The Effects of Labour Market Policies in an Economy with an Informal Sector

In this article, we build an equilibrium search and matching model of an economy with an informal sector. Our model extends Mortensen and Pissarides (1994) by allowing for ex ante worker heterogeneity with respect to formal‐sector productivity. We use the model to analyse the effects of labour market policy on informal‐sector and formal‐sector output, on the division of the workforce into unemployment, informal‐sector employment and formal‐sector employment, and on wages. Finally, we examine the distributional implications of labour market policy; specifically, we analyse how labour market policy affects the distributions of wages and productivities across formal‐sector matches.