Adjustment under trade liberalization, labor market segmentation, and informal employment: A dynamic general equilibrium analysis of a three-sector-open economy

This paper analyses the effects of trade liberalization in an economy with an informal sector and significant informal employment, defined as employment which does not abide with labor market regulations, including minimum wage and social security laws. Foreign trade reforms subject domestic firms to increased foreign competition, leading them to seek ways to cut back production costs, most notably labor costs. Cutting labor costs can be accomplished in one of three ways, including laying off workers (who subsequently look for employment in the informal sector) and possibly replacing them with part time workers; cutting down or eliminating worker benefits, putting the workers in informally employed status; or establishing subcontracting relationships with smaller scale firms which already employ workers informally. In this paper, we concentrate on the first effect. The effects of trade liberalization are examined in the context of a dynamic general equilibrium model of a small open economy with three sectors including an informal sector, a formal sector, an agricultural sector, and a segmented labor market. Particularly, at the steady-state utilizing comparative statics, we find that lowering the import tariff rates, or protection measures to the export sector (under trade liberalization reforms) increase the size of informal employment, with a fall in the wages of the informally employed. Increased exposure to foreign competition, or in other words, bringing the price of the traded goods closer to world prices, lead the formal sector firms seek ways to cut labor costs, which lowers the demand for skilled as well as unskilled labor in the formal sector (and possibly replaced with capital).