Is the Formal Sector too Large or too Small? A Reexamination of Minimum Wages in Developing Countries

This paper reexamines the issue of the division of the labor force between the two sub-markets (formal and informal) of a developing economy. The formal sector is represented by a matching model with vertically differentiated workers. Assuming that firms hire their best applicants, we state that the formal sector is too small in terms of its labor force but too large in terms of job creation. Next we show that introducing a minimum wage increases the size of the formal sector with respect both to its labor force and to job creation. In accordance with the well-known paradox of Harris and Todaro, the enlargement of the formal market is accompanied by a rise in unemployment. However, when associated with a tax on job creation, the introduction of a minimum wage in the formal sector improves the efficiency of the labor market by making the formal sector more attractive to workers.