1 INTRODUCTION:
This is the first sentence of my introduction. My paper examines the impact of subsidy
policies, given to the informal sector,on urban unemployment and domestic factor
income. At the present juncture, it is well known to all development economists that the
informal sector provides jobs to many unemployeds. This is true irrespective of the
level of development.At the same time, it is also observed that huze unemployment also
exists in many countries where informal sector plays important role in the employment
generating activities.One question obviously comes: why such huze unemployment
exists even when the informal sector is very large? Fields(1975,1989) and Gupta(1993)
have explained this1. This paper explains such co-existence in terms of consumption-
efficiency hypothesis of Leibenstein(1957). The basic idea of the consumption-
efficiency hypothesis is that a worker’s efficiency is positively related to the wage rate
he receives. This is generally valid in the case of low income workers who consume the
whole wage income and suffers from malnutrition. The employers use this wage as an
instrument of profit maximisation and the optimum wage appears to be unique and
independent of other economic variables. This wage rigidity at the equilibrium level
explains involuntary unemployment.
The development literature shows that from time to time Government of many small
countries have given output subsidy to the informal sector to combat unemployment, to
enhance informal employment and to uplift country’s welfare. The present paper tries
to explain theoretically the impact of such policy on urban unemployment and
domestic factor income where urban formal wage rate is endogenous and urban
informal sector is internationalised.. The trade unionism of many developing countries
may lead to endogenous urban formal wage rate.We also observe in many developing
countries that the products of the urban informal sector are also globally traded.2 Our
main finding is that subsidies given to the urban informal sector lowers urban
unemployment and raises domestic factor income.The result provides adequate basis
for Governments’ subsidization program for the urban informal sector. At present, this
is very important when global tendency runs against subsidies
Section 2 develops the model and gives the results. Section 3 concludes.
2. THE MODEL
We consider a small open economy consisting of three sectors: urban formal sector(u),
urban informal sector (i) and rural sector (r). The goods produced in the three sectors