Job creation and job destruction in the presence of informal labour markets

Recessions and policy interventions in labor markets in developing countries are characterized not only by changes in the unemployment rate, but also by changes in the proportion of formal or protected jobs. This reallocation between "regulated" and "unregulated" jobs is large and occurs mainly because the job …nding rate of formal jobs reacts substantially more than the job finding rate of informal jobs. This paper presents a search and matching model to capture this fact. I assume that …rms operate the intra-firm margin of formality, choosing to legalize only those matches that are good enough to compensate the costs of formality. In this framework, recessions or stricter regulations in the labor market trigger two e¤ects. As expected, they lower the incentives to post vacancies (meeting effect), but also affect the firms’ hiring standards, favoring informal contracts (offer effect). This new channel sheds light on how the actions of policy makers alter the outcomes in an economy with informal jobs. For instance, attempts to protect employment by increasing firing costs will reallocate workers to the "unprotected" informal sector, where job destruction is high. They are also likely to increase unemployment.