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The purpose of this paper is to understand labor market regulations and their consequences for the allocation of resources.

This paper constructs a theoretical model to study labor market regulations in developing countries and how it affects the allocation of resources between the less productive informal activities and more productive formal activities. It also provides empirical support for some theoretical results using cross-country data.

When workers are risk-averse and the market for insurance against labor income risk is missing, regulations that provide insurance to workers (such as severance payments) reduce misallocation. However, regulations that simply create barriers to the dismissal of workers increase misallocation and end up reducing the welfare of workers. This study also provides some empirical evidence broadly consistent with the theoretical results using cross-country data. While dismissal regulations increase the share of informal employment, severance payments to workers do not.

The empirical exercise is constrained by the lack of availability of good data on the informal sector.

The analysis of the alternative labor market regulations analyzed in this paper in the presence of risk-averse workers is an original contribution to the literature.