Product Market Regulation, Firm Size, Unemploymentand Informality in Developing Economies

This paper studies the impact of product and labor market regulations on informality andunemployment in a general framework where formal and informal firms are subject to thesame externalities, differing only with respect to some parameter values. Both formal andinformal firms have monopoly power in the goods market, they are subject to matchingfriction in the labor market, and wages are determined through bargaining between largefirms and their workers. The informal sector is found to be endogenously more competitivethan the formal one. We find that lower strictness of product or labor market regulations leadto a simultaneous reduction in informality and unemployment. The difference between thesetwo policy options lies on their effect on wages. Lessening product market strictnessincreases wages in both sector but also increases the formal sector wage premium. Theopposite is true for labor market regulation. Finally, we show that the so-called overhiringexternality due to wage bargaining translates into a smaller relative size of the informalsector....