The Lighthouse Effect and Beyond

A large body of empirical literature indicates that, contrary to predictions from economic theory, wages in the informal sector increase after a minimum wage hike. This phenomenon was so far explained as a byproduct of a signal (a lighthouse) conveyed by statutory minima to wage setting in the informal sector. A simple matching model shows that an increase in wages in the informal sector may also be induced by significant sorting and composition effects between the formal and the shadow sectors in the aftermath of the increase in the minimum wage. Using data on Brazil, we find that sorting accounts for at least one third of the increase in average wages in the informal sector after a minimum wage hike. This contribution of endogenous sorting to wage dynamics in the informal sector is also increasing over time.