The Urban Informal Sector and Poverty: Effects of Trade Reform and Capital Mobility in India

Abstract

Studies on formal-informal interactions in the labor markets of developing countries claim that economic reform increases the level of informal activity. Although the extent of such claims differs across countries, it is generally believed that reform is likely to depress informal wage by contracting the formal sector and driving labor onto its informal counterpart. However, available empirical evidence suggests that real wage and real fixed assets in the informal manufacturing sector have risen significantly across most states in post-liberalization India. Using this as a benchmark, we formalize a general equilibrium model of inter-sectoral capital mobility and informal wage to argue that, with limited degree of capital mobility, trade reform reduces the informal wage. This is the conventional wisdom usually obtained under a partial equilibrium framework. However, with increased mobility of capital this result is reversed. We offer detailed empirical evidence on the movements of real wage in the informal sector in India and how this affects poverty at the state level. The basic result on income mobility is corroborated by a primary survey in the province of West Bengal, for which we offer descriptive analysis on household income levels in the province's informal manufacturing and service sectors.