Self-employment, wage employment, and informality in a developing economy

J Bennett,M D Rablen

doi:10.1093/oep/gpu047

Abstract

We construct a simple model incorporating various urban labour market phenomena obtaining in developing economies, and we give a diagrammatic formulation of the market equilibrium. Our initial formulation assumes an integrated labour market and allows for entrepreneurship, self-employment, and wage employment. We then introduce labour market segmentation. In equilibrium voluntary and involuntary self-employment, formal and informal wage employment, and formal and informal entrepreneurship may all coexist. We illustrate the model by an example calibrated on Latin American data, examining individual labour market transitions and implications of education/training and labour market policies.

Highlights

Urban labour markets in developing economies exhibit considerable diversity, typically including substantial segments of both voluntary and involuntary self-employment and of formal and informal wage employment
The aim of the present article is to formulate a simple model that incorporates all of these labour market states, as well as different types of entrepreneurship, and develop a diagrammatic analysis of market equilibrium
Agents concerned, we show the preference amongst the three options of entrepreneurship, self-employment, and informal wage employment, given that all three options are involuntary in the sense that these agents would prefer formal wage employment

Summary

Introduction

Urban labour markets in developing economies exhibit considerable diversity, typically including substantial segments of both voluntary and involuntary self-employment and of formal and informal wage employment. That a potential inefficiency exists (in addition to the distortion caused by the minimum wage rate): agents who are lucky enough to gain formal jobs may have a comparative advantage in self-employment In equilibrium this has an adverse effect on output by both informal and formal firms. Gollin (2008) is an exception, developing a dynamic equilibrium model of capital accumulation in which an agent’s time is split between self-employment and working as a wage employee None of these contributions allow for the simultaneous existence of voluntary and involuntary informality.

The benchmark model

Labour market segmentation

An application to Latin American data

Findings

Concluding comments