Formalization of informal employment

Abstract

I analyze mechanism of the firm’s formalization using occupational choice model with the focus on human capital factors and firm size. Using an equilibrium matching problem on the profit maximization of a representative firm, I find that there is a positive assortative matching with regards to the firm’s technological characteristics and manager abilities which the firm will employ. Using the result of the positive assortative matching on firm’s technology and managing skills in the equilibrium, I show that the optimum firm size possesses discontinuity in managing skills so that an informal firm may produce more employment than a formal one. The reduction of financial burdens required in the formal sector does not contribute to increasing the formal employment, even when the formalization is the optimum decision made by a firm.