Informal production and labour market segmentation

Abstract

An industry is modeled in which entrepreneurs, who are heterogeneous in ability, may produce formally or informally. Two cases are distinguished, with and without labour market segmentation, for which different patterns of formal/informal supply obtain. Without segmentation, informality may generate production where otherwise there would be none. Typically, however, a trade-off obtains: when informality makes output higher it cuts the profit of the most able entrepreneurs, potentially damaging growth. With segmentation, informality causes some replacement of ‘good’ jobs by ‘bad,’ and total employment may be affected in either direction; without segmentation the effect on total employment is weakly positive.