A Multisector Model of Labor Markets in Developing Countries: Implications for poverty reducing policies

We develop a multi-sector model of labor markets in developing countries in which workers can be in any of four states i) employed in the formal urban sector, ii) employed in the informal urban sector, iii) unemployed in the urban sector or, iv) employed in agriculture. Workers differ in the productivity of formal sector employment and there are floor wages below which firms can’t set wages. Migration between urban and rural areas can take place at a cost. We find that the informal sector consists of both workers that are there because of rationing of formal employment brought about by floor wages, as well as workers which end up in this sector because of choice. We also find that workers with the lowest level of formal sector productivity locate in rural areas, while those with higher productivity migrate to the cities. We use the model to understand the impact of different policies on the allocation of workers among different employment options and on poverty. We then extend the model to take into account inter-linkages between labor markets and growth, in particular we allow for feedback effects of labor markets on growth through learning by doing.