Characterisation of Economic Growth in Developing Economies with Informal Sector

Abstract

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.