effort—in the formal sector. The resulting increase in the supply of labor in the informal sector exerts a downward pressure on the real wage earned by unskilled workers, which may be large enough to dominate the upward direct effect associated with a depreciation of the real exchange rate on the real product wage there. As shown in Appendix I, the direct effect will dominate if as assumed before the elasticity of substitution between skilled and unskilled labor in the production of traded goods is not too large.
Equations (23) and (24) determine the behavior of foreign assets and the marginal utility of wealth over time. Given the solution for μ, equation (22) determines the equilibrium level of the real exchange rate.
Steady-State Equilibrium
Citation: IMF Working Papers 1994, 056; 10.5089/9781451968248.001.A001
Consider a permanent, unanticipated reduction at t = 0 in government spending on nontraded goods. The dynamics of adjustment are illustrated in Figure 3. A permanent reduction in government spending implies that there is an incipient excess supply of nontraded goods (for a given level of external debt), inducing a real depreciation—a drop in the relative price of the non-traded goods. Furthermore, the long-term openness of the country improves, reducing the interest rate ρ facing the country. For a given marginal utility of wealth there is an incipient current account surplus, which induces a leftward shift in the
Reduction in Government Spending
Citation: IMF Working Papers 1994, 056; 10.5089/9781451968248.001.A001
Consider now a permanent, unanticipated reduction in the minimum wage for unskilled workers. The drop in the minimum wage affects production in the formal sector via two channels. The direct effect is to increase the demand for unskilled workers in the formal sector, thus increasing production. The indirect effect is a reduction in labor supply in the informal sector, which therefore leads to an increase in the market-clearing wage for unskilled workers. This in turn translates, through the efficiency condition (5), in an upward adjustment in the real wage earned by skilled workers. Thus, while the direct effect increases employment of unskilled workers in the formal sector, the indirect effect works towards a reduction in employment of skilled workers. In Appendix I we derive the sum of these effects, and show that there is a strong presumption that the direct effect will dominate. 18/ Hence, the presence of efficiency wages and segmented labor markets does not alter the neoclassical presumption in the two- sector framework considered here: a reduction in the minimum wage that is enforced only in the formal sector improves the competitiveness of the country, leading to an expansion of the formal sector and a contraction of the informal sector. The extent to which this result continues to hold under imperfect labor mobility is discussed below.
The “pro-trade bias” associated with the drop in the minimum wage implies that the adjustment path it induces will be qualitatively similar to the transitional dynamics depicted in Figure 3. The long-run reduction in the relative size of the informal sector improves the creditworthiness of the country, shifting the curve
III. Taxation and Unemployment Benefits
In developing countries, taxation affect mostly firms and workers operating in the formal sector—in a similar manner to labor market regulations. While this asymmetric feature of tax systems in the developing world may well be the optimal policy response given administrative and othe institutional constraints, it may lead to severe distortions in supply and demand decisions in the short run. In this section, we generalize the framework developed above so as to account for direct income taxation and unemployment benefits for skilled workers in the formal sector, and examine how these modifications affect the determination of sectoral wages, productivity and the composition of employment.
Firms in the formal sector determine as before the optimal levels of employment of both categories of labor as well as skilled workers’ wages, without facing a binding quantity constraint in either segment of the labor market. However, instead of assuming that skilled workers who are not hired in the formal sector enter the labor force in the informal sector, we now assume that unsuccessful applicants choose to remain unemployed while perceiving a government-financed unemployment benefit. 19/ The unemployment insurance scheme is financed in part by a tax on wage income, levied at the rate 0 < ι < 1 on skilled workers employed in the production of traded goods.
Using the budget constraint (20’). and equations (29), (30) and the dynamic equations driving the economy, we can now examine the effect of a modification of the income tax rate and unemployment benefits. Given that the level of employment of skilled workers is determined by firms in the formal sector, the government budget constraint (20’) establishes a link between the income tax on wages, and the level of unemployment compensation for high-ability workers. As long as the elasticity of the demand for skilled workers (with respect to their own wage) is small relative to the wage premium σ, higher unemployment compensation requires a higher tax rate for a given level of employment of skilled workers. There exists, thus, an unemployment Laffer curve which, as derived formally in Appendix II and as displayed in Figure 4—drawn for a given level of the real exchange rate—has an inverted U-shape in the
The Unemployment Laffer Curve
Citation: IMF Working Papers 1994, 056; 10.5089/9781451968248.001.A001
Assuming that the economy operates on the upward-sloping portion of the efficient frontier of the Laffer curve (between points A and B in Figure 4), a lower level of unemployment compensation raises the level of employment of skilled workers as a result of two complementary effects. First, it reduces directly the efficiency wage by lowering the opportunity cost of skilled workers’ effort. Second, it reduces the tax rate on skilled workers—as a result of the government budget constraint—thus reducing the producer real wage (see equation 28 for both effects). The net outcome is a higher level of employment of skilled labor. This generates spillover effects, increasing the demand for unskilled labor, bidding the market-clearing wage up and reducing labor absorption in the informal sector. Thus, a lower level of unemployment benefits for skilled workers leads to an expansion of the formal sector and a contraction of the informal economy. The dynamic adjustment process is qualitatively similar to the one depicted in Figure 3.
Solving the complete model using equations (20’). (33) and (34), we can now analyze the effect of a modification of the unemployment benefit rate, θ. 20/ Suppose that we operate along the “efficient” portion of the unemployment Laffer curve, implying that a drop in θ calls for a lower income tax rate. Applying (33) and (34) it follows that a drop in the unemployment benefit rate will reduce the efficiency coefficient σ as a result of both a lower opportunity wage and a lower income tax rate, and will increase the equilibrium level of effort. Applying the equilibrium conditions determining employment in the formal economy, it can be shown that output expands in the formal sector and contracts in the informal sector, at a rate proportional to the difference between the increase in effort and the fall in skilled workers’ wage. 21/ While the mechanism through which these results obtain are qualitatively similar to those discussed in the first part of this section, there is an additional channel in the present case that reinforces the expansion of the formal sector: the resulting increase in equilibrium effort.
IV. Labor Mobility, Sectoral Wages, and Unemployment
In the foregoing analysis, unskilled workers that were not hired in the formal sector were able to join immediately the labor force in the informal sector. By assuming that new entrants were successfully bidding wages down, we obviated the possibility that involuntary unemployment of that category of labor could emerge in equilibrium. However, assuming perfect mobility across sectors may lack realism, particularly in a short-run context. Workers typically incur a variety of costs (such as relocation expenses or congestion costs) that may prevent instant reallocation of the labor force. In this section we consider the case where movements of unskilled labor across sectors take place gradually, rather than instantaneously. We also maintain the assumptions made in section II regarding the effort decision of skilled workers and continue to take the composition of the labor force as given. In this extended framework, unemployment of both categories of labor may emerge in the long run.
Equation (38) indicates that in the steady state, an increase in the minimum wage has an ambiguous effect on the overall unemployment rate of unskilled workers. A rise in the market-clearing wage (induced, for instance, by an increase in governemnt spending on goods produced in the informal sector, gI) reduces overall unemployment of unskilled labor.
Given the dynamic equation (36), the extended framework described above can also be used to examine the short-run effects of fiscal and labor market policies unemployment. By rewriting appropriately the government budget constraint (20) 25/ and condensing the model yields now a differential equation system in three variables: the marginal utility of wealth, the stock of traded bonds, and the size of the labor force comprised of unskilled workers in the formal sector. Although we omit mathenatical details here, it is intuitively clear that the impact effect of a change in the fiscal and labor market policy instruments discussed in previous sections will not alter the qualitative features highlighted before. 26/ In particular, the net effect of a reduction in government spending on aggregate output and the unemployment rate is likely to be ambiguous on impact.
An important implication of the foregoing analysis, thus, is that there may be no close relationship between changes in output and the unemployment rate—that is, no stable Okun’s law—as a result of spillover effects between the formal and informal segments of the urban labor market. In periods of adverse macroeconomic shocks (resulting, for instance, from cuts in government expenditure), skilled and unskilled workers laid off in the formal sector may seek employment in the informal sector, exerting downward pressure on wages there. Although the wage efficiency effect is likely to dampen the initial reduction in the work force of the formal sector, the sectoral reallocation of labor—which may be particularly marked in the absence of unemployment benefits in the formal sector and non-prohibitive relocation costs—may lead to large shifts in the composition of employment, with little effect on the aggregate unemployment rate. To the extent that labor productivity is lower in the informal sector, negative shocks to output will lead to a fall in average productivity rather than as a rise in open unemployment.
The available evidence suggests indeed that spillover effects of the type described above may have played a significant role in the recent behavior of labor markets in developing countries. Figure 5 displays the behavior of output and the open unemployment rate over time for a group of 12 developing countries during the 1980s. Although the data must be interpreted with care, 27/ they seem to indicate the absence of a stable relation between the rate of output growth and unemployment. The more detailed evidence examined by Horton et al. (1991), Riveros (1990) and Turnham (1993) also suggests the occurence of large shifts in the composition of employment from the formal to the informal sector in several countries in Latin America, as well as in several other nations of Africa and Asia, particularly during the recessionary years of the 1980s. 28/
Output and Unemployment in Developing Countries
Citation: IMF Working Papers 1994, 056; 10.5089/9781451968248.001.A001
Sources: ILO Yearbook and International Financial statistics.V. Summary and conclusions
The purpose of this paper has been to examine the implications of fiscal and labor market policies on output, wages and unemployment in a general equilibrium model of a small open developing economy with a large informal sector, a heterogeneous work force, and segmented labor markets. The production structure that we considered assumes that while production in the formal sector consists of traded goods and uses skilled and unskilled labor, output in the informal sector consists of nontraded goods produced using only unskilled labor. Firms in the formal sector were assumed to set the wage rate for skilled labor so as to minimize labor costs per efficiency unit. Skilled workers’ effort was shown to depend positively on their wage relative to the wage paid in the informal sector. Unskilled workers employed in the formal sector were assumed to earn a legally-fixed minimum wage, while wages of unskilled workers hired in the informal sector were taken to be fully flexible. In equilibrium, as a result of efficiency considerations, a noncompetitive wage differential emerges across skill categories. The efficiency wage for skilled workers, however, does not depend directly on the minimum wage.
Under the assumption of perfect labor mobility across sectors, we showed that a permanent, unanticipated reduction in government spending on nontraded goods leads in the long run to a depreciation of the real exchange rate, a fall in the market-clearing wage for unskilled labor, an increase in the production of traded goods, and a lower stock of net foreign assets held by the private sector. A permanent, unanticipated reduction in the minimum wage for unskilled workers was also shown to increase output and the demand for labor in the formal sector. Hence, in a two-sector economy in which the minimum wage is enforced only in the formal sector and wages in one segment of the labor market are competitively determined, efficiency wage considerations do not alter the standard neoclassical presumption: a reduction in the minimum wage improves competitiveness, and expands the formal sector at the expense of the informal sector.
The basic framework was subsequently extended to introduce direct income taxation and unemployment benefits for skilled workers in the formal sector. Assuming first that the unemployment benefit scheme consisted of paying a constant real wage to the unemployed, we showed that the economy faces an unemployment Laffer curve relating the minimum wage and the income tax rate. If the economy operates on the “correct” portion of the Laffer curve, a reduction in the level of unemployment compensation wil raise the level of employment of skilled workers—thus leading to an expansion of the relative size of the formal sector. If, alternatively, the unemployment benefit scheme is assumed to link the level of compensation to the minimum wage for unskilled workers and the after-tax wage for skilled workers, a reduction in the unemployment benefit rate is also likely to lead to an expansion of output, effort and employment in the formal sector—at a rate proportional to the difference between the increase in effort and the fall in the premium associated with skilled workers’ wage.
Finally, we considered the case where unskilled workers face a decision to migrate from the informal sector to the formal sector. We derived the incentive structure on the basis of which workers form their decision, along the lines suggested by Harris and Todaro (1970). By focusing the analysis on the long run, we showed that the overall unemployment rate of unskilled workers varies inversely with the market-clearing wage for unskilled labor, but that a change in the minimum wage for unskilled labor in the formal sector has an ambiguous effect. An important prediction of the model, the absence of a stable relation between output and unemployment in the short run, appeared to be consistent with the available evidence for developing countries.
The analytical framework developed here can be further extended in a variety of directions. One area of investigation would be to consider a situation where there exist technological “input-output” links between the formal and the informal sectors. For instance, the formal sector may be assumed to produce an intermediate good that is used in the production process for informal-sector goods. Complementarity effects of this type are likely to alter substantially the effect of macroeconomic shocks on output and the allocation of labor across sectors. Another possibility would be to examine the implications of alternatives to the Harris-Todaro intersectoral migration mechanism, perhaps by introducing the kind of heterogeneities discussed by Lindbeck and Snower (1991). It may also be useful to explore, in a growth context, the effects of alternative mechanisms that may account for movements over time across skill categories, thus explaining endogenously changes in the composition of the labor force. Skill improvements take place through a variety of institutional forms, such as apprenticeship programs, on-the-job training, and internal labor markets. At the same time, training may impose a cost on firms and thus affect the sensitivity of the demand for labor with respect to changes in current wages. A final issue of importance would be to explain why government impose minimum wage laws in the first place—a phenomenon that creates, in our model, market segmentation for unskilled workers. A political economy approach may provide the critical elements necessary to account for the incentives to restrict wage flexibility. 29/ A sensible point of departure might be the recognition that formal-sector workers may be better organized (through pressure groups, for instance) than informal-sector workers, and may thus have a greater ability to force incumbent policymakers to legislate in their favor.
Although these extensions may prove valuable in their own right, they are unlikely to alter some of the key results of this paper. In particular, worker heterogeneity and labor market segmentatation (induced by institutional constraints and firms’ optimizing behavior) are essential elements in explaining the functioning of urban labor markets in developing countries, and play a key role in the transmission process of macroeconomic and structural policy shocks on output and employment. In a setting where the level of employment is determined by firms, policymakers will typically face a tradeoff in using unemployment benefits and direct taxation of income. These results have important implications for the design of macroeconomic reform programs.
Appendix I
Since
Note that a sufficient condition for
The quantity in brackets on the right-hand side of equation (A12) is unambiguously positive if γ > ε. If this condition holds, then ∂QI /∂z < 0, as indicated in the text.
Appendix II
This Appendix provides a formal derivation of the slope of the unemployment Laffer curve. From equations (20′) and (28), we have
where
where
It is straightforward to show that a reduction in total government spending g leads to a leftward shift of the efficient frontier—thus reducting the tax rate needed to support a given level of unemployment compensation for skilled workers. An increase in the parameter measuring the wage efficiency premium σ shifts the efficient frontier downwards, because it implies that a given unemployment compensation and given taxes are associated with higher cost for skilled labor. To compensate for it, holding the tax rate given, requires a lower wage benefit. Finally, a reduction in the supply of skilled labor implies that, for a given unemployment benefit, that unemployment is smaller, hence the tax rate required to finance the benefit scheme is lower. The efficient frontier shifts leftwards in this case.
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Joshua Aizenman is a Professor of Economics at Dartmouth College. He was a visiting scholar in the Research Department of the Fund when this paper was written. The authors would like to thank, without implication, Donald Mathieson and Dennis Snower for helpful discussions and comments on an earlier draft.
See, for instance, Mazumdar (1983) and Turnham (1993). Rural labor markets, which account for a substantial component of employment in many developing countries, are characterized by a large share of self-employed persons and unpaid family workers. Wage earners bound by explicit contracts are also employed in agriculture, but is a less common occurence.
See Rosenzweig (1988) and Turnham (1993). Empirical estimates usually measure employement in the informal sector as the sum of self-employed workers, unpaid family workers, and domestic workers. Existing data must, however, be interpreted with care.
The implications of labor market segmentation in the absence of worker heterogeneity have been examined by Agénor and Santaella (1993) and Demekas (1990) in a short-term macroeconomic context, and by Edwards (1988) in the context of trade and structural reforms.
Assuming that the formal sector produces also a nontraded good would complicate the analysis without yielding additional insight.
There is by now a voluminous literature in developed countries that views involuntary unemployment as the result of efficiency wages. See Weiss (1990) and, for a more critical view, Carmichael (1990). Agenor and Santaella (1993) examine the impact of macroeconomic policy shocks in a two-sector model of an open economy with homogeneous labor and relative wage rigidity induced by efficiency considerations.
The dichotomy in wage formation can be justified by assuming that efficiency considerations result from firms’ desire to avert shirking (as discussed below) and minimize the cost of monitoring workers’ effort. Assume also, as argued in the introduction, that the formal sector consists essentially of “large” firms, while the informal sector consists only of “small” firms. A plausible conjecture is therefore that small firms can monitor nearly costlessly the level of effort produced by their workers, thus obviating the need to pay efficiency wages.
For convenience, time subscripts are omitted in what follows. Except otherwise indicated, the total derivative of a function of a single argument is denoted by a prime.
The quantity 1-e could be viewed here as measuring leasure, although the supply of hours is assumed fixed for both categories of workers (see below).
Our formalization of the decision process that workers face shares some common features with the well-known shirking model of Shapiro and Stiglitz (1984). It differs, however, in two crucial aspects. First, the choice of an effort level in our framework is continuous, while it is a discrete one in the Shapiro-Stiglitz model. Second, in our framework it is only the current market conditions that matter while in the Shapiro-Stiglitz framework workers form their decisions on the basis of the expected discounted utility stream associated with alternative options. We have provided in a different context (Agenor and Aizenman, 1994) an extension of the Shapiro-Stiglitz model to the labor market setup considered here.
Equations (4) yield the standard Solow condition, which indicates that in equilibrium the elasticity of effort with respect to the product wage must be equal to unity. See Weiss (1990).
If we had assumed that skilled workers provide a minimum level of effort em when shirking while employed in the formal sector or when hired in the informal sector, the term (1 - γ) 1nem would have appeared on the right-hand side of equation (2) and the level of effort that would obtain when the wage ratio is unity would be em instead of 0.
For clarity, only the consumption part of households’ utility is explicitly specified in equation (15), since consumption and effort decisions were assumed to be separable. To simplify calculations, the instantaneous utility derived from total consumption is taken to be logarithmic, while consumption itself is assumed to be a Cobb-Douglas function in the two categories of goods.
See Agenor and Santaella (1993) for a discussion of the first effect. The formulation used here captures the idea that the world interest rate faced by a small country is a function not only of the existing level of debt but also of the potential capacity to repay, which in turn depends on the economy’s ability to produce traded goods as opposed to nontraded goods in the long run. See Aizenman (1989b) for a discussion of the role of openness in determining the country-specific interest rate on world markets.
For simplicity, we assume ρ() to be continuously differentiable. More generally, the function could have a “kink” at a critical value of the stock of bonds. We also impose ρ(0,.) = β, which fixes the real interest rate, for a zero level of net indebtedness, to the rate of time preference.
Given our sign assumptions, the determinant of the coefficient matrix in equation (25) is negative. Note that this condition holds irrespective of the value taken by d(ρb)/db.
The slope of the [b = 0] curve would be positive if we had assumed that d(ρb)/db > 0. But since the slope of SS does not depend on this derivative, the dynamics of the model would remain qualitatively the same.
More precisely, we show in Appendix I that the direct effect dominates as long as the share of the informal sector is large, the substitutability between skilled and unskilled workers is not too large, or the formal sector is labor intensive.
Assuming that only a given proportion of excess supply in the market for skilled workers enters the unskilled labor force would not have any qualitative effect on the analysis. We do not elaborate here on reasons why skilled workers may refuse to work as unskilled labor in the informal economy. Important considerations however are likely to be the loss of social prestige that such a decision may entail, the potentially adverse signaling effect towards future employers, search efficiency (it may be easier to look for a formal-sector job while being unemployed), the perception that human capital may deteriorate rapidly, thus hampering re-entry in the skilled labor force, or that the wage in the informal sector provides less utility than a combination of leisure and unemployment benefit.
The effects of a change in the income tax rate are qualitatively similar to those discussed previously.
This assumption is consistent with the observation made above that firms in the informal sector can readily monitor the level of effort provided by their workers. Without loss of generality, we normalize the constant level of effort to zero.
The absence of a forward-looking component in wage expectations formed by unskilled workers may be justified by the existence of large costs associated with search, and by the lack of sophistication of the unskilled labor force.
Note that the reason why the choice between being employed or unemployed in the formal sector is not trivial is because unskilled workers must supply labor in a lump-sum fashion. Put differently, tU is not a decision variable.
This results, of course, from the fact that the proportion of the unskilled labor force seeking employment in the formal sector cannot change on impact. The transitional dynamics will in any case differ, as shown by Agenor and Santaella (1993) in a somewhat similar context.
Published measures of unemployment mostly include only unemployed workers looking for jobs in the formal sector, but not underemployed workers in the informal and rural sectors.
Perceived constraints on the level of employment in the formal sector may also discourage job seeking and lead some workers to simply drop out (at least temporarily) of the labor force, following adverse movements in output. Conversely, positive output shocks may lead to large inflows into the labor force. This “discouraged worker” effect, which is not captured in our framework, may also play a role in explaining the low correlation between output and the unemployment rate in developing countries. In addition, firms can dampen the effect of output shocks on employment by varying hours of work (through overtime), rather than through adjustment in the workforce.
A different approach is adopted by Drazen (1986), who argues that minimum wage legislation may be welfare-improving—relative to the competitive equilibrium—in a model where information about worker quality is imperfect and labor quality rises with increases in the average market wage, as in urban labor markets in developing countries where entrants are migrants from rural areas.
Note that if ε → 1(the production function is linear and skilled and unskilled labor are perfectly substitutable inputs), firms in the formal sector would never hire skilled workers since in equilibrium ωS > ωU.