Informal Labour and Credit Markets: A Survey.

hoc assumption about some features characterizing the formal rather than the informal
sector.²¹

Yet another initial way to model informality involves cost-benefit analysis. Within this
approach, the informal sector is seen as an unregulated, largely voluntary, sector (Lucas
(1978) and Rauch (1991)), where agents ponder the costs of becoming formal against the
benefits of being informal.

In section 4 we will review recent advances in modelling informality in the presence of
labour frictions, namely the search-matching theoretical framework and its multi-sectoral
extensions. Relative to the models of the Harris-Todaro tradition, the richer labour market
structure of the search-matching framework determines the wage in the formal sector
endogenously, and allows for a wider range of effects to be analyzed. Relative to the
voluntary view of informality, the search-matching approach microfounds the decision of
firms and workers to enter the formal/informal sector, while distinguishing among the
three margins of informality by focusing on the flows between formal and informal labour
market, and unemployment.

4 Informality and labour market frictions

Building on the earlier literature, a variety of more sophisticated models have been devel-
oped to portray formal, informal and integrated labour markets. In these models, trading
frictions in the formal and/or informal sectors are important and it is possible to deter-
mine rules governing the flows between the two sectors, as well to and from the pool of
unemployed.

For most of these second generation models, the workhorse model involves incorpo-
rating the search matching model of Mortensen-Pissarides in Harris and Todaro (1970)’s
model. In this case the question of how informal-formal jobs are created is not very differ-
ent from the distinction between the creation/destruction of rural and urban jobs and the
approach is in line with the standard equilibrium model of the labour market with market
frictions and occupational/participation choice (e.g. McKenna (1987) and Garibaldi and
Wasmer (2001)).

²¹The “old search” literature with migration (Fields (1975)) can also be considered an early attempt to
explain and model the existence of an informal sector.

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