Should informal sector be subsidised?

Where Pj is the producer’s effective price of the jth good, Wj is the wage rate in the jth
sector,R is therental rate on capital, Vi is the cost of one efficiency unit of labour in the
urban informal sector, Cj is the unit cost of production of the jth sector.3

The cost of one efficiency unit of labour in the urban informal sector is given by:

Vi= (Wi / h(Wi)            .(8).

The condition for minimisation of unit cost of labour (expressed in efficiency unit) is
given by

(h' (Wi) Wi / h (Wi) ) = 1     ∙∙∙(9)

Workers migrate form the rural region to the urban region; and a fraction of the urban
labour force remains unemployed. The migration mechanism is of Harris-Todaro
(1970) type. Thus, the labour market equilibrium is given by the equality between the
actual rural wage rate and the expected urban wage rate. The Harris-Todaro (1970)
migration equilibrium condition is given by the following equation :

Wr = Wu (Lu/ (L-Lr) ) + Wi(Li / (L-Lr))         . (10),

where L is the total labour endowment of the entire economy,Lj is the level of
employment in the jth sector.We assume that the total amount of capital stock (KD) and
the size of labour force are given. Capital is fully employed. However, there exists open
unemployment of labour in the urban region. Capital is perfectly mobile among the
three sectors 4 . Thus, we have a common rate of return on capital in all the three
sectors. The full utilisation of capital stock leads to the following equation :

kuLu + kiLi + krLr = K    ...(11)

It is assumed that the urban formal sector is more capital intensive than the rural sector
in value terms .

The level of urban unemployment(U) is given by :

U = L-Lu-Li-Lr                            (12)

The total factor income(Y) of the economy is given by

Y = WuLu + WiLi + WrLr + RK           . (13)

And is equal to the national income in the absence of any tax or subsidy imposed on
factor income. Using Equations “(10)” and “(13)” we get,

Y = WrL + RK                     . (13a)

urban formal sector’s wage rate is assumed to be endogenous. Urban formal wage rate
is positively associated with the urban informal wage rate and the rural wage rate and is

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