Should informal sector be subsidised?



4

inversely related to the urban unemployment. Thus , the urban formal wage function is
given by :

Wu = Wu (Wi , Wr , U)                                ...   (14)

Where (δWu / δWj ) 0 for j = i , r and (δWu / δU ) 0.

We follow Khan (1980) to justify the equation “(13.1)”with the help of Calvo (1978)
and Stiglitz (1974). Calvo (1978) has emphasised the role of trade unions in the
determination of urban formal wage rate. Calvo (1978) assumes that trade unions’
utility depends on the wages received by their members and on the alternative sources
of employment. Thus, if we assume that labourers in the urban formal sector are
unionised the increase in rural wage rate, W
r (urban informal wage rate , Wi) makes
rural employment (urban informal sector’s employment ) more attractive to the trade
union members. As a result , the utility of the trade union falls. Hence , the trade union
demands higher urban formal wage rate , W
u , to maintain the same level of utility .
The effect of urban unemployment on urban formal wage rate can be explained in terms
of the labour turn - over model of Stiglitz (1974) . Stiglitz (1974) has shown that , as
unemployment falls , it becomes easier for the workers to quit and take other jobs.
Thus the quit rate rises ; and this raises the cost of recruitment of new workers and the
indirect training cost of labour. To combat these increases , firms must pay higher
urban wage when quit rate rises due to the reduction in urban unemployment. Thus ,
urban formal wage rate and urban unemployment vary inversely.This completes the
equational structure of the model.

Equation “(9)” yields equilibrium value of Wi . Then Equation “(8)” determines the
value of V
i and Equation “(4)” determines the value of h . We get the value of R from
Equation “(6)” , given P
i and vi . Equation “(7)” yields the value of Wr , given Pr and R.
Equation “(5)” determines W
u , given Pu and R . Thus , we get the values of ku , ki and
k
r from the Equations “(14)” , “(15)” and “(16)” . We can solve for equilibrium value
of U from Equation “(13.1)” , given W
u , Wi and Wr . The levels of employment in the
three sectors L
u , Li and Lr are obtained solving Equations “(10)”,”(11)” and “(12)”
simultaneously. Finally , we get the value of Y from Equation “(14a)”.

3.COMPARATIVE STATIC EFFECTS

Suppose that Pi is raised due to subsidization to the informal sector. Then Equation

“(6)” shows that R will rise , given Vi . Then Wr and Wu will fall , given Pr and Pu ( see



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