Inflow of Foreign Capital and Trade Liberalization in a Model with an Informal Sector and Urban Unemployment

Abstract

The paper has made a modest attempt to analyze the effects of liberalized trade and investment policies on welfare and open unemployment in a developing economy in terms of a three sector Harris-Todaro (1970) type general equilibrium model. Following empirical evidence it is assumed that there are strong barriers to entry even into the urban informal sector that are reflected in the wage rigidity in this sector, which leads to the simultaneous existence of open unemployment and an urban informal sector in the migration equilibrium. The paper deserves special attention for its interesting results. For example, contrary to the conventional immiserizing result, the paper shows that an inflow of foreign capital in either of the two broad sectors of the economy may be welfare improving. On the contrary, a reduction in import tariff may lower national welfare. Besides, an inflow of foreign capital into the urban sector (a reduction in import tariff) leads to an expansion (a contraction) of the urban sector of the economy. This policy is likely to ameliorate (aggravate) the problem of urban unemployment. These results are completely opposite to those generated by the standard Harris-Todaro model.

Keywords: Informal Sector, Urban Unemployment, Foreign Capital Inflow, Trade Liberalization, Welfare, Harris-Todaro Framework, Wage Rigidity

JEL Classification: F2, F21, O17