Collaborative Research: Trade and Informality in the Presence of Labor Market Frictions

Yale University, New Haven CT

Investigators

Abstract

How does trade liberalization affect the labor market of natives? Recent research exploring the Brazilian trade liberalization of the 1990s shows that regions that were hit harder by the liberalization episode faced a strong increase in unemployment and a less accentuated increase in informality in the medium run. In the longer run, however, regions that were hit harder by trade liberalization experienced a strong increase in informality, but no significant increase in unemployment. This experience in Brazil is inconsistent with traditional trade models which typically predict a decrease in informality after a trade liberalization. This project will therefore investigate trade and informality by developing a novel model of trade featuring heterogeneous firms, informality, and labor market frictions. Ultimately, this project will improve public understanding of trade and the informal sector, and further inform policy-making about developing and emerging market economies. Aiming to better understand the mechanisms through which trade induced this reallocation and its consequences for welfare, this project will develop a model of trade and labor market informality in the presence of labor market frictions. In the model, heterogeneous firms endogenously choose in what sector they wish to operate (formal or informal) and formal firms decide what fraction of workers they wish to hire formally and informally. Labor market frictions vary across formal and informal labor markets. The model will be estimated by employing multiple sources of micro data. The investigators will use the estimated model to address the following important questions: (1) To what extent does the informal sector smooth labor market outcomes of workers displaced from the formal sector due to trade liberalization?; (2) How do policies directed toward the informal sector (monitoring and regulation enforcement, payroll taxes, revenue taxes, etc) interact with trade liberalization?; (3) How are the welfare consequences of trade affected by the presence of the informal sector and by policies directed towards this sector? (4) How can deregulation of the formal labor market affect the dynamics of trade liberalization?