Informality and agglomeration economies: in search of the missing links

The informal sector absorbs on average 50% of employment in developing countries. However, it has not been considered in New Economic Geography (NEG) models that try to explain urbanization and agglomeration in developing countries. In a first attempt to bridge this gap, we develop a NEG model that incorporates the informal sector. Empirical evidence shows that the informal sector is mainly composed of relatively small firms that are unskilled labor intensive, face capital restrictions and that, given scale limitations, do not trade interregionally or internationally. Thus, besides an increasing returns to scale manufacturing sector, our model allows for an informal services sector with constant returns to scale and high transport cost. We investigate competitive as well as complementary roles for the informal sector and the manufacturing sector. To do so, we model competition on the demand side by allowing substitution between manufacturing and informal sector goods and complementary linkages on the production side, in the form of input requirements in manufacturing from the informal sector. Labor is mobile between industries and locations. The model predicts where informal employment flourishes. An informal sector arises at every location, but depending on manufacturing transport cost and preferences, the industrial or the rural location hosts the larger share of informal production. Vice versa, the size and characteristics of the informal sector have an effect on the long run outcome of the model. Not only does the informal sector influence the model's centripetal forces, but informal supply shocks (and regulation) may also determine the selection of one of multiple long run equilibria. Thus, an expanding informal sector can have both structural and long-run consequences for economic activity. In terms of policy, the paper shows that recommendations regarding rural-urban migration in developing countries are sensitive to agglomeration effects.