Firm Heterogeneity, Informal Wage and Good Governance


  • Sugata Marjit is indebted to Ravi Kanbur and Jan Svejnar for comments and for the invitation to attend the conference on “Enforcement, Evasion and Informality: Theory and Practice, an International Conference in Honor of Katherine Terrell” held at the University of Michigan, Ann Arbor in June 2010. The idea of this paper was conceived during a visit to Cornell University in the Summer of 2009. Hospitality of the Department of Applied Economics and Management is acknowledged. We thank Anindita Majumder for research assistance. The authors are also indebted to two anonymous reviewers for helpful comments. The usual disclaimer applies.

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This paper provides an analysis of enforcement policies applicable to formal sector in dual labor markets, using a framework with heterogeneous firms, endogenous determination of informal wage, and politically dictated enforcement strategies. Firms that operate both in the formal and informal sectors do very little to increase employment when faced with the opportunity of hiring workers in the informal labor market. Thus enforcement of labor laws and other regulations should not have aggregate employment effects, particularly when workers are productively homogeneous. For firms operating exclusively in the informal sector, the outcome is different. Such features determine the stringency of enforcement in a market characterized by firms with varying levels of productivity. For example, in the case of firms with relatively high levels of productivity, enforcement has to be stricter than in the case with relatively low productivity firms. Taxing the more productive seems to be the optimal strategy.