Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/320094 
Year of Publication: 
2025
Series/Report no.: 
CESifo Working Paper No. 11873
Publisher: 
CESifo GmbH, Munich
Abstract: 
We examine the effects of international trade in the presence of a set of domestic distortions giving rise to informality, a prevalent phenomenon in developing countries. In our quantitative model, the informal sector arises from burdensome taxes and regulations that are imperfectly enforced by the government. In equilibrium, smaller, less productive firms face fewer distortions than larger, more productive ones, potentially leading to substantial misallocation. We show that in settings with a large informal sector, the gains from trade are significantly amplified, as reductions in trade barriers imply a reallocation of resources from initially less distorted to more distorted firms. We confirm findings from earlier reduced-form studies that the informal sector mitigates the impact of negative labor demand shocks on unemployment. Nonetheless, the informal sector can exacerbate the adverse real income effects of economic downturns, amplifying misallocation. Last, our research sheds light on the relationship between trade openness and cross-firm wage inequality.
Subjects: 
trade liberalization
misallocation
distortions
informality
JEL: 
F14
F16
J46
O17
Document Type: 
Working Paper
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