Capital Inflow, Strategic Subcontracting, and Formal Employment

This paper shows that capital inflow can increase formal employment with labor mar- ket rigidity even when cheaper labor is accessible outside the formal sector. In a simple duopoly setting, if subcontracting to the informal sector is strategic to deal with the bargaining power of formal workers, the model finds that better foreign technology and access to the informal sector of the foreign firm reduces the prohibitive tariff for attract- ing foreign capital and can raise formal employment, by limiting the wage rise due to the combined effect of competition, wage, and technology. While the increased capital flow raises the wage through the competition effect, the level of labor-saving technology and the strategic subcontracting to the informal sector moderate it, showing an inverted U-shaped wage curve against the level of technology. After a critical level of technological superiority, the union wage can be limited to a level such that the foreign firm does not need to subcontract. The firm-level analysis across countries reveals that the results are consistent with our theoretical predictions. JEL Code: F13, F14, F16, F21