Investment and growth in a developing economy with vast informal sector

In developing economies like India, ‘informal’ sector occupies a large portion of GDP and employment. In the wake of slowdown in investments across countries and ensuing fall in the GDP growth rates, the question that arises is the following. If an economy suffers from growth slowdown, and since investment is often believed to be a driver of growth, should more investments go to the formal sector or to the informal sector? In what ways outcomes are different in terms of composition of output, employment, and wages? The issue may be a particular interest to India where slowdown in investments is believed to be the primary reason behind the recent sluggish growth of the economy. This paper theoretically evaluates the effects of investments on sectoral wage rates, output and employment composition, and growth in a developing economy consisting of a vast informal sector in a general equilibrium framework with endogenous demand and sector specific capital. The model traces, beginning with capital market disequilibrium and labour market distortion, whether investments into the sectors lead to equilibrium in capital and labour markets over time. This approach is distinctly different from the existing literature that is primarily engaged with finding out comparative statics results of a change in policy variables such as tariff rate and subsidy/tax. This paper also brings in endogenous demand that is mostly missing thus far. The model highlights the following results. Investments in the formal sector increase the size of the sector and cause the informal sector to shrink. The labour market distortion goes away as wages are eventually equalized across the sectors, after which the capital market equilibrium is achieved. Equalisation of wages is similar to the ‘turning point’ of the Lewis model of development. On the other hand, investments in the informal sector increase its own size but do not alter the size of the formal sector. Much contrary to the previous case, capital market equilibrium is achieved first, so the labour market distortion stays, leading to the existence of a persistent wage gap in the long run. One way of avoiding the possibility of the informal sector becoming large in size would be to subsidize the short-run capital return in the formal sector. This of course is a ‘second-best’ policy to counteracting the distortion in the labour market.