Minimum Wage, Informality, and Efficiency

With René Díaz de León

What are the effects of the minimum wage on efficiency in labor markets with a large informal sector? I develop a labor monopsonistic competition framework where firms endogenously sort into the formal or informal sector to potentially circumvent government policy. An increase in the minimum wage level incentivizes firms to become informal, thou the aggregate shift to informality could take time as existing formal firms cannot disappear from the view of the government. I calibrate the model to match moments of the wage and firm size distribution of both the formal and the informal sector in Mexico. I find that in the short run, moderate increases in the minimum wage can offset labor market power and increase both the formality rate and efficiency. In the long-run as firm composition shifts to the informal sector, these positive effects disappear, and it is efficiency-maximizing to set the minimum wage at a non-binding level.