Modeling Informality Formally: Households and Firms

Abstract

Informality is widespread in most developing countries. In Latin America, 50 percent of salaried employees work informally. 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. In our model both heterogeneous firms and workers have preferences over the sector they operate and choose optimally whether to function formally or informally. There are two labor markets, one formal and the other informal, and both firms and workers act unconstrained in them. By contrast, a prominent feature of the pre-existing literature is the idea that worker's decisions play no role in determining the equilibrium of the economy. Using our model, we show that an increase in the participation of secondary workers would tend to raise the level of informality in the economy. This effect partially accounts for the increases in informality seen in Latin America over the past two decades.

The impact of a social program on labor informality: The case of AUH in Argentina

“…In fact, Latin American secondary workers are less likely to operate in the formal economy than primary workers, ceteris paribus. Galiani and Weinschelbaum (2012) find that the increased labor force participation of secondary workers in Latin America explains much of the surge in the labor informality rate in the region.…”

“…It was probably optimal for the firms (and more acceptable for the government and the trade unions) to avoid layoffs if the crisis was expected to be short, and instead reduce costs by delaying the formalization of new workers until the crisis was overcome. Some authors have argued that in developing countries firms may adjust labor benefits among their workers as a cost-minimizing mechanism, alternative to wages and employment (Galiani andWeinschelbaum, 2012, Viollaz, 2014). M A N U S C R I P T ACCEPTED MANUSCRIPT 20 due to the crisis, a behavior that should have increased further the formalization rates of 2010.…”

“…Non-contributive transfers, such as AUH, may induce strategic behavior within the household (Bérgolo and Cruces, 2013;Galiani and Weinschelbaum, 2012).…”

“…A more recent approach proposes to enrich the analysis of labor informality by incorporating non-pecuniary preferences of workers.14 Galiani and Weinschelbaum (2012), for example, suggest a model in which firms choose to operate whether formally or informally depending on their managerial ability, while workers decide optimally in which sector (formal or informal) they locate according to their human capital endowment. In this model wages and formal sector size are determined endogenously.…”

Transaction costs and economic growth under common legal system: State‐level evidence from Mexico

“…High transaction costs can easily preclude or even deny access to property rights. When the access to property rights is difficult or costly, the net effect are strong incentives for informality (De Soto, 2000;Galiani & Weinschelbaum, 2012), especially for small firms unable to overcome initial transaction cost constraints. By contrast, low-cost and broad-based access to property rights tends to encourage the labor market participation, savings and investment rates in response to the legal structure of property and availability of the collateral.…”