A study on the skill premium and informality

Abstract

Skill premium as defined by the ratio of the skilled labor wage to the unskilled labor wage is said to be explained by the relative labor ratio and the equipment-skill ratio. In this paper, the relation between the skill premium and the size of the informal sector is observed and a positive relation has been found, based on the regression results. A dynamic stochastic general equilibrium model is also set up in order to observe the relation between these variables. According to the model results, a higher skill premium occurs when the size of the informal sector is lower. Although it seems contradictory to the regression results, it is believed to be associated with the higher level of output produced in the low informal sector case. The effect of the informal sector size on the way skill premium is affected by productivity shocks is observed and it has been found that a greater size of informal sector causes skill premium to be affected more from the neutral productivity shocks. On the other hand, a lower level of informal sector causes skill premium to be affected more from the investment specific productivity shocks.