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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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