Pablo Garriga
Gabriel Ulyssea
Costas Meghir
Pinelopi Koujianou Goldberg
Rafael Dix-Carneiro
Alessandro Toppeta
Áureo de Paula
Orazio Attanasio
Seth Zimmerman
Joseph Price
Valerie Michelman
Camille Semelet
Anne Brockmeyer
Pierre Bachas
Santiago Pérez
Elisa Jácome
Leah Boustan
Ran Abramitzky
Jesse Rothstein
Jeffrey T. Denning
Sandra Black
Wei Cui
Mathieu Leduc
Philippe Jehiel
Shivam Gujral
Suraj Sridhar
Attila Lindner
Arindrajit Dube
Pascual Restrepo
Łukasz Rachel
Benjamin Moll
Kirill Borusyak
Michael McMahon
Frederic Malherbe
Gabor Pinter
Angus Foulis
Saleem Bahaj
Stone Centre
Phil Thornton
James Baggaley
Xavier Jaravel
Richard Blundell
Parama Chaudhury
Dani Rodrik
Alan Olivi
Vincent Sterk
Davide Melcangi
Enrico Miglino
Fabian Kosse
Daniel Wilhelm
Azeem M. Shaikh
Joseph Romano
Magne Mogstad
Suresh Naidu
Ilyana Kuziemko
Daniel Herbst
Henry Farber
Lisa Windsteiger
Ruben Durante
Mathias Dolls
Cevat Giray Aksoy
Angel Sánchez
Penélope Hernández
Antonio Cabrales
Wendy Carlin
Suphanit Piyapromdee
Garud Iyengar
Willemien Kets
Rajiv Sethi
Ralph Luetticke
Benjamin Born
Amy Bogaard
Mattia Fochesato
Samuel Bowles
Guanyi Wang
CORE
David Cai
Toru Kitagawa
Michela Tincani
Christian Bayer
Arun Advani
Elliott Ash
Imran Rasul

Trade and informality in the presence of labor market frictions and regulations

What is this research about and why did you do it?

The informal sector accounts for a large part of the economy in most developing countries, comprising between 20-80 percent of the labour force and an equally large share of firms. Moreover, shifts into and out of informality constitute important margins of labour market adjustment to trade shocks in these countries. Yet, we still know little about the overall labour market and welfare effects of trade liberalisation in settings characterised by extensive labour market regulation, weak enforcement, and informality, which characterize many developing economies. Our research fills this gap by developing a structural equilibrium model of trade and informality.

How did you answer this question?

We develop a model that features tradable and non-tradable sectors that are connected through input-output linkages. Within each sector, firms with different levels of productivity choose to operate in the formal or informal sectors, subject to labour market frictions and regulations, such as a minimum wage, firing costs, and taxes. Regulations are imperfectly enforced by the government, generating incentives for small firms to be informal. We estimate the model using multiple micro data sources from Brazil and use it to perform counterfactual experiments to quantify the effects of trade openness on informality, unemployment, welfare, productivity, and wage inequality.

What did you find?

We find that, in the long-run (we focus on comparisons across steady states), trade openness has strong positive effects on productivity and welfare, even though it leads to an increase in unemployment. As for inequality, the Figure shows that wage inequality (measured by the standard deviation of log-wages) within the formal tradable sector increases with greater trade openness. This comes from an increase in the wage premium paid by exporting firms. In contrast, inequality within the informal tradable sector falls, which is a consequence of the market exit of low productivity informal firms that pay lower wages. Inequality within the formal and informal non-tradable sector increases, but the gap between average wages in the informal and formal sectors falls. Taken together, these different forces imply a reduction in overall inequality in the tradable and non-tradable sectors as trade is opened up.

Relationship between Trade openness and wage inequality (standard deviation of log-wages). The horizontal axis denotes changes in iceberg trade costs, τ; larger values of τc denote higher trade costs, and lower values of τc indicate greater openness; τc = 6 represents the autarchy scenario. Vertical axis shows the standard deviation of log-wages, which measures inequality.

What implications does this have for the research on wealth concentration or economic inequality?

Our findings regarding inequality contrast with what is typically found in the literature, which is that trade openness leads to higher inequality. However, previous studies have typically focused on the formal tradable sector. Our research highlights the importance of incorporating the non-tradable sector and, crucially, the informal sector when analysing the effects of trade opening on inequality in developing countries. More broadly, our research shows that incorporating informality can lead to substantially different conclusions about the aggregate effects of trade, in particular on productivity and welfare.

What are the next steps in your agenda?

We would like to understand more broadly how informality interacts with other frictions – such as financial frictions – and how these interactions could shape the effects of different aggregate shocks in low- and middle-income countries.

Citation and related resources

This paper can be cited as follows: Dix-Carneiro, R., Goldberg, P. K., Meghir, C., and Ulyssea, G. (2021) 'Trade and Informality in the Presence of Labor Market Frictions and Regulations.' NBER Working Paper 28391

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