Job Creation and Job Destruction in the Presence of Informal Labor Markets

This paper presents a search and matching model to account for the most salient facts of labor markets with informal jobs in developing countries. The data suggests that workers reallocate from formal jobs into informal jobs in recessions, as well as when policy makers intervene in the market. This reallocation is mainly driven by the large and procyclical swings of the job …nding rate in the formal sector relative to the stability of the job …nding rate in the informal sector. The model captures this fact by assuming that …rms operate the intra-…rm 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 e¤ect), but also a¤ect the …rms’hiring standards, favoring informal contracts (o¤er e¤ect). 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 …ring costs will reallocate workers to the "unprotected" informal sector, where job destruction is high. They are also likely to increase unemployment. JEL classi…cation: J64, H26, O17