The paper presents a general equilibrium model of a developing economy with a capital intensive formal sector and a large informal sector with sector‐specific capital to analyse the effects of investments on the sectoral returns to capital, sectoral wage rates, and composition of output and employment. Beginning with capital market disequilibrium (unequal sectoral rates of return) and labour market distortion (formal‐informal wage gap), the model traces the evolution of the economy till capital market equilibrium is attained. The investments in the formal sector equalise the wages (a “turning point” in growth à la Lewis) and reduces the size of the informal sector. The sectoral rates of returns equalise only if there is no factor intensity reversal, otherwise the economy specialises in the production of formal goods. The investments in the informal sector equalise the rates of return, do not affect the size of the formal sector and finally, a formal‐informal wage gap persists provided factor intensities are not reversed.
INTRODUCTION "Growth" and "unemployment" are topics that always remain contemporary in economic theory and policy-the recent example being the phenomenon of "great recession" in the United States and EU. Usually, growth is about the accumulation of productive factors over the long run and unemployment is typically seen as a short-run phenomenon (with employment level approaching the so-called "NAIRU" in the long run). In the standard neoclassical growth (exogenous and endogenous) models, the optimal programme is a path along which all input factors are fully employed. However,
Purpose
This paper aims to theoretically find out whether investments could close the formal-informal wage gap in India.
Design/methodology/approach
The paper builds a general equilibrium model of a developing economy with a large informal sector and a capital-intensive formal sector with sector-specific capital and incorporates endogenous demand.
Findings
With homothetic preferences, a small initial wage premium and elastic relative demand, investment in the formal sector is likely to close the wage gap, but the gap persists with non-homothetic preferences. However, investment in the informal sector is unlikely to close the wage gap with either type of preferences.
Originality/value
Though labour market distortions in developing economies leading to a formal-informal wage gap are well-documented in the development literature, little attention has been given to the question of whether such a gap would close over time.
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