Product Market Regulation, Firm Size, Unemployment and Informality in Developing Economies

This paper studies the impact of product and labor market regulations on the number and size of firms in the formal and informal sectors, as well as on relative wages, relative size of the two sectors and overall unemployment. We show that entry costs in the formal sector tend to make informal firms smaller and more numerous than informal firms, i.e., such costs render the informal sector relatively more competitive. Furthermore, it is possible to reduce informality without increasing unemployment or reducing workers’ wage by reducing entry costs in the formal sector rather than reducing labor market regulations. We also highlight a number of externalities stemming from labor and product market imperfections, allowing the size of those distortions to differ across sectors. We show that, while the so-called overhiring externality takes place in both sectors, this translates into a smaller relative size of the informal sector.