Economic Reform, Informal-Formal Sector Linkages and Intervention in the Informal Sector in Developing Countries: A Paradox

Within a general equilibrium framework of a developing economy with a foreign owned factor of production, this paper questions whether the informal-formal sector relationship is pro-cyclical/complementary - expansion or contraction in one necessarily implies an expansion or contraction in the other - when the informal sector is subject to a technological shock. We derive a necessary and sufficient condition under which a positive shock to the informal sector results in an emphcontraction in both the size of the urban formal sector and the informal sector. Thus, although our result shows that the informal-formal sector relationship is pro-cyclical, it nevertheless calls into question the conventional wisdom on the benefits of intervention in the informal sector of developing economies, particularly where multinational corporations sub-contract certain labor-intensive stages of production to the informal sector.