This paper aims to theoretically find out whether investments could close the formal-informal wage gap in India.
The paper builds a general equilibrium model of a developing economy with a large informal sector and a capital-intensive formal sector with sector-specific capital and incorporates endogenous demand.
With homothetic preferences, a small initial wage premium and elastic relative demand, investment in the formal sector is likely to close the wage gap, but the gap persists with non-homothetic preferences. However, investment in the informal sector is unlikely to close the wage gap with either type of preferences.
Though labour market distortions in developing economies leading to a formal-informal wage gap are well-documented in the development literature, little attention has been given to the question of whether such a gap would close over time.