Modeling Informality Formally: Households and Firms
Abstract: Informality is widespread in most developing countries. Three stylized facts characterize informality: 1) small firms tend to operate informally while large firms tend to operate formally; 2) unskilled workers tend to be informal while skilled ones have formal jobs; 3) Ceteris paribus, secondary workers are less likely to operate formally than primary workers. We develop a model that account for all these facts. At the policy front, the main lesson from our paper is that governments should not only consider labor demand but also labor supply when tackling informality. Policies that reduce the supply of workers in the informal labor market at given wages will increase the level of formality in the economy. This has noteworthy implications for the design of welfare programs in developing countries.
